Lehman is gone but new financial crises may await

(MoneyWatch) It's been five years since the collapse of Lehman Brothers. Has anything changed?

Far from being jailed, bankers who presided over the frauds that brought down the U.S. economy in 2008 have kept their money and are living large. "Too big to fail" is now part of the national lexicon, describing banks that remain so big and leveraged that their collapse could imperil economies around the world. An overhaul of financial laws is in limbo as regulators tasked with writing the rules move at a glacial pace. And the apparent front-runner for the country's next central banker is a man who helped create and defend many of the policies blamed for creating the mess in the first place.

With the major pieces of the previous crisis still in place, many experts worry that it's just a question of time before another crisis occurs.

A bit of history is in order. In the run-up to the meltdown, the world's biggest banks, unencumbered by Depression-era legislation separating commercial banking from investment banking, began creating and selling bonds backed by thousands of mortgages. As investor demand for these derivatives, a security whose value derives from another asset, Wall Street banks urged mortgage lenders to issue more and more loans.

Standards for evaluating whether borrowers qualified for a mortgage, such as income and employment, were jettisoned, resulting in what came to be known as "liar loans." Exempt from regulation, subprime lenders such as Ameriquest, First Alliance Mortgage and Countrywide turned their businesses into assembly lines of bad loans. Fraud was rife.

As the banks packaged loans into derivatives that neither the firms' own CEOs nor investors fully understood, the idea of risk went out the window. As the crisis erupted the country's largest financial institutions, swollen with debt used to buy and sell worthless financial products, were at the heart of the scandal.

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While there were voices warning of disaster as the housing bubble inflated, the country's regulators and other institutions were sanguine. Credit ratings agencies such as Standard & Poor's and Moody's (MCO) -- paid by the banks to evaluate the securities -- gave them clean bills of health. As for the government, deregulation and lax supervision ruled the day. Instead, top officials across the agencies charged with policing the banks preached the merits of laissez-faire.

It was inevitable that the securitized garbage would ignite. After Bear Stearns collapsed in 2008 and was sold to JP Morgan Chase (JPM) with government aid, political pressure on the Bush administration by Republicans who opposed bailouts helped prompt officials to refuse any such help to Lehman. But the experiment in selective free market consequences ended badly: Insurance giant AIG (AIG), which had guaranteed many of the mortgage-backed securities issued by Wall Street, was swamped with red ink, money market funds plunged in value and global panic set in.

"Lehman was a systemically dangerous institution which was allowed to fail," said William Black, a former banking regulator and prosecutor who now teaches law and economics at the University of Missouri in Kansas City. "It prompted the largest run in history on money market mutual funds -- over $30 billion in two days. They absolutely lost their minds at Treasury and the Fed. Then when AIG went down, they had no clue what the risk was."

"The regulators had created such a regulatory black hole that they had no clue how to even get information about what was going on," he added. "They were scared. Five years later? We've made the problem worse -- Bear Stearns, CountryWide, Washington Mutual have all been acquired by banks that were already systemically dangerous."

For Black, whose investigations led to prison terms for such people such as Charles Keating during the savings and loan crisis in the 1980s, the size of the banks isn't the only problem. He argues that the structure encouraging fraudulent behavior in finance is still firmly in place. One active ingredient: massive executive compensation. The outsized pay on Wall Street not only spurs top executives to take dangerous risks, but also filters down to rank-and-file employees, discouraging whistle-blowing and encouraging dishonesty.

"You can't go to thousands of Enron employees and say, 'I want you to engage in fraud.' But you can say that through compensation," he said.

As such problems continue to fester on the Street, the federal watchdogs tasked with overseeing Big Finance remain mostly toothless.

"When you look at who has been hired at the SEC recently, starting with Mary Jo White, every last one of them worked for a Wall Street defense firm," said Former U.S. Senator Ted Kaufman, author of defeated legislation to break up the big banks.

Dodd-Frank, the massive law passed in 2010 and touted as a safeguard against future financial crises, is by many lights a deeply flawed bill that failed to address fundamental issues, such as the conflict of interest between ratings agencies, the size of banks or their fundamental structure. In any case, it remains largely dormant, with more than half the rules yet to be written by the SEC.

Meanwhile, even Dodd-Frank's biggest proponents, including President Barack Obama, acknowledged that additional legislation would be required to protect the financial system. But for now the door to further reform is shut -- despite the broad consensus across the political spectrum that the biggest banks are over-leveraged and as dangerous as ever.

"There's nothing moving," Kaufman said. "As long as Congress and the administration don't want to do anything, nothing is going to happen. There's an unholy alliance between Wall Street, Obama and Congress."

Kaufman is gratified that the Federal Reserve under Ben Bernanke has sought to raise capital requirements for banks. That effectively makes them smaller since they must keep more money on hand to offset potential losses and makes it harder to borrow recklessly. But he and others believe another crisis is entirely possible, perhaps inevitable.

"I was an engineer," said Kaufman, who began his career working at DuPont before becoming a top aide to then Sen. Joe Biden and later a senator representing Delaware himself. "If you build a rocket and it falls on its side and blows up, and then you build an identical rocket, it will fall on its side and blow up, too."

Kaufman thinks the next problem could take years to surface -- or happen at any moment. If the cause isn't another real estate frenzy fueled by dishonest lending, he said the trigger could come from abroad, say, if a eurozone country defaults or because of an economic meltdown in China.

And where are the people who were at the heart of the scandal now?

Lawrence Summers, an acolyte of former Treasury Secretary Robert Rubin and one of the most strident advocates of financial deregulation, is now being touted as Mr. Obama's leading candidate to lead the Fed.

"Rubin and Summers were the chief architects of the crisis," Black said. "The idea that you would bring back the leading architect of the crisis and promote him, precisely because he's a failure and will do the will of the banks, is the ultimate embracing of crony captialsim by the Obama administration."

As for the others, the Center for Public Integrity has compiled a deeply reported series detailing their post-crisis lives, noting dryly that "none of them are hurting for money."

Among the regulators, ex-SEC chief Christopher Cox, ridiculed for doing nothing in the run-up to the crisis, now advises and defends companies that run into regulatory trouble. Former Treasury Secretary Henry Paulson, who argued strenuously against government rules that would hobble the "competitiveness" of the nation's biggest banks, was already rich from his role as head of Goldman Sachs (GS). He has written a book and takes in even more money on the lecture circuit. Mr. Obama's recently departed Treasury chief, Timothy Geithner, who two years before the crisis claimed that banks regulated themselves, is working on a memoir and is a member of the Council on Foreign Relations.

As for the bankers, Kaufman notes that none, in contrast to the stock market collapse of 1929, have jumped out of windows from shame. Jimmy Cayne, Bear Stearns' CEO at the time of the 2008 crisis, who famously played in a bridge tournament while his firm was going down in flames, is still playing bridge and living in a multi-million dollar condo in New York's storied Plaza Hotel. The Center for Public Integrity estimates he brought home about $375 million. Former Lehman CEO Dick Fuld repaired to his Greenwich, Conn., mansion, where he maintains contacts with some former colleagues and underlings.

Among mortgage bankers, former CountryWide CEO Angelo Mozillo exited the business with well over $100 million. By contrast, CPI reports that senior executives with the 25 biggest subprime lenders during the bubble remain in the mortgage racket.

"The fact is, we have demonstrated that you can get extremely wealthy with immunity from criminal laws and virtual immunity from civil laws," Black said. "We've proven that fraud pays. That makes the next fraud much more likely."