There have been plenty of books on the financial crises but most aren't quite as entertaining and, to be frank, potty mouthed, as this one. Matt Taibbi is a muck racking reporter for the Rolling Stone who, I suspect, will be the first up against the wall when our corporate overlords decide they can stop even pretending to care about the rule of law. The book lays out some of the facts about how exactly a bunch of insanely greedy evil doers destroyed our economy with the active help of 'our' government. I can't say these folks are criminals because we live in a criminal state where the evil doers simply have the laws changed to make their acts legal. In this blog article I look at the part of his book that deals with the mortgage crises.
There are many parts to the story that Mr. Taibbi tells but I'll stick to what I see as the highlights. This means I'm leaving out lots of information about Alan Greenspan, AIG and Goldman Sachs.
The core of the problem
It all begins with collateralized debt obligations (CDOs). These are essentially bonds that bundle together groups of debts. One of the biggest sources of debt used to create CDOs are home mortgages. The way CDOs are generally structured is that the CDOs are split into three tranches, senior, mezzanine and junk. The idea is that if mortgages start missing payments then the people who own the junk tranche will not get paid. If a lot of mortgages start missing payments then the people in the mezzanine tranche get hit. Finally if lots and lots of people stop making payments on their mortgages then finally the senior tranche gets hit. The banks argued with the credit rating agencies that the probability of the senior tranches ever losing money was so low that those tranches should be ranked as AAA. The rating agencies not just agreed but in fact went out of their way to provide detailed guidance to banks on how to structure CDOs to make sure they would get AAA ratings. Both the banks and the rating agencies won here. The rating agencies get paid by folks who issue CDOs and the more CDOs that are issued the more the ratings agencies get paid. The banks win because they could take mortgages, even low quality mortgages and through the magic of CDOs turn their junk into AAA rated securities.
Although CDOs had been available for quite some time they really hit big around 2000 when the market was depressed and treasuries (the traditional source of AAA rated bonds) weren't paying well. By law banks, insurance companies, pension companies, etc. could only buy AAA rated bonds. So when CDOs showed up paying more than treasuries at around the same cost with a AAA rating it was like crack. Everybody wanted a hit.
Suddenly banks needed huge numbers of mortgages to quickly churn into CDOs. So this led to enormous mortgage fraud. All sorts of fun terms were invented like NINJA loans (No Income, No Job or Assets) or liar loans (where people could state their income without any verification). Whole industries popped up to help fake up people's credit ratings so they could quality. It didn't matter if these mortgages were fraudulent since the banks wouldn't be holding them long enough to get burned. They just needed the mortgages to hold together long enough to become CDOs, at that point, it was someone else's problem. So the focus was - get people into mortgages by any means possible.
Now if things had stopped there then by the end of 2007 we would have been looking at around $1.4 trillion worth of bad loans. That's a lot of money but not a real disaster. The actual cost of the bailout by around 2009 was in the region of $13 trillion. So where did the other $11.6 trillion come from?
Making it worse
The first step in making things worse was the Commodity Futures Modernization Act (CFMA) of 2000 which essentially deregulated derivatives. A derivative is just a bet on 'something'. A classic example are weather derivatives that bet on how cold or hot a particular winter will be. However, like any bet, one needs to capitalize the bet. In other words, one needs to put money aside to pay off the bet in case one loses. The problem was that CFMA didn't require capitalization. This meant that people could bet with each other using derivatives without having enough money put aside to pay off if they lose. The dangers of improperly capitalized derivatives were already well understood from the Orange County bankruptcy of 1994, the Bankers Trust scandal of 1995 and the near market destruction caused by the failure of Long Term Capital Management in 1998, etc. But all of this was ignored and the CFMA passed.
The second step in making things worse are called Credit Default Swaps (CDS). These are kind of like insurance contracts. Let's say one is worried that a CDO is going to go bad (perhaps one doesn't quite trust that AAA rating). In that case one could buy a CDS against the CDO. If the CDO defaults then the issuer of the CDS pays off the buyer.
Except that thanks to the CFMA companies that sold CDS's didn't have to capitalize their CDS's. In other words, they didn't have to put money aside in case the CDO they were insuring with the CDS went bad. This meant that if a CDO went bad then not only was the person who bought the CDS on the CDO out their money but the person selling the CDS was also legally liable for the insurance they promised the purchaser. In other words the total debt in the economy, once CDOs started going bad, doubled.
The situation got worse thanks, again, to the CFMA which effectively allowed naked CDS's. In theory a CDS is used by someone who owns an asset and wants to insure it. With a naked CDS one can buy insurance on an asset one doesn't own. This is effectively a form of shorting. It lets the buyer bet that an asset is going to go bankrupt. With naked CDS's it was suddenly possible to expose a much larger group of people to the outcome of a particular CDO.
Sticking us with the bill
One can potentially understand why the CDOs going bad were a problem since lots of systemically important actors like insurance companies, banks, pension trusts, etc. had purchased them. So in theory the government could have just paid off the $1.4 trillion and called it a day. But the reason the CDSs mattered had to do with major changes in the regulatory environment in the United States. Without those changes the issues with CDS's would have just been a bunch of broke gamblers instead of a broke nation.
There are lots of places one could start but I'm going to start with the Gramm-Leach-Bliley (GLB) act of 1999. This act repealed the Glass-Steagall act of 1933. Glass-Steagall made it illegal for insurance companies, savings banks or investment banks to merge. The logic being that two of these entities (insurance companies and savings banks) are absolutely critical to the functioning of the world economy and so shouldn't be exposed to each other's risk and most certainly shouldn't be exposed to the kind of risks that investment banks take. With GLB this legally mandated fire walling was over. The term 'bancassurance' got coined and suddenly savings banks, investment banks and insurance companies couldn't merge fast enough. The end result were mega financial companies whose failure would literally rip apart the financial structure of the world. Thanks to GLB 'too big to fail' was now in full effect.
Well guess who was issuing those CDOs and CDSs? And, even better, guess who were the major buyers of CDOs and CDSs? Yup, in both cases it was insurance companies and major banks. So when the Ponzi scheme that was the mortgage market finally started falling apart in 2007 or so it was the mega-banks that were in deep trouble both coming and going.
Except now that the banks, thanks to GLB, were too big to fail (if they went, they were taking the whole world with them, individual savings accounts would be wiped out, pension funds would be wiped out, insurance wouldn't be paid out, etc.) it became impossible to let the banks fail. Exactly the situation Glass-Steagall had been passed to prevent had happened.
What was even more fun was that tons of CDSs had been sold against the banks themselves! In other words plenty of people were happy to bet on the banks failing. So as the banks started to go down those CDSs came due which made things even worse since now the banks (who issued the CDS's against each other) didn't have the money to pay those off either. The entire financial system was in a death spiral. This freaked everyone out and amongst other things froze liquidity world wide as no banks were willing to lend money to any other bank, even just for a day, because they were afraid the bank they lent to might go bust. Without liquidity companies everywhere suddenly found that they couldn't do things like pay their payrolls or their bills. The entire financial system was freezing up.
So we ended up with a trillion dollar bailout. And yes, it's more complicated than that. And yes the bailouts were horribly abused to let the big banks make free profits by taking risk free zero interest money from the government and turn it into various interest paying financial vehicles that the banks made, well, bank on. But that's another story.
The key parts of this story had to do with the absence of effective regulation. Without empowered, intelligent, motivated regulators to keep mega banks from forming, to prevent systemic risk, a blow up was just a matter of time. In fact, now the probability of another blow up is higher than it was before the mortgage crises. The reason is that no effective regulations have been passed and now there are even fewer mega-banks. And those mega-banks understand that they can do no wrong. They might as well take all the risks they want because if things blow up the government (read: Us) have no choice but to ride to the rescue. And this is without even talking about the revolving door between Wall Street and their 'regulators'.
But it's unclear to me how this situation can ever be prevented. Wall Street floods government at all levels with money to push their interests which are basically to take as many risks as possible with them keeping the upside and the people taking the risk. Who is going to stand against this wall of money? To put this in perspective today roughly 400 people (the Forbes 400) have the same wealth as half the population of the United States. In other words if we put all the assets of roughly 150,000,000 people together it would just about equal what those 400 people are worth. How the heck can we expect 1.5 million people to effectively lobby our government in a coherent way as 400 people can? The total lack of meaningful regulation after the latest fiasco answers the question, we can't.
So we are going to go through this again and again and again until there is simply nothing left. Or we can radically change the laws in this country. We can understand that inequalities of wealth on the level of the United States are incompatible with democracy and freedom. We can have a small group of super wealthy or we can have freedom, we can't have both.