The Birth of the Modern Banker

The following is an excellent excerpt from the book “MAKERS AND TAKERS: The Rise of Finance and The Fall of American Business” by Rana Foroohar from Chapter 1: “The Rise of Finance” on page 40 and I quote: “The Birth of the Modern Banker – This transition in American capitalism, from family-owned and family-funded firms to bank-funded corporations, got a powerful boost in the Civil War–a shift that illuminated the traditional embedded relationship between finance and the government (which depends on bankers to fund its endeavors).  Abraham Lincoln’s administration had a terrible time trying to sell bonds and raise funds for the war on its own, so it turned to big banks in New York, Boston, and Philadelphia to do the job.  Thus investment banking, as well as its ties to government, began to grow.  So did banking’s relationship with middle America.  Then, as now, there were no rules dividing traditional lending from the sale of securities, and so banks did both.  This predictably resulted in a number of market crises, including the so-called Black Friday crash of 1869, which bankrupted a number of high-profile financial firms that had, like so many institutions today, been trying to push the risky securities of companies with which they did business.

Nevertheless, financiers’ relationship with both government and business only got tighter.  Bankers became a big source of campaign contributions for politicians and sat on the boards of companies for which they increasingly helped issue and sell securities, many of them of dubious quality.   There were a few major corporations that chose to expand the old-fashioned way–by actually reinvesting their earnings.  One of those was Standard Oil, whose founder, John D. Rockefeller, was skeptical of depending on the banking sector for corporate well-being.   “I think a concern so large as we are should have its own money and be independent of the ‘Street,'” he once said.  But not many companies agreed, or could afford to feel that way.  Stock offerings for growing American companies began to proliferate.  Even the Rockefellers eventually got on board, as Henry Huttleston Rogers and William Rockefeller (two leading Standard Oil executives) teamed up with the National City Bank to launch the Amalgamated Copper Company; it owned, among other properties, the soon-infamous Anadonda copper mines.

The Anaconda mine scandal involved a financial trick that anyone familiar with the crisis of 2008 will know well: bankers knowingly selling clients and the general public financial producers that were essentially junk, while marketing them as the next big thing.  It was also the culmination of nearly three decades of financial sector growth, loosening of banking standards, attempts to better regulate a banking industry that was perceived as being increasingly risky and out of control, and vigorous pushback from the industry itself, which spent millions of dollars trying to avoid being constrained.  If this sounds familiar, it should.  The crash of 1929 and the Great Depression, like the crisis of 2008 and the Great Recession, didn’t happen overnight.   They happened over decades during which risk, debt, and excess credit built up in the financial system, unchecked by policy makers who were increasingly beholden to the sector–the very same one that was instrumental in financing both the expansion of the US economy (via IPOs, real estate loans, and the sale of securities to a burgeoning middle class) and, eventually, World War I.  Then, as now, financiers used their privileged position to argue that if they were stymied in their attempts to make increasingly large profits, the capitalist system itself would collapse.  It eventually did, of course–not in spite of finance, but because of it.

It’s no accident that the size of the financial sector today as a percentage of GDP is at levels equaled only on the eve of the Great Depression.  Like the decade leading up the financial crisis of 2008, the Roaring Twenties were marked by not only financial boom and technological wonder, but also massive income inequality.  Worker wages stagnated and those of the upper classes grew, bolstered in large part by stock prices.   Another similarity was a rise in debt, both public and private, which was used to mask the declining spending power of the lower and middle classes and its dampening effect on GDP growth.  Then, as now, when people couldn’t afford to buy, they borrowed–Americans in the 1920s bought more than three-quarters of major household items on credit.  Moreover, lured by aggressive advertising campaigns by banks and the proliferation of war bonds, which had been pushed by a government eager to raise funds, the American public began investing for the first time enmasse in the securities markets.  As Harvard economist historian Edwin Gay put it, millions of people who had never done anything with their money but save it were suddenly borrowing and investing in securities.  “They were not. . . educated in the use of credit; they simply received a new vision of its possibilities.  The basis was thus laid for the vast and credulous post-war market for credit which culminated in the portentuous speculation of 1928 and 1929.”

Sound familiar?

Charles Mitchell, Ferdninand Pecora, and the Crisis of 1929 – The run-up in debt and consumer credit aren’t the only similarity between the periods leading up to the Great Depression and the Great Recession.  Everyone remembers Senator Carl Levin, who cochaired the Senate investigation into the roots of the 2008 financial crisis, grilling the heads of Wall Street institutions like Washington Mutual, Moody’s, and Goldman Sachs over the subprime debacle.  But hardly anyone knows that there was precedent for these spectacles seventy-seven years earlier, in 1932, when the Senate conducted the Pecora hearings, named for chief investigator Ferninand Pecora, on the reasons for the stock market crash of 1929.  The first banker on the hot seat back then was Charles “Sunshine Charley” Mitchell, the chairman of Citi’s predecessor, the National City Bank of New York.

National City had actually started the crisis on a good footing.  Like most major New York banks, it was holding around 20 percent equity capital on its balance sheets–ten times more than the 2-5 percent average for large institutions today (and a target that many contemporary advocates of banking reform would like to see reinstated).  When the panic of 1929 began, National City was flush enough to pump $25 million into the system, which held off the crash for about six months.  But as Pecora investigations eventually uncovered, National City itself was one of the main causes of the stock market crash.  Like the Too Big to Fail institutions of the twenty-first century, this bank and many others had knowingly sold bad securities to their customers without disclosing hidden interests in the transactions.  Banks had, in essence, shorted their own clients, trading against them in order to make money for the house.  For example, the run-up to the crash of 1929, National City aggressively peddled its holdings in Anaconda Copper to clients as soon as the price of copper began dropping, while continuing to recommend the stock as a sound investment.  No wonder that Senator Carter Glass said in 1929 the Mitchell “more than any 50 men is responsible for this stock crash.”   But like the bankers of today, Mitchell got off without jail time.  He continued to work on Wall Street after his public shaming, even though he left National City in disgrace just days after taking the stand and paid government officials (with whom he’d done many cozy deals) $1.1 million in back taxes.

The crisis had one big upside, though.  Senator Glass, along with Congressman Henry Steagall, crafted the Glass-Steagall Act to separate commercial and investment banking in the United States.  For more than six decades afterward, the law helped to ring-fence commercial lending from risky proprietary trading.    Glass-Steagall also created the Federal Deposit Insurance Corporation (FDIC), which insured bank depositors up to $5,000 each, reducing the risk of bank runs and assuring the general public that it would be safe in case of a financial crisis.  Finally, the legislation put limits on the amount of interest that banks could offer savers to attract their money.  This measure, known as Regulation Q, was designed in part to prevent banks from competing too vigorously with one another for deposits by offering higher and higher interest rates, which might in turn push them into some sort of risky investments that had precipitated Black Tuesday in 1929.  The idea behind all of it was to make banking a safe, boring utility, something that facilitated business rather than disrupted it or competed with it for investment.

And it worked, at least for a few decades.  The period between the Great Depression and the 1960s was one in which banking was held largely in check, providing mostly plain-vanilla services to average people.  Think of the 1946 movie It’s a Wonderful Life, in which Jimmy Stewart’s character, George Bailey, stems a bank run with a famous monologue explaining the local building and loans as the glue holding the community together: “The money’s not here. Your money’s in Joe’s house that’s right next to yours.  And in the Kennedy house and Mrs. Macklin’s house and a hundred others.”  Bankers of the time thought of themselves not as dealmakers but as stewards of individual wealth and lubricators of industry.  They were people who turned savings into investments.  They made mostly conservative loans to conservative people and businesses.  Indeed, in the wake of the Pecora hearings, National City Bank replaced its discredited chairman, Charles Mitchell, with James Perkins, a man who “looked like a New England farmer.”  Trading was verboten, and no loan could be made without the sign-off of three officers.  Things were sleepy, for sure.  But the fact that finance was tightly moored to the real economy during this period is one reason, according to Piketty, that inequality was also historically low.   Finance had finally been tamed, and the economy was less risky because of it.  Or at least that’s the way it was until Walter Wriston come on the scene.

The Million-Dollar Banker – National City Bank, like all commercial banks after Glass-Steagall, had become a safe, predictable, boring place to work.  But Walter Wriston, a returning GI with a graduate degree in foreign affairs from Tufts who took an entry-level job with the bank in 1946, would change all that.  Wriston was a child of privilege; his father, a successful academic who eventually became president of Brown University, had argued against the government planning of the New Deal and idolized Adam Smith and his “invisible hand.”  (No matter that Smith only mentioned the hand a few times, briefly, in a couple of his works, or that this Scottish economist who came to emblematize laissez-faire economic thinking had built his ideas at a time when the economy was mostly small, family-owned businesses rather than large and growing corporations.)  Smith’s core belief–namely, that markets worked better than government planning only when all players enjoyed equal footing and complete price transparency–had already been lost to the “markets know best” and “selfishness is good” simplification of his theories.

Wriston bought into the CliffsNotes version of the Smith doctrine wholeheartedly.  What’s more, he believed that banking should no longer play second fiddle to industry in America.   He wanted to find a way to make finance a more fun and glamorous business, one that could be even more profitable than the sectors to which it was supposed to be in service.  Wriston eventually bought to First National City Bank (the firms; new name after it merged with First National Bank in 1955) a host of new ideas about how to challenge old regulatory regimes, use technology to grow operations, expand in both national and international markets, and offer up more credit to companies and to the individual consumer, the latter having been largely ignored by big commercial banks.  In many ways he was the model for Sandy Weill, a man who once believed that globalization, technology, and consumer culture could drive the financial industry to new heights if only it could be freed from the post-Depression regulatory regime.

Wriston wanted to find a way to lure deposits, which had been falling, via higher interest rates, thus earning the bank more profits, which could then be invested in the more glamorous ventures he dreamed of.  This involved pushing hard against barriers like Regulation Q, as well as others that made it difficult for banks to expand across states or internationally.   Like Weill several decades later, Wriston would act first and ask questions of regulators second.  He aggressively sought out areas of finance with higher profit margins and made inroads into new instruments once considered quite risky, like shipping loans.  Such complicated financial maneuvering soon began to backfire in big and unexpected ways.  By pioneering the use of ship charters as collateral, for example, Wriston expedited the decline of the American-flag tanker fleet, since the Greeks built for half the price and would domicile ships in places like Liberia and Panama, where owners paid almost no taxes.

But by then, Wriston and his bank were moving into new and increasingly elaborate financial products.  In the early 1960s, in a foreshadowing of the kind of “innovation” that would come to characterize the modern banking industry, Wriston developed an ingenious way around the Glass-Steagall rules.  His solution, the first to blur the line between lending and trading, became known as the negotiable certificate of deposit, or the CD.  These securities were inspired by a Greek shipping tycoon who wanted a place to stash his funds away from his personal bank accounts, where the IRS could tap them.  Negotiable CDs began to function as special time-limited savings accounts with higher-than-normal interest rates for companies and rich people (you needed $100,000 to buy one).   Deposits poured in, and First National City began another, even more profitable business: buying and selling the CDs on a secondary market.  Everyone thought that the new strategy, which involved lending to other financial entities that would then trade investors’ products, probably broke the Glass-Steagall rules.  But the government and the Fed, eager to keep banks solvent, did not stop the music.  Within a year, $1 billion worth of negotiable CDs had been issued, and the market continued to grow as the securities were offered in smaller denominations, allowing average investors into the party.

Wriston had also begun to focus on American consumers who, hit by rising inflation that ate away at their returns, were unsatisfied with their traditional savings and checking accounts and were looking for ways to extend their buying power.  Wriston gave it to them in 1957 with the introduction of the first credit card.  Slowly, regulations around interest rates and the price of credit began to fall away.  Money was becoming not a limited commodity but something you could buy–at the right price, anyway.  By the mid-1970s, all of these inventions and many others had made First National City the most profitable financial institution in America–and Wriston, now the CEO, was quite a player, driving around New York in a red Corvette.  He was well on his way to becoming the first commercial banker since the Great Depression to earn more than $1 million in one year.  He had also made powerful friends in Washington, as an adviser to the Kennedy and Nixon administrations.  (A few years later, under President Ronald Reagan, Wriston would sit on the president’s Economic Policy Advisory Board and help craft some of his infamous “trickle-down” economic policies.)

The success of the CD and other Wriston-led innovations was more than just a windfall for First National City, which changed its name to Citibank in 1976.  It also set off an industry-wide chain reaction, as other financial institutions began searching for more and more high-yield products.  Smaller thrift banks with fewer rate restrictions invented the mutual fund.  Bankers at Salomon Brothers, which would later be acquired by Citi, started experimenting with packaging mortgages into securities.  Financial institutions started to try out derivatives, in the form of futures trading.  It was hard for regulators to resist the growth of all this securitization, since every time interest rates went up, money would flow out of the banks, who would then demand a hike in the Regulation Q interest rate ceiling, and the Fed, frightened of capital flight, would comply.

It was a vicious cycle, but no one in Washington had the resolve to slow it down–and, to be fair, it wasn’t completely clear at that point what was happening.  Besides, the end goal of all this nipping and tucking of the rules, which had been to encourage more credit to flow to individuals and businesses, was failing.   Even the government’s own effort to create more mortgage financing, by developing a market for mortgage-backed securities via the Government National Mortgage Association (GNMA, which would come to be known as Ginnie Mae) did not improve things.  In the end, it only pulled money away from thrifts, which supplied most of the mortgage lending, since deposits could now get better yields on the tradable products.  Finance was gradually becoming an end in and of itself, rather than a facilitator for real business.  In many ways, the creation of the CD and the secondary market for trading it marked a turning point for banking in the postwar era.  The size of the sector began to grow, as did its focus on coming up with ways to game the system to make more money–two trends that fed on each other.    Banking was no longer a utility.  Just as Wriston had hoped, it was increasingly a high-speed, high-stakes business.

Buoyed by his successes, Wriston told the Street that he wanted his bank’s earnings to grow at 15 percent a year, rather than the usual single digits; this would necessitate keeping less capital on hand and taking on more leverage.  To encourage employees to do whatever it took to hit that target, Citi also changed its compensation structure and began awarding stock options based on the value of its shares (which of course encouraged even greater risk taking and creative accounting to hide bad assets on income statements).  None of it worried Wall Street’s million-dollar banker.  Wriston had a dream–one that Sandy Weill would realize many years later.  He wanted an institution to become a one-stop shop that would supply any financial product–from mortgages to securities to deposit accounts to trading platforms–to businesses and individuals.  That goal would come with many unintended consequences.”

(A VERY INTERESTING STUDY OF WHAT CAUSED THE 1929 CRASH.  SOMETHING YOU CANNOT IGNORE BUT UP TO NOW, IT SEEMS LIKE OUR GOVERNMENT CHOOSES TO IGNORE IT.  ALSO THE THEORY THAT IF YOU GIVE WEALTHY PEOPLE MONEY, IT WILL TRICKLE-DOWN AND CREATE JOBS, WHICH SEEMS RIDICULOUS BECAUSE WHAT WOULD BE THEIR DESIRE TO CREATE MORE JOBS BUT TO MAKE MONEY.   AND WHY WOULD THE MERGING OF TWO COMPANIES CREATE MORE JOBS OR MORE MONEY, UNLESS PRICE FIXING WAS INVOLVED, WHICH WOULD BE ILLEGAL.

LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran

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About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog (my.barackobama.com) and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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