Elizabeth Warren vs. Wall Street

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Make Bankers Pay For Their Mistakes

As a bankruptcy lawyer, Warren believes that regulatory reform must put the possibility of failure back on the table for America's biggest banks.

Americans tend to think of Too Big to Fail in terms of the billions of dollars it cost us in TARP funds and Federal Reserve guarantees. But Warren insists that the problem is best understood as a permanent form of federal insurance – one extended only to the world's richest and riskiest financial institutions, and one that produces ongoing hidden costs. In March, for example, the rating agency Moody's disclosed that it has upgraded Citi's debt solely because it believes the government will step in to prevent default. How much does the government charge for that guarantee? "Zero. Zip. Nada," says Warren. "They paid not a penny for an insurance policy that's worth billions." That gives big banks an advantage over smaller competitors, fueling consolidation and encouraging risk.

As Warren sees it, there are three basic strategies available for ending the era of Too Big to Fail. Break up the banks. Prohibit them from engaging in too-risky behaviors, such as running their own hedge funds with federally insured deposits. Or create a credible form of bankruptcy that enables regulators to pull the plug on failing banks before they take down the entire economy. Although she believes all three will probably need to be used in concert, Warren views the third element as the linchpin. "I hope it is never necessary to kill off one of these companies, because that's a scary moment," she says. "But that's the point of law. Bankruptcy is there to have a set of rules in place for the potentially catastrophic moment."

Warren believes there are two reforms necessary to make bankruptcy work for massive, interconnected financial firms. First, make the process as painful as possible for those responsible. "The bankers have to know that they'll go down with the ship," she says. "Under TARP, the executives got to keep their jobs and earn bigger and fatter bonuses than ever before." Wall Street needs to know, she says, that if their institutions falter, top management will get sacked, shareholders will be wiped out, and creditors will get back pennies on the dollar. "It has to be tough enough so that the Goldman Sachs of the future will want to manage themselves – no matter what – to avoid bankruptcy."

The second key, Warren says, is to close the loophole that Wall Street lobbyists carved out in 2005, when Congress overhauled the nation's bankruptcy laws. Before the latest crisis, Chapter 11 bankruptcy was a tool powerful enough to wind down even massive, interconnected institutions like Enron. But the loophole introduced in 2005 allowed the holders of derivative contracts to ignore the freeze on a bankrupt company's assets. The collapse of Lehman Brothers brought the entire economy to its knees, says Warren, because derivatives holders were allowed by law to make a run on the bank, hollowing out Lehman's carcass while the firm's other creditors were frozen out. The resulting panic sparked a market-wide contagion, which led to TARP. If financial reform doesn't shut down this derivatives loophole, Warren warns, "it's not real."

The tricky part of big-bank bankruptcy, Warren knows, is that taxpayer money may have to be made available to "fund runways for the bad landings." That requires Congress to perform a balancing act: It needs to hold banks accountable for their mistakes while injecting enough money into the system to stop a cascade of failures. "If they don't find a way to calm the creditors, then the next Uncle Hank won't use the bankruptcy authority," says Warren. "Instead, he will do a wholesale bailout – which is TARP 2.0."


Stop Cooking The Books

The good news is that Warren's first two rules have a significant chance of becoming law. The House has already passed a version of the CFPA. And the bill under consideration in the Senate grapples seriously with bankruptcy authority – though Warren cautions that "the pieces are not all quite there yet."

The bad news is that there's another key to reform that's not contemplated in either bill: accounting reform. The fixes passed by Congress after the collapse of Enron in 2001, it turns out, were nothing but cosmetic changes that papered over the crisis. They did nothing to stop Lehman Brothers from inventing off-book accounting scams with code names like "Repo 105," or to force AIG to report the massive risks it was amassing, or to prevent Goldman Sachs from masking Greece's debt with phantom trades. "Was Enron a giant how-to manual?" asks Warren. "Have we learned nothing from Enron but how to do it? It's in everybody's analysis now of what went wrong in the current crisis – and yet there's virtually no serious call to deal with it."

If anything, funny-money accounting has received a federal seal of approval. Remember all those "toxic assets" that TARP funds were supposed to buy up and dispose of? They're still on the books of big banks. The only thing that's changed are the accounting rules. With a wink from federal regulators, banks can now pretend that such assets are worth more than any buyer would pay for them. The same behavior has defined the response to the looming crisis in commercial mortgages. By the end of 2010, Warren calculates, half of all commercial real estate loans will be underwater. But so far, the government's response has been, once again, to simply tweak the rules for how to account for loans in default.

The goal of financial reform is to lay out the rules of the road for the next 50 years. But the best guardrails, Warren says, aren't going to make much difference if our economic engine blows up because we failed to make the necessary repairs. With toxic assets and commercial real estate, the economy's "check engine" light has gone on twice. But instead of fixing what's wrong, we effectively told the mechanic, Just turn off the damn light. This "extend-and-pretend approach," says Warren, destroys transparency and makes financial statements meaningless. "If this part doesn't get fixed," she warns, "then every effort to rebuild the economy will ultimately fail."

Warren knows that passing real reform will be tough, given the influence of Wall Street. Over the past decade, the financial sector has spent nearly $4 billion – more than any other industry – to sway policy in Washington. Capitol Hill now swarms with more than 1,400 bank lobbyists – three for every member of Congress. Chris Dodd, the chairman of the Senate Banking Committee, is not seeking re-election, in part, because of a scandal in which the nation's largest subprime lender gave him a sweetheart deal on his mortgage. And President Obama's top economic advisers played a central role in lifting key regulation, as Larry Summers did in the Clinton White House, and failing to police the reckless bets that caused the crisis, as Timothy Geithner did as head of the New York Fed. "There are times I despair," Warren says. "A year and a half ago, I thought that the will would be there to rewrite the rules of the road. But the Wall Street lobbyists have so dominated the conversation in Washington that even the most obvious reforms have become a heavy lift."

But Warren hasn't given up. In recent weeks, she says, the prospects for meaningful reform have gotten considerably brighter, thanks to the president's victory on health care. "There was a point that Washington would have accepted anything," she says. "A couple of statutes that there could be a nice signing ceremony around – and everyone dusts their hands off and says, 'That's great. We're done.' But we're past that point. I don't think they can get away with that anymore."

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