The Frontline series final segment frames the culture on Wall Street as it was and as it continues to be despite imperatives to reform. The American economy was driven to the edge of an abyss but rescued; for the moment. We remain at the precipice of financial catastrophe.
Every year in December, bankers find out if the bets they made that year have paid off. It is Christmas on Wall Street. By some measures, 2011 was a dismal year to be a banker. Stocks took a nosedive. But this year, banks set side $20 billion in bonuses. Since the crash of ’08, banks have paid out more than $80 billion in bonuses. While officials in Washington focus on rule-making, nothing really seems to have changed the culture of Wall Street. A culture some feel, has simply lost its bearings.
John Fullerton is a former banker who says it all began when banks started trading for their own gain and not for their customers’. It was the rise of trading that shifted the culture, he says, and with that came this much more short term, profit generating, competitive mentality. It was a cult of “more, more, more…grow, grow, grow” making the culture on Wall Street fundamentally unhealthy. Fullerton began to believe it was beginning to change his own values.
“I grew less happy about my work and what I was doing every day. Candidly, I felt it was beginning to change my own values. You know, how I looked at myself and how I valued myself.” – John Fullerton
Cathy O’Neill, a mathematician, came to Wall Street in 2007 after beginning her career in academia. Undergraduate at UC Berkeley, graduate work at Harvard then on to MIT, she applied to work at a hedge fund and got the job. She was a “quant.” Quants use statistical methods to look for patterns in markets. Her work was used to predict when big pension funds would buy or sell, so that her firm could jump in ahead of their trades.
“I just felt like I was doing something immoral. I was taking advantage of people I don’t even know whose retirements were in these funds. We all put money into our 401ks and Wall Street takes this money and just skims off like a certain percentage every quarter. At the very end of somebody’s career, they retire and they get some of that back. This is this person’s money and it’s just basically going to Wall Street. This doesn’t seem right”. – Cathy O’Neil, DE Shaw, 2007 – 2009
Graduates in math and computer science worked to design trading software for the trading houses. They did not perceive they are doing anything wrong, just that they weren’t doing anything positive. What they see is that they have enabled traders to make enormous sums of money and that they should share in a portion of that.
“What that incentivizes is that I’m going to go for broke, I’m going to try and make as much money as I can, and if that blows up three years from now, that’s not going to affect the bonus I make today.” – Alexis Goldstein
A young trader at a Wall Street bank can make about $150,000 a year. But based on performance, that number can rise quickly. “Star” traders can make up to five to ten million dollars a year. Compensation is not public, for obvious reasons. It wasn’t always this way.
For most of the last century, bankers made the same salary as lawyers, doctors, and engineers. The last time Wall Street saw extravagant compensation was in the run up to the crash of 1929. The 1920s were a period of financial frenzy and a stock market boom that was characterized by a lot of innovative risk taking. Adjusted for inflation, the compensation of bankers of that time rival that of bankers today. But it didn’t last and from that, we got a period of reform that led to regulation.
“You could make good money, don’t get me wrong, but it was boring. It was very straight-forward. It was about being in the community. It was about understanding who was a good credit risk. That’s the history of American banking.” – Simon Johnson, Chief Economist, IMF, 2007-2008
In the old days, Wall Street and the finance industry provided essential services. Banks financed things that got done, like railroads or the interstate system, things that finance was supposed to be about.
“What has entirely changed is that they’re in the business of making money for themselves. If it happens that they can also finance something along the way, okay. But that is no longer part of the core business.” – Denis Kelleher, Better Markets, Inc.
The changes were formalized in the late ’90s as the last of the Depression Era reforms were lifted with the repeal of the Glass-Steagall Law. Traditional commercial banks were allowed to merge with trading oriented investment banks. Trading activity and bank profits rose quickly. The trading side grew overwhelming larger than the banking side and that and salaries as much as five times higher drew talent to that side of the ledger. Many ended up doing proprietary trading; trading for the bank’s own account.
Derivatives were where the really big money was made. Derivatives can be many things, but they are essentially contracts or bets that derive their value from the performance of something else: an interest rate, a bond, a stock, a loan, a currency, a commodity, virtually anything. For traders, derivatives are a perfect product. As much as two thirds of the trading revenue was derived from derivatives. The problem with derivatives is that they can be very dangerous for unsophisticated customers. Often involving highly leveraged bets, a small change in market conditions can mean huge losses. Traders are incentivized to get the deals done, even at the customer’s expense.
“There was a phrase “ripping someone’s face off” that was used on the trading floor to describe when you sold something to a client who didn’t understand it and you were able to extract a massive fee because they didn’t understand it. And the idea was that this was a good thing because what you were making more money for the bank. And that sort of spirit of being antagonistic to your client actually took on a significant life on Wall Street. – Frank Partnoy, Derivatives trader 1993 -1995 and Author, Infectious Greed
Banks want to do business where there is less regulation. Beginning in the ’90s, many American banks found London preferable to New York, outside the purview of American regulators. In some instances the key risk taking activities were in London. Hundreds of young bankers moved there from Wall Street to pursue careers in derivatives trading.
There was a small army of bankers pushing derivatives to European markets. On the trading floor they were known as F9 monkeys. An F9 monkey was someone pricing quality structures. You just had to put in a few inputs, press F9, and it would determine the price of the instrument and the hedge as well. After pricing, teams of investment bankers hit the road.
“They’re called investment bankers but they’re effectively salesmen, Their job is to go out and sell the stuff that the bank is creating. Just in the same way a pharmaceuticals company would have a very large sales force to go around selling their latest version of whatever the particular drug of the moment is.” – John Cassidy, The New Yorker
Customers who were supposedly sophisticated investors were actually hoping for financial alchemy. The bankers fanned out across Europe looking for the type of client that didn’t understand the product in order to sell the product.
In 2003, a team of investment bankers from Bear Stearns arrived in Casino, about an hour south of Rome and met with officials at city hall. They told the officials they could lower their borrowing costs from the 5% they were paying to 1% or 2%. They offered up a derivative, an interest rate swap of some kind that as long as something doesn’t happen in the market, rates will remain low. They signed a contract and they benefitted from lower borrowing costs. But soon after the deal was signed, the interest rate the deal was pegged to began to rise. Casino found itself paying hundreds of thousands of dollars more in interest than they’d bargained for.
“These bankers were so smart. They made towns believe they could profit. Unfortunately, we common people we are tiny pawns, maneuvered by these princes of high finance. – Carmello Palumbo, former Casino city councilman
The people being sold these products had very little understanding at all. They should never have been allowed to even talk to these investment bankers at all. It was crazy get even get into these kinds of conversations.
Casino ended up paying Bear Stearns over a million dollars in interest. The town sued the bank, now owned by JP Morgan and received a half million dollar settlement, still left in the red.
There were abuses. In every market there are abuses. There were abuses in the derivatives market. Because of the opaqueness of the derivatives, it was probably easier to abuse in some cases…It obviously doesn’t cover the profession in glory. When you go through a period like we all did, where really large amounts of money were available to individuals, we’re talking bonuses, the incentive to cheat is very high; it’s very high” – Bill Winters, CEO, JP Morgan
Over 1,000 cities and municipalities across Europe entered into similar deals with other banks and institutions. Potential losses are said to be in the billions. Scores of lawsuits have been filed.
“I think very few people knew what they were buying…But in a way, I think it is more on the investors’ side that the due diligence has to be done. I mean, you know, it’s an open market. So I put more blame on the investors than the banks that were selling them.” – Claudio Costamagna, Goldman Sachs, 1998 -2006
It wasn’t just in Europe. Banks did deals in America too, in places like Birmingham, Alabama, seat of Jefferson County. Jefferson County had a problem. In 1996 it had squandered over $2 billion to build a state of the art sewage system. People were left with sewers to nowhere and huge monthly bills. In 2002, the county was looking to refinance the sewer debt by issuing another $3 billion in bonds. Wall Street bankers came knocking.
They came down here like sharks to raw meat in the water and took advantage, full advantage of the opportunity that was here to make a lot of money. – George Martin, Assistant U.S. Attorney, Alabama
One banker who called was Charles LeCroy. He was a leading producer at JP Morgan, supposedly the largest profit center that JP Morgan had for several years running. He was selling all over the country. One of the products he was pitching to Jefferson County was an interest rate swap similar to the one Casino entered into. He promised with the refinancing, it would hold the sewer rate increases to single digits and over the long run save the county $300 to $400 million. In late 2002, a former local TV reporter turned politician, Larry Langford, took charge of the county’s finances.
I think the bankers in New York, with Larry Langford sitting across from them, had to stifle the laugh. Because you had a guy here, who had no idea about swaps, had no idea about auction rate securities, had no idea about the financial market. – Barnett Wright, Birmingham News
Langford decided to consult a friend, Birmingham financial advisor Bill Blount. His friend looked at it and told Langford it was a pretty good deal; just swap the debt, you won’t have to raise rates, everything looks good. They didn’t just do it once. They didn’t just do it once, they did it several times, swapping low to high, variable to fixed, fixed back to variable. These were very sophisticated trades; literally betting against the market.
“In 2008, when the music stopped, in the fall, they pull out the chairs, they’re several chairs short.” – David Hooks, Debt Manager, Jefferson County
What the county didn’t account for was a big change in the markets. In 2008, it all went horribly wrong. The county suddenly owed hundreds of millions of dollars in fees and penalties to its debt holders, including JP Morgan.
“We knew we could not pay the warrants. We knew we could not sustain the debt that we had amassed. When the derivatives and the variable rates shot up. And so, we just put off the fact that we were in bankruptcy, just like an alcoholic who never admits that they’re alcoholic.” – Tony Petelos, Manager, Jefferson County
It turned out that LeCroy had paid money to Langford’s friend, Bill Blount. According to Federal prosecutors, the money was for bribes: $3.5 million from JP Morgan to Blount who in turn passed money and gifts to Langford. In 2010, Langford went to jail on charges of bribery and fraud. He is currently serving a 15 year sentence. His friend, Bill Blount, cooperated with authorities and is serving four and a half years. JP Morgan settled with the SEC for $25 million and was ordered to forgive the county, fees totaling $697 million. Charles LeCroy was sentenced to 3 months in jail after a similar deal in Philadelphia.
In November 2011, after years of corruption and mismanagement, Jefferson County filed the largest municipal bankruptcy in U.S. history. Across the country, over 100 school districts, hospitals, as well as scores of state and local governments bought interest rate swaps. With the crash, the deals backfired. In the last five years, swaps have cost American taxpayers $20 billion.
On Wall Street, the derivatives business is sometimes called the solutions business. Traders are constantly looking for big problems to solve. Big problems usually represent big opportunities. Some of the biggest problems and “opportunities” were in Europe, starting in the ’90s when countries were starting to bid to join the Euro club.
“It became very clear that the question of who was going to be let into the club or not was going to rely very heavily upon statistics. It’s a bit like your SAT scores for the university. The question of how those account ledgers is absolutely key. And what happened, as so often in finance, was that bankers bartered a dull geeky area that was incredibly important, that almost no one understood, and the politicians certainly weren’t looking at and thought ‘Aha! Here is a chance for arbitrage.'”- Gillian Tett, Financial Times
Regulatory arbitrage is an esoteric term used on Wall Street for figuring out a way to get around the law. Wall Street has become very good at figuring out a complicated financial structure that achieves some objective that you couldn’t achieve otherwise in a legal way. Violating the spirit of the regulation was the game. Bankers descended on European capitals with solutions using derivatives; a way to adjust macro-economic imbalances by speculating.
Countries used other tricks too. The French were cooking their books by reclassifying their pension obligations; the Germans were cooking their books with gold transactions; this was a time when Europeans were generally cooking their books. The first known case of a country using derivatives to window dress it’s accounts was in Italy. Officials in Rome turned to JP Morgan for help. Italy and JP Morgan entered into a currency swap, a commonly used derivative that in effect lowered their debt. Except in this case, the derivative was much more complex. It had a built in loan. Because of the arrangement, with the loan obscured by the derivative, the loan did not appear on the financial statement. It potentially deceived the other countries in the Euro zone that Italy had cleaned up their books more than they had. In 1999, Italy was allowed into the Euro zone.
In 2003, a secret deal between Goldman Sachs and Greece was reported. Goldman has sold Greece several giant swaps that had helped Greece meet its targets to enter the Euro zone. When the story was published, nothing happened. This was the largest sovereign derivative deal ever reported. It reduced Greece’s debt by around 2%. What other deals there were was not known. It was an off the balance sheet loan, legal within the rules of the time, but off balance sheet. It was a very expensive form of borrowing for Greece; interest of about 16% per year; not unlike a sub-prime mortgage. Most banks were seeing if they could replicate it.
“The reaction wasn’t…scandal: ‘My goodness, I can’t believe Goldman Sachs has pushed it this far and clearly has broken the spirit of the law.’ The reaction was, ‘You’d better go down to Athens and find out if there’s anything more to do. How did you miss this?” – Desiree Fixler, JP Morgan, 2001 – 2004
With its books dressed, Greece had kicked its problems down the road. For the next several years, Greece would also go on a massive spending spree. Between 2001 and 2008, Greece’s debt had doubled. No one wanted to ask any hard questions.
“I would put it cynically as follows: For several years, Greek governments pretended to keep their public finances in order. And their European partners pretended to believe them.” – Professor Loukas Tsoukalis, University of Athens
The reckoning came in 2009. A newly elected government claimed to not know the extent to which Greece was in debt. It announced the deficit would be double the one previously projected and six times as big as the one originally planned.
“Not until we sat down, in the General Accounting Office, and slowly stripped they layers of expenditures that were new, but were not really being recorded or declared; not until that time did we realize what we had was a very, very serious problem.” Giorgos Papakonstantinou, Greek Finance Minister, 2009 – 2011
Other nations in Europe felt betrayed. Bond traders from New York to London started dumping Greek sovereign bonds. The very institutions that had helped to fuel the Greek spending spree pulled back. Without credit, the government had to cut spending. People took to the streets in protest.
“I find it hard to believe that the continent that can figure out precisely how many centrifuges Iran is running at this moment enriching Plutonium and uranium, couldn’t figure out that the Greeks were cooking their books doing currency transactions with Goldman Sachs. I think they knew. In fact, I know they knew. And they just didn’t care.” Bill Winters, CEO, JP Morgan
In 2010, the value of the Euro dropped precipitously. Italy, Ireland, and Portugal began their own downward spirals. Today it’s Spain, an economy four and a half times larger than that of Greece.
“Some creative accounting is used by virtually every self-respecting government that I can think of. Right? But here again, the Greeks went beyond the pale.” – Professor Loukas Tsoukalis, University of Athens
If difficulties in Europe lead to the failure of a big American bank, it could be catastrophic. Since 2007, the five biggest banks in America have become larger. Today they control assets equal to 56% of the American economy.
Last fall, as the European debt crisis worsened, Occupy Wall Street launched its protests in New York.
“You know, Occupy Wall Street was being criticized from the very beginning for these people not really knowing how the system works. And, what I realized was “You know what? Nobody knows how the system works. Even the people in finance don’t understand the system. They understand their little corner of the system. But very few people would come forward and say “I am an expert on the financial system. I know how everything works…” – Cathy O’Neil, DE Shaw, 2007 – 2009
The occupiers know that the result of the system is not working for them. That’s enough. They system is a huge black box and they are seeing the output of that black box. A lot of them are college educated, they have enormous student loans, and they don’t have a job. That is the output they see: them and all the people around them don’t have jobs and have huge debts. They don’t have the power to address the system and to question it.
“…I feel like the occupiers should be appreciated. That in spite of the fact that they don’t understand it, they’re willing to come out and say ‘This isn’t working. The system isn’t working.'” – Cathy O’Neil, DE Shaw, 2007 – 2009
In Washington, other battles are being fought. On one side are the 12 Federal agencies responsible for protecting the public interests. On the other, the bank lobby. Ever since the passage of the Dodd-Frank Financial Reform Act of 2010, the two groups have been in a virtual deadlock over what kind of rules are acceptable. The industry has spent over $320 million lobbying lawmakers. The regulators face an uphill battle.
Generally speaking, it’s not a level playing field. The banks have got vast resources. They have very highly paid inside counsels whose job it is to outwit the regulators. It’s a game. And, over time, what we’ve seen is that the winners of this game are usually the banks rather than the regulators.” – John Cassidy, Author How Markets Fail
To date, the rule writing process has been slow. Few rules have been finalized. At the Federal Deposit Insurance Corporation (FDIC), regulators meet to discuss banks that are too big to fail. They have pulled together a group of financial heavyweights. It is the job of the FDIC’s Office of Complex Financial Institutions to plan for a big bank failure. They are there to mitigate systemic risks. There are many questions: how to unwind derivative contracts; how to protect customers’ money; how to deal with foreign subsidiaries; how to prevent catastrophe.
“I don’t know how this ends. We like to think we live in unique times, but during the 1920’s we had a tremendous amount of financial innovation. And when we had the great crash and we came out of it we had a series of investigations that led to the securities laws. My hope is that we’ll learn the lessons that we learned from 1929. Maybe it will take longer for us to learn the lessons of 2007 and 2008. Maybe we’ll need another several crises to get us there.” – Frank Partnoy, Author, Infectious Greed
Some believe the answer is to roll back time. Former Fed Chief Volcker has proposed a rule that would reinstate a cornerstone of the Depression Era Glass-Steagall Act, separating proprietary trading from traditional customer-oriented banking.
“There seems to be no willingness to address the conflict of interest inherent in modern banking. Because that would mean essentially pulling apart the two parts of the bank: the proprietary trading and the client focus businesses. And there is no real energy or traction for dealing with that issue.” – Satyajit Das, Author, Extreme Money
Occupy Wall Street has formed its own group to review the Volcker Rule. After extensive industry lobbying, the rule has ballooned from ten pages to almost 300 of exemptions and loopholes.
“The risk section of the Volcker Rule is really vague, really vague. You knew, I worked in risk. I mean, if I’m a bank, I can game this. We need people who are experts; who have gamed the system.” – Cathy O’Neil, DE Shaw, 2007 – 2009
They submitted their proposals to the SEC, the FDIC and the Fed in the hope that the Volcker Rule would be tightened up. Normally the only people who comment on these regulations are the industries that are about to be regulated.
“Banks were reformed after the Great Depression. They absolutely were. It was a political will issue and it continues to be. The question isn’t ‘Are we going to create something perfect?’ It is ‘Are we going to create something better than this?’ It’s actually a pretty low bar. So I think it’s definitely achievable.” – Cathy O’Neil, DE Shaw, 2007 – 2009
Recently the government tried to create tougher rules for banks that trade more than $100 million of swaps annually. The bank lobby swung into action. The outcome: only banks trading more than $8 billion would be subject to oversight, leaving 85% of all derivative players, outside the reach of regulators.
“Because of our belief that finance sort of drives everything, the crisis was an opportunity to change that; to ask questions like ‘What is the role of finance in our economy? What is the role of banks?’ But I suspect it is very hard. Because it’s very difficult to change gods. And in the modern age, our god was finance. Except it’s turned out to be a very cruel and destructive god.” – Satyajit Das, Author, Extreme Money