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Partners, Not Regulators: The Federal Reserve’s Role In The Financial Collapse

Gretchen Morgenson and Joshua Rosner

This is an adaptation from “Reckless Endangerment”, an exploration of the origins of the recent financial crisis, by Gretchen Morgenson and Joshua Rosner. The book will be published today by Times Books. This excerpt examines the cozy relationship between Alan Greenspan’s Federal Reserve and the banks the Fed was charged with regulating. This is the second of three excerpts.

To regulators at the Federal Reserve Board, the financial crisis of 1998 and the collapse of the giant hedge fund Long-Term Capital Management had been an undeniably terrifying event. Officials at the prestigious New York Fed knew how extraordinary it had been for them to help the hedge fund; they were sensitive to the fact that they had aided in a speculator’s rescue and worked hard to downplay their role.

In the months and years after the rescue, many Fed officials spoke publicly of the lessons to be learned from the disaster. Chief among them were the dangers of increasingly interconnected world markets and economies and the threats of institutions that had grown so large that their failures could imperil the entire financial system.

“It was a humbling and enlightening experience for us all,” said Roger Ferguson, a member of the Board of Governors of the Federal Reserve, in a 1998 speech touching on the Long-Term Capital rescue. “It should cause all of us to reassess our practices and our views about the underlying nature of market risks.”

But this advice appears to have been for public consumption only because it went unheeded, especially within Ferguson’s own organization. Indeed, the Fed seemed to have conducted precious little soul-searching as the 1998 crisis receded into the mists of investors’ memories.

One big reason everyone felt they could move on from the LTCM mess was the stupendous performance of the stock market, especially the technology sector. It is an investing truth that rising markets create complacency and in late 1998, with the Dow Jones Industrial Average marching inexorably to the never-before-scaled 10,000 level, investors were especially unfazed. The index of 30 industrial stocks had started off the 1990s at 2,753, but in March 1999 it closed above 10,000 for the first time.

It was a bubble that would create tens of billions in losses and considerable angst when it popped in 2000. But while the good times were rolling, top financial regulators like Alan Greenspan exulted over the wonders of technological advancements. Although it was obvious to many that the technology stock mania would end badly, Greenspan and his colleagues at the Fed refused to tamp down the euphoria. They could have raised margin requirements, for example, increasing the amount of their own money investors had to put up to buy stock using borrowed funds.

Even as they ignored the stock market bubble, these very regulators were laying the groundwork for a subsequent, far more virulent mania in the credit markets – which helped finance, among other things, mortgages and home ownership. Regulators did this by siding with the banks that wanted to loosen the capital strings that bound them, too tightly they thought, in this brave new world.

Unfettered capitalism coupled with the ownership society – where individuals were invited to participate in the wealth creation engine of the financial markets – had become a potent combination. It had produced riches for corporate executives and considerable wealth for individuals, and had replaced federal deficits with an unheard-of government surplus, generated largely from taxes paid by investors on their market gains.

The belief that the free market could police itself better than any government regulator had already taken hold. So, even as Ferguson and other Federal Reserve officials paid lip service to the important lessons of the 1998 crisis, their actions showed that they ignored those lessons. Instead of heightening the scrutiny of risky practices among the big banks they oversaw, the Fed backed these institutions’ desires to reduce capital requirements and increase their leverage and profits. Instead of reining in financial institutions in areas that could result in losses, Fed officials loosened them.

In other words, the Fed was busy becoming a pushover, not a policeman.

“It was explicit in those years, if you worked inside the Fed, that you were partners with the banks,” said a former Fed official. “You were not adversaries.”

One of the banks’ crucial partners at the Fed, albeit behind the scenes, was Ferguson, the vice chairman. From 1997, when he joined the Federal Reserve as a governor, until he resigned to return to the private sector in 2006, Ferguson was a strong advocate for the banks among global financial regulators.

President Clinton appointed Ferguson vice chairman of the Fed in 1999. He began his career as a lawyer at Davis, Polk & Wardwell, advising some of the nation’s largest banks on mergers and acquisitions, initial public offerings, and syndicated loans. Davis, Polk was closely linked to the Fed; years later, during the financial maelstrom of 2008, the firm would advise the New York Fed on its various bailouts.

Ferguson was also the Fed’s point man on the Basel Committee, the group of central bankers and international financial regulators that met regularly to discuss and hammer out international banking standards. And according to those who interacted with Ferguson in this capacity, he consistently pushed for rule changes requested by the nation’s largest banks and that were beneficial to them.

In 1998, when the Fed governors voted 5-0 to approve the mega-merger of Citibank and Travelers, Ferguson abstained. His wife, Annette Nazareth, was a managing director at Smith Barney, a Travelers unit, when the application was being considered.

In a speech in October 1999 to the Bond Market Association in New York City, Ferguson outlined his preference for less, not more, regulation. “Heavier supervision and regulation of banks and other financial firms is not a solution, despite the size of some institutions today and their potential for contributing to systemic risk,” he said. “Increased oversight can undermine market discipline and contribute to moral hazard. Less reliance on governments and more on market forces is the key to preparing the financial system for the next millennium.”

A belief had arisen during the late 1990s that bankers had so improved their risk-management and loss-prediction techniques that regulators could rely on the banks to decide how much extra funding they needed to keep in their coffers in case of a financial downturn – a surplus guided by regulatory measurements known as “capital standards.”


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