On May 2, 2011, US Treasury Secretary Timothy Geithner sent his third ultimatum to Congress noting that the US is set to reach its statutory debt limit of $14.3 trillion by May 16, and unless the ceiling was raised by August 2, the country could face default. ‘The economy is still in the early stages of recovery,’ he warned, ‘and financial markets here and around the world are watching the United States closely. Delaying action risks a loss of confidence and accompanying negative economic effects.’ These will have a ‘catastrophic economic impact’ and ‘broad range of government payments would have to be stopped, limited or delayed, including military salaries, Social Security and Medicare payments, interest on debt, unemployment benefits and tax refunds.’ It will also lead to ‘sharply higher interest rates and borrowing costs, declining home values and reduced retirement savings for Americans.’ Mostly ominously, it will ‘cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover.’
The situation doubtless sounds dire, but there is something mildly ironic about a Treasury Secretary warning the government against losing the trust of an industry which he only recently rescued with an extraordinary cash transfusion of $4.1 trillion in public money. The real costs of the bailout are estimated by Bloomberg at $ 12.8 trillion. But it is easy to overlook the consistency in Geithner’s assessment: the US government was a hostage to the financial industry when it faced collapse, and it is a hostage to it when its own economic future turns increasingly uncertain. The doubling of US national debt between 2004 and 2011 is merely a symptom of the problem—two wars and the bailout have both paid a part—but at its root are the regulatory failures and conflict of interests which are embodied in the person of Timothy Geithner. For over two decades the US Treasury has functioned as a de facto arm of Wall Street, eschewing its regulatory function to act as a passive enabler. Little surprise then that three years after the crisis the institutions that caused the collapse continue to evade responsibility and the price is instead paid by the taxpayer in exorbitant, lost homes and depleting employment opportunities.
How did things go so bad?
John Lanchester’ Whoops!: Why everyone owes everyone and no one can pay is a lucid, intelligent, and often amusing account of the causes of the financial crisis. A layperson could not ask for a better introduction to the concepts and practices of finance and the alphabet soup of financial instruments which contributed to the global crisis. He does so in an intuitive manner with examples, anecdotes and even literary allusions. He attributes the global financial crisis to four factors: ‘a climate (the post-Cold War victory party of free-market capitalism), a problem (the sub-prime mortgages), a mistake (the mathematical models of risk) and a failure, that of the regulators.’ The financial regime that eventually led to the global crisis of 2008 was inaugurated around the same time the neoliberal order took off. It began in the early 1980s with Federal Reserve chief Paul Volcker’s monetary policies and Ronald Reagan’s appointment of Donald Regan as Treasury Secretary who quickly proceeded to liberalize the Savings and Loans industry with the 1982 Garn-St Germain Depository Institutions Act which created insurance for mortgage lenders, thereby increasing recklessness. In Britain, a similar regime was introduced by Margaret Thatcher in 1986 in what came to be known as ‘big bang’, the simultaneously abolition of all barriers, separations and rules demarcating different areas of banking and finance. By the end of the decade Wall Street and the City of London were a formidable force. But it was in the heady triumphalism following the collapse of the Berlin Wall that finance capital was truly unleashed.
The transformation was heralded by Bill Clinton’s stacking of his treasury department with Wall Street stalwarts and ideological free-marketeers. Under Robert Rubin and Lawrence Summers financial regulations were eroded and the industry was further consolidated. Both endorsed the Gramm-Leach-Bliley Act of 1999, which, among other things, repealed the New Deal-era Glass-Steagall Act which had until then enforced a separation between commercial and investment banking. For 40 years after the Great Depression, this had ensured steady growth without any financial crises. The immediate aim of the legislation was to legalize the merger of Citicorp and Travellers into a new entity, Citigroup, which had taken place a year earlier in violation of the Glass-Steagall Act. The long term consequences of this deregulation would be catastrophic for the public, but it would handsomely reward its architects. Rubin would go on to make $126 million as the vice chairman of Citigroup. These conflicts of interest are comprehensively explored in Charles Ferguson’s Oscar-winning Inside Job, a hard-hitting investigation of the causes and consequences of the financial crisis.
The deregulations of the 1980s had already caused several crises, including the Savings and Loans scandal which resulted in the first property bubble which in the UK led to half a million people losing their homes and in the US to a crash that cost taxpayers $124.6 billion contributing to the 1990-1991 recession; the October 1987 Black Monday crash, a collapse more precipitous than any since the Great Crash of 1929; the giant internet bubble fuelled mainly by investment banks which finally burst in March 2000 when the Nasdaq index for tech stocks fell by 80 percent wiping out $5 trillion in investment losses; and finally the collapse of Enron which left markets reeling. The regulatory failures in both cases foreshadowed the problems that would contribute to the sub-prime mortgage scandal which triggered the global financial crisis.
The crucial development in this regard was the rise of derivatives, a type of financial instrument, with roots in gambling, which is used to manage risk. It gives an investor the right to buy in future a product at an agreed price. The right can itself be sold. In their rudimentary form, derivatives include Options, which give one the right but not the obligation to buy or sell something at a specified future date; and Futures, which give one both the right and obligation to buy or sell. Futures are naturally riskier. They serve as a cheap form of insurance, allowing buyers to hedge their risks; but mostly, they are used for speculation thereby magnifying the risks. (All forms of derivatives are made comprehensible by Lanchester with entertaining examples.)
First developed in the commodities markets, derivatives have been in use since at least 1637 when they caused the Dutch Tulip crash. The market in derivatives was eventually professionalized, entering the realm of finance as trade in shares. It really took off after Fischer Black and Myron Scholes developed an equation that purported to calculate the price of financial derivatives based on the value of the underlying assets. The market was mathematized and beginning in the 1990s, was given a further boost by the developments in information and communications technology. By the end of the decade, derivatives had expanded into a $50 trillion market. But as the market grew, the derivatives also became more complex. They were designed mostly by math PhDs and were often incomprehensible to the managers (Some mathematicians were even encouraged to establish their own hedge funds). But there was also an attempt to actively conceal the real assets underlying the derivatives. This led to an odd situation where the market in derivatives was several times larger than the price of their underlying assets. Today the market exceeds the total world economic output of $60 trillion by a factor of ten.
A key factor that contributed to the collapse, writes Lanchester, was the inability of the mathematicians to appreciate the difference between risk and uncertainty. Risk can be managed, uncertainty can’t—it was therefore left out of the equation. Investors like Warren Buffet, who understood this difference, shunned derivatives. But for the gamblers of Wall Street seeking to maximize profits while deferring risks, new types of derivatives presented an ideal tool. The most destructive category was the Credit Default Swap (CDS) which allowed investors to exchange revenues without trading underlying assets. Swaps had been in operation since 1981, but in the early 1990s JP Morgan streamlined them into CDS’s which helped minimize risk by spreading it in the financial system. This would later enable the destructive practice of widespread sub-prime lending, making the loans to people with bad or no credit histories seemingly risk-free by selling the risk to others.
The process was further streamlined and industrialized through the process of Securitization, which allowed loans to be bundled together into packages so that buyers of the derivatives could rely on safety in numbers and the law of averages. Through a process known as Tranching, the securities could be categorized into different risk levels and sold off accordingly with riskier securities paying the highest rates of interest. Banks further insulated themselves from risk with the creation of offshore shell companies called Special Purpose Vehicles (SPV) to assume the risk. Thus they were able to remove the swaps from the bank’s balance sheet, simultaneously generating income and freeing capital to lend elsewhere. Thus was born Collateralized Debt Obligations (CDO)–a pool of debt by a group of borrowers added together and sold as a set of bonds paying a range of different interest rates.
In the US if interest rates in the late 1970s early 1980s were at 20 percent, by June 2003 they had reached a remarkable low of 1 percent by Federal Reserve chairman Alan Greenspan’s fiat. Investors had lost faith in socks following the dot-com bubble and the Enron scandal and the low interest rates made bonds a poor investment. But it was an ideal environment for buying houses. Investors soon a profitable segment in the large pool of low-income, high-risk borrowers, whose meagre or non-existent credit histories had made them ineligible for mortgages at prime rates. Many of them were willing to pay higher interest rates, making them an attractive market for lenders. Meanwhile securitization had freed up capital for further lending. The only obstacles were statistical: how to manage risk when the borrower had no credit history. This was resolved by a mathematician named David X. Li, who used something called a Gaussian Copula Function to assess risk by correlating one borrowers insurance price (CDS) with those of others rather than the record of the individual borrower, ignoring both history and underlying data. The markets embraced it as it could reduce the unquantifiable risk of mortgage-backed CDOs, particularly sub-prime loans with meagre data, to a number. History was altogether ignored. This opened up the market for sub-prime mortgage lending. The market in CDOs went from $275 million in 2000 to $4.7 trillion in 2006; the CDS market went from $920 billion in2001 to $62 trillion in 2007! Lanchester explains:
Banks and financial institutions were now able to buy job lots of mortgages and put them together into a single pool. Then they could divide that pool up into unit which could be sold on to investors. That took the risk off the bank’s books and freed the capital to be lent to someone else.
The risk no longer belonged to the lenders; it was securitized and sold on. They could take bigger punts. They were aided in this by the credit rating agencies, which knowingly rated the riskiest of loans as safe—two thirds were rated AAA, the highest rating, as safe as the US government securities! (They would later claim first amendment protection for their misleading ratings, passing them off as mere ‘opinions’) As the rating agencies relied on lenders for their business (whom the law required to underwrite the rating bills), they obliged by providing the ratings the lenders asked for (as one internal email by a Standard & Poor’s employee put it: ‘It could be structured by cows and we would rate it.’) The rating agencies made billions, quadrupling profits in the case of Moody’s, one of the giant three. Lenders meanwhile created custom bonds to fit the rating agencies’ criteria, further concealing the risks. These included CDOs of CDOs—CDO2—and Structured Investment Vehicle (SIV) which were set up like SPVs. To manage an industry grown big and complicated, complex statistical tools were relied on to assess and contain risk. The most prominent among these was Value at Risk or VaR, a statistical tool that reduced market risk to a single number. VaR’s three components presented a time frame, a number with the amount of money at risk and a fixed probability of 1 to 5 percent of the money being lost. VaR’s brought a degree of certainty which made them popular in the derivatives market. But as Lanchester notes, VaR, like all probabilistic and computer-based systems, is only as good as its data, and in most areas of the market there just wasn’t sufficient data. Secondly, VaR was based on the bell curve and hence worked well only under normal circumstances. He gives the example of a theatre where patterns of movement under normal circumstances could do little to predict how people might move once someone shouts ‘fire!’ Most bankers were relying on VaRs to calculate the risk, hence were blind to uncertainties.
In the first half of 2006 alone, Goldman Sachs — the company Matt Taibbi has aptly labelled ‘the great American bubble machine‘ — had sold $3.1 billion worth of these toxic CDOs. By the end of the year, Goldman Sachs wasn’t just selling them, but actively betting against them while assuring customers they were highly secure investments. Meanwhile it hedged against potential losses by purchasing CDS from insurance giant AIG. It could now bet against CDOs it didn’t own and get paid if the CDOs failed. Most brazenly, it joined hedge fund manager John Paulson, who was had made $12 billion betting against the mortgage market, to create more CDOs. The investment bankers were counting on the market’s collapse.
This displacement of risk, which separated lender from borrower through securitization, encouraged predatory lending: ‘mortgage lenders doing everything they could to sign up borrowers at higher-than-ordinary, sub-prime interest rates.’ Some of this happened in UK (where an extraordinary 70 percent own their own homes as compared to 40 percent of Germans), but overwhelmingly it happened in the US. Lenders exploited the desperation or naivety of first time home-owners to get them to sign mortgage agreements at a price far higher than initially agreed. Brokers even put people who qualified for prime loans in the sub-prime bracket to benefit from the higher interest rates. The targets were often minorities. Wells Fargo is today being sued for systematically targeting African Americans for sub-prime loans even where they qualified for better rates. Borrowers were often also tricked into signing jury trial waivers. To most borrowers housing looked like a safe bet: prices were steadily on the rise, reaching 194 percent of real value by 2007. Where in Germany a regulations prevent banks from lending borrowers more than 60 percent of the house price and in France no more than a third of the income, according to journalist Allan Sloan, in the US Goldman Sachs had lent on average 99.3 percent of the house price to borrowers. According to one former mortgage broker 70 percent of the mortgage applications were erroneous or fraudulent and by 2006, 60 percent of sub-prime applicants were exaggerating income by 50 percent. In American Casino, a fascinating investigation of the sub-prime lending scandal, Andrew and Leslie Cockburn reveal that by 2006, 61 percent of the borrowers categorized sub-prime actually qualified for prime rates.
As the property market boomed, the financial bubble grew bigger, and Wall Street compensations increased. Annual cash bonuses doubled between 2003 and 2006. Countrywide Financial, the largest sub-prime lender, issued $97 billion in loans and made $11 billion profits. Its CEO Angelo Mozilo made $470 million, $140 of which came from dumping stocks in the 12 months before the collapse. Richard Fuld, the CEO of Lehman Brothers, one of the top underwriters of sub-prime loans, took home $485 million in bonuses. Stan O’Neill, the CEO of Merrill Lynch, received $90 million in one year alone, later allowed to retire with $161 million in severance pay. His successor received $87 million in 2007, and gave out over $3.6 billion in bonuses days after government bailout.
The financial industry’s math prodigies had used the Gaussian Copula Function to conclude that the possibility of the current market implosion—i.e. 20 percent decline in house prices—was so remote that it could occur only once in several trillion years—regardless of the fact that property prices had already fallen by 20 percent twice in the past couple of decades. For Goldman Sachs CEO David Viniar, developments at the beginning of the crisis were ‘25-standard deviation moves, several days in a row.’ In other words, notes Lanchester, the likelihood of house prices dropping and people with bad credit being unable to pay their mortgages was turned into the unlikeliest event in the history of the universe! The data on historical CDS correlation proved useless because the new sub-prime mortgages had never seen a period of crisis. By October 2007, a third of the sub-prime loans had already defaulted. Soon millions more would be foreclosed. The market for CDOs eventually collapsed leaving investment banks like AIG with hundreds of billion dollars in toxic assets and loans.
Why was this market, which was big enough to threaten the health of global economies, left unsupervised?
Alan Greenspan, a disciple of crackpot novelist Ayn Rand, was opposed to any government meddling in the working of the markets. Indeed, his long tenure at the Federal Reserve began shortly after he had pocketed $40,000 to write a defence of Charles Keating, the Savings and Loan executive who would shortly go to prison for fraud, racketeering and conspiracy. Greenspan was also an admirer of derivatives. He refused to use his authority to rein in the out-of-control mortgage industry using the Home Ownership and Equity Protection Act. Greenspan was succeed in 2006—the top year for sub-prime lending—by Ben Bernanke, who also turned a blind eye. The Securities and Exchange Commission likewise failed to conduct a single investigation. Indeed, it cut 146 employees from its enforcement division, and its office of risk management had a staff of 1. The sole exception was Brooksley Born, the chairman of the Commodity Futures Trading Commission (CFTC), who tried to regulate derivatives in 1998 only to be bullied by Treasury Secretary Lawrence Summers into desisting (Summers’s sensitivity is understandable considering that he would go on to make $20 million working for a hedge fund dealing in derivatives). Geenspan, Robert Rubin, and SEC chairman Arthur Levitt took it further on 7 May 1998 issuing a statement condemning Bourne and recommending legislation to keep derivatives unregulated.
A derivatives lobby, the International Swaps and Derivatives Association has been in operation since 1985, but it had its major triumph in 2000 when it lobbied the Congress to pass the Commodity Futures Modernization Act which exempted CDSs from regulation. Henry Paulson, the Goldman Sachs CEO who had overseen the largest sales of toxic CDOs and lobbied for the easing of restrictions on leverage—i.e. the amount of cash a bank has to hold in reserve in proportion to the money it lends—was appointed Treasury Secretary by Bush in 2006. Unsurprisingly, as late as 9 February 2008, he remained in denial about the recession which had already set in four months earlier. His predecessors, Rubin and Summers were equally vehement in their opposition to government regulation. Indeed, in 2005 when IMF chief economist Raghuram Rajan raised the alarm about the incentive structure of the industry which rewarded risk and overlooked failure, Summers contemptuously dismissed his warnings. Alarms were also raised by economist Nouriel Roubini, journalist Allan Sloan and IMF chairman Dominique Strauss-Kahn, but to little effect.
A month after Paulson assured the public that there was no recession, the investment giant Bear Stearns collapsed. Foreclosures were already an epidemic and the CDO market had collapsed. But the biggest shocks came later in the year first when on 7 September Fannie Mae and Freddie Mac, the giant underwriters of the American mortgage industry, were nationalized. On 14 September Merrill Lynch was taken over by Bank of America. On 15 September, the banking giant Lehman Brothers went into receivership. The next day investment giant AIG—one of the biggest players in the CDS and CDO market—had to be bailed out because it was ‘too big to fail.’ Between 16 September 2008 and 1 March 2009, AIG would receive four bailouts, each progressively larger. (The government was really bailing out AIG’s insurees, not all of which were American companies. As Lanchester notes, the value of AIG’s own shares was no more than $2 billion. It cost 85 times more to save it than it would have to buy it.) On 21 September Goldman Sachs and Morgan Stanley converted their legal status to holding banks in order go gain access to state funds in return for increased supervision. Meanwhile over 300 major mortgage lenders have gone out of business since 2006. By early 2010, there had been 6 million foreclosures in the US with some estimating 9 million more in the next three years.
So how have the banks behaved since receiving the massive public bailouts? As Charles Ferguson, director of Inside Job, pointed out in his Oscar speech, the government has yet to prosecute a single banker. With a Treasury Department stacked with former Goldman Sachs employees, and with over 50 percent of its campaign finances originating in Wall Street, the Obama administration is unlikely to bring charges against the lords of finance. In January 2011 the Financial Crisis Inquiry Commission published the Financial Crisis Inquiry Report, and in April 2011 The Senate Permanent Committee on Investigations released the Levin-Coburn report (pdf). Both were thorough in their scope and damning in their conclusions—and both were ignored by congressional leaders, and consequently by the media. Meanwhile in Britain, where the consequences have been no less devastating, the media has been preoccupied with bread and circuses even as the effect of redundancy notices, reduced welfare payments, and diminishing social services will soon be experienced by many as the new fiscal year begins. This story is on-going, and one could do worse at this point than to pick up a copy of Whoops!, Inside Job, and American Casino to make sense of how we got here, and if there is a way out.