In the depths of the Great Depression, the American government set up social and financial safety nets to prevent another treacherous economic downspiral and financial panic. The strategy seemed to work: in the years since, recessions and bear markets have been milder. There has been no depression, and panics have been fleeting. But now, a few outspoken economists fear that a depression — a prolonged downturn, accompanied by severe financial distress — is a possibility, if only remote. One reason: those safety nets are severely shredded.
The social safety nets — the entitlement programs set up in the 1930s and their later refinements — are in tatters. The Medicare trust fund will run out in 2019, and the Social Security fund’s reserves will be depleted in 2041. David Walker, former head of the U.S. Government Accountability Office, has been going around the country on Fiscal Wake-Up Tours, warning that the nation is on a financial collision course: there is not enough money to handle coming baby boomer retirements; the Medicare prescription drug benefit plan is a disaster; tax cuts have been irresponsible; the Iraq War is draining available funds; government pensions at all levels are far too generous; and Congress has no budget controls. Walker recently joined a private group trying to educate citizens on the similarities between America today and the Roman Empire in its final years.
The financial safety nets are in tatters too. They were set up to prevent market manipulation and thwart debt-based pyramids. The 1920s was a decade of wild speculation enriching a favored few but eventually wiping out almost all investors. A handful of crooks would create pools to drive a stock up, then bail out when it hit a predetermined peak. They would work similar magic in driving a stock down.
The stock pyramids, facilitated by piles of debt, were the most dangerous. The Van Sweringen brothers built a pyramid of railroad stocks; Samuel Insull had an infamous utilities pyramid. As the stocks crashed and the basic businesses foundered, the debts could not be paid. The pyramids collapsed, exacerbating the fall of the overall market. Viewing one jerry-built debt pyramid, President Franklin Delano Roosevelt called it “a 96-inch dog wagged by a 4-inch tail.”
In this environment, the United States passed rigid securities laws and set up the Securities and Exchange Commission. Its mission was to protect small investors from the depredations of corporate titans and Wall Street. Now the mission (unstated, of course) is exactly the reverse: to protect the titans and Wall Street. One way it’s done is through what San Diego attorney Gary Aguirre, a former commission investigator, calls the “rotating door.” Lawyers work for the agency for several years and then go with big law firms for $2 million or $3 million a year. When they are at the agency, they do dubious favors for the powerful firms representing stock manipulators. For example, John Moores dumped $487 million of stock in Peregrine Systems during the period in which the books were cooked. Evidence shows Moores knew about the phony accounting. Moores hired his personal lawyer, Charles La Bella, to oversee a whitewash by the law firm of Latham & Watkins. To no one’s surprise, it exonerated Moores and put the blame on his underlings. The study was ridiculous, pointed out victims. The SEC official in charge of the Peregrine case blessed the Latham & Watkins study — then went to work for Latham & Watkins.
Three years ago, the securities commission notified Bear Stearns that it intended to bring an enforcement action against the firm for overvaluing $63 million of subprime mortgage–related derivatives. Two years later, the investigation was quietly closed. Gary Aguirre suspects that backroom pressure from law firms killed the matter. If the case had proceeded, the subprime crisis might have been averted, he suggests.
“Fixing the SEC so it can protect investors will not be easy,” says Gary Aguirre, who has returned to San Diego after several years in Washington, D.C. “Powerful interests want the SEC to be just the way it is or even weaker.” Opacity, thy name is Wall Street. “Over the last decade there has developed a second financial market — unregulated, off the balance sheets. It has grown geometrically.” This second financial market has been a comfy home for subprime mortgage instruments, derivatives such as credit default swaps, hedge fund monkey business, offshore money pools, and other collusive contrivances. “The nation has two capital markets: one is semitransparent and semiregulated, the other is opaque and unregulated.” And the Securities and Exchange Commission looks the other way — deliberately.
“The investment banks sold the regulators on the theory of counterparty discipline,” says Gary Aguirre. Translated, that means “Trust us.” Trust these gamblers to be prudent when doing business — say, buying a derivatives contract — from a third party. But the collapse of Bear Stearns, and the fact that almost no firm on Wall Street detected the subprime mortgage fraud, should explode any theory of counterparty discipline. The idea was never more than “a myth sold to regulators so investment banks can operate in the shadows without regulation.”
In the Bear Stearns crisis, the Federal Reserve began loaning money to the big securities firms. In the years since the Great Depression, it had only loaned to commercial banks. So it is generally accepted that these brokerage firms will have to be regulated. Last week, Treasury Secretary Henry Paulson introduced a “regulation lite” package. Don’t expect meaningful regulation of Wall Street. For example, the Treasury only vaguely refers to possible regulatory supervision of complex derivatives, which are the villains. That would be like 1930s regulators winking at Insull and the Van Sweringen brothers, surreptitiously encouraging them to keep building their debt pyramids.
Commercial banks are supposed to be regulated. But the essence of white-collar fraud is contrived complexity. Derivatives, sated with mathematical formulae and Greek symbols, are perfect tools for that. In keeping these inscrutable derivatives off their balance sheets, the commercial banks have evaded reserve requirements, creating a shadow banking system with starkly inadequate reserves. The securities firms, too, have a shadow system; as long as they have their major weapon, complex derivatives, they can evade regulation.