The 2008 Meltdown of the Financial Services Industry

This article is an excerpt from my book Collusion. The 2008 meltdown of the financial services industry, the result of ego, greed, the lack of accountability, the lack of transparency, and the undue influence of highly compensated “Thought Leaders,” cost tens of millions of people their savings, their jobs, and their homes.

Over the years, commentators have pointed to specific events which may have contributed to the 2008 meltdown. Let’s take a look at a few.

In 1981, President Reagan started a 30-year period of financial deregulation. Deregulated Savings & Loans were now allowed to make risky investments with their depositors’ money. As a result, by 1990, hundreds of Savings & Loans had failed.

The failure of the Lincoln Savings & Loan Association which was headed by Charles Keating is instructive. In 1985, Keating hired Alan Greenspan when federal regulators began investigating him. Alan Greenspan praised Keating. Greenspan stated, “There is ‘no foreseeable risk to allow Charles Keating to invest his customers’ money’ due to Mr. Keating’s sound business plan and managerial expertise.” Keating reportedly paid Greenspan $40,000 for his opinion. Keating went to prison shortly afterwards. Alan was appointed Chairman of the Federal Reserve by Reagan. He was reappointed by Clinton and Bush.

By the late 1990s, the financial sector consolidated into a few gigantic firms (each too big to fail).

In 1999, with support from Federal Reserve Chairman Greenspan, Treasury Secretary Rubin and his successor Larry Summers, Congress passed the Gramm-Leach-Bliley Act which overturned the Glass-Steagall Act. The Glass-Steagall Act, also known as the Banking Act of 1933, was passed by Congress in 1933. Glass-Steagall, enacted as an emergency response to the failure of nearly 5,000 banks during the Great Depression, prohibited banks from being “engaged principally” in non-banking activities, such as the securities or insurance business. Firms were thus forced to choose between becoming a bank engaged in simple lending or an investment bank engaged in securities underwriting and dealing. Subsequent legislation in 1956 would extend this restriction to bank holding companies.

Since deregulation, Wall Street banks have been involved in fraud, money laundering, and cooking their books. Investment banks continued to pay fines but did not admit any wrongdoing.

The financial industry developed a wide range of derivative instruments in the 1990s, most of which were not regulated. As the name implies, a derivative is a contract whose value derives from some other asset, such as a commodity, bond, stock, or currency. Rather than trade or exchange the underlying asset itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset. Key to derivatives is that those who buy and sell them are each making a bet on the future value of that asset. Derivatives can be used by investors to speculate and to make a profit if the value of the underlying asset moves the way they expect. Alternatively, traders can use derivatives to hedge or mitigate risk in the underlying asset, by entering into a derivative contract whose value moves in the opposite direction to their underlying position and cancels part or all of it out.

The Commodity Futures Trading Commission (“CFTC”) oversaw the derivatives market. In the late 1990s, Brooksley Born, the chairwoman of the CFTC, raised concerns about the potential risks of the unregulated market in many derivative instruments. Unlike stocks, bonds, and options, there was no clearinghouse for trades in most of the new derivative instruments. Without a transparent record, derivative trades could become a source of dispute and uncertainty.

Born’s public concerns were vociferously opposed by Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and Rubin’s successor, Larry Summers. They saw no reason to interfere with the new innovations in financial markets. After one meeting between the nation’s top financial regulators, Secretary Rubin was reported to say to Chairwoman Born, “You’re not going to do anything, right?” The debate left Born politically isolated, and she left the CFTC in mid-1999. Later that year, Greenspan and Rubin issued a report along with Born’s successor at CFTC that recommended no regulation on derivatives.

Ultimately, the fate of derivatives regulation was decided in Congress. Senator Phil Gramm, cosponsor of the Gramm-Leach-Bliley Act, was one of several Congressmen to push legislation that would deregulate the market. Gramm, in particular, wanted strict language to limit the direct oversight of the CFTC and SEC. A group of regulators, including the Chairs of the CFTC and SEC as well as Treasury Secretary Summers, reached a compromise with Gramm, and Congress moved quickly on the bill.

On December 15, 2000, the 262-page Commodity Futures Modernization Act of 2000 was included as a rider to the Consolidated Appropriations Act for FY 2001, an 11,000 page spending bill. The legislation, passed without debate or review, exempted derivatives from regulation and made a special exemption for energy derivative trading that would gain notoriety as the “Enron loophole.” It was signed into law on December 21, 2000 by President Clinton. Use of derivatives exploded dramatically.

After leaving the Senate, Phil Gramm became vice chairman of UBS.

In a completely unregulated market, derivatives trading expanded quickly, increasing from a total outstanding nominal value of US$106 trillion in 2001, to a value of US$531 trillion in 2008. This rapid growth overwhelmed the legal and technological infrastructure of the industry. Commercial banks - the major players in the market - could make trades so quickly and enter contracts so freely that oftentimes no firm was certain who owed exactly how much to whom.

The unregulated market in derivatives and swaps resulted in two ticking time bombs: the securitization of subprime mortgage-backed Collateralized Debt Obligations (CDOs) and Credit Derivative Swaps (CDSs).

The “securitization food chain” was comprised of home buyers, lenders, investment banks, and investors. The concept is fairly simple. A lender makes a loan to a home buyer. The lender sells this mortgage to an investment bank. The investment bank bundles this mortgage with other loans and creates CDOs which the investment bank sells to investors. The problem is that the lender who makes the initial loan to the home buyer is no longer at risk of failure if the loan is not repaid. Now, when home owners pay their mortgages, the money goes to investors all over the world.

Investment banks pay the rating agencies (e.g., Moody’s, Standard & Poor’s, and Fitch) to evaluate CDOs. Since the ratings agencies have no liability if their ratings prove wrong, subprime mortgage-backed CDOs almost always received a “AAA” rating. The three rating agencies made billions of dollars by giving the highest ratings to the riskiest CDOs.

Here’s the first ticking time bomb. The lenders don’t care if the borrowers can repay loans so the lenders make riskier loans. The investment banks don’t care either because the more CDOs they sell, the higher their profits. Actually, the investment banks preferred the riskiest subprime loans because they carried higher interest rates. The rating agencies, since they have no liability if their ratings prove wrong, are more than happy to give the riskiest CDOs a “AAA” rating.

Between 2001 and 2007, anyone could get a mortgage. As a result, housing prices skyrocketed. It is estimated that housing prices effectively doubled between 1996 and 2006. The investment banks were borrowing heavily to buy more loans in order to create more CDOs. Even though the subprime mortgage-backed CDO market was nothing more than a Ponzi scheme, Alan Greenspan continued to refuse to regulate derivatives. Greenspan’s deregulation ideology significantly contributed to the 2008 meltdown of the financial services industry.

Leverage ratio means the ratio between borrowed money and an investment bank’s own money. The more an investment bank borrows, the higher its leverage. In 2004, the SEC relaxed the limits on leverage to allow investment banks to increase their borrowing. What could possibly go wrong?

Here’s the second ticking time bomb. In 2001, three securities insurance companies dominated the U.S. financial sector: AIG, MBIA, and AMBAC. AIG was selling huge quantities of derivatives called Credit Derivative Swaps (CDSs)

CDSs act like an insurance policy. An investor who owns a CDO pays AIG, for example, a quarterly premium for a CDS. If the CDO goes bad, AIG pays the investor for his losses. But unlike regular insurance, speculators could also purchase CDSs from AIG to bet against CDOs they didn’t own. The result is that if a CDO goes bad, the loss is much greater because more people “insured” the CDO. Since CDSs were unregulated, AIG didn’t have to put aside any money to cover potential losses.

The investment banks’ incentive structure generated huge cash bonuses based on short term profits but imposed no penalties for later losses. This encouraged investment bankers to take risks that could eventually destroy their banks or result in a financial crisis.

Hank Paulson was CEO of Goldman Sachs in 2006. George Bush nominated him to be Treasury Secretary. In late 2006, Goldman Sachs purchased CDSs from AIG to bet against CDOs they didn’t own and were paid when the CDOs failed. Goldman Sachs didn’t tell its customers they didn’t like CDOs anymore. It is a safe bet that Hank did not say a word either.

Just pause for a second. Yes, incredibly, investment banks were selling CDOs to their customers while they were betting against these CDOs with CDSs.

Ben Bernanke became Chairman of the Federal Reserve Board in Feb 2006. He did nothing in regard to CDOs.

In 2008, the “securitization food chain” imploded. Lenders could no longer sell their loans to the investment banks. The market for CDOs collapsed. In March 2008, Bear Stearns ran out of cash and was acquired for US$2/share by JP Morgan Chase.

In September 2008, Fannie Mae and Freddie Mac were taken over by the government; AIG was taken over by the government; and Hank Paulson and Ben Bernanke asked Congress for US$700 billion to bail out the investment banks. In October 2008, President Bush signed a US$700 billion bailout bill.

By early 2010, the number of foreclosures in the U.S. reached 6 million.

The men who destroyed their own companies and plunged the world into a financial crisis walked away from the wreckage with their fortunes intact. For example, the top five executives at Lehman Brothers made over US$1 billion between 2000 and 2007. When Lehman went bankrupt, they kept all their money.

The financial sector employs thousands of lobbyists. Between 1998 and 2008, the financial industry spent over US$5 billion on lobbying and campaign contributions.

The financial services industry even corrupted the study of economics itself. Since the 1980s, academic economists have been major advocates of deregulation and have played powerful roles in shaping U.S. government policy. Even after the crisis, many prominent university professors of economics opposed reform.

Many of these “unbiased” university professors of economics made fortunes by helping the financial industry shape public debate and government policy (consulting, speaking engagements and serving as board directors).

Martin Feldstein (Professor of Economics, Harvard) was a major architect of deregulation. From 1988 to 2009, he was on the board of directors of AIG which paid him millions of dollars. Although he wrote a significant number of articles, Feldstein never investigated unregulated CDSs.

Glenn Hubbard (Dean, Columbia Business School) has stated that he does not believe the financial services industry has too much political power in the U.S. In November 2004, Hubbard co-authored a widely-read paper titled “How Capital Markets Enhance Economic Performance & Facilitate Job Creation,” with William Dudley (Chief Economist of Goldman Sachs & Co.) in which Hubbard praises credit derivatives. He states credit derivatives improve the allocation of capital, distribute risk and enhance the stability of the U.S. banking system.

The inequality of wealth in the U.S. is now greater than in any other developed country. For the first time in history, average Americans have less education and are less prosperous than their parents.

It’s a Wall Street government. President Obama chose Timothy Geithner as Treasury Secretary. Obama picked Gary Gensler (former Goldman Sachs’ executive who had helped ban the regulation of derivatives) to head the CFTC. Obama’s Chief Economic Advisor was Larry Summers.

In short, the 2008 meltdown of the financial services industry was due to a total lack of transparency, a total lack of accountability, and a small group of very cooperative players who were driven by ego and insatiable greed which resulted in the explosion in the unregulated market of CDOs on the frontend and CDSs on the backend.

Meltdowns occur when regulators don’t regulate.