Dodd-Frank: How investment banks contributed to the financial crisis


The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in response to the financial crisis of 2008, added new regulations and new regulators for some—but not all—of the institutions whose actions led to the crisis. Over the next several days, we’ll be taking a look at each of the major groups of contributors to the economic crisis, who the major players were, what political influence they brought to bear on Congress and regulators, how Dodd-Frank intends to regulate them, and, using our new Dodd-Frank Meeting Logs tool, what rules these groups are trying to influence as agencies implement the legislation.

Group:  Investment banks
Key players in the financial crisis: Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley
Regulators: Federal Reserve Bank, Securities and Exchange Commission, Treasury, Commodity Futures Trading Commission, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency.

How They Helped Cause the Crisis: These storied investment banks were at the forefront of the financial meltdown, earning big fees for packaging questionable mortgages into securities and selling them. The firms had such a huge appetite for these investments, which brought in hefty fees and earned large bonuses for executives, that they pressed for more and more mortgages to package and sell, despite their shakiness. Meanwhile, they sunk enormous amounts into their own proprietary trading on risky derivatives. The first investment bank to keel under the pressure when mortgage-backed securities soured was Bear Stearns, after two of its hedge funds that had invested heavily in subprime mortgages went under in 2007. In March 2008, there was a run on the bank as its partners on derivatives contracts, short-term loans known as “repos,” and others demanded money. J.P. Morgan Chase stepped in to rescue the bank with government help to the tune of a $30 billion loan by the Federal Reserve Bank of New York. By September, Lehman Brothers was in big trouble. Over the course of a week, two private deals to acquire the failing bank fell through. The government refused to bail out the bank, deeming it too far gone, and on Monday, Sept. 15, it filed for bankruptcy. The same day, Merrill Lynch announced it would be bought by Bank of America. On September 22, Goldman Sachs and Morgan Stanley made it known they would become bank holding companies, a move that would subject them to more government regulation but also enable them to engage in activities that would help them raise capital, such as accepting retail deposits. The failure and reconfiguration of the big investment banks wreaked havoc on the global economy; credit virtually froze, profits plummeted, and a deep recession took hold. The survivors took tens of millions in bailout money and loans from the federal government.

Political Influence: Bear Stearns’ federal political contributions trailed off after the 2006 election cycle, while Lehman Brothers contributed $667,000 in the 2008 election cycle in contributions to federal politicians before it failed. Bank of America, which acquired Merrill Lynch, contributed $1.4 million in 2010, up from $1.6 million in 2006, the previous non-presidential election cycle. Its reported federal lobbying expenses peaked in 2008 at $4.9 million. Goldman Sachs reported record federal lobbying in 2010, as the Dodd-Frank financial law was being debated, at $4.6 million; its federal campaign contributions totals, $1.6 million in the 2010 election cycle, however, were higher earlier in the decade. Morgan Stanley reported $2.75 million in lobbying in 2010 and $668,000 in federal campaign contributions in that election cycle, down from previous totals. Goldman Sachs is in some ways sui generis in its connections to Washington—Treasury Secretaries (Robert Rubin in the Clinton administration, Henry Paulson in the Bush administration), a U.S. Trade Representative (Robert Zoellick)—even the head of the government’s bailout efforts under Presidents George W. Bush and, briefly, President Barack Obama (Neel Kashkari) hailed from Goldman Sachs. And Mark Patterson, currently chief of staff of the Treasury Dept., was hired away from the investment bank.

How They Fared: Goldman Sachs’ and Morgan Stanley’s first quarter reports showed declining profits. The firms have had to make major changes; in anticipation of new rules regarding proprietary trading, known as the “Volcker rule,” both Goldman Sachs and Morgan Stanley shut down trading desks that had been profit centers. However, Goldman Sachs’ filings show it is still claiming profit from its own investments, which it reportedly believes will not be affected by the new rule.

How Dodd-Frank Regulates Them: There is hardly a part of the Dodd-Frank financial law that does not affect these firms, from capital requirements to a ban on proprietary trading to new oversight of derivatives trading to designations of “too big to fail” institutions.
Goldman Sachs is being particularly aggressive in its lobbying. In its most recent federal lobbying report, the firm listed eight on-staff lobbyists who were lobbying on Dodd-Frank implementation. It also had hired several outside firms to help in its efforts, including such high powered lobbyists as GOPer Kenneth Duberstein; former House Majority Leader Rep. Dick Gephardt , D., Mo. ;  former Senator Trent Lott, R.,  Miss.; and Sen. John Breaux.  The firm reported more meetings with federal agencies than any other company. It’s also been the most active firm approaching regulators. Goldman Sachs has argued that Dodd-Frank should not apply to its overseas operations, had positions on virtually every aspect of swap regulations, from position limits to real time disclosure to derivative clearinghouse organizations to swap execution facilities, and has lobbied on the Volcker Rule.

Morgan Stanley reported three in-house lobbyists working on Dodd-Frank implementation and has also hired outside help. The firm has had 58 meetings with regulators on issues ranging from the future of Fannie Mae and Freddie Mac, implementation of the Volcker Rule and swap regulations, Dodd-Frank’s impact on European regulations and to discuss the Consumer Financial Protection Board.