Exploring the Impacts of Governmental Regulations
on the Financial Industry Surrounding the Great
Recession
Zack Fisher
Management 302
The Stakeholder Organization
Professor Comas
12/13/14
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Table of Contents
Executive Summary……………………………………………………………………………….3
Before the Crash: 1980-2007……………………………………………………………………...4
The Economic Collapse: 2008…………………………………………………………………….7
The Great Recession: 2008-2009………………………………………………………………...10
Introduction of New Regulations………………………………………..……….........................12
Results of New Regulations……………………………………………………………………...14
Moving Forward: 2014 and Beyond……………………………………………………………..16
Works Cited…………………………………………………………………………...................18
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Executive Summary
September 15th, 2008 was a day that will live in infamy in the annals of the history of the
United States. That Monday morning brought the announcement of the titanic investment bank
Lehman Brothers filing for Chapter 11 bankruptcy protection. The collapse of Lehman Brothers,
an iconic American financial institution for 158 years, set off a chain of reactions that would
drastically alter the financial industry and the way Americans viewed it. Lehman Brothers was
just the tip of the iceberg, as the country fell into its most serious period of economic decline
since the Great Depression in the 1930s. Later dubbed “The Great Recession”, this period was
kicked off with the collapse of Lehman Brothers.
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This report will focus on what happened before, during, and after the Great Recession.
Specifically, what were the impacts of the deregulations that preceded the downturn and
regulations that followed it? Has Wall Street and the financial industry really changed in a way
that will prevent another serious crisis from occurring?
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http://sync.democraticunderground.com/10021662221
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Before the Crash: 1980-2007:
The roots of the Great Recession can be traced back to over 25 years before the actual
recession took place. Governmental decisions made as far back as the early 1980s played a
strong role in the economic collapse. After significant economic struggles during the late 1970s
under Jimmy Carter’s administration, new President Ronald Reagan sought to make Wall Street
and the White House see eye-to-eye. The financial industry had been tightly regulated. Most
regular banks were local businesses, and they were prohibited from speculating with depositor’s
savings. Investment banks, such as Lehman Brothers, were small, private partnerships (Ferguson
9). Reagan’s administration sought to loosen the reins on the financial industry in an effort to
stimulate economic growth and prosperity. In 1982, the administration deregulated savings and
loan companies, which essentially ended Depression era New Deal restrictions on mortgage
lending (Krugman). This act set the tone for a new way of thinking regarding how Americans
handled their money. Gone were the days of saving as much of your income as possible. Instead,
with the memory of the Great Depression long in the rearview mirror, people and companies
overextended themselves and began making riskier and riskier investments.
The deregulation that took place throughout the 1980s led to an explosion of the
American economy. Investment banks went public, which gave them enormous amounts of
stockholder money. As a result, people on Wall Street began to get rich (Ferguson 13). This
growth of the financial industry was almost like an addiction for American society. People got
hooked and became rich. No one wanted no slow the good times, not even the government.
Deregulation continued in the 1990s under Bill Clinton’s administration. The financial sector had
grown so dominant that it captured the political system. During this time, massive financial firms
such as Lehman Brothers became highly leveraged and heavily invested in subprime mortgages
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or mortgage-backed securities. By the late 1990s and early 2000s, big banks like Lehman
Brothers, Morgan Stanley, Merrill Lynch, and Bear Stearns enjoyed a high level of prestige,
along with record-breaking profits (Kakani 2). The center of the American economy, which
previously featured historic companies such as General Motors and Ford, now focused on these
massive financial institutions. By the late 1990s, the financial sector had consolidated into a few
gigantic firms (Ferguson 14). The problem this created was that the financial firms were
incredibly intertwined with the entire economic system, to the point where their failure could
threaten to destroy the entire American economy.
The Clinton administration only aided the rapid expansion of the bloated financial firms.
In 1999, Congress repealed the Glass-Steagall Act of 1933, which was originally passed during
the Great Depression. It was repealed in response to the previously illegal merger of Citicorp and
Travelers. Citicorp and Travelers merged to form Citigroup, the largest financial services
company in the world (Ferguson 15). By the 2000s, five investment banks and two financial
conglomerates had an overwhelming amount of power and control over the American economy.
The investment banks were Goldman Sachs, Lehman Brothers, Bear Stearns, Merrill Lynch, and
Morgan Stanley, while the other two powerhouses were JP Morgan and the aforementioned
Citigroup. Unfortunately for the average American, these firms were taking an increasing
amount of questionable risks with people’s money. As previously discussed, lending agencies
now had no real regulation, and virtually anyone could secure a loan, regardless of their realistic
ability to repay it. Firms started lending money to borrowers that did not qualify for “prime”
mortgages. These subprime mortgages had a higher interest rates and fees, and carried a much
greater chance that they would not be repaid (Rotemberg 3). The amount of subprime mortgages
being issued continued to increase quickly in the 2000s.
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The investment banks would buy the mortgages, prime or subprime from the lenders, and
then turn them along with other loans into Collateralized Debt Obligations (CDOs). These CDOs
were complex derivatives that the investment banks would sell to investors (Ferguson 23). Given
the inclusion of subprime mortgages in the CDOs, the CDOs clearly represented an extremely
risky investment. However, profits for investment banks increased greatly with the sale of CDOs,
and the massive financial firms soon found their balance sheets littered with toxic assets.
Total foreclosure-related legal filings from RealtyTrac
Quarter Filings
2005 Q1
. Q2 201,358
. Q3 223,224
. Q4 234,278
2006 Q1
. Q2 272,108
. Q3 318,355
. Q4 345,554
2007 Q1
. Q2 488,488
. Q3 635,159
. Q4 642,150
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Not surprisingly, foreclosures skyrocketed due to the increase in subprime mortgages. As a
result, the CDOs or mortgage-backed securities had no backing or support to prevent them from
imploding. The investment banks were stuck holding billions of dollars in loans, CDOs, and real
estate that they could not sell (Ferguson 46). As the calendar turned to 2008, economic disaster
was brewing although not many people appeared to see it coming. This overall lack of foresight
set people and companies up to be blindsided by potential economic issues. Unfortunately for the
nation, the subprime mortgages were a true powder keg, waiting to explode and cause the burst
of the ever-growing financial bubble.
Source: Compiled by casewriter with data from RealtyTrac. These filings include the “Notice of Default”, “Lis
Pendens” (also a legal notice to borrowers), “Notice of Foreclosure Sale”, “Notice of Trustee Sale”, and “REOs”,
which are instances where a bank repurchases its foreclosed property.
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The Economic Collapse: 2008
By the spring of 2008, the financial bubble was on the brink of bursting. Decades worth
of risky investments and leveraging had placed all seven major financial institutions in hot water.
However, just how hot was yet to be determined. It’s remarkable that top executives failed to see
the impending collapse coming. Executives such as Lehman Brothers CEO Dick Fuld and
Merrill Lynch CEO John Thain were seemingly blinded by the enormous profits their firms were
making, leading to massive personal bonuses as well. However, Fuld got a phone call from
Treasury Secretary Hank Paulson on March 15th, 2008 that would kick-start the decline of
Lehman Brothers in what would be it’s final year of existence. Paulson was calling to give Fuld
news that the Fed had arranged for Bear Stearns to be sold to JP Morgan for only $2 a share. If
Bear Stearns had not been sold, it would have gone bankrupt Monday morning, despite the fact
that it’s stock was still trading at $30 a share on Friday (Sorkin 11). The collapse and subsequent
sale of Bear Stearns was shocking, and had serious effects on the stock market and the economy.
However, the sale was really just the tip of the financial iceberg, foreshadowing the negative
events that would stricken the nation’s economy in the coming six months.
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Bear Stearns’ heavy involvement in the mortgage market played a significant role in their
decline and eventual sale. The massive financial institution had suffered a “run” when lenders
stopped providing financing and counterparties unwound positions and withdrew cash from the
firm (Rose 6). Bear Stearns simply did not have the necessary capital available, and soon ran into
a liquidity crisis. The government bailed out Bear Stearns by arranging the sale to JP Morgan. In
the mind of the Fed, Bear Stearns had to be bailed out in order to prevent a major negative
impact on the economy as a whole. Unfortunately for Lehman Brothers, Merrill Lynch, and the
other investment banks, their balance sheets were filled with the same toxic assets that had
driven Bear Stearns into the ground. Bear Stearns was the first firm to fall, but it would not be
the last.
In the following months, Lehman Brothers and other firms attempted to right the ship by
raising new capital and restoring investor confidence. However, despite what happened to Bear
Stearns, nobody seemed to understand the magnitude or the severity of the situation. As late as
June 5th, 2008, Federal Reserve Chairman Ben Bernanke had declared, “at this point, the troubles
in the subprime sector seem unlikely to seriously spill over to the broader economy or financial
system” (Sorkin 89). Unfortunately, as the summer wore on, it became increasingly apparent that
several prestigious firms, especially Lehman Brothers and Merrill Lynch, were in serious
trouble. By September, Lehman Brothers’ stock price had fallen to single digits. Merrill Lynch,
sensing that they would be the next firm to fall after Lehman, began to look for a potential buyer
that they could make a deal with to save their firm. If Lehman were swallowed up, there would
be a run on the next biggest broker-dealer. This left Merrill Lynch, perhaps the most iconic
investment bank in the nation, on the brink of ruin (Sorkin 312). John Thain, CEO of Merrill
Lynch, and Ken Lewis, CEO of Bank of America, were able to reach a merger deal on Sunday,
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September 14th for $29 dollars a share. It was a far cry from the close to $80 that Merrill Lynch
had been selling for, but the firm was saved.
Unfortunately for Lehman Brothers, there was a reason Bank of America chose to acquire
Merrill Lynch instead. Merrill was in bad shape, but Lehman was significantly worse. With
Merrill Lynch now off the table as a buyer and Monday morning rapidly approaching, CEO Dick
Fuld was running out of options. Only Barclay’s remained as a potential buyer, but news arrived
that the British government required a shareholder vote to secure the deal. There was no way
such a vote could take place before the US markets opened Monday morning (Brandriff 1). Fuld
was out of options, and had no choice but to declare Chapter 11 bankruptcy protection for his
beloved, 158 year old firm.
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Paulson, Bernanke, and other government officials knew the backlash from allowing Lehman to
go bankrupt would be severe. After all, these were the men who orchestrated the Bear Stearns/JP
Morgan merger/bailout. However, the intensity with which the US economy reacted to the
collapse of Lehman Brothers triggered an economic downturn unlike any seen in this country
since the Great Depression in the 1930s.
4
http://www.ft.com/cms/s/0/d9792572-8358-11dd-907e-000077b07658.html#axzz3LlFOknRo
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The Great Recession: 2008-2009
The stock market and entire United States economy plummeted following the
announcement of Lehman Brothers’ bankruptcy on September 15th, 2008. Thousands of jobs
were lost, unemployment rose, and people suffered significant financial losses. The collapse of
Lehman Brothers and the merger of Merrill Lynch and Bank of America destroyed investor
confidence. As a result, investors pulled large amounts of money out of the investment banks,
causing serious liquidity problems for Morgan Stanley and Goldman Sachs. People and experts
alike were shocked that the Fed allowed Lehman Brothers to fail, especially after they arranged
for Bear Stearns to be saved six months earlier through the JP Morgan deal. Lehman Brothers
was seen as “too big to fail”, and now that it had unexpectedly crumbled to bankruptcy, no one
knew what would happen next. Uncertainty and rumors ran rampant about which investment
bank would be next to fall. People even wondered if 2008 would mark the end of the American
financial system as we know it.
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To make matters worse, global insurance giant AIG was teetering on the brink of bankruptcy as
well due to a lack of liquidity. The collapse of AIG, following Lehman’s bankruptcy, would
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threaten to destroy the American economy and send the country into a depression rivaling the
Great Depression over seventy years prior. The US government had to act.
Paulson, Bernanke, and New York Federal Reserve President Tim Geithner spearheaded
the government’s response to the crisis. The government reacted by creating huge stimulus
packages that greatly increased national deficits and debts and by loosening monetary policies by
dropping interest rates close to zero, which hugely expanded the money supply (Cadieux 1).
Additionally, the Federal Reserve offered bailout money to AIG and individual banks in an effort
to prevent them from failing. After all, these financial institutions had grown over the previous
two decades to a level where they truly were “too big to fail.” As American’s struggles extended
through 2008 and into 2009, the disconnect between Wall Street and the everyday person
continued to grow. People blamed a lack of responsibility on Wall Street for what happened, and
pointed to the government bailouts, which cost billions in taxpayer money, as examples of just
how the financial industry had become.
Middle class, everyday Americans were crushed by the financial crisis. Families had
borrowed an extensive amount of money to finance their homes, cars, educations, and more.
Between 1980 and 2007, the bottom ninety percent of Americans were losing ground. The
majority of the money lost by the middle class went to the top one percent of society. For the
first time in this country’s history, average Americans had less education and were less
prosperous than their parents, all as a result of the greed and irresponsibility on Wall Street that
led to the Great Recession (Ferguson 69). By late 2009, the investment banks seemed to be back
on track. Goldman Sachs received a record profit of $13.4 billion in 2009, and the firm paid out
$16.2 billion in employee bonuses. This figure broke down to a staggering $498,000 per
employee (Sorkin 545). With unemployment still around ten percent, this drastic difference in
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success between Wall Street and the everyday American was startling given the events of just
twelve months before. President Barrack Obama had taken office in 2009 on the promise of
significant reform efforts geared towards Wall Street, and took to chastising the financial
industry publically. On CBS’s 60 Minutes, President Obama declared, “I did not run for office to
be helping out a bunch of fat-cat bankers on Wall Street” (Sorkin 546). Changes clearly needed
to be made to Wall Street and the financial system. Fresh regulations had to be put in place and
enforced to reign in the financial industry and prevent a collapse like the Great Recession from
occurring again. However, the question remained: Was President Obama merely paying lip
service to the need for financial regulations in order to secure political support, or was his
administration bent on making significant reforms that would protect the economy and limit
Wall Street’s incredible power moving forward?
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Introduction and Analysis of New Regulations
From the start, there were concerning signs from the Obama administration that pointed
towards Wall Street not being held accountable for the Great Recession. First, Obama selected
Tim Geithner to be his Treasury Secretary. Geithner, who previously served as the President of
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the New York Federal Reserve, was instrumental in the bailouts and mergers that took place in
the Fall of 2008. Additionally, Obama picked Gary Gensler, a former Goldman Sachs executive
who helped ban the regulation of derivatives to lead the Commodity Futures Trading
Commission (Ferguson 70). To compromise matters even more, Larry Summers was appointed
Obama’s chief economic advisor. Summers was Bill Clinton’s Secretary of the Treasury in 1999
when the Clinton administration abolished the Glass-Steagall Act (Fingleton). Once in office,
Obama clearly did not surround himself with economic advisors who promoted regulation and
holding the investment banks accountable, which seemed contradictory to his previous campaign
statements. After Obama took office, much needed reforms and regulations were slow to be put
in place.
By mid 2010, not a single senior financial executive had been criminally prosecuted, or
even arrested. Additionally, not a single financial firm had been prosecuted criminally for
securities or accounting fraud, and the Obama administration had made no attempt to recover
any of the compensation given to financial executives during the bubble (Ferguson 72). The
economy was slowly recovering, but at great cost to society. Somehow, the financial institutions
and their executives that caused the crisis remained in power, with no new regulations to control
them. However, all of that was supposed to change on July 21st, 2010. On that day, President
Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, or
Dodd-Frank. After years of waiting, Dodd-Frank was supposed to bring about the sweeping
reforms that the financial industry desperately needed. President Obama publically declared that
he’d dealt a significant blow to the excessive financial corruption that had caused the Great
Recession. On the day Dodd-Frank was signed into law, Obama stated, “These reforms represent
the strongest consumer financial protections in history. In history. The American people will
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never again be asked to foot the bill for Wall Street’s mistakes” (Taibbi 1). Originally, the act
was seen as a great political move, one that would curtail the investment banks and restore
credibility and honesty to the financial system. Dodd-Frank was widely considered to be the
strongest piece of financial reform since the Glass-Steagall Act was passed in 1933.
Dodd-Frank was a 2,300 page document that for all intents and purposes rewrote the
rules of Wall Street. The days of lavish executive compensation, reckless handling of investor’s
money, and constant promotion of risky investments were supposed to end with the passing of
Dodd-Frank. No longer would a financial institution be considered “too big to fail”. As a result,
the investment banks would be much more accountable and responsible, since they could no
longer rely on the government to bail them out of the mess they created for themselves. DoddFrank was going to put an end to predatory lending in the mortgage markets, crack down on
hidden fees and penalties in credit contracts, and create a powerful new Consumer Financial
Protection Bureau to safeguard ordinary consumers. Big banks would be banned from gambling
with taxpayer money (Taibbi 1). Additionally, the Volcker Rule within the legislation would
prevent banks from engaging in dangerous speculation (Taibbi 1). Dodd-Frank appeared to be
exactly what the country needed, and the legislation was praised nationally as such. However,
problems soon began to prop up, as those who praised Dodd-Frank drastically underestimated
the power the financial industry had grown to possess over the previous several decades of
deregulation.
Results of New Regulations
Clearly, Dodd-Frank greatly contrasted with the interests of the powerful financial
institutions. Despite the Great Recession, Wall Street saw no reason why it should change it’s
high-flying, risk taking ways. After all, Wall Street knew it had reached the point where it was
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indeed too big to fail. The investment banks were comfortable taking excessive risks with
investor’s money because they knew they could always count on the Fed to bail them out if
trouble arose. The economy could not afford the collapse of another investment bank after what
happened with Lehman Brothers. Following the enactment of Dodd-Frank, Wall Street and its
lobbyists set out to strangle the power and influence of the legislation.
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Unfortunately for the rest of the United States, the investment banks have succeeded in
strangling Dodd-Frank, leaving it almost toothless today. The once powerful piece of legislation
was destroyed by the banks following a strategy that offers a dependable blueprint of defeating
any regulations, and for guaranteeing that when it comes to the economy, might will always
equal right (Taibbi 2). Once Wall Street lobbyists were exposed to the original draft of the
legislation, they went to work watering down the bill so that the final draft beared little
resemblance to the original proposal. The strategic, impactful lobbyists attacked Dodd-Frank
with full force, strangling it from the get-go, bullying regulators, stalling votes, and passing
loopholes. Although the Obama administration pitched the bill as a powerful financial game
changer, the truth remains that the version of Dodd-Frank that was passed in congress wasn’t
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nearly as strong or regulatory as experts and politicians made it out to be. Wall Street flexed its
muscles to ensure that Dodd-Frank would not carry the brawn it was intended to. For example,
the Volcker Rule banning proprietary gambling survived, but not before getting its brains beaten
out in last minute conference negotiations with the assist of Treasury Secretary Geithner (Taibbi
3). Additionally, the Consumer Financial Protection Bureau, went from being a strong,
independently run agency to a smaller bureau buried deep inside the Federal Reserve System.
Geithner, Gensler and many others appointed by the Obama administration aided the lobbyists
in weakening Dodd-Frank before it was passed. Now over four years since the passing of DoddFrank, the act is without influence or competence due to actions by both Wall Street their fiends
in Congress and the White House.
Moving Forward: 2014 and Beyond
Overall, the Great Recession did not happen overnight. What took place in 2008 and
2009 was a financial crisis over two decades in the making. The Dodd-Frank Act did not do
nearly enough to curtail the actions of Wall Street and it’s major investment banks.
Unfortunately, the legislation was sunk for the same reason that the financial crisis happened in
the first place: Wall Street was too big to fail. Regulatory acts such as Dodd-Frank are great in
theory, but when dealing with financial titans such as Goldman Sachs, Morgan Stanley, and JP
Morgan, more drastic and impactful measures must be taken. Obama, Geithner, and the
Democratic leadership in Congress never seriously entertained enacting the most necessary and
obvious reform at all- breaking up the “systemically important financial institutions” (Taibbi 4).
This oversight was a crucial mistake. The bloated investment banks had been allowed to grow to
an enormous size since the 1980s. Their size created an interdependency and systemic
importance so substantial that it set off the financial crisis when Lehman Brothers imploded. Yet
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somehow, even today in the wake of the Great Recession no actions have been made to reign in
the size, influence, and control of the big-time financial institutions.
The only way to significantly change Wall Street and the financial industry in order to
avoid another financial crisis similar to 2008 is to break up the investment banks. Stripping,
Goldman Sachs, Citigroup, Morgan Stanley, and the others of their power and dividing them up
by banks, investment banks, and financial institutions would greatly limit the financial
capabilities of the industry giants. If the banks are no longer considered too big to fail, they will
be forced to act much more responsibly and honestly with their investor’s money. Honesty and
responsibility have been lacking from Wall Street for well over a decade now, eroded away by a
lack of regulation and an infatuation with excessive profits and luxury. Having the power and
money in the financial system consolidated in a few enormous firms is an extremely dangerous
way to operate, as seen in 2008, and it increases the systemic risk in the market. A less drastic
wealth distribution would alleviate the control of the dominant firms. However, to break up the
investment banks would take a systematic and industry wide commitment to change. The high
rollers on Wall Street would certainly not sit on the sidelines while their beloved firms and
inflated profits are broken into pieces.
A new generation of reformers in politics is needed to usher in such a drastic change. The
breakdown of the investment banks would be a long and difficult congressional fight, but with
the right leadership and support, the change could be made. As those who were involved with
Wall Street in the 1990s and 2000s begin to fade into obscurity, new voices will emerge. The
nation has a strong disdain for Wall Street following the Great Recession, and the right
leadership over the next decade could allow for breaking up the investment banks to take place.
The last thing this country needs is a repeat of 2008 because Wall Street remained too big to fail.
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Works Cited
Brandriff, Christopher, and George Allayannis. "The Weekend That Changed Wall Street."
Darden Business Publishing: University of Virginia (2009)
Cadieux, Danielle. "The Great Recession, 2007-2010: Causes and Consequences." The
University of Western Ontario (2010)
Fingleton, Eamonn. "The Fed Succession: Goodbye Larry Summers." Forbes Spring 2013.
Inside Job. Dir. Charles Ferguson. By Adam Bolt and Chad Beck. Sony Pictures Classics, 2010.
Transcript.
Kakani, Ram K. Lehman Brother's Fall. U of Western Ontario, 2012.
Krugman, Paul. "Reagan Did It." The New York Times [New York] 31 May 2009.
Rose, Clayton S., and Anand Ahuja. "Before the Fall: Lehman Brothers 2008." Harvard
Business School (2011)
Rotemberg, Julio. "Subprime Meltdown: American Housing and Global Financial Turmoil."
Harvard Business School (2008).
Sorkin, Andrew Ross. Too Big to Fail: The Inside Story of How Wall Street and Washington
Fought to Save the Financial System from Crisis--and Themselves. New York: Viking,
2009.
Taibbi, Matt. "How Wall Street Killed Financial Reform." Rolling Stone 22 Sept. 2012: 1-17.