Bank debate stalls in Senate as industry polishes image

As Wall Street braces for an epic political battle, it is difficult to exaggerate either what is at stake or how battered is the financial industry's public image.

Almost three years after the first financial tremors, the strongest impetus behind reforming a crisis-prone system is public outrage about the behavior of the nation's largest financial institutions. More than two-thirds of the public last month held a somewhat or very unfavorable view of the nation's big banks, according to a Pew Financial Reform Project poll.

That was before Wall Street's standard operating procedures were exposed to scrutiny as never before. In the past three weeks, the inner workings of Goldman Sachs, Lehman Bros., Citibank and Washington Mutual have been paraded before congressional panels and found badly wanting. "The myth of finance is getting exploded," says Simon Johnson, former chief economist of the International Monetary Fund and co-author of 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown.

The White House on Monday said the president "strongly supports" Sen. Chris Dodd's proposed reshaping of financial regulation, regarded as the most sweeping makeover since the Great Depression. Yet, the Senate's Democratic leadership on Monday failed to muster the necessary 60 votes to open debate on the legislation. Details remain in flux amid Republican opposition, but the measure in its current form would establish a council of regulators to monitor financial risks, create a new consumer protection agency under the auspices of the Federal Reserve Board and set new limits on the trading of derivatives.

Coming as the economy staggers out of intensive care into a long recuperation, the bill has unleashed a frenzy of lobbying. The banking industry is battling a provision that would require commercial banks to divest themselves of derivatives-trading operations and opposes granting states more power to regulate consumer finance, said Scott Talbott of the Financial Services Roundtable, an industry group.

The financial sector's deep pockets usually ensure it a respectful hearing on Capitol Hill. But the industry has lost some of its swagger amid the recent revelations about its operations.

"Wall Street is on the wrong side of this fight," said Sen. Carl Levin, D-Mich., who chairs the Senate Permanent Subcommittee on Investigations, which has been probing the financial crisis.

The big short

Since the housing market imploded in 2007, more than 8 million jobs have been lost, along with $10 trillion in household wealth. The Pew poll found that 46% of Americans say they or someone they know has lost their job in the past year.

Goldman Sachs (GS), often regarded as home to the nation's savviest financiers, finds itself the government's most prominent target. The firm is battling a Securities and Exchange Commission complaint alleging that it misled investors about a synthetic security called a collateralized debt obligation. Called "Abacus," the investment, which was tied to the value of a bevy of mortgage-backed securities, was sold to a German bank on the basis that it had been designed by an independent third party. The SEC alleges a prominent hedge fund manager named John Paulson had helped pick the CDO's component parts while making a hefty bet it would fail — something Goldman did not disclose to its German client.

"The harm here is to all of us. The toxins that Goldman Sachs and others helped inject into our financial system have done incalculable harm to people who have never heard of a synthetic CDO and have no defenses against the harm that such exotic Wall Street creations can cause," said Levin, whose subcommittee will hear testimony today from Goldman's CEO, Lloyd Blankfein.

Goldman flatly rejects Levin's account that it shorted housing-related securities — or bet on them to decline. "We didn't have a massive short against the housing market, and we certainly did not bet against our clients," Blankfein says in a copy of his prepared testimony.

At today's showdown hearing, a central point of dispute will be Goldman's financial results. Levin told reporters Monday that Goldman made $3.7 billion shorting the housing market in 2007, though it also lost an unspecified amount on investments designed to increase in value if house prices rose.

Blankfein, however, will testify that the firm made less than $500 million in 2007 on residential housing investments and lost $1.2 billion the next year as the financial crisis intensified. Such investments were a sliver of the global firm's operations. In 2007, Goldman reported net income of $11.6 billion on total revenue of $46 billion.

The Goldman boss will also acknowledge public ire at the financial industry. He plans to express "gratitude" for the $10 billion in taxpayer funds that carried the firm through the crisis, and note that Goldman had paid the money back plus a 23% annualized return. And he calls the SEC's filing of a civil complaint against the firm "one of the worst days in my professional life."

Pretty unwise

Goldman is only one of the firms that have been pilloried for their role in the nation's worst financial crisis since the Great Depression.

Lehman Bros., whose September 2008 bankruptcy triggered the most acute phase of the crisis, was portrayed earlier this month in deeply unflattering terms before the House Financial Services Committee.

The firm ignored its own risk limits to pursue lucrative business deals, according to a court-appointed examiner. In late 2006, Lehman management scrapped a limit on the size of individual deals because it was costing the firm profits. It deliberately left many of its riskiest assets out of stress tests it conducted on its portfolio, rendering the examinations "meaningless." And in May 2007, the firm proceeded with an investment called "Archstone" even though its internal control systems warned against doing so.

Lehman ultimately absorbed write-downs of "hundreds of millions of dollars" on the deal, examiner Anton Valukas concluded. "Archstone was one of the investments that put Lehman on or over the brink; yet, it was a transaction that would not have been made had Lehman adhered to its own risk limits," he said.

Valukas also castigated Lehman for failing to disclose the use of a $50 billion accounting maneuver called "Repo 105," which acted to "artificially and deceptively reduce Lehman's reported net leverage and, therefore, the market perception of Lehman's viability."

Richard Fuld, former CEO of the bankrupt investment bank, said he "had no recollection of hearing anything about" the accounting gimmick. But he said the device had been vetted by the firm's auditor and had been booked properly.

Citibank(C), whose massive bets on the subprime mortgage market left it unable to survive without $45 billion in taxpayer cash and a $300 billion government guarantee, was battered in front of the Financial Crisis Inquiry Commission. The nation's largest bank nearly failed because the securities it thought were among the safest in its portfolio were actually financial time bombs.

So-called super-senior tranches of mortgage bonds boasted a triple-A credit rating, but cost the bank more than $30 billion in write-downs over a year and a half, former CEO Charles Prince told the bipartisan panel. "People believed — and they believed with a level of certainty that is difficult to appreciate today — that the super-senior tranches would never be touched by these problems. ... Sitting here today, that belief looks pretty unwise," Prince said. "It obviously turned out to be wrong."

Washington Mutual, whose September 2008 collapse marked the largest bank failure in U.S. history, gambled its business on ratcheting up loan issuance by its subprime unit. Between 2000 and 2007, WaMu and its subprime subsidiary made $77 billion in loans to customers with poor or no credit histories. In the stampede for profits, sloppiness ensued.

"One Sales Associate admitted that during that crunch time some of the Associates would 'manufacture' asset statements from previous loan doc[ument]s," because the pressure was "tremendous," and they had been told to get the loans funded, "whatever it took," said an April 2008 internal WaMu audit cited by Levin at an April 13 hearing.

While Wall Street's reputation has taken a beating recently, government regulators have fared little better. Valukas told the House Financial Services Committee that both the Securities and Exchange Commission and the Federal Reserve Bank of New York were chronically passive.

In October 2007, for example, when SEC officials learned that Lehman was exceeding a "risk appetite limit" it had pledged would not be breached "under any circumstances," they did nothing.

"The SEC simply acquiesced," Valukas said.

In May and June 2008, a few months before the firm's failure shook global markets, Lehman failed "several stress tests," Valukas testified. Yet, neither agency required Lehman to do anything to fortify its balance sheet.

Even the chief regulator of them all — former Fed chairman Alan Greenspan— has been forced to confess error.

"We tried to do the best we could with the data we had," he said April 7. "Did we make mistakes? Of course we made mistakes."

The big banks' woes — and the regulators' failure to curb them — point to a central question that some fear the current reform push will not address: Are the nation's big banks simply too big? Citibank's Prince testified that he never saw his $2 trillion institution as too big to manage. And the industry is prepared to fight any explicit attempt to break up the industry's big six —Bank of America (BAC), JPMorgan Chase (JPM), Wells Fargo (WFC), Citibank, Goldman Sachs and Morgan Stanley (MS).

But others argue that overly big banks just mean unacceptable risks for the wider economy. The Bank of England's Andrew Haldane says there is no evidence that banks can operate more efficiently by getting bigger once they reach $100 billion in assets. "Above that threshold, there is evidence, if anything, of diseconomies of scale," he said in a speech in Hong Kong last month.

In 2008, 145 global banks exceeded that level. The danger comes when a firm that big — think Lehman Bros. — fails. No bank above the $100 billion threshold that failed during the crisis, Haldane said, was wound down without shaking the wider economy.

(Published by USA Today - April 27, 2010)