The Wall Street Government
What went wrong in 2008? Was it a mere accident, that on 15th of Sept.
2008, you read the wall street journal and read about the financial crisis and
the fall of Lehman brothers? Or was it because of the out of control financial
sector? Or was it the failure of the American democracy? I'll leave that upon
you to find your own answer. But what were the reasons? You'll find a lot of
people saying that, the reason for the crash was subprime loans or derivatives
but I think that these were the tools, rightly said by Sir Warren Buffett that
are the tools for mass destruction. What is the difference between tool and
reason? Tool is used to execute the reason, and then what is the reason of the
failure of so called "Economic Prosperity"? Money? Greed? Well it
seems like greed is legal on Wall Street these days. Many people also ask why
there has not been any criminal investigation on the companies or the people
behind it, the very logical answer which I find is that if there will be a
criminal investigation then you'll find the culprits.
To understand what went wrong in 2008 we need to go back to 1929 after
the great depression United States had an 40 years of economic growth without
any single financial crisis, the financial industry was tightly regulated, most
regular banks were local business and they were prohibited on speculating with
the depositors money. Investment banks which handled stock and bond trading
were small private partnership and in the traditional investment banking
partnership model the partners put the money up and obviously the partners
watch that money very carefully, they wanted to live well but they didn't want
to bench on anything. In the 1980s the financial industry exploded the
investment banks went public giving them huge amount of stock holder money,
people on Wall Street started getting rich. In 1981 president Ronald Regan
chose its treasury secretary Donald Regan, the CEO of the investment bank
Merrill Lynch. The Regan administration supported by economists and financial
lobbyist started a 30 year period of financial deregulation. In 1982 the Regan
administration deregulated savings and loan companies allowing them to make
riskier investment with their depositors money but by the end of the decade 100s
of savings and loan companies had failed, this crisis cost tax payers $124
billion and cost many people their life savings, one of the most extreme cases
was of Charles Keating. In 1985 when
federal regulators started investigating him, Keating hired an economist named
Alan Greenspan, in his letter to regulators Greenspan praised Keating sound
business plan and expertise and he sees no risk to invest Keating his
customer’s money, Keating reportedly paid Greenspan $ 40,000. Charles Keating
went to prison shortly afterwards but as for Alan Greenspan he was appointed the
chairman of the Federal Reserve (Central Bank of America), Greenspan was
reappointed by President Clinton and George.W.Bush.
During the Clinton Administration deregulation continued under
Greenspan. By the late 1990s the financial sector has consolidated into few
gigantic firms each of them so large that their failure could threaten the
whole system and the Clinton administration helped them even grow larger. In
1998 Citicorp and Travelers merged to form Citigroup, the largest financial
services company in the world, the merger violated the Glass Steagall Act, the
law passed after the great depression which prevented banks from consumer
deposits from engaging into risky investment banking activities. It was illegal
to acquire Travelers, Greenspan said nothing the Federal Reserve gave them an
exemption for a year and they got the new law passed. In 1999 at the urging of
Larry Summers and Robert Rubin, Congress passed Gramm-Leach-Bliley Act which
overturned Glass Steagall Act and create way for future such mergers; Robert
Rubin would later make $126 million as vice chairman of Citigroup. Why do you
have big banks? Well bank like lobbying power and banks knows when they are too
big they will be bailed. The next crisis came at the end of the 1990s; the
investment banks felt a massive bubble in internet the stocks which was
followed by a crash in 2001, that caused $5 trillion in investment losses, the
SEC had done nothing. In December 2002, 10 investment banks settle a case for
total $1.4 billion and promised to change their ways. Since deregulation
begin, the world's biggest financial firms have been caught laundering money,
defrauding customers and cooking their books again and again and again.
Beginning in the 1990s deregulation and advances in technology led to an
explosion of a complex financial product called Derivatives, economists and
bankers thought that they played market safer but instead they made them
unstable. Using derivatives, bankers would virtually gamble on anything, they
could bet on the rise or fall of the oil prices, even the weather. By the late
1990s Derivatives were $50 trillion unregulated market. In 1998 someone tried
to regulate them. In the May of 1998, the CFTC issued a proposal to regulate
derivatives, Clinton's treasury department had an immediate response,
Greenspan, Rubin and SEC Chairman Levitt issued a joined statement and
recommending legislation to keep derivatives unregulated. In December of 2000
Congress passed the Commodity Futures Modernization Act which banned the
regulation of derivatives.
By the time George.W.Bush took office in 2001 the US Financial Sector
was vastly more profitable, concentrated and powerful than ever before.
Dominating these industry were 5 investment banks, 2 financial conglomerates, 3
securities insurance companies and 3 rating agencies and linking them all
together was Securitization Food Chain, a new system which connected trillions
of dollars in mortgages and other loans with investor all over the world. In
the old system when the home owner paid mortgage every month the money went to
their local lender and since mortgages took decades to repay the lenders were
careful, in the new system lenders sold the mortgage to the investment banks,
the investment banks combined of thousands of other loans and mortgages
including car loan, student load and credit card debts to create complex derivatives
called Collateralized Debt Obligation, the investment banks then sold these
CDOs to the investor, now when home owner pay their mortgages the money went to
the investor all across the world, the investment bank paid rating agencies to
evaluate their CDOs and many of them were given a AAA rating which is the
highest possible investment grade. These made CDOs popular with retirement funds.
This system was a ticking time bomb, lender didn't care anymore that whether a
borrower could repay or not. So they started making riskier loans, the
investment banks didn't care either, the more CDO they sold higher their
profits and the rating agencies which were paid by the investment banks had no
liability if the rating of their CDOs proved bad. Between 2000 and 2003 the
number of mortgage loans made each year nearly quite doubled. Everybody in this
Securitization of Food Chain from the very beginning until the end, they didn’t
care about the quality of mortgage, they were concerned about maximizing their
volume. In the early 2000s there was huge increase in the riskiest loan called
subprime, but when thousands of subprimes were combined to create CDOs, many of
them received AAA ratings. The investment banks actually preferred subprime
loans, as they carried higher interest rates. This led to massive increase in
predatory lending. Borrowers were needlessly placed in expensive subprime
loans, and many loans were given to people who could not repay them. Since
anyone could get a mortgage home purchases and housing prices skyrocketed, the
result the biggest financial bubble in history. It was a huge boom in housing
which made no sense at all. Last time we had a housing bubble was in the late
1980s in that case the increase in the home prices was relatively minor and
that housing bubble was led to a relatively serve recession. Until 1996 and
2006 the real home prices effectively doubled. The subprime lending increased
from $30 billion a year to over $600 billion a year in funding in 10 years.
Countrywide Financial Corp, the largest subprime lender issued loans worth $97
billion, it made over $11 billion dollars in profits as a result. On Wall
Street annual cash bonuses spiked, traders and CEOs became enormously wealthy
during the bubble. Lehman Brothers was the top underwriter of subprime lending
and their CEO Richard Fuld took home $485 million. By 2006 about 40% of all
profits of S&P 500 firms were coming from financial institutions. It wasn’t
real profit, wasn’t real income, it was just money which was just being created
by the system and booked as income, 3 years down the road there’s a default
it’s all wiped out, it was great global ponzi scheme. Through the Home
Ownership and Equity Protection Act, the Federal Reserve had a broad authority
to regulate the mortgage industry but Fed chairman Alan Greenspan refused to
use to it. The SEC conducted no major investigations to investment banks during
the bubble.
During the bubble, the
investment banks were borrowing heavily to buy more loans and create more CDOs.
The ratio between borrowed money and the bank’s own money was leverage, the
more the banks borrowed the higher their leverage. In 2004 Henry Paulson, the
CEO of Goldman Sachs helped lobbied SEC to relax limits on leverage, allowing
the banks to sharply increase their borrowings. The SEC somehow decided
investment banks to gamble a lot more, that was nuts I don’t know they did that
but they did that. Investment banks leveraging up to the level of 33:1 which
means a tiny decrease in the value of their asset base would leave them
insolvent. There was another ticking time bomb into the financial system, AIG
the world’s largest insurance company was selling huge amount of derivatives
called Credit Default Swaps. For the investors who owned CDOs, CDS worked like
an insurance policy. Investor who purchased CDS paid AIG quarterly premium, if
the CDO went bad, AIG promised their investor to pay for their losses. But unlike
regular insurance speculators could also buy CDS from AIG in order to bet CDOs
they didn’t own. In insurance you can only insure something you own, let’s say
you and I own a property. I own a house, I can only insure that house once, but
the derivatives essentially enables anyone to actually insure that house, so
you can insure that somebody else could do that, so 50 people might insure my
house. So if my house burns down the number of losses in the system becomes proportionally
larger. Since CDS were unregulated, AIG didn’t have to put aside any money to
cover potential losses, instead AIG paid their employees huge cash bonuses as
soon as contracts were signed but if the CDOs later went bad then AIG would be
on the hook. AIG’s Financial Products division in London issued $500 billion
worth of CDS during the bubble, many of them CDOs backed by subprime mortgages.
The 400 employees at AIGFP made $3.5 billion between 2000 and 2007, Joseph Cassano
the head of AIGFP personally made $315 million. In 2007 AIG’s auditors raised
warning, one of them Joseph St. Denis resigned in protest after Cassano repeatedly
blocked from investigating AIGFP’s accounting. In 2005 Raghuram Rajan, then the
chief economist of the IMF delivered a paper at Jackson
Hole Economic Symposium. Rajan’s paper focused on incentive structure that
generated huge cash bonuses based on short term profits but which imposed no
penalty for later losses, Rajan argued that these incentives encourage bankers
to take risk that might destroy their own firm or even the entire financial
system. You’re gonna make an extra $2 million a year or $10 million a year by
putting your financial institution at risk, someone else pays the bill, you
don't pay the bill, would make that bet, most people on wall street said sure
I'll make that bet. It never was enough, they don't wanna own one home, they
wanna 5 homes and they wanna an expensive penthouse at Park Avenue and
they wanna have their own private jet.
Goldman Sachs sold at least $3.1 billion
worth of these toxic CDOs by the first half of 2006, the CEO of Goldman Sachs
of this time was Henry Paulson, the highest paid CEO on Wall Street. In 2006
Henry Paulson was nominated to be the secretary of the treasury. One might
think it would be difficult for Paulson to adjust to government salary but
taking the job as the treasury secretary was the best financial decision of his
life, Paulson had sell its $480 million of Goldman Stock when he went to work
for the government but because of the law passed by the first president Bush,
he didn't have to pay any taxes on it. It saved him $50 million. By the late
2006 Goldman had taken things a step further, it just didn’t sell toxic CDOs,
it actively started betting against them at the time it was telling customers
that they were high quality investments. By purchasing CDS from AIG, Goldman
could bet against the CDO it didn’t own and get paid when CDOs failed. Goldman
bought at least $22 billion worth of CDS from AIG, it was so much that Goldman
realized that AIG itself might go bankrupt, so they spent $150 million insuring
themselves against AIG’s potential collapse, then in 2007 Goldman went even further,
they started selling CDOs specifically designed so that more money their customer
lost the more money Goldman Sachs made. Morgan Stanley was also selling mortgage
securities that it was betting against and now it’s being sued by the government
employees of Virgin Island for fraud. The 3 rating agencies Moody’s, S&P
and Fitch made billions of dollars giving high ratings to risky securities.
Moody’s the largest rating agency tripled its profits from 2000 to 2007. AAA
rated securities skyrocketed from a handful to thousands and thousands. No
major actions could be taken against the rating agencies as according to them
it was mere their “opinion” and had no liability if the CDO failed.
The next part of the blog will come soon which will talk about the crisis and it's after effect