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— Analysis —
It's one, he says, that marks an important moment in the complex relationship between regulators and the banking industry. "This really marks a dramatic and fundamental change in how the Fed perceives financial crises," he says, noting that the central bank has now become the effective regulator of the entire market economy. Whether this is good or bad is besides the point, he says, adding that the U.S. has few options.
Schwartz received his bachelor's and law degrees at Temple University and an M.B.A. from Columbia Business School. He began his career at the Fed, which he joined in 1974, under then-Chairman Arthur Burns, rising to become associate general counsel for the Fed Board of Governors. "I'm one of those people who came down to get some Washington experience and ended up with a fatal case of Potomac fever," he says. In his decade at the Fed, Schwartz worked under chairmen Burns, G. William Miller and Paul Volcker. After leaving the Fed, Schwartz joined Skadden Arps, where he advised clients on navigating the S&L crisis. In 1995, he left to form his own firm, and ever since he's been advising bank clients dealing with the myriad of banking regulators. Schwartz talked with The Deal's Vipal Monga about the breadth of the banking crisis and the regulatory response to it. The Deal: How bad are things for the banks, and how does what we're seeing now compare with the scope and depth of previous crises you've witnessed? Gilbert Schwartz: I think the scope is clearly much broader in terms of impact and influence than I think anything we've seen before, certainly anything I've seen since I came to Washington. You might have had a handful of the big institutions having significant problems, but it was typically on one kind of issue. Now you have this broad-brush problem that affects virtually everybody. I don't think I've ever seen in the past as big an inability of regulators to be able to deal with the situation. As the crises come up, they seem to be creating ad hoc resolutions and decisions. I've also never seen so much reliance upon the Fed as the savior of the banking system. What's your sense of the regulatory response today compared with the response in previous crises? Why has the Fed been so central this time around? When I was at the Fed, many organizations over the years asked for access to the discount window, starting with Lockheed, Penn Central, New York City and Chrysler. They all knocked on the Fed's discount window, and always the chairman would say, "Sorry, it's not our problem. Go talk to somebody else who will deal with the issue." Those were significant crises. But somehow this was different. I don't know whether it was because of the acceleration or the telescoping of the potential problem, whereby the financial system could have collapsed overnight if they hadn't bailed out Bear Stearns and the other investment banks, or whether they just had a sea change in terms of their attitude towards the purpose of the discount window. But it really did mark a dramatic and fundamental change in how the Fed perceives financial crises. What do you think about the response to Fannie Mae and Freddie Mac so far? Well, again, you have somebody knocking on the door and saying we're in a meltdown crisis situation. I guess I'm still in my mind mystified as to why the Fed thought it was necessary to provide the backstop on that one. Now I'm thinking, geez, all you have to do is to assert to the Fed there's going to be a collapse in X market and then they'll take extraordinary steps. I guess that's what happened with Bear and that presumably is what happened with Freddie and Fannie. Saying this market's going to collapse, you've got to step in and do something, which they obviously did. I don't know what would be the next market. What has this done to the Fed's role in the economy? I think it's confirmed the Gramm-Leach-Bliley Act structure that alluded to the fact that the Fed was going to be the overseer of the financial system. While functional regulation was the theme of Gramm-Leach-Bliley, nonetheless the act said the Federal Reserve is going to be at the pinnacle of overseeing what goes on in financial holding companies. Now the Fed is at the pinnacle of overseeing what's going on in the economy generally and in the financial markets. You no longer need a financial holding company as a connection between the Fed and what's going on. All you need is the Fed up there overseeing everything in the financial markets. Who else are you going to rely upon? Who else is there? I'm not sure that there's another game in town. If you're going to say you are the lender of last resort and we're going to look to you to provide liquidity to particular segments of the financial industry when it's needed, it seems to me the flip side of that has to be you will have the authority to monitor everything that's going on, because we never know when we're going to need you. What does an increase of their supervisory capacity do to their independence? What about the danger that the Fed will be politicized? I think that's a red herring. The Fed has always been sensitive to political pressures. But being politicized doesn't mean that you cave into the politics every time the White House calls. But I view being sensitive to the political environment as important. For example, when Jimmy Carter wanted to put credit controls on back in 1980, Volcker went along with it. Everybody knew that they were stupid and they weren't going to work. Credit controls never work, but the Fed went along with it because that was national policy. I think there's a distinction between kowtowing to the White House versus being sensitive to the implications of what they're going to do. I think clearly Volcker's decision to jack up interest rates in '79 and '80 and other periods was taken with the full understanding of the political implications. Over a year into the banking crisis, where are we today? You have to assume that there's still more to go. I don't know if you saw Greenspan's comments the other day in The Wall Street Journal. It's classic Greenspan. He said, "I think we're going to reach the bottom by mid-next year, but then we might not reach the bottom then." The problem is that if we haven't reached the bottom, I think there's going to be another round of significant problems in the banking system because a lot of securities have not been written down. They've been labeled temporarily impaired, and you don't have to take a hit to your balance sheet unless they're permanently impaired. But if the real estate market doesn't turn around or doesn't stabilize, the accountants are going to have to make a decision as to whether the banks have to write off against capital some of these securities that have been depreciated that are now being held as temporarily impaired. If we do have to write them off, then I think there is just going to be much more chaos. There has been a lot of criticism directed at regulators for allowing off-balance-sheet entities like structured investment vehicles to exist at banks. Were regulators complicit in this to some extent? When you look at the credit card securitizations, you don't seem to have these kinds of problems. I'll tell you why: The monoline credit card banks started off, and they were going like gangbusters, creating cards and creating products and getting the distribution out there, and their stock prices just skyrocketed. And one day they said to themselves, "Well, everybody who has good credit has a credit card, and all we're doing is cannibalizing our own cardholder base, and the only way we're growing is to cannibalize other peoples' cardholder base. So let's look for a new market. Let's look for subprime credit card holders." But the agencies jumped down their throats, just absolutely creamed them, and made them put up three times the amount of capital against those cards and put pressure on them. [Capital] One was under a memorandum of understanding for subprime credit card lending. Eventually, there was so much pressure put on these entities that they essentially went away. MBNA was acquired by Bank of America. Cap One expanded by becoming a bank. That was as a direct result of what the banking regulators saw as subprime borrowers not being a very good risk. Then you sort of turn around and you say to yourself, "Well, where were the regulators in the mortgage market?" I don't have any specific evidence of it, but there is no question in my mind that the examiners in the field, who are very savvy people, sent e-mails and communications to head office saying, "Hey, this stuff is really bad. How can you say that a no-doc loan isn't bad?" These examiners have been around for three cycles. They know that what goes up is going to come down. You've got to believe that somewhere, buried in the bowels of the agency, are communications which said you've got to do something about this and the agencies just ignored it because the residential mortgage lending and residential market was driving the economy. It was the engine that created jobs throughout the economy. You look at everything that goes along with housing: furniture, appliances, construction. That's what took us out of the recession in the early '90s, and that's what kept the economy booming. As the expression goes, nobody wanted to be the skunk at the garden party. Who is going to pull the plug? Do you think that just looking past this current trauma that we may see a wave of foreign buying of weakened U.S. banks? I think that's going to be a major source of resolution to some of these problems. I think they're going to view the opportunities, the longer-term opportunities, here. They're willing to put their money into some of these institutions to improve them. But I think that's not going to occur until there's an assumption that we've reached the bottom. I think that the risk of putting your money into an institution and watching it continue to deteriorate opens them up too [much] for criticism. It's one thing for a fund to do that. It's another thing for a big banking organization to do that. We've had significant changes in the industry over the past 30 years, the largest of which was the repeal of the Glass-Steagall Act. What sort of impact do you think those changes have played in today's turmoil? I think the jury really is still out on that. For example, the insurance products: In terms of manufacturing those products, I don't think there are any big banks that have acquired insurers. Citi dumped Travelers. And so it kind of went the other way. In terms of investment banking, I guess there's been a lot more involvement of some institutions like Chase and Citi in investment banking. But not all the ones who got in trouble were the ones that were affiliated with banking organizations. I'm not sure the affiliation side of it necessarily mattered. If they had been independent, I think the banks still would have put the [mortgage] products into their portfolios for the purposes of increasing their yield. What do you think of the idea of investment banks acquiring depository institutions to get access to stable sources of funding? I don't think it's likely at all. I really don't. I think that maybe the affiliation side helps in terms of having access to more capital, but if you can't use the funds of the insured deposits to fund your investment banking operations, what's the point of having insured deposits? But I think they are clearly going to use less leverage. I think that's going to be modified significantly. But I personally don't think they're going to change very much in terms of their operations. They're still going to be taking significant risks. The profitability may go down a bit because their leverage is going to go down, but I just don't see their operations changing significantly. I think they're going to have a lot more oversight in terms of having to report to the Fed and to the SEC and to whatever else what they're doing on a far more current basis, but I don't think they're going to have rigorous oversight and rigorous regulation of their activities. Why make the distinction between the amount of oversight and how rigorous it will be? Well, remember that you're only dealing with a handful of institutions, some of which are extraordinarily influential and powerful. I don't think they're about to give in very willingly to significant restraints on their ability to earn income. |
Gilbert T. Schwartz, founding partner of Washington-based law firm Schwartz & Ballen LLP, has seen his share of financial crises, turmoil and transformation. Having worked at the Federal Reserve, then at New York law firm Skadden, Arps, Slate, Meagher & Flom LLP, Schwartz, 61, has had a ringside seat to upheavals in the banking sector such as the emerging-markets debt crisis of the early 1980s, the savings and loan implosion of the late 1980s, the debates that led to the repeal of the Glass-Steagall Act and now what he calls the broadest financial crisis he has ever seen.
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