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

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?

Before the Crash: 1980-2007:

1 http://sync.democraticunderground.com/10021662221

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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

or mortgage-backed securities. By the late 1990s and early 2000s, big banks like Lehman

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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 RealtyTracQuarter 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 2

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.

The Economic Collapse: 20082 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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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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3 http://upload.wikimedia.org/wikipedia/commons/2/2b/Finance-dowjones-chart1.jpg

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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

5 http://www.shadowstats.com/imgs/2012/739/image012.gif

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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

6 http://upload.wikimedia.org/wikipedia/commons/thumb/d/d7/2008_Top1percentUSA.png/300px-2008_Top1percentUSA.png

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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. Dodd-

Frank 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

nearly as strong or regulatory as experts and politicians made it out to be. Wall Street flexed its 7 http://upload.wikimedia.org/wikipedia/commons/thumb/9/92/NYUGDPFinancialShare.jpg/325px-NYUGDPFinancialShare.jpg

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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 Dodd-

Frank, 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.

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