An Interview with Charles R. Morris.
Millions of words have been written about the ongoing financial disaster largely caused by the subprime mortgage mess. But the most concise and easiest to understand handbook on the issue is almost certainly Charles R. Morris’ The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash. The book, published in March, spent several weeks on The New York Times best-seller list, and for good reason: The book explains in clear language exactly what happened and why.
Morris, a lawyer and former banker who lives in Manhattan, has written 11 books. His articles have been published in myriad publications, including Atlantic Monthly, The New York Times and BusinessWeek. He exchanged e-mails with Observer contributing writer Robert Bryce in early August.
Texas Observer: You wrote a recent piece for BusinessWeek in which you argue that it is “essential to shrink the hypertrophied financial sector.” Why has the financial sector grown so large over the past few decades?
Charles Morris: Financial rewards on Wall Street have been rising much faster than in the rest of the economy for about 20 years. Commerce Department surveys show that financial sector profits were more than 40 percent of all corporate profits in 2007, far out of proportion to their share of output. Those rewards sucked in the cream of each year’s B-school grads, top mathematicians and physicists, lawyers, etc. Couple that with the anti-regulatory atmosphere of the last couple decades, and we have seen an orgy of truly irresponsible, destructive “innovation”-anything to drive up earnings.
The subprime crisis was purely a Wall Street invention. Subprime lending had always been a tiny sliver of the mortgage market, mostly within the Federal Housing Administration. In 2004 or so, Wall Street realized they needed higher mortgage yields to sell the complicated, mortgage-backed structures that produced their biggest fees. They started acquiring subprime lenders, paying brokers premiums for high-yield mortgages and the like, until by 2006, high-risk mortgages were about a third of all new originations. Nobody seemed to care that most of them could never be repaid; the focus was just on the fees. It’s not much different from what happened with the infamous “investment trusts” that National City and other big banks were flogging in the late 1920s.
TO: Perhaps the most important single deregulatory move of the past few decades was the repeal of the Glass-Steagall Act, a law created in 1933 that kept banks, insurance companies, and brokerage houses from merging with each other. Glass-Steagall was replaced by the Gramm-Leach-Bliley Financial Services Modernization Act (named for the trio of Republicans who sponsored it, Sen. Phil Gramm of Texas, U.S. Rep. Jim Leach of Iowa, and U.S. Rep. Thomas Bliley of Virginia), which was signed into law in 1999. How culpable is Gramm for our current mess?
CM: Gramm-Leach was part of the zeitgeist, and by the time it was passed, the big banks had long since worked around the old rules, so Glass-Steagall had already become virtually a dead letter. Investment banks had been stripping away the bread-and-butter lending businesses of the commercial banks, so Gramm-Leach was partly just an attempt to restore some balance. The root problem wasn’t Gramm-Leach, but the prevailing dogma that self-regulated markets were inherently superior to supervised markets.
TO: Speaking of Glass-Steagall, you wrote in your book that Congress “should seriously consider restoring some version” of it, including the separation of commercial banking and investment banking. Why is this so important?
CM: Over the long term, financial sector profits have been about twice as high as corporate profits as a whole, which flies in the face of economic theory. High peak profits at financial companies make sense because they are so highly leveraged. But that should also expose them to commensurately greater losses, so profits would be about average over the cycle. But we tend to socialize financial sector losses, as we’re doing now, while allowing partners and shareholders to keep their profits from the booms.
I think we need a rigid distinction between regulated and unregulated financial companies. Only the regulated sectors would have access to deposit insurance, the Fed window, etc., while there would be strong legal bars against government support for the unregulated sector. [The “Fed window” refers to lending that the Federal Reserve normally provides to depository commercial banks. The Fed recently opened its “window” to Wall Street investment banks.]
The regulated sectors would have strict leverage rules, and be intentionally a bit boring. Enforcing such distinctions would require very carefully crafted legislation. And I admit it would probably be hard to pass. Everyone deplores “moral hazard,” but bankers make a lot of money when they succumb to it.
TO: In our recent phone conversation, we talked about the role of hedge funds and their use of leverage, which is magnifying the potential damage of the derivatives now being employed. You said, “We can’t control hedge funds. But we can stop regulated banks from lending to hedge funds.” What effect will that prohibition on lending have?
CM: There are many different kinds of hedge funds, of course. But a common strategy is to earn outsized returns by using extremely high leverage; and the leveraged lending, most of the time, comes from banks. If rich people want to invest in high-risk, high-leverage undertakings, that’s their business. But regulated banks with a potential claim on public support shouldn’t be allowed to lend to them, or be allowed to lend only with a very high capital penalty. If a hedge fund, or a highly leveraged investment bank, a Goldman Sachs, say, is at risk of failing, the core banking and payments system won’t be at risk. The corollary of that, of course, is that if a hedge fund or an unregulated investment bank, say, gets into big trouble, they must simply fail, no matter how much damage it causes, which is why the barriers to a bailout would have to be written into law. Markets can’t work if there is a “social safety net” for the biggest players.
TO: It’s obvious from your book that you are no fan of Alan Greenspan and his laissez-faire attitude toward financial markets. How responsible is he for our current situation?
CM: To state it as generously as possible: Greenspan is the classic case of a good man in a job for much too long. Starting with the 1987 market crash, he built his reputation as a financial genius by intervening, often very adroitly, to supply fresh market capital at moments of crisis. He did the same thing after 9/11 and the 2001-2002 recession, but then kept rates much too low for much too long. His anti-regulatory zealotry also blinded him to the obvious asset bubble building up. And that’s not hindsight; there were a lot of warnings, including from other governments.
TO: Given your book’s take on Paul Volcker and how he addressed the problems in the U.S. economy in the 1980s, it appears that you favor higher interest rates as a way to strengthen the dollar and therefore restore credibility to the U.S. financial system. That will almost certainly lower oil prices. It’s also likely to trigger a sharp recession. But you think that a quick (and likely painful) recession is the best cure for our financial ailments. Why?
CM: By my rough count, the federal government has already poured some $2 trillion into propping up the financial sector-that’s including new Fed lending facilities, expanded lending by Freddie and Fannie (much of which goes to buying up mortgages from banks), the spending rebates, the new housing bill, and so on.
Consumers have been spending far more than their incomes, at least since 2004 or so, personal savings rates are near zero, retirements are looming, we have crippling trade deficits and a collapsing dollar, which is a big factor in the oil price rise. And the current federal strategy is just to keep all that going, pouring in borrowed federal money to make up for the fall in consumer borrowing.
It’s the most shortsighted, let’s-get-through-the-next-month strategy possible-not unlike strapped consumers playing credit-card roulette. I fear we’re just making the ultimate reckoning worse and worse, much as Japan did when it covered up its asset bubble through the 1990s.
The recessions that Volcker triggered in 1981 and 1982 were awful, but he managed to wrench the country onto a radically different course. I don’t think there’s any choice. Consumer spending rates are still near an all-time peak relative to income, and overall debt is still rising. We need a radical change of course. Whether McCain or Obama wins the presidency, they should try to get this behind them in their first two years.
TO: I agree that we need better regulation of financial institutions. But it appears that financial chicanery happens on a regular, almost predictable cycle. In the ’80s we had Ivan Boesky and Michael Milken. In the ’90s we had the savings and loan debacle and the Barings Bank meltdown. In the early ’00s, we had Enron and Adelphia. We’ll never be able to stop all the scam artists, but will more regulation reduce the frequency of the disasters?
CM: My hopes are more modest than that. I just want to stop the scams going on now. If Wall Street and its lobbyists have their way, we’ll end up with a total Wall Street bailout, plus some cosmetic regulatory changes … It’s the same kind of thing that’s proved such a brilliant success at the Department of Homeland Security.
TO: Perhaps your most important recommendation is this: “Force tough leverage constraints on regulated institutions while moving all risky exposures onto the balance sheet.” Enron and other companies were experts at moving their risky assets off the balance sheet. If we are to achieve better regulation of assets and assure that they get properly accounted for on the balance sheet, won’t that require better funding of regulatory agencies like the Securities and Exchange Commission?
CM: There are two ways to defeat regulation: One is to pass toothless laws; the other is to pass tough laws and not finance them. The [Food and Drug Administration] is perhaps the classic case of the second one, even more than the SEC. But, yes, it’s pointless to create regulatory regimes without the tools to do their jobs.
TO: Your book is titled The Trillion Dollar Meltdown. Will the final cost be $1 trillion? Or more?
CM: More. It looks like probably $1.5 to $2 trillion at this point, although there may never be a final accounting.