As I See It: Paying Attention
August 22, 2011 Victor Rozek
“How the hell did this happen?” The late fiction writer Robert B. Parker called it “humanity’s cry.” For those not paying attention, that always seems to be the question, after the fact. Why are jobs so scarce? Why did the deficit explode? What happened to the economy? Tardy but reasonable questions given the misinformation surrounding our seemingly rapid decline. If you’ve lost your job, or are fearful of losing it; if you’re searching for work but can’t find it; if you’re unable to make your mortgage payment, or know someone who has lost their home, it’d be nice to at least know why it’s all falling apart.
Americans have a painfully short memory. The deficit that has the economy spinning and politicians hyperventilating, didn’t exist until the a Texan gave nearly $2 trillion in tax breaks to the wealthiest Americans and squandered another $1 trillion in two largely unnecessary wars. Wasting the surplus didn’t help, but it was not the first sign of global economic meltdown. That came from a sparsely populated country most Americans can’t find on a map: Iceland.
Iceland was a prosperous and stable nation with a population of 320,000 and a GDP of $13 billion. In 2000 its lawmakers caved under intense lobbying pressure and adopted a broad policy of deregulation. Three of Iceland’s largest banks were privatized, and although they had not previously operated outside the country, during the next five years they borrowed a whopping $120 billion–nearly ten times the amount of Iceland’s entire economic output. Bankers gave themselves raises, stocks went up by a factor of nine, and housing prices doubled. Like bears gorging on salmon, the country was getting fat on borrowed money.
American auditing firms found nothing wrong with this arrangement. Rating agencies upgraded the banks to AAA investment status. But by 2008 Iceland’s banks could not repay the loans. They collapsed and, overnight, unemployment tripled. Many Icelanders lost their life savings. It was a harbinger of things to come.
That same year, the bankruptcy of investment bank Lehman Brothers and the collapse of the world’s largest insurer, AIG, triggered a global recession. The cause of the meltdown is superbly chronicled in a recent DVD called Inside Job, must viewing for anyone with lingering questions.
After the Great Depression, the U.S. enjoyed 40 years of growth without a major financial crisis. Banks were made safe, prohibited from speculating, and financial markets were strictly regulated. The 1980s, however, saw the beginning of a 30-year deregulation frenzy. And financial crises followed.
In 1982 the savings and loan banks were deregulated allowing them to make risky investments with their depositors’ money. By the end of the decade, hundreds of S&Ls had failed, and taxpayers were presented with a $124 billion bailout. Many lost their life savings. Tom Brokaw called it “The biggest bank heist in our history.” Today that statement seems naive.
Since deregulating S&Ls worked out so well, in 1999 Congress passed the Gramm-Leach-Bliley Act, which overturned Glass-Steagall–the law which, since the Great Depression, prevented banks from gambling with their customers’ savings. Predictably, the next crisis came just two years later. Investment banks created a massive bubble in Internet stocks. When the crash came in 2001, investors lost $5 trillion. Investigators discovered that investment banks were promoting Internet companies they knew would fail because stock analysts were paid by the amount of business they brought in, not the profitability of their recommendations–a practice that continues today. Ten investment banks were fined a total of $1.4 billion and promised to behave.
The 1990s also saw the rise of complex financial products called derivatives, including spinoffs called credit default swaps. So convoluted were these products that billionaire George Soros once admitted he didn’t know exactly what credit default swaps were. Derivatives turned out to be the financial version of weapons of mass destruction. They provided the means for Type-A risk takers on Wall Street to bet on nearly anything, from the rise or fall of oil prices to the weather. By the year 2000, derivatives were a $50 trillion market–completely unregulated. A number of sober economists warned of potential disaster, but attempts to regulate derivatives was beaten back by the financial lobby with the acquiescence of the Clinton administration.
The housing crisis began when the old mortgage system was replaced by derivative-based speculation. Traditionally, a home buyer borrowed from a lender and paid that lender back. Lenders were careful about making loans because they personally stood to lose if the borrower defaulted.
Under the new system, however, lenders sold mortgages to investment banks. The banks, in turn, combined thousands of mortgages with car loans, student loans, credit card debt, etc., to create complex derivatives called Collateralized Debt Obligations (CDOs), which were then sold to investors. The mortgage borrower was now repaying investors all over the world. Lenders, having already sold their mortgages, no longer cared if borrowers were unable to repay. So they started making increasingly riskier loans, including subprime loans to people who would not normally qualify. Investment banks didn’t care, because the more CDOs they sold, the higher their profits. And the ratings agencies that should have warned investors were paid by the banks. They had no liability if their ratings were false, so they assigned the highest AAA ratings to some of the riskiest CDOs.
The party was in full swing. Between 2000 and 2003, the number of mortgage loans quadrupled annually. High risk subprime loans increased from $30 billion a year to over $600 billion a year. Banks borrowed more and more money to create more CDOs until some were leveraged at a rate of 33:1. (Leverage refers to what banks borrow verses what they actually own. A rate of 3:1 is thought to be prudent.) As a result, a tiny 3 percent decrease in their asset base would leave them insolvent. The risk was insane, unless you knew you were too big to fail.
Countrywide Financial made $11 billion in profits on $97 billion in subprime loans. The CEO of the about-to-go-bankrupt Lehman Brothers took home a tidy $485 million. Bonuses soared. But insiders knew they were selling what they themselves called “crap.” So they hedged their bets. AIG was selling another type of derivative called credit default swaps ($500 billion worth). Investors paid AIG a quarterly sum to insure their CDOs. If the CDO failed, AIG would reimburse the investor. But unlike regular insurance, speculators could bet against CDOs they were selling or didn’t actually own. And that’s what the investment banks did.
Goldman Sachs, and others, began betting against the CDOs they were aggressively recommending to investors. They bought $22 billion of insurance from AIG. And then, realizing the amount was ridiculously high, insured themselves further against the collapse of AIG. The more money their customers lost, the more Goldman made. But as the bubble began to burst, lenders could no longer sell their loans to investment banks and many went under. The market for CDOs collapsed and the investment banks were stuck with bad loans and real estate they couldn’t sell. The numbers are still incomplete, but to date Wall Street has cost the world tens-of-trillions of dollars, rendered over 30 million people unemployed, and doubled America’s national debt.
For which they were handsomely rewarded.
Before leaving office, Bush signed the $700 billion bailout package, and appointed Henry Paulson, fierce champion of derivatives and deregulation and former CEO of the Goldman Sachs, to be Treasury Secretary. Obama doubled down on the bailouts and appointed many of the same crooks to his financial team. According to Inside Job, “not a single senior financial executive has been prosecuted or even arrested. No special prosecutor has been appointed. Not a single financial firm has been criminally prosecuted for securities or accounting fraud. No attempt was made to recover executive compensation.” The men that caused the problems are still in power. The coup has already taken place, it just wasn’t officially announced.
We live in a nanny state for the powerful. Economic inequality is higher in the U.S. than in any other industrialized nation. For the first time in modern history, average Americans have less education and are less prosperous than their parents. What swamp have we come to inhabit when, in the words of The New York Times, “we cut the fixed incomes of our parents and grandparents so hedge fund managers can keep their 15 percent tax rates.”
There was a time when big wealth was used for big purpose. We built the interstate highway system, aspired to end poverty, we walked on the moon. These days wealth is used to create more wealth, without the intermediary step of creating anything useful or lasting. Nothing is built or manufactured. No new jobs are created. Financial markets are vast virtual casinos where speculators bet on the hourly value of currency, next year’s soybean prices, the default of mortgage holders, and the collapse of nations.
What happened in this country was a disaster, but it was not accidental. Like arson, the fires were deliberately set, stoked by Wall Street gamblers who speculated with our lives and futures. They were set by extremists who insist to this day that eliminating regulations, encouraging recklessness, and rewarding greed will make us safe and prosperous.
Since deregulation, Wall Street firms have been caught laundering money, defrauding customers, and cooking their books–over and over again. The biggest risk may not be investing your money with Wall Street, but trusting them not to find new ways to steal it. But people have short memories. No doubt many will be asking that same question again a few years from now. “How the hell did this happen?”