I’m reading Simon Johnson and James Kwak’s new book — “13 Bankers, the Wall Street Takeover and the Next Financial Meltdown” — and posting a summary and excerpts of each chapter.

In chapter two, “Other People’s Oligarchs,” Johnson and Kwak give details of financial meltdowns in the 1990’s — Mexico, Russia, the Czech Republic and Urkraine in 1994 and Southeast Asia, Korea, Brazil and Russia in 1997-1998.  They write that oligarchs who controlled the finances of those countries were blamed.

Johnson and Kwak write that it was widely assumed that the United States was immune from financial problems of of  countries with “emerging markets.”  But, “In September-October 2008, when Lehman Brothers collapsed and panic seized the U.S. economy, money flooded out of the private financial system in what looked like a classic emerging market crisis.”

They write, “When the federal government began rescuing major banks presided over by ultra-wealthy executives — while letting smaller banks fail by the dozens — it began to seem as if our government was bailing out is own uniquely American oligarchy.”

Here is an excerpt from the conclusion of this chapter:

“In similar situations in the 1990s, the United States had urged emerging market countries to deal with the basis economic nd political factors that had created devastating crises.  This advice was often perceived as arrogant, but the basic logic was sound:  when an existing economic elite has led a country into a deep crisis, it is time for change.  And the crisis itself presents a unique, but short-lived, opportunity for change.

“As in Korea a decade before, a new president came to power in the United States in the midst of the crisis.  And just like Kim Dae-jung in Korea, Barack Obama had campaigned as a candidate of change.  Yet far from applying the advice it had so liberally dispensed to others, the U.S. government instead organized generous financial support for its existing economic elite, leaving the captains of the financial sector in place.”

Previous posts about this book:

• “13 Bankers” — Introduction
• “13 Bankers” — Chapter One: Thomas Jefferson and the Financial Aristocracy

In testimony, May 4, 2010, from Jamie Galbraith before the Subcommittee on Crime on the role that fraud played in the financial crisis, Mr. Galbraith said sub-prime mortgage was a “license to steal.” He said, “Given a license to steal, thieves get busy. And because their performance seems so good, they quickly come to dominate their markets; the bad players driving out the good.:

Galbraith said, “At its heart, the financial crisis was a breakdown in the rule of law in America.” And he warns, “If fraud – or even the perception of fraud – comes to dominate the system, then there is no foundation for a market in the securities. They become trash. And more deeply, so do the institutions responsible for creating, rating and selling them. Including, so long as it fails to respond with appropriate force, the legal system itself.”

Galbraith recommends: “There must be a thorough, transparent, effective, radical cleaning of the financial sector and also of those public officials who failed the public trust. The financiers must be made to feel, in their bones, the power of the law. And the public, which lives by the law, must see very clearly and unambiguously that this is the case.”

Other Excerpts:

• I write to you from a disgraced profession. Economic theory, as widely taught since the 1980s, failed miserably to understand the forces behind the financial crisis.
• Economists have soft- pedaled the role of fraud in every crisis they examined, including the Savings & Loan debacle, the Russian transition, the Asian meltdown and the dot.com bubble. They continue to do so now.
• The criminologist-economist William K. Black of the University of Missouri-Kansas City is our leading systematic analyst of the relationship between financial crime and financial crisis. Black points out that accounting fraud is a sure thing when you can control the institution engaging in it: “the best way to rob a bank is to own one.”
• The experience of the Savings and Loan crisis was of businesses taken over for the explicit purpose of stripping them, of bleeding them dry. This was established in court: there were over one thousand felony convictions in the wake of that debacle.
• In California in the 1980s, Charles Keating realized that an S&L charter was a “license to steal.” In the 2000s, sub-prime mortgage origination was much the same thing. Given a license to steal, thieves get busy. And because their performance seems so good, they quickly come to dominate their markets; the bad players driving out the good.
• The complexity of the mortgage finance sector before the crisis highlights another characteristic marker of fraud. … An efforts a year ago by Representative Doggett to persuade Secretary Geithner to examine and report thoroughly on the extent of fraud in the underlying mortgage records received an epic run-around.
• When sub-prime mortgages were bundled and securitized, the ratings agencies failed to examine the underlying loan quality. Instead they substituted statistical models, in order to generate ratings that would make the resulting RMBS acceptable to investors.
• An older strand of institutional economics understood that a security is a contract in law. It can only be as good as the legal system that stands behind it. Some fraud is inevitable, but in a functioning system it must be rare. It must be considered – and rightly – a minor problem.
• If fraud – or even the perception of fraud – comes to dominate the system, then there is no foundation for a market in the securities. They become trash. And more deeply, so do the institutions responsible for creating, rating and selling them. Including, so long as it fails to respond with appropriate force, the legal system itself.
• Control frauds always fail in the end. But the failure of the firm does not mean the fraud fails: the perpetrators often walk away rich. At some point, this requires subverting, suborning or defeating the law. This is where crime and politics intersect. At its heart, therefore, the financial crisis was a breakdown in the rule of law in America.
• Ask yourselves: is it possible for mortgage originators, ratings agencies, underwriters, insurers and supervising agencies NOT to have known that the system of housing finance had become infested with fraud? Every statistical indicator of fraudulent practice – growth and profitability – suggests otherwise. Every examination of the record so far suggests otherwise. The very language in use: “liars’ loans,” “ninja loans,” “neutron loans,” and “toxic waste,” tells you that people knew. I have also heard the expression, “IBG,YBG;” the meaning of that bit of code was: “I’ll be gone, you’ll be gone.”
• Let us suppose that the investigation that you are about to begin confirms the existence of pervasive fraud, involving millions of mortgages, thousands of appraisers, underwriters, analysts, and the executives of the companies in which they worked, as well as public officials who assisted by turning a Nelson’s Eye. What is the appropriate response?
• You have to act. The true alternative is a failure extending over time from the economic to the political system. Just as too few predicted the financial crisis, it may be that too few are today speaking frankly about where a failure to deal with the aftermath may lead.
• In this situation, let me suggest, the country faces an existential threat. Either the legal system must do its work. Or the market system cannot be restored. There must be a thorough, transparent, effective, radical cleaning of the financial sector and also of those public officials who failed the public trust. The financiers must be made to feel, in their bones, the power of the law. And the public, which lives by the law, must see very clearly and unambiguously that this is the case. Thank you.

Written By Mike Bock

I’m reading “13 Bankers,” a just published book written by Simon Johnson and James Kwak. The preface to this book says, “Even after the ruinous financial crisis of 2008, America is still beset by the depredation of an oligarchy that is now bigger, more profitable, and more resistant to regulation than ever.  The six megabanks … together control assets amounting, astonishingly, to more than 60% of the country’s Gross Domestic Product … continue to hold the global economy hostage, threatening yet another financial meltdown.”

The question:  “How did this come to be — and what is to be done?”

The book has seven chapters and I’m intending on reporting on each chapter and printing excerpts from each chapter.  Today, I’m excerpting Chapter One, “Thomas Jefferson and the Financial Aristocracy.”  This chapter is 25 pages and outlines the historical framework of today’s financial crisis.   The sentence that most caught my eye in this chapter describes banking after the big reforms made in response in The Great Depression:  “Postwar commercial banking became similar to a regulated utility, enjoying moderate profits with little risk and low competition.” Tomorrow, I’m excepting Chapter Two:  “Other People’s Oligarchs”

From “13 Bankers,” Chapter One:  “Thomas Jefferson and the Financial Aristocracy.”

• Jefferson was deeply suspicious of banks and criticized them in vitriolic terms, writing, “I sincerely believe, with you, that banking institutions are more dangerous than standing armies.”
• Jefferson was opposed by Alexander Hamilton, Washington’s secretary of the treasury, who favored a stronger federal government that actively supported economic development — particularly that government would ensure that sufficient credit was available to fund economic development and transform America into a prosperous entrepreneurial country.
• By 1825, when the United States and the United Kingdom had roughly the same population (11.1 million and 12.9 million, respectively), the United States had nearly 2.5 times the amount of bank capital as the United Kingdom.
• While Hamilton may have been right about economics, that was not Jefferson’s primary concern. His fear of large financial institutions had nothing to do with the efficient allocation of capital and everything to do with power.
• Although Jefferson lost the battle … the cause of restraining concentrated economic or financial power was taken up by three of his most important successors.  In the 1830’s, Andrew Jackson showdown with the Second Bank of the United States …. At the beginning of the twentieth century … Theodore Roosevelt….During the Great Depression of the 1930’s Franklin Delano Roosevelt was finally able to break up the largest banks and constrain their risky activities.
• Both Jefferson and Jackson saw a powerful bank as a corrupting influence that could undermine the proper functioning of a democratic government.
• By the late nineteenth century, industrialization had created a powerful economic elite that held political power at all levels, with its supporters in substantial control of the Senate, the Republican Party, and the presidency.
• By the late nineteenth century, the Senate had become known as the “Millionaires’ Club.”
• New industrial trusts  emerged late in the nineteenth century. … Standard Oil was an early pioneer of the trusts …A handful of bankers led by J.P. Morgan played a central role in this rapid transformation of the business landscape … Morgan’s empire handled … as much as 40% of the total capital raised at the beginning of the twentieth century.
• After McKinley’s assassination in 1901, Theodore Roosevelt adopted “trust busting” as a signature policy and made improved supervision of large corporations a major theme in his 1901 State of the Union address.
• The Panic of 1907, which nearly brought  the financial system crashing down, clearly demonstrated the risks the American economy was running with a highly concentrated industrial security, a lightly regulated financial sector, and no central bank to backstop the financial system in a crisis.
• The Federal Reserve Act of 1913 reduced the autonomy of the central bank and gave the government a stronger hand in its operations, notably through a Federal Reserve Board appointed by the president.
• The Federal Reserve Act did little to constrain the banks themselves, leaving them free to engage in  risky lending and generate huge economic booms that would be politically difficult to rein in.  (It) had the power to engineer a bailout, but not to curb the risky activities that could make one necessary.
• The 1920’s were a period of significant deregulation, as Republican administrations dismantled the system of state control developing in order to fight the First World War. … The anti regulatory policies of the 1920’s helped make possible a period of rampant financial speculation, driven by investment banks and closely related firms that sold and traded securities in an unregulated free-for-all.
• For the last seventy years there has been heated debate over whether the Fed could have prevented the financial crisis of 1929 from evolving in the Great Depression.  … Clearly something had gone badly wrong.  The problem was …there was no effective check on the private banks as a group, whose appetite for risk had created a massive boom and a monumental bust.
• The magnitude and severity of the Great Depression created the opportunity for a sweeping overhaul of the relationship between government and banks.
• FDR’s favorite president was Andrew Jackson. …Both men shared an appreciation for the working of democracy and a fear that unconstrained private interests could undermine both eh economy and the political system.  In a sense they were both descendants of Jefferson.
• In January 1926, Roosevelt said, “Our enemies of today are the forces of privilege and greed within our own borders  … Jackson sought social justice; Jackson fought for human rights in his many battles to protect the people against autocratic or oligarchic aggression.”
• The Glass-Steagall Act (1933) separated commercial banking from investment banking to prevent commercial banks from being “infected” by the risky activities of investment banks. …As a result J.P. Morgan was forced to spin off its investment banking operations, which become Morgan Stanley.
• The system that took form after 1933, in which banks gained government protection in exchange for accepting strict regulation was the basis for half a century of financial stability — the largest in American history.
• Postwar commercial banking became similar to a regulated utility, enjoying moderate profits with little risk and low competition. …The half century following the Glass-Steagall Act saw by far the fewest bank failures in American history.
• The laws of the 1930s were intended to protect the economy from a concentrated, powerful, lightly regulated financial sector.  In the 1970s they were beginning to look out of step with the modern world.
• By the 1990s, Jefferson and Jackson … seemed more irrelevant than ever, and FDR’s New Deal was under widespread attack.
• The 1990s were a decade of financial and economic crises … in emerging markets … from Latin America to Southeast Asia to Russia. Fast growing economies were periodically imploding in financial crises that imposed widespread misery on their populations. For the economic gurus in Washington, this was an opportunity to teach the rest of the world why they should become more like the United States.  We did not realize they were already more like us than we cared to admit.

Written By Mike Bock