The dangerous myth we still believe about the Lehman Brothers bust

The central error in the popular post-crisis consensus was the idea that naive believers in the self-policing efficiency of markets led us over the precipice. Greenspan was painted as the high priestof this laissez-fairy-tale delusion, and people seized on a moment when he appeared to plead guilty: Under the pressure of congressional questioning, he confessed to a “flaw” in his pro-market ideology. What Greenspan meant was that all belief systems — whether pro-government or pro-market — are imperfect. But that subtlety was lost. Quoted and requoted without proportion or context, Greenspan’s purported mea culpa threatened to define his legacy.

.. Bestsellers by two Nobel Prize-winning behaviorists — Daniel Kahneman and Richard Thaler — encouraged people to see the crisis as proof that this new science had been ignored, as did contributions from the sublime storyteller Michael Lewis.

.. Contrary to myth, Greenspan himself never believed that markets were efficient. In his youth, he wrote lucidly about bubbles and crashes and regarded market inefficiencies as so obvious that he sought to exploit them by day trading

.. As Fed chairman years later, Greenspan frequently reminded his colleagues that periods of prosperity could be punctured by “irrational exuberance” in financial markets.

.. political constraints, not intellectual failures, prevented policymakers from curbing the housing mania. Nobody remembers that in 2001 the Greenspan Fed banned the most abusive subprime mortgages, for the good reason that the ban was circumvented. But why was it circumvented? The answer is that the capture of Congress by financial lobbies ensured the balkanization of regulation into an alphabet soup of agencies, many of them underfunded and ineffective.

.. Nonbank mortgage lenders, for example, came under the authority of the Federal Trade Commission, which had no resources to conduct preemptive supervision. Small wonder that the sharp practices in the industry became egregious, or that nonbanks continue to dominate today’s mortgage business.

.. The Greenspan Fed also tried to force more capital into the banks it supervised, but it soon realized that this would drive risk-taking into various “shadow banks” that lay outside its authority

.. Greenspan also pushed for tougher regulation of the Federal National Mortgage Association and Federal Home Loan Mortgage Corporation (a.k.a. Fannie Mae and Freddie Mac), the government-backed mortgage giants, presciently observing that they posed “a systemic risk sometime in the future.” Fannie’s lobbyists hit back with a TV ad warning Congress not to back the Greenspan plan. That buried it.

.. The important lesson of the crisis is not that markets are fallible, which every thoughtful person knew already. It is that essential regulations — the sort that the supposedly anti-regulation Greenspan actually favored — are stymied by fractured government machinery and rapacious lobbies.

.. Even today, the financial system has multiple overseers answerable to multiple congressional committees, because all this multiplying produces extra opportunities for lawmakers to extract campaign contributions.

.. Vast government subsidies still encourage Americans to take big mortgages; Fannie Mae and Freddie Mac still operate, despite endless talk of breaking them up. And although post-2008 regulations have ensured that banks are better capitalized, the lobbyists are pushing back. Merely a decade after the Lehman bankruptcy brought the world economy to its knees, the Trump administration is listening to them.

Why the S.E.C. Didn’t Hit Goldman Sachs Harder

Why did no top bankers go to prison? Some have pointed out that statutes weren’t strong enough in some areas and resources were scarce, and while there is truth in those arguments, subtler reasons were also at play. During a year spent researching for a book on this subject, I’ve come across case after case in which regulators were reluctant to use the laws and resources available to them. Members of the public don’t have a full sense of the issue, because they rarely get to see how such decisions are made inside government agencies.

.. Kidney, for his part, came to believe that the big banks had “captured” his agency—that is, that the S.E.C., which is charged with keeping financial institutions in line, had become overly cautious to the point of cowardice.

.. The bank, IKB, was cautious enough to ask that Goldman hire an independent asset manager to assemble the deal and look out for its interests.

.. This is where things got dodgy. Unbeknownst to IKB, Paulson & Company improved its odds of success by inducing the manager, a company called ACA Capital, to include the diciest possible housing bonds in the deal. Paulson wasn’t just betting on the horse race. The fund was secretly slipping Quaaludes to the favorite. ACA did not understand that Paulson was betting against the security. Goldman knew, but didn’t give either ACA or IKB the full picture. (For its part, Paulson & Company contended that ACA was free to reject its suggestions and said that it never misled anyone in the deal.)

.. When S.E.C. officials discovered this, in 2009, they decided that Goldman Sachs had misled both the German bank and ACA by making false statements and omitting what the law terms “material details”—and that these actions constituted a violation of securities law.

.. When Kidney looked at the work that had been done on the case, he found what he considered serious shortcomings. For one, S.E.C. investigators had not interviewed enough executives. For another, the staff decided to charge only the lowest man on the totem pole, a midlevel Goldman trader named Fabrice Tourre

.. Charging only Goldman, he said, would send exactly the wrong message to Wall Street. “This appears to be an unbelievable fraud,” he wrote to his boss, Luis Mejia. “I do

.. The S.E.C. team had not interviewed Tourre’s direct superior, Jonathan Egol. Nor had they questioned top bankers in Goldman’s mortgage businesses or any of the bank’s senior executives. Even more surprising to Kidney, the agency had not taken testimony from John Paulson, the key figure at his eponymous hedge fund. It seemed to Kidney, as he reviewed the case materials, that the agency had spent more time and effort investigating much smaller insider-trading cases.

.. Part of the problem was that high-level Goldman executives had been savvier in how they communicated: when topics broached sensitive territory in e-mails, they would often write “LDL”—let’s discuss live.

.. In a December 30th e-mail, sent to the entire group investigating the deal, Muoio offered an explanation for what had happened during the bubble years: “Now that we are gearing up to bring a handful of cases in this area, I suggest that we keep in mind that the vast majority of the losses suffered had nothing to do with fraud and the like and are more fairly attributable to lesser human failings of greed, arrogance and stupidity of which we are all guilty from time to time.”

.. Kidney told me that he thought the S.E.C. could avail itself of a broader interpretation of securities law. He argued that the agency should file civil actions against top players at both the bank and the hedge fund under a concept called “scheme liability”—a doctrine of securities law that makes it illegal to sell financial products whose main purpose is to deceive investors.

.. Muoio, in a recent interview with me, dismissed Kidney’s complaints. “I cannot imagine any basis for claiming ‘regulatory capture,’ given that I have never worked in industry or finance and given the cases I have made, including very significant cases against banks, auditing firms, companies and senior executives,” he said.

.. But to Kidney, the driving force was something subtler. Over the course of three decades, the concept of the government as an active player had been tarnished in the minds of the public and the civil servants working inside the agency. In his view, regulatory capture is a psychological process in which officials become increasingly gun shy in the face of criticism from their bosses, Congress, and the industry the agency is supposed to oversee. Leads aren’t pursued. Cases are never opened. Wall Street executives are not forced to explain their actions.

Wall Street’s Sugar Mama

But Clinton offered a message that the collected plutocrats found reassuring, according to accounts offered by several attendees, declaring that the banker-bashing so popular within both political parties was unproductive and indeed foolish. Striking a soothing note on the global financial crisis, she told the audience, in effect: We all got into this mess together, and we’re all going to have to work together to get out of it. What the bankers heard her to say was just what they would hope for from a prospective presidential candidate: Beating up the finance industry isn’t going to improve the economy—it needs to stop.

.. Certainly, Clinton offered the money men—and, yes, they are mostly men—at Goldman’s HQ a bit of a morale boost. “It was like, ‘Here’s someone who doesn’t want to vilify us but wants to get business back in the game,’” said an attendee.

.. My guess is that in the speeches, Clinton likely acknowledges her various friends and acquaintances at Goldman Sachs (and other Wall Street firms) and praises them for the work they are doing.

Yes, it’s standard small talk. But it could look really, really bad in the context of the current campaign. Imagine a transcript of Clinton speaking to some big bank or investment firm where she thanks a litany of people she’s “been friends with forever” and then praises the broader enterprise for “all you do.”

In the hands of Sanders and his campaign team/supporters, that sort of thing could wind up being very problematic to Clinton’s attempts — already somewhat clumsy — to cast herself as a true progressive fighter for the 99 percent against the 1 percent. It might even prove deadly to those attempts.