Lehman's lessons slow to take hold

Five years ago, the U.S. government refused to rescue debt-ridden Lehman Brothers. Its collapse helped send the teetering global finance industry into free fall.

TV images of stock markets plunging and young bankers who thought they were future masters of the universe leaving Lehman’s offices for the last time with their belongings in cardboard boxes are still fresh in the mind.

Or at least, some minds.

“People have forgotten about the crisis,” said Anat Admati, professor of finance and economics at the Stanford Graduate School of Business and a member of the advisory committee to the Federal Deposit Insurance Corporation.

When she said people, she meant principally bankers, followed by politicians and regulators.

“If you were an average Joe losing your job, or your house was foreclosed upon because of the crisis and recession, you haven’t forgotten,” she said.

But five years on, Wall Street appears to be reveling in collective memory loss. The largest banks have become even larger and are gambling heavily in high-risk investments again, while the promised regulatory crackdown is slow and falling short.

Now prominent voices are warning, on this milestone Lehman anniversary, that another crisis is inevitable and the leading banks should be broken up.

Sen. Elizabeth Warren, D-Mass., is co-sponsoring a bill with Republican Sen. John McCain of Arizona to reinstate the law enacted in 1933 after the Great Depression to divide institutions into commercial banks, which mainly deal with commercial customer deposits and loans, and investment banks that trade in the capital markets.

“It would reduce ‘too big’ by dismantling the behemoths, so that big banks would still be big – but not too big to fail, or, for that matter, too big to manage, too big to regulate, too big for trial or too big for jail,” she said in a speech at George Washington Law School on Thursday, referring also to the tiny number of punishments that have been handed out to companies and their executives since 2008.

The original law, the Glass-Steagall Act, was repealed in the late ’90s. Banks then grew exponentially and traded on both sides of the line again, ominously using their solid deposit coffers to back ever-riskier securities deals involving stocks, debt (including bad mortgages) and the complex and esoteric world of derivatives.

When the overheated, overexposed system exploded and Lehman went bankrupt, the spreading world market panic and credit freeze forced the U.S. government to step in and use $700 billion in public money for bank takeovers and to prop up companies in banking and beyond deemed “too big to fail.”

That phrase has become so ubiquitous it’s sardonically known as TBTF in seemingly unembarrassed financial circles these days – because almost nothing has changed.

Since the crisis some of the names at the top are different, but the six biggest U.S. banks are substantially larger than they were in 2007.

JPMorgan Chase – which bought the first casualty of failing markets in 2008, Bear Stearns, then Washington Mutual – is the largest. Together with Bank of America (which acquired the stricken Merrill Lynch), Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley, their assets now total almost $10 trillion – 28 percent more than they were worth just before things turned sour.

But they are also carrying high proportions of debt and are exposed to more than $200 trillion worth of derivatives contracts, according to the U.S. Comptroller of the Currencies, that are the equivalent of betting on everything from interest rates to foreign exchange to commodities prices, for potentially spectacular gains – or losses.

“Congress and the regulators should look at measures forcing some break-ups of the super-banks, the three or four that have grown massively in size since the crisis,” said Ed Mierzwinski, director of consumer programs at the Washington-based advocacy organization U.S. Public Interest Research Group.

“They need to look at reinstating the wall between investment banking and consumer banking at the bigger banks, breaking them up to protect the public against the risks of these complicated trading instruments,” he added.

Populist lobbying group Public Citizen points out that the fifth anniversary of the Lehman Brothers collapse actually also marks the deadline that the Federal Reserve gave to Goldman Sachs and Morgan Stanley to sell their substantial assets not strictly related to traditional banking. There is no word yet on whether that will happen.

“The Fed is saying you can’t make commercial loans and home loans and gamble on Wall Street at the same time. But the banks are so big they not only manipulate the markets, they are manipulating Washington,” said Bart Naylor, financial policy analyst for Public Citizen. “A crisis will happen again, we don’t know when, or whether it will be $3 trillion or $20 trillion but it will happen because the government have not fixed the rules.”

Professor Admati echoed these concerns, saying that regulatory reforms introduced so far since 2008 are framed as if future crises are “somehow inevitable.”

“They are talking about crisis management, not crisis prevention,” she said.

In 2010 Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. Two of its three main pillars already implemented are the Consumer Financial Protection Bureau, a public watchdog over financial products such as mortgages to credit card interest charges, and laws allowing the government to step in, take over and wind up a failing bank.

But the third pillar – the so-called Volcker Rule, chiefly associated with preventing rather than handling another meltdown on Wall Street – is mired in delay and disagreement. So far, fewer than half the provisions of Dodd-Frank have been finalized and implemented.

The Volcker Rule is designed largely to ban speculative trading by commercial banks using their own funds. The justification is that it should be left to investment banks and hedge funds, where customers don’t expect a guarantee of their investments being safe or underwritten by a federal safety net.

But the Volcker Rule intends to include exceptions for certain types of trading – and this gray area is where the financial industry and their expensive lawyers and lobbyists have brought their full weight to bear on regulators and politicians, trying to loosen the restrictions. The result is deadlock and a vague projection that the details could be finished by the end of the year – more than three years after Dodd-Frank was outlined and only if warring regulators can agree.

“There remains a fragility in the system that’s vulnerable to shifts in confidence about the stability of banks that are using assets to buy dodgy securities and we have not changed anything to prevent a recurrence of that,” said Anil Kashyap, professor of economics and finance at the University of Chicago’s Booth School of Business.

Meanwhile, because of their status as non-commercial banks, the failure of Bear Stearns, Lehman Brothers and the giant insurer AIG in the 2008 crisis would not even have been prevented by Dodd-Frank.

Last month, President Obama met with Treasury chiefs and regulators at the White House and urged them to speed up reform – seemingly to no avail as regulators remain in disagreement and the industry continues to keep the Volcker Rule at bay.

The U.S. Commodity Futures Trading Commission, one of the lead regulators, has disclosed more than 2,000 meetings between banking lobbyists and regulators since Frank-Dodd was proposed.

Open Secrets, a research group tracking money in U.S. politics, has reported disclosures by the Senate Office of Public Records that banking and finance institutions spent more than $200 million last year on lobbyists to pressure members of Congress and regulators to loosen the provisions of Dodd-Frank and the Volcker Rule.

Open Secrets also reported that in 2012 the finance, insurance and real estate industries collectively donated $100 million to Democrats and $193 million to Republicans in Congress.

And Public Citizen has calculated that for every lobbyist campaigning for financial system reform, there are 11 campaigning against reform.

In 2009, Sen. Dick Durbin, D-Ill., said on the radio: “The banks -- hard to believe in a time when we're facing a banking crisis that many of the banks created -- are still the most powerful lobby on Capitol Hill … they frankly own the place.”

Professor Admati – who, as well as being an academic and regulatory advisor, has also co-authored the book, “The Bankers’ New Clothes” – said she believes little has changed since that remark. She called the lobbying figures “disheartening,” and said they encouraged lawmakers to “develop corruptive tendencies.”

Warren used her speech last week to express outrage at Congress’ failure to get tough with the banks and step in where regulators are dithering or turning blind eyes.

But the situation is so dire she was forced into defiance via The Bible.

"David can beat Goliath on Too Big to Fail,” she said. “We just have to pick up the slingshot again.”