As Markets Reel, the Blame Game Begins

Wall Street is now at the mercy of Washington.

The collapse of Lehman Brothers and Merrill Lynch a week after the government takeover of Fannie Mae and Freddie Mac is evoking full-throated cries on the campaign trail for tighter regulation and oversight of the once-swaggering investment banking industry. Lines formed to join the blame game on Capitol Hill, and a 5-month-old, royal-blue, dry-as-a-bone Treasury Department proposal to revamp the industry and its overseers is suddenly a red-hot read.

Facing reporters at the White House on Monday, Wall-Street-titan-turned-Treasury-Secretary Henry Paulson deflected questions about whom to finger for the meltdown, saying simply: “I’m playing the hand that was dealt to me.” So is Wall Street, and it’s folding. With each New York closing, the ranks of the industries’ advocates are shrinking at cosmic speed. In a succession of Sundays, the formidable lobbying shops for Lehman, Merrill Lynch, Fannie and Freddie have gone silent. Throw in the earlier demise of Bear Stearns, and three-fifths of the investment banking Washington operations are on the sidelines.

Their political action committees, once used to make friends and campaign donations, are headed for the Federal Election Commission’s termination files. “At the beginning of the year, there were five investment banks. Now we’re down to two. That also means there were five PACs, and now we’re down to two. Believe me, that matters,” said one banking industry lobbyist.

Since 1989, Lehman’s employees and PAC have given more than $9 million in campaign contributions to candidates, according to the Center for Responsive Politics. Lehman’s PAC typically doles out about $250,000 to lawmakers each election cycle. It had dispersed just $162,000 this cycle, mostly to Democrats, before it went bankrupt on Monday. Merrill Lynch, which will now become a part of Bank of America, was even bigger. Since 1989, its executives and PAC donated more than $13.7 million to candidates, with the vast majority going to Republicans.

In the past two cycles, Merrill Lynch divided its giving more evenly between the two parties. Executives at both firms were also active in the presidential campaign, with Republican John McCain benefiting the most. McCain could count five Merrill Lynch and Lehman executives among his bundlers. He’d already received about $1 million from Merrill Lynch employees and nearly $300,000 from Lehman workers.

Democrat Barack Obama had just one Lehman-employed bundler. He’d received $313,000 from Lehman workers and an anemic $173,000 from those at Merrill Lynch. The money flow reflects key differences between the two candidates on the issue of reform.

McCain has called for a commission to study the investment industry and recommend changes, including consolidating the various institutions charged with regulating them. Obama gave a speech in March, at the time of the Bear Stearns bailout, blasting the industry and the wealth gap that has emerged between Wall Street and Main Street.

Like McCain, Obama is calling for streamlining the bureaucracy that overseas the business. But Obama also wants greater disclosure for investors and a broader definition of which businesses get regulated. No matter who’s elected, the next administration might have a much easier job of watching over the investment banking industry simply because it will be so tiny.

Only Goldman Sachs and Morgan Stanley are still standing, to be joined by the new Merrill Lynch branch over at Bank of America. It’s a staggering setback, but Paulson said he’d let “historians” parcel out the blame. Lucky for us, the mantra on Capitol Hill and among the bank lobbying survivors was, “Why wait?”

The game begins with the bankers who made bad mortgage loans, the so-called subprime loans to buyers who sometimes put no money down and underwent no background checks. The next finger points at those who converted those loans into securities and sold them on Wall Street without correctly valuing or disclosing the risk inherent in them. With the housing market hot, hot, hot, investment houses gobbled up them up without a worry about risk. After all, the bubble would never burst, and the money was pouring in.

As the transactions morphed and raced through the financial system, Washington was left largely in the dark. “We have to pity the government in a lot of ways,” says Robert F. Bruner, dean of the Darden School of Business at the University of Virginia. “Wall Street innovates so rapidly, it’s difficult for government to keep up.” Asked what Washington should have done, one industry insider said: “Nothing. Unless they’re going to start telling firms how to invest.

Government can do that in China. It can’t do it here.” Perhaps, but Washington doesn’t get a free pass from all corners. Congress had been warned for years that Fannie Mae and Freddie Mac, the two quasi-private home lenders, were on shaky ground. But lawmakers who had long been coddled and feted by Fannie and Freddie refused to tighten oversight of them. If they had, a tough regulator might have spied the inherent risks in the subprime market and required them to increase their cash cushion to counter future losses. And such a move would have sent a signal to Wall Street to take greater care, said an investment industry insider.

Others argue that the Federal Reserve Board should take some blame for keeping interest rates too low for too long and not seeing the threat of the subprime loan industry. Lower rates “fueled lending and made investors crazy for anything that could squeeze out a bit more yield,” said a financial trade association official. Treasury and the White House are fingered for failing to institute the very reforms they now advocate. A healthier and more efficient oversight operation might have caught the systemic risk of the subprime loans earlier.

Still, even among Democrats, there’s sympathy for Paulson, who has been forced to pick the winners and losers among his old banking buddies. Said one senior aide: “Paulson’s just the guy who’s catching the babies being thrown out the window. The fire started on this administration’s watch, pre-Paulson.”

Finally, there’s the Securities and Exchange Commission, which rates investments. “They had conflicts of interest,” noted the financial trade association official. “They were advising Wall Street banks on how to structure [structured investment vehicles] et cetera, then rating the resulting paper — and clearly they didn’t stress-test the ratings very well.” Said Bruner, “The SEC should have embraced real-time, Internet-based reporting of market value, so at the close of business each day, the public knew the value of these assets. The lack of transparency is at the core of every panic. The inability to know what the heck is going on puts investors on the sidelines, and they don’t put their money in play.”