A decade of financial creativity!

Lee Drutman: A decade of financial creativity!

01:00 AM EST on Wednesday, January 21, 2009

LEE DRUTMAN

WASHINGTON

THIS YEAR marks the tenth anniversary of the Gramm-Leach-Bliley Act, the landmark deregulatory law that breathlessly cast aside the antiquated notion that there should be protection against excessive risk-taking and conflict of interest in the financial-services industry. “In this era of economic prosperity,” Rep. Thomas J. Bliley Jr. (R.-Va.) said at the time, “we have decided that freedom is the answer.”) A mega-wave of Wall Street mergers promptly followed.

So, then, what better way to commemorate this historic moment than with the newly announced break-up of Citigroup, whose 1998 mega-merger had once upon a time forced Congress’s hand by brazenly violating the existing cross-ownership provisions in the old Glass-Steagall Act? Instead of trying to stop the merger, federal lawmakers decided to at last give in to more than two decades of lobbying by the industry and repeal Glass-Steagall. “The world changes, and we have to change with it,” said Sen. Phil Gramm (R.-Texas). “We have taken a step that will greatly increase the variety of financial services that will be available to people all over America.”

On Jan. 13, Citigroup CEO Vikram Pandit announced that conglomeration had officially failed as a business model. His company would be dumping several units, including its Smith Barney brokerage. The new company would look remarkably like the Citicorp of the 1990s — back before it merged with Travelers, and well before it discovered that somehow it was on the hook for $306 billion in “toxic assets” (enough to qualify for a $45 billion taxpayer bailout!).

It’s funny: When Gramm-Leach-Bliley initially passed, Sandy Weill and John Reed, Citigroup’s co-chairmen and co-chief executives, prophetically predicted that “this legislation will unleash the creativity of our industry.” How true: Never has a decade seen more fiscal creativity.

But their next prediction, that “all Americans — investors, savers and insureds — will be better served” has been a bit less prophetic. Unless by all Americans, Weill and Reed only meant people like them. Each earned about $26 million the year of the merger. Weill also pulled in a remarkable $785 million in compensation between 1995 and 2000.

But back to the creativity bit. The first acts of the post-deregulation Wall Street resourcefulness surrounded the relentless cheerleading behind the great Ponzi scheme commonly known as the tech bubble. The poster child for this was Jack Grubman, Citigroup’s visionary $20 million-a-year tech analyst, inventively telling everyone to Buy! Buy! Buy! WorldCom, Global Crossing and Qwest — all a steal at any price!

But why was Grubman so hot to trot on such rot? Probably because the investment-banking wing of Citigroup was getting rich underwriting the these companies’ stock offerings, but only so long as the brokerage wing of Citigroup could whip the stock-buying public into an appropriate frenzy. These same conflicts of interest were rampant across Wall Street.

Citigroup, along with many other Wall Street banks, also showed remarkable, newly unleashed ingenuity in developing and then helping to execute many of the funny-business transactions that Enron used to commit massive fraud. (Citigroup later paid $255 million in fines to the Securities and Exchange Commission. Other banks were also fined.)

The next wave of unleashed innovation on Wall Street, of course, was the massively creative and fabulously complex array of mortgage-backed securities. Remarkably, even though nobody now appears to have actually understood what they were buying, everybody on Wall Street somehow thought they could make money on these assets, or at least use them to win massive short-term personal bonuses, regardless of how the game of hot potato ultimately turned out.

Had this colossally stupid investment craze taken place in the pre-conglomerate world, things would still have turned out poorly when it finally become clear that housing prices do not, in fact, outpace real income growth forever and, yes, people with no assets and no job do, in fact, sometimes default on their loans. But things turned out even worse because these giant Wall Street conglomerates had far more money to play with than the investment banks of yore, and leveraged their assets on the order of 30 to 1 (with permission from the kind, gentle Securities and Exchange Commission). As a result, it seems that now almost the entire economy is on the hook. The analogy here is to the compulsive gambler who not only bets his savings, but also his house. And his kid’s college savings. And all on something very, very stupid.

So here’s to 10 years of the freedom, creativity and the wide variety of financial services we were promised. And how, amazingly, it all led us right back to where we started — and so much worse for the wear.

Lee Drutman, an occasional contributor, is a research fellow in governance studies at the Brookings Institution, in Washington.

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