CHAPTER 3

Interests

Dishonest dealing and speculative enterprise are merely the occasional incidents of our real prosperity.

—President Theodore Roosevelt to George B. Cortelyou, October 25, 1907

Despite recent abuses of the public’s trust, our economy remains fundamentally sound and strong, and the vast majority of business people are living by the rules. Yet, confidence is the cornerstone of our economic system, so a few bad actors can tarnish our entire free enterprise system. We must have rules and laws that restore faith in the integrity of American business. The government will fully investigate reports of corporate fraud, and hold the guilty parties accountable for misleading shareholders and employees. Executives who commit fraud will face financial penalties, and, when they are guilty of criminal wrongdoing, they will face jail time.

—President George W. Bush, weekly radio address, June 29, 2002

Never again should we let the schemes of a reckless few put the world’s financial system—and our people’s well-being—at risk.

—President Barack Obama, address to G20 Summit, September 25, 2009

IN THE EPIGRAPHS GIVEN HERE, Presidents Roosevelt, Bush, and Obama were doing their best to reassure financial markets when miscreants were in full public view. Roosevelt’s remarks came just after the unraveling of the corner on United Copper and three weeks before the suicide of the banker Charles Barney, who was caught up in the scandal. Bush’s radio address came the week before WorldCom’s recently resigned CEO Bernard Ebbers was to testify before the House Financial Services Committee. (“Bad actor” Ebbers is now serving a twenty-five-year sentence in a federal prison.) Obama was speaking at the time of a widespread populist reaction to the federal bailout of financial firms and to the large bonuses received by the executives of these firms.

Of course, few would challenge these presidents’ assertions about how a majority live by the rules. It is a taboo to express an opinion that almost everyone is, in fact, dishonest, or, at best, highly self-interested. This taboo is politically relevant because it legitimizes weak legal and regulatory standards and weak enforcement of those standards that do exist.

But the “few bad apples” theory invoked by the three leaders and others almost certainly understates the role of legally and ethically dubious behavior in generating the current and past financial crises. In the introduction to part I, we mentioned the steroid scandal in major league baseball. Baseball players typify the behavior of Americans. From jaywalking, to hiring illegal gardeners and nannies, to not paying social security taxes on legal domestics, to doing drugs, to cheating on taxes, to getting disability benefits when there is no disability, to speeding, to insurance fraud, and so on, most Americans engage in some lawbreaking on a daily basis. We should not expect business people and financiers to behave any differently.

With specific reference to the financial crisis, former hedge fund manager Michael Burry has expressed a position quite opposite to that of the presidents: “The salient point about the modern vintage of housing-related fraud is its integral place within our nation’s institutions.”¹ And President John F. Kennedy once privately proclaimed, “My father always told me that all businessmen were sons of bitches.”²

After his statement went viral, 1962 style, Kennedy did some public backtracking. In public, politicians must stick with the bad apples theory. This claim, however, invokes only half of the metaphor. The other half concerns spoiling the whole barrel. Competitive pressures in the marketplace force businesses and firms to push legal and ethical barriers simply to keep up with those firms that breach them. This was clearly the case in major league baseball as the pressure to keep up lured many more athletes into using banned substances. Bernard Madoff’s ability to lure billions away from other investment funds with his Ponzi scheme may not have led other firms to directly emulate his lawbreaking, but it is likely to have led others into more risky investments so as not to lose even more investors. Similarly, competitors of Bernie Ebbers and WorldCom may have made poor investments in an attempt to emulate the false profits shown in WorldCom accounting statements.³ The example most germane to the financial crisis is how the profits of investment banks in the first decade of the new century induced commercial banks to take on more risk to boost earnings.

Politics is also an important channel for the spread of rot. In some cases, market participants use political connections and influences to legalize and legitimate their currently illegal behavior. Our discussion of Phil Gramm in this book’s introduction drew attention to one of the most important examples of this phenomenon: Enron’s lobbying to exempt energy trades from government regulation.⁴ The lobbying was rewarded with the infamous “Enron loophole” in the Commodity Futures Modernization Act of 2000. We also saw, in chapter 2, how Fannie Mae’s 2003 annual report drew attention to that government-sponsored enterprise’s connections to Angelo Mozilo of Countrywide Financial. “Friends of Angelo” loans were received by Senators Chris Dodd (D-CT) and Kent Conrad (D-ND); George W. Bush’s Housing and Urban Development (HUD) secretary Alphonso Jackson; Clinton HUD secretary Donna Shalala; diplomat Richard Holbrooke; and James Johnson, former Fannie Mae head and adviser to Walter Mondale, John Kerry, and Barack Obama.⁵ (The Mozilo connection ended Johnson’s formal participation in the Obama presidential campaign, but it has not kept him from a directorship at Goldman Sachs.) In 2010, Mozilo agreed to a $67.5 million settlement with the Securities and Exchange Commission (SEC) to avoid trial on fraud and insider trading charges. Most of the settlement will be paid by Bank of America, which acquired Countrywide in 2008.⁶

Firms taking questionable risks, like Countrywide, may seek political protection from government intervention. Deniz Igan, Prachi Mishra, and Thierry Tressel show that it was the most risky lenders who lobbied against tightened lending rules in the subprime crisis.⁷ Thomas Romer and Barry Weingast indicate that it was the least solvent savings and loan (S&L) institutions that were the strong advocates for regulatory forbearance in the S&L crisis.⁸ These were cases where firms fought against tighter regulatory standards.

Disadvantaged firms might seek government relief from the effects of questionable activities. But often the relief they seek is not for the government to clarify or enforce existing law but for it to impose weaker standards. They seek changes to the law so that they can engage in the behavior causing the harm. This dynamic led to the 1999 repeal of the Glass-Steagall Act’s separation of investment and commercial banking. Many financial holding companies began exploiting loopholes in the law and its regulatory framework that allowed them to begin breaking down barriers between the two forms of banking. But rather than lobby for stronger laws and better enforcement, most of the companies who lost market share to the more integrated firms simply sought repeal so that they could compete. Similarly, the JOBS Act passed by Congress in 2012 weakened disclosure requirements for “emerging growth” companies. Appeals for lax regulation are facilitated by the “bad apples” taboo expressed in the reassuring words we cited from Presidents Roosevelt, Bush, and Obama at the beginning of this chapter. If fraud and other agency problems are rare and sporadic rather than epidemic, the financial elite can indulge in the self-serving belief that markets can self-regulate.

What explains the taboo? Politicians are much less reluctant to claim that ghettos are full of earned income tax credit fraudsters, welfare queens, drug dealers, and violent criminals. Politicians observe no taboo against singling out some categories of Americans as having a proclivity for crime; why not the financial services industry? Undoubtedly because the industry packs political power and can deliver rewards to the Phil and Wendy Gramms. We emphasize that the Gramms were far from unique. As we indicated in this book’s introduction, the board of American International Group (AIG) was stocked with former officials from both Republican and Democratic administrations. In addition, White House advisers including Larry Summers, Franklin Raines, Peter Orszag, and Rahm Emanuel found their way to Wall Street or Fannie Mae at one time or another.

Our point here is that although overtly illegal behavior is important for understanding financial crises, even more focus should go to activities that qualify as legal. It’s the “honest graft” of special interest politics that packs a real punch.

The Power of Special Interests

How do special interests such as those in the financial services industry influence political decision makers? Political scientists tend to focus on three different channels of influence: mobilizing constituencies, direct political expenditures in the form of campaign contributions, and the production and provision of information through lobbying. We consider each of these channels in turn.

Mobilizing Constituencies

As we discussed in the previous chapter, members of Congress do not simply channel the views of their average constituent into the legislative process. More often than not they bring their own beliefs and ideologies to bear on the decisions they make. But this is not to say that constituency preferences are not important in many circumstances. In particular, on highly salient issues toward which active constituents have strong, well-informed preferences, politicians are quite likely to heed such views.

Unlike such interest groups as the National Rifle Association (NRA) or the AARP (formerly the American Association of Retired Persons), the power of the financial sector does not arise from the raw numbers of voters it commands. Indeed, employment in the financial sector is small, but concentrated in certain regions: New York City, New Jersey, and Connecticut. As one can see from table 3.1, no congressional district has more than 14 percent of its labor force working in the financial or insurance sectors.⁹ The real estate sector (see table 3.2) is smaller and less concentrated, but it is overrepresented in places like Florida, California, and Nevada, where the housing bubble was the greatest.

But despite the small size of these groups, members of Congress are very responsive to their views. First, as we saw above, employees in the financial sector are quite well-to-do. In a recent book, Larry Bartels argues that senators are considerably more responsive to the opinions of high-income than middle-income constituents, and not responsive at all to the views of low-income citizens.¹⁰ Also (as is true for many industries) workers in the financial sector are well informed about how various laws and regulations affect their industry. They are likely to know when a legislator or regulator makes a decision adverse to those interests (and plenty of industry groups are ready to inform them if any decision escapes their attention).

The political influence of the big banks has grown in recent years as a consequence of the ending of restrictions on interstate branch banking and on brokerage activities by commercial banks. Just as defense contractors have long benefited from lobbying by subcontractors scattered throughout the country, Bank of America, Citibank, JPMorgan Chase, and Wells Fargo now have branches in most congressional districts. McBank has replaced the Bailey Building and Loan of It’s a Wonderful Life.

TABLE 3.1

Top 25 House districts for finance and insurance employment in 2000

In many ways, the political influence of the financial services industry is similar to that of other sectors of the economy. If financial services lobbying had undue influence on the Dodd-Frank Wall Street Reform and Consumer Protection Act and its subsequent implementation, the same could be said for the health care industry with regard to both Bush’s prescription drug plan and Obama’s health care bill. The retail drug industry and the hospital industry have, like retail banking, become more concentrated.

TABLE 3.2.

Top 25 districts for real estate employment in 2000

One area where the financial sector excels and is distinct is political participation. Reflecting the importance of politics to their industry, employees of the financial sector are actively engaged in politics. One aspect of this engagement is heavy participation in electoral politics. In the 2004 American National Election Study (ANES), 88 percent of those employed in finance and insurance reported voting in the presidential election compared to just 76 percent of the other respondents.¹¹ Employees in the financial sector are also more likely to

•   Try to influence the votes of others (53 percent to 48 percent)

•   Attend a campaign meeting, rally, or speech (13 percent to 7 percent)

•   Work on a campaign (5 percent to 3 percent)

Not surprisingly, the political engagement of the financial services industry is even stronger in the area where money counts: campaign contributions. A full 25 percent of the ANES financial services industry respondents report making a campaign contribution in 2004, compared to just 8 percent of those who worked outside the sector. However, as we discuss below when we present the sheer magnitude of financial services campaign contributions, this seventeen-point gap radically understates the political mobilization of this sector.

Another factor that works in favor of the financial industry is that legislators are not likely to feel much cross-pressure from other constituents on matters related to finance. Such matters are technically complex and not very interesting to most voters. Voters whose stock portfolios and homes are appreciating in value may be hard to convince of a need for more financial regulation. Consider the mutual fund scandals that came to light in 2003. Mutual fund traders had a practice of executing “late trades” at the previous day’s closing price. This practice essentially represents an illegal transfer from the accounts of regular mutual fund clients to the late traders.¹² Although the practice violates security laws, it appears to have been widespread before New York attorney general Eliot Spitzer and the SEC began their investigations.¹³ These illegal trades were facilitated by regulations that in principle allowed after-hours trades to be executed at the closing price only if the order was made prior to closing. But lax enforcement led to rampant cheating of individual investors in favor of institutions. The complexity of the regulations surrounding these practices and the fact that individual mutual fund investors were still making money (though perhaps not as much) meant that there was little political pressure to investigate before Spitzer stepped in. Afterward the SEC proposed a “hard close” rule that prohibited executing any orders at the previous closing price after 4 p.m. But after extensive industry lobbying the rule was abandoned.

Political pressure against the financial sector builds substantially only during a crisis and in its aftermath. For example, Atif Mian, Amir Sufi, and Francesco Trebbi find that high foreclosure and delinquency rates among Republican constituents led many Republican legislators to support the Housing and Economic Recovery Act of 2008, which contained government subsidies for renegotiating mortgages.¹⁴ But in many cases, the cross-pressure emerges not as well-informed opposition to financial market deregulation or executive compensation practices but as a populist anti–Wall Street reaction. Constituency pressure to rein in executive compensation and bonuses was obviously an important factor in the House of Representatives’ vote to tax AIG retention bonuses at a punitive rate of 90 percent. In chapter 7 we show that Republican House members running for reelection in 2008 were less likely to support Secretary Paulson’s initial Troubled Asset Relief Program (TARP I) than were those Republicans who had announced their retirement.

Financing Campaigns

The second weapon in the arsenal of financial interests is direct political expenditure through campaign contributions to legislators, presidential candidates, and political parties.

The importance of campaign contributions in determining policy outcomes may be exaggerated.¹⁵ Lehman Brothers is a particularly salient example. From 2004 to 2008, Lehman employees made substantial contributions, less than those of Goldman Sachs, Citibank, and JPMorgan Chase, but ahead of Bank of America.¹⁶ These contributions did not save Lehman from bankruptcy. It is, moreover, often the case that there is conflict within the financial services industry over policy change. Randall Kroszner and Thomas Stratmann argue that Glass-Steagall survived for sixty-six years in large part because the financial services industry, split into securities, commercial banking, and insurance sectors, could not agree on the nature of reform. Each sector, in turn, used contributions to compete for influence against the other two sectors.¹⁷ Outside of the financial sector, the importance of interindustry competition has recently been highlighted by the conflict between entertainment and Internet organizations over the regulation of Internet piracy. But greater consolidation of different business lines into large financial holding companies has muted these intrafinance conflicts over policy.

On the other hand, even if no firm or sector wins all the time, there is little doubt that the campaign cash the financial industry contributes in each election cycle boosts its clout in Washington. When the industry “has its act together,” coordinated contributions can change policy. An example is the change in bankruptcy law in 2005 brought about by the stealthily named National Consumer Bankruptcy Coalition, which coordinated contributions for major creditors.¹⁸

Using data provided by the Center for Responsive Politics (CRP),¹⁹ we can examine in some detail the extent of the campaign fundraising undertaken by the financial sector. Figure 3.1 reveals that campaign contributions from the financial sector increased almost threefold between 1992 and 2008, even after adjusting for inflation. This growth exceeds that of all of the industrial sectors tracked by the CPR with the exception of the legal profession.

The current magnitudes of giving are also astonishing. Four subsectors of the industry are in the top ten of all industry contributors (securities and investments, real estate, insurance, and miscellaneous finance). Combined, the industry contributions swamp the second-place industry—the legal profession.²⁰

Figure 3.1. Campaign contributions from the financial sector. Campaign contributions from the financial sector have increased sharply, especially from securities, investment banking, and real estate, the sectors most involved in the subprime mortgage crisis.

Figure 3.1 also reveals that the growth in financial industry contributions has been concentrated in two sectors: securities and investments, and real estate. Securities and investments, in contrast to commercial banking, is the sector that Philippon and Reshef identify as accounting for most of the wage increases in financial services relative to other sectors of the economy.²¹ It is certainly no coincidence that financial services and real estate played such a big role in the 2008 financial crisis.

Moreover, a few firms and trade associations account for the bulk of the contributions. The largest political action committee (PAC) contributor in the 2010 election cycle in the commercial banking sector was the American Bankers Association. The board of this association is basically controlled by the four big national banks, JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo. The big four and the association donated $4.9 million of the total $9.0 million contributions from the commercial banking sector PACs. Goldman Sachs, Credit Suisse, and UBS had the fourth-, fifth-, and sixth-largest PACs in the securities and investments category. In total campaign contributions, which include money given directly to political parties as well as to candidates, Goldman Sachs, at $38.3 million, and Citibank, at $29.5 million, were the second- and third-largest corporate contributors from 1989 to 2012. (AT&T was the largest.)

Of course, it is not simply the magnitude of the contributions that matter but the way they are allocated. Figure 3.2 demonstrates how different financial sectors allocated their money across the two political parties since 1990. Two features stand out. The first is the importance of majority party control of Congress. The financial industry tends to shift its contributions based on which party controls Congress. Before 1994, a majority of the money went to the Democratic Party, which controlled the House and the Senate. Following the 1994 elections, contributions shifted dramatically in favor of the newly empowered Republicans. This is especially true of the contributions from insurers and commercial banks. Following the Democratic takeover in 2006, the money switched back to about where it had been in the early 1990s. It shifted back to the Republicans again after the 2010 midterm elections.

The second important point is how well the Democratic Party has done with the securities and real estate industries even during the period when it had little power in Washington. Although it may seem inconsistent with the Democratic Party’s liberal ideological orientation, the financial sector has become a very important constituency for the party. Indeed, it has become the “money” wing of the party that helps compensate for the increasingly downscale “votes” wing of the party. Many factors helped seal this alliance. The first is that much of the financial sector is located on the socially liberal coasts—in New York, Boston, Los Angeles, and San Francisco.²² It is not surprising that these areas would support liberal social and cultural causes through the Democratic Party. Perhaps not all of the money is intended to influence the Democrats on financial matters, yet clearly, the level of these contributions heightens the party’s sensitivity to those interests.

Figure 3.2. Democratic share of contributions. The Democrats have always received a substantial share of the contributions from the financial services industry. Their share is greatest when they control Congress. The figure shows contributions over each two-year election cycle. The period 1995–2006 represents years when the Republicans controlled the outgoing Congress. The Democrats controlled in 1989–94 and 2007–10.

From the party’s perspective, high finance makes an ideal money wing almost as good as Hollywood. Unlike many other industries, hedge funds and banks do not directly pollute the environment and do not have especially tendentious labor relations. Thus, the industry has relatively little conflict with other Democratic constituencies such as environmentalists and labor unions.²³ Goldman Sachs is notably welcoming to gay men and lesbians.²⁴ Criticism of hedge funds, in particular, by other Democratic constituencies is difficult due to the light disclosure requirements for their activities. Of course, as we will see, what was an ideal alliance during the boom is not necessarily one that can survive the bust.

Perhaps more important than how the industry allocates funds across parties is how it supports individual legislators. Consider table 3.3, which outlines average financial industry contributions to various groups of House incumbents for the 2007–8 election cycle.

TABLE 3.3

Financial industry contributions to house incumbents, 2007–8 election cycle

The partisan differences are quite small. Only $9,000 separates the average Democrat from the average Republican. This allocation reflects the bipartisan strategies that these industries pursued.

The ideological differences are somewhat more substantial. The more conservative wing of each party (moderate Democrats and conservative Republicans) garners substantially more contributions than the more liberal factions. The emphasis on the Financial Services Committee, with its role in oversight and new legislation, is clear. The typical committee member receives almost twice as much as the average nonmember. Contributions do at least correlate with voting decisions. Contributions made during the 2007–8 election cycle appear to have paid off when the bubble popped. The members who supported the Paulson TARP bailout received substantially more contributions than those who opposed it.

Information and Lobbying

Because legislators often lack the time or expertise to master complex policy areas, they must naturally turn to others for information or advice. While members can rely on congressional and committee staffs to some degree, most of the time they depend on outside lobbyists and interest groups for information about the consequences of policy choices. This political fact of life is true across almost all policy domains, but it is especially important in financial regulation.

Finance, banking, and insurance are very complex industries. This has only become truer with the proliferation of derivatives, swaps, and other complex financial instruments. One has to be a rocket scientist (or at least on par with one mathematically) to understand much of what has gone on in the financial sector over the past generation.²⁵ Moreover, this expertise is lucrative. Someone who truly knows the ins and outs of the financial sector could make far more money working for a financial firm (or lobbying for it) than working as a staffer on Capitol Hill. Consequently, the “information asymmetry” between financial sector lobbyists and legislators is unusually large. The informational advantage of the financial sector should work to its advantage when its members participate in the political process and lobby.

This political information gap works much the same way that it works in private markets. Just as stock jobbers sell near worthless securities to unsophisticated buyers, financial sector lobbyists monger dubious “reforms” to legislators. The lobbyists have little incentive to push policies that contribute to the long-run economic welfare of the nation. Their focus is on short-term profits and competitive advantage. When times are good, the message that unregulated financial markets enhance the general welfare sells especially well.

The information asymmetry between the financial sector and policy makers is also a source of “negative” power for the industry. The period of the past thirty years has been one of vast innovation in the financial sector. New products routinely exploit previously unknown loopholes in securities law and regulation. A recent, relatively simple example is Goldman Sachs’s creating a pool of investors to buy an interest in Facebook in 2011; the product allowed Facebook to raise capital while escaping the 499 investor limit that would force it to become a public company. (Facebook finally held its initial public offering in 2012.) After a public outcry, Goldman restricted the investment to a loophole for foreign investors who “do not count.”²⁶ But careful regulatory oversight of the many less-transparent innovations requires intensive knowledge of the new practices and their effects. Not only is this information concentrated within the industry but the industry may have little incentive to provide it to policy makers. Indeed, a claim of “business secrets” may make it impossible for regulators to obtain it on their own. Consequently, policy makers are presented with a Morton’s Fork between bad outcomes arising under laissez-faire and stifling innovation through regulation.

As an example, consider “high frequency algorithmic” trading.²⁷ The idea is to have powerful computers analyze, within fractions of a second, every blip and dip of markets and execute trades. The use of these algorithms may be efficiency-enhancing, but there are legitimate concerns about a destabilizing effect. What if thousands of these algorithms sold at the same dip? Might that not turn a dip into a crash? A flash crash related to high-frequency trading occurred on May 6, 2010. The incident illustrates how both the SEC and the Commodity Futures Trading Commission (CFTC) lack the capacity and information for monitoring financial transactions and innovation. The joint report of these agencies accounting for the crash was issued only on September 30 of that year.²⁸ Consequently, this lack of capacity has left regulation largely to the industry itself.²⁹

Lobbying is extremely important for the financial sector. It spends roughly the same amount on lobbying as on campaign contributions. Since 1998, lobbying expenditures are subject to public disclosure. We cannot break out expenditures on lobbying specific legislators or political parties, but we can look at the total amounts. These are indicated for securities and investments, commercial banks, and real estate in figure 3.3.³⁰ Lobbying expenditures rose sharply in the first decade of the twenty-first century, particularly in the securities and investments sector.

Among commercial banks, the big four survivors of the crash, Bank of America, JPMorgan Chase, Wells Fargo, and Citibank, account for about one-third of all commercial banking lobbying expenditures. They are also, as previously noted, on the boards of the American Bankers Association and the Consumer Bankers Association. The two associations are the biggest single lobbyists in the commercial bank category. The two trade groups, the four big banks, and Barclays represent more than half of all commercial banking lobbying expenditure. It should be no surprise that Goldman Sachs makes the highest lobbying expenditure among securities and investments firms.

Figure 3.3. Lobbying expenditures by financial and real estate firms. Expenditures soared during the bubble and continued to grow after the pop, with the exception of real estate.

As the housing bubble popped, lobbying by the real estate sector declined. The details tell a story. The largest real estate lobbying organization is the National Association of Realtors, which accounts for about one-third of all lobbying expenses in the sector, spending more than $22 million in 2011. This was not a decline, but a new record, as indicated by OpenSecrets.org. Even as home sales fell and association membership fell from 1.36 million in 2007 to 1.07 million in 2011, lobbying by the association increased.

Where, then, did the decline in real estate sector lobbying come from? A huge chunk came from Fannie and Freddie, which ended their lobbying after being nationalized in 2008. They had been the second- and third-largest lobbying organizations in the real estate sector. The National Association of Mortgage Brokers also reduced its expenditures dramatically: the group spent $2,319,485 in 2009 but only $210,000 in 2011. Mortgage brokering collapsed as the lenders turned to in-house mortgage origination with stiffer standards. Home building also collapsed. This sector, kept separately by OpenSecrets.org, showed a decline from $9.8 million in 2009 to $4.6 million in 2011. The drop would appear to be related to the large oversupply of housing after the bubble. With low expectations that Washington would favor even more building and with many builders in financial distress, the sector downsized its political activity.

Political expenditures, informational asymmetry, and constituent pressures mix into ideology as influences on the individual behavior of members of Congress and on the White House. In chapter 4 we explore how individuals interact within the political system.