The Wall Street Government

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