Fairy Tale Capitalism: Fact and Fiction Behind Too Big to Fail

By Emily EisenLohr

“If something goes wrong, it’s going to be a big mess!” That 2004 warning came during the SEC’s approval of a new regulation intended to help investment banks avoid regulation. Confusing?

In 1998 the large hedge fund Long-Term Capital Management was close to collapse. The Federal Reserve deemed it sufficiently large to present systemic risk and organized a “rescue” by a group of its largest banks. No taxpayer money was involved, but the event caught the eye of Congress. Congressmen and government officials vowed that something needed to be done about financial risk and regulation.

Then Congress ignored LTCM’s lessons. Congress removed the barriers between investment and commercial banking in 1999. The following year Congress passed legislation that ensured that over-the-counter derivatives would not be regulated. Something else was going on.

The real history of the systemic bubble began at least ten years ago. The implosion of this bubble is far larger than LTCM with even more complex risks and financial instruments. This meltdown involved huge taxpayer-funded bailouts. The public is paying attention this time, but is Congress really dealing with systemic risk?

Many fictions surround the financial meltdown. Which political party is most responsible? Can regulators prevent another crisis? How do credit ratings play a hidden role? Can Congress tame systemic risk without shrinking big banks?

In simple terms Emily Eisenlohr guides Main Street down Wall Street, where finance meets politics. She provides both simple explanations for the less financially savvy and simple illustrations to show even the experts how systemic risk remains, making future bailouts a given. She believes you don’t need to trade derivatives or have a Ph.D. in economics to understand this little history.

• Language: English
• Publisher: AuthorHouse
• Release date: Sep 9, 2010
• ISBN: 9781452034058

Emily EisenLohr

Emily Eisenlohr lived the building of the systemic risk bubble. As a corporate banker, rating agency analyst and Chartered Financial Analyst she gained an inside view of global banking, investment management, risk management and credit ratings. In recent years she has been actively engaged as a public policy advocate, particularly in education finance.             Emily’s corporate banking career spanned 15 years at two big “money center” banks, the First National Bank of Chicago, now part of JPMorgan Chase, and Citicorp/Citibank, now part of Citigroup. She joined First Chicago’s prestigious First Scholar management training program in 1980. Emily subsequently managed First Chicago’s corporate foreign exchange exposure hedging and its bank trading limits. As a corporate banker she marketed a broad range of banking services to multinational clients. Joining Citicorp in 1986, Emily was responsible for the profitability of Citicorp’s relationships with some of the world’s largest multinational corporations. These complex client relationships involved coordination among product specialists and other relationship managers in nearly 100 countries, marketing services as diverse and complex as derivatives, securitizations, commercial lending and off-balance-sheet structures. In 1995 Emily assumed responsibility for an $88 billion portfolio of power sector credit ratings at Moody’s Investors Service. As a Senior Credit Officer she not only managed credit ratings in a deregulating utility sector, but was also nominated to a committee that communicated Moody’s rating process to the financial community. Emily was well regarded by utility executives, both buy-side and sell-side analysts and her Moody’s peers for her thorough preparation and her ratings advocacy. She also had a reputation for being willing to promote well-grounded contrarian views. She became a popular public speaker for her work on trading risk and its impact on credit ratings. She lives in Connecticut with her husband and son.  

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© 2010 Emily Eisenlohr. All rights reserved.

No part of this book may be reproduced, stored in a retrieval system, or

transmitted by any means without the written permission of the author.

This book is a work of non-fiction. Unless otherwise noted, the author and the publisher

make no explicit guarantees as to the accuracy of the information contained in this book

and in some cases, names of people and places have been altered to protect their privacy.

Published by AuthorHouse 10/08/2021

ISBN: 978-1-4520-3407-2 (sc)

ISBN: 978-1-4520-3406-5 (hc)

ISBN: 978-1-4520-3405-8 (e)

Library of Congress Control Number: 2010910086

Any people depicted in stock imagery provided by Getty Images are models,

and such images are being used for illustrative purposes only.

Certain stock imagery © Getty Images.

Because of the dynamic nature of the Internet, any web addresses or links contained in

this book may have changed since publication and may no longer be valid. The views

expressed in this work are solely those of the author and do not necessarily reflect the

views of the publisher, and the publisher hereby disclaims any responsibility for them.

To my family, without whose support this book could

never have been written – my husband, David; my son,

Christopher; and my parents, Audrey and Doug

Contents

Introduction

Traveling Back Through History: The Roadmap

Part I     Creating the Web

Chapter 1     Financially Engineering a Superhighway for Risk: The 1980s and Beyond

Chapter 2     Derivatives: The Mass in Financial Weapons of Mass Destruction

Chapter 3     Risk Management Evolution: Creating the Systemic Web

Chapter 4     What Are Bank Holding Companies, and Why Should Taxpayers Care?

Part II     Money’s Influence on Politics and Law

Chapter 5     Assault on the Credit Culture

Chapter 6     Larry Summers Raises an Excellent Point: It’s Legal.

Chapter 7     Political Underpinnings of Systemic Risk

Chapter 8     Congress’s Institutional Memory?

Part III     Responsibility or Irresponsibility?

Chapter 9     Don’t Ask. Don’t Tell. Who Is Responsible?

Chapter 10   The Hare Beats the Tortoise

About the Author

Introduction

This is a simple history of the growth of the systemic risk bubble, largely covering a decade. It attempts to distill the complexities into as simple terms as possible for the less financially savvy, while including all essential components. It is based upon my personal experience having worked at both Citibank and Moody’s Investors Service and on my perspective as a professional financial analyst.

I have drawn four major conclusions:

1. Systemic risk will dominate our financial markets as long as the biggest financial institutions remain at their present size and engaged in the same risk-shifting activities with limited restraints. The big banks will continue to own us. Only legislation can change this situation.

2. The primary protection against systemic risk is holding CEOs and their boards of directors responsible and accountable for the risks assumed by their organizations. Regulators are important, but they can never keep up with innovation and competition.

3. The U.S. government inserted itself into mortgage markets over the course of forty years. Its highly distorting role needs to be shrunk to its most essential policy objectives – on budget, not hidden.

4. The U.S. taxpayer is trapped in a political vacuum between the Democrats and the Republicans on these issues. This may be the greatest challenge.

Many fictions are being promoted about the financial crisis and market reform. Expecting regulators to be the sole solution to systemic risk is one of the fictions being foisted on the American public. Regulators can never be the first level of defense against systemic bubbles for reasons that are laid out in the final chapter.

Many wonderfully-researched personal accounts have been published on the people and events surrounding the financial meltdown. But few seem to deal with the legal, financial and political web that makes the largest financial institutions Too Big To Fail.

Members of Congress frequently state that they cannot support any future bailouts. They intend to pass legislation that promises to prevent future bailouts. This is another big fiction. They may pass legislation, but legislation debated to date does little to prevent future bubbles. The current market structure ensures that if one of the largest banks collapses, they all would still need a bailout. The first section shows why.

If Congress really passed legislation that limited the ability of the government to support financial institutions, the financial system would collapse. The rating agencies have warned of downward ratings pressures. Citigroup would go bankrupt within days after the resulting credit ratings downgrades. Being a major derivatives dealer, Citigroup would take the other large banks with it.

We’ve seen numerous sessions of public testimony at Congressional hearings where regulators, rating agency executives and corporate CEOs have been castigated for their roles in the financial crisis. Public punishment benefits both politicians and the public mood. These hearings are directed at public anger and revenge, not at addressing the underlying causes of the crisis.

Trust is the underpinning of a healthy financial system. The rating agencies are in the spotlight because credit quality is such an essential attribute of trust. Ordinary people need to trust the banks where they deposit their money. Banks need to trust other banks, upon which they so dearly depend for the sharing of their day-to-day cash excesses and shortfalls. Derivatives traders need to know that their counterparties will still be in business many years into the future when a large portion of their contracts settle.

From the smallest player to the most sophisticated, trust governs behavior. Nobody will deal with a person or institution he or she doesn’t trust. Ratings provide a level of trust. But people need to trust the ratings themselves and the agencies that assign them.

We’ve tended to resort to the government to provide that level of trust, from the FDIC deposit guarantee to huge expectations of regulators. The government should not be the first place to look for a solution to systemic risk. The first protection against a systemic risk bubble is through individuals taking personal responsibility for their decisions and the risks they assume, especially those in charge of our largest financial corporations.

A consumer protection agency would provide some protection to the ordinary citizen. But it shouldn’t be the top priority in financial reform. Expecting a government agency to protect consumers from systemic abuse is another fiction. The Securities and Exchange Commission has had authority to oversee financial markets for decades, yet often failed to enforce those laws and its own regulations. It perpetually claims to be understaffed, but its issues run deeper. Another agency would have similar enforcement challenges.

Goldman Sachs serves as the lightning rod for public anger over what the largest financial institutions have done to this country. They earned this attention along with their millions. They still are the most brilliant and successful of our investment banks. But punishing Goldman alone is to miss the causes of this crisis. Revenge and punishment look backward. Justice may be served, but systemic risk would not change. We need forward-looking measures that ensure a meltdown of this magnitude does not happen again.

The other large financial firms all over the globe were and are doing just what Goldman does. They take maximum advantage of the cheapest money they can find to provide benefits to their clients and to themselves. They seek the highest return possible for the least risk for their firms. Therefore they will use even the perception of government support to their benefit.

The risks of these firms’ trading activities were borne increasingly by taxpayers over this past decade. All the big firms buy and sell credit insurance. All act as large derivatives dealers. All have huge and highly profitable relationships with hedge funds, the least regulated sector of the financial services industry. To make this solely a Goldman prosecution is to sidestep the issue of market structure.

As we approach the election, the partisan Blame Game will intensify. Chapters 7 and 8 show how both parties share the blame.

Proposed legislation to date addresses the tail end of failure of these large institutions. If the financial system were viewed as a sick patient, the Senate and House proposals would be doing nothing more than adding more ambulances and hospitals. They do little to attack the cause of the illness.

When our largest financial firms are at the point of failure, it is too late to avoid the need for taxpayer support. What is even worse is that as they start to weaken, risk management practices can cause a quick collapse (as in Enron’s case). If Congress passed legislation that really prevented future bailouts, the rating agencies would have no choice but to downgrade the biggest banks immediately. They have repeatedly warned the markets that legislation could put downward pressure on bank ratings.

Current Congressional debate rests on the assumption that there is an orderly process for resolution of a bankruptcy among our largest financial institutions, a process that doesn’t involve bailouts. This is a fiction. The size, interconnectedness and complexity of our largest financial institutions ensure that there is no orderly resolution and that taxpayer dollars will be required in the event of future failures. Just labeling an institution systemically significant and assigning a regulator to oversee it is not going to reduce systemic risk. That label provides only a smoke screen promoting obscurity and making those on the elite list even Too Bigger To Fail.

All these fictions are exposed in this book. We need more honest debate. The unavoidable need for taxpayer bailouts arises from four sources, each of which will be presented. They are:

1. Concentration. Banks were allowed to merge and acquire each other. The largest banks today are huge, with surprising concentration in derivatives trading. Their mergers and activities were driven by the search for cheap money – cheap due to government involvement.

2. Interconnectedness. Banks always have had a degree of interconnectedness. Derivatives risk management practices created a much tighter web, particularly among the largest. Hedge funds are major users of derivatives, yet nobody really understands or oversees how they fit into the web.

3. Removal of barriers. Glass-Steagall barriers between investment and commercial banking protected the federal government deposit guarantee. The barriers were removed, but the deposit guarantee – substantially larger – remained. Trading is now propped up by government money.

4. Government involvement. Government’s intrusion into private markets expanded over the past four decades with the creation of government-sponsored enterprises. They added cheap funding to an overheated, securitized housing market. Reducing this dependency will be painful.

The standard that should be created to ensure real change in systemic risk management is private sector responsibility and accountability. Boards of directors are responsible to shareholders. Boards appoint the CEO. This is where meaningful change will start. But this is also where money that supports our political process arises.

This book might have been titled Over-The-Counter Derivatives Regulation: A Brief History of Nothin’, but the book’s scope isn’t so narrow. It traces the period from the pivotal years of 1998 and 1999 through the financial collapse, particularly 2008 and 2009. Modern systemic risk arises from legislation passed in 1998 and 1999 as much as from derivatives trading and risk management.

Modern systemic risk also rests on the cynical view that the American public will never understand finance, that they won’t get what has happened and therefore that nothing needs to change. Politicians know that the public forgets rather quickly. A key regulator warned Congress of this ten years ago.

This book is intended for those who want to understand our situation. It keeps math simple. It demands only that you can see that numbers are large, are growing or are relatively bigger or smaller than numbers nearby, with the occasional use of simple addition or subtraction.

I divide systemic risk into two types, 20th century and 21st century. Deposit insurance, mergers and lack of CEO accountability were major factors in 20th century systemic risk. Derivatives created 21st century systemic risk and added a potent weapon of financial mass destruction, to quote Mr. Buffett.

Congress added the government-sponsored enterprises (GSEs) Fannie Mae, Freddie Mac and Ginnie Mae to the 20th century systemic risk bubble. As my political science professor said of politicians several decades ago, In the needs of others they find their opportunities. A home is a basic need. Cheaper financing to purchase a home is hard to resist. And when the housing market started to collapse, of course the government was going to step in. In this need our political and economic elite found their opportunities.

21st century systemic risk arises from the network of derivatives contracts, credit management practices, use of collateral and the role of credit ratings that create a web among all the big banks. Bank mergers and acquisitions, which picked up speed towards the end of the 1990s, and the legislation that repealed the Glass-Steagall Act led to both increased bank concentrations and a weaker credit culture.

Starting with Bear Stearns’ collapse, regulators stared into the abyss that might have occurred had the chain of failures been allowed to play out. They then tested the theory that government shouldn’t bail out large financial firms. Lehman’s bankruptcy demonstrated how utterly devastating a collapse of these large, interconnected firms would be. After Lehman they were making it up as they went along.

Congress showed that our representatives were in no mood to bail and couldn’t get it done in a timely fashion even if they could appreciate the gravity of the financial situation. At that point the Fed really started to bail in the way that only the Fed can, assisted by the nation’s top financial talent and officials and by the U.S. Treasury. That the financial system is still standing is a measure of their skill and success in managing markets and their ability to tap into taxpayers’ pockets.

Unless the issues of size, interconnectivity and government involvement are addressed, we will continue to live in an economic Neverland between socialism and capitalism, lacking clarity for action and direction.

The argument is developed in three sections. A roadmap follows this introduction to guide the reader through each chapter.

Part 1: Creating the 21st Century Systemic Web

This section describes how the superhighway of risk was built and fed the profit machine. The interconnectedness among the largest institutions grew due to risk management practices.

Part 2: The Money Machine Owns Congress

This section describes how the banks became financial behemoths, controlling even higher profits. The money was applied to buy the legislation and lack of oversight desired by the financial industry.

Part 3: Resurrecting Responsibility

This section explores how responsibility for risk assumption was largely eliminated through the political manipulations of influential Democrats and Republicans during the past decade. It also lays out issues and proposals for debate to try to resurrect responsibility within the risk/return balance underlying true capitalism.

The need for this book popped into my mind during the Bear Stearns rescue. I pointed out to my friends that the government was not rescuing Bear Stearns. It was rescuing the firm’s counterparties.

At first a humorous book seemed in order. The similarities to the fairy tale, The Emperor’s New Clothes, were striking. We’ve had our share of tailors telling our emperors how wonderful our new financial garments are, with many adults going along with the charade. The financial fairy tale ended as quickly as the old fairy tale when the markets froze up. As a child I played the game of Hearts with my brothers. You didn’t want to get caught holding the Queen of Spades. After the Bear Stearns debacle, nobody wanted to hold real estate assets. Not only did the auction-rate and remarketed securities markets freeze up, but they also took the commercial paper market with them, along with money market funds which invest heavily in commercial paper. In all my years as a corporate banker at Citibank structuring the credit backstops for multinational corporations’ commercial paper programs and marketing the early securitization vehicles I never dreamed of such a freeze. As the meltdown grew in magnitude and spread throughout the economy and my neighborhood, it became hard to envision laughing at who might have been holding the Queen of Spades – the real estate assets. The holders are our neighbors, our pension funds, our university endowments and our not-for-profits. The list goes on, and across continents.

But the title stuck. Fairy Tale Capitalism is what we are living. You can’t have true capitalism if you have such extensive government involvement in the markets.

Government officials and financial leaders are my primary storytellers. I used only publicly available information to tell this story. I researched testimony, reports, publications and speeches by Federal regulators and their staff, the top financial officers in our Federal government, CEOs of the big financial corporations, Congressmen and the rating agencies. I used company 10-Ks – their formal annual financial reports for investors required to be filed with the Securities and Exchange Commission. It is their information, data and observations. I just connect the nearly two-decade-long dots. Nearly all sources are available on the web.

I lived these developments. As a former Citibank corporate vice president I lived the decline of the credit culture at the big commercial banks. For fifteen years starting in 1980 I worked at two money center banks. That term at the time meant big commercial banks with international scope. The first, the First National Bank of Chicago, whose parent was called First Chicago Corporation, has now been subsumed into JPMorgan Chase through several mergers. The second was Citibank, whose parent at the time was called Citicorp – a big, international, largely commercial bank back then. Its parent is now called Citigroup, and it is one of the big universal banks. As a former Senior Credit Officer in the power sector at Moody’s Investors Service from May 1995 until October 2000, I lived the life of a rating agency credit analyst sandwiched among issuers, investors and investment banks.

Over those twenty years I observed and dealt with senior financial executives, analyzed complex corporate credit, managed credit risk and bank trading limits, marketed a wide variety of financial products and structures and advocated for the $88 billion in corporate credit ratings for which I was responsible at Moody’s. I’ve personally dealt with counterparty risk, legal documents, credit agreements, securitizations and derivatives master agreements. I am also well-versed in accounting and the analysis of financial reports, having become a Chartered Financial Analyst, or CFA, in 1994.

Any reader should understand the bias of an author. Here’s my disclosure statement. I have no present role or contemplated role with the credit rating agencies, nor do I own stock in any of them. I’ve used some of their public materials, but have had no discussions with them for this book. My only tie at this point is my experience within Moody’s and as a user of credit ratings. On the political side, I have always been a registered Independent and have voted for members of both parties. My only political activities to date have been in support of education. I also have no present role or contemplated role at a large financial institution or regulatory body. Thank you, Chris Dodd, for not running for re-election. I reside in Connecticut, but this isn’t an anti-Chris Dodd manifesto. He is just one player in a bigger drama.

I am also not a lawyer. I would recommend that any M.B.A. candidate take a good course in business law as I did at the University of Chicago, but I also had a professional interest in growing my understanding of law and following legal developments that affect banking and securities investing. One has to do that as a finance professional. I also worked with lawyers structuring credit agreements and on other documents over my entire business career. But readers will see that you don’t need to be a practicing lawyer to see how the web of modern systemic risk arose and expanded.

How does anyone write a simple book on the meltdown? I used two words as my guide. Of course the most important is Trust. The other is the trickiest word surrounding capitalism:

Exploit.

Exploit first means to take advantage of an opportunity for one’s own benefit. It is one of the foundations of capitalism. It is how individuals exercise their personal choices and decision-making.

The second meaning has a more negative tone. It means taking advantage of an opportunity for personal benefit, but at the expense of another. Others bear negative consequences of the individual’s actions.

The debate is finding the tipping points of policy. When does exploitation start to have market structure or systemic implications? When does it destroy trust? When do corporations, their CEOs and their traders stop being responsible for their activities and start foisting their trading risks onto the taxpayer? How does one impose regulatory oversight without hindering truly competitive risk-taking, the foundation of capitalism?

Alan Greenspan and friends were correct in one regard. Markets do play the best disciplinary role. They and their Ayn-Randian acolytes just need to practice what they preach. If they believe one should be able to take a risk and suffer the consequences in addition to the rewards, then allow the markets to be structured so that this can occur.

I tried to stay focused on that policy tipping point – when systemic risk grows to a level requiring emergency government intervention.

Main Street shouldn’t be at battle with Wall Street. We reside in the same economy and also in the same nation. Neither capitalism nor democracy is being served until the true cause of systemic risk is understood and addressed.

Acknowledgment

I am grateful to many people who helped me put this history together. Because of the sensitivity of the subject matter most would prefer to remain anonymous.

My biggest thanks go to those who read all or parts of the first draft and offered their thoughtful impressions and suggestions. I’ve tried to incorporate them all.

Thanks go also to my friends and to many, many acquaintances for all those discussions of the meltdown and