I recently read Michael Lewis’s The Big Short, which offers a compelling peek into Wall Street during the subprime boom and collapse. Lewis is famous for a prior book, Liar’s Poker, which drew attention to the mendacity and immorality of the Wall Street 1980s culture (remember Michael Milken and his fictional counterpart, Gordon Gecko?). Lewis makes the point that the errors of the 1980s were the same errors of the 2000s, only greatly magnified and infinitely more complex. There was never any serious attempt to rein in Wall Street after the 1980s debacle. In fact, the trend ran in the other direction – politicians enjoyed sucking on the Wall Street teat, and either deregulated or refuse to allow regulation to keep up with innovation. The Big Short is an enjoyable read. It will also make you angry. For even though I’m very familiar with the economics behind the crisis, I was not prepared for the revelations in this book concerning the behavior of the big investment banks. This is the stunning part.
The news about Wall Street had not really permeated into popular culture. For sure, there is outrage about the bailouts but no real conception of why they were bailed out and who is ultimately to blame. Instead, the right-wing has given us an alternative narrative whereby the true villains are the government, the GSEs like Fannie Mae and Freddie Mac, and the poor people who took out reckless mortgages. The story is simple: the government wanted to support homeownership among the poor, and so directed Fannie and Freddie to guarantee mortgages that eventually went bad. This story plays well in a culture polluted by laissez-faire liberalism, but it is also a story promoted by monied interests opposed to regulation. It’s in their interests to feed it. And there are plenty of people, including Catholics like Michael Novak who are willing to oblige.
Except that this story is completely false. The subprime crisis was a private sector affair. During the peak subprime years (2004-07), the issuance of mortgage-backed securities by the GSEs fell dramatically, and private issuance mushroomed. By 2006, 84 percent of the subprime mortgages were issued by private lending institutions. It is true that the GSEs tried to jump on the subprime bandwagon at the last minute – envying the huge Wall Street profits – but by then it was too late. And only 20-25 percent of subprime loans came from institutions fully under the Community Reinvestment Act (CRA), which stands next to ACORN on the list of right-wing bogeyman. In fact, lending under the CRA was particularly prudent.
No, pretty much all of the subprime mendacity began on Wall Street and ended on Wall Street. One thing Lewis brings out is how well protected the subprime lenders were, even when it became clear that the goal was to hoodwink the borrower – offer an attractive teaser rate, and then bury a substantial adjustment two years down the line in confusing legalistic language. Court cases filed by consumer advocates were thrown out by judges with ties to the subprime lenders. The reason the lenders could get away with this is because they had no skin in the game – they sold off the mortgages to the Wall Street houses long before the reset would push borrowers into default. They gambled with people’s lives and won.
But this is still not the story. If this were the story, then we would have seen a wave of defaults that would have put a lot of banks out of business and caused a lot of investors to lose money. It would have been tough, but manageable. It would not have caused the worse recession since the Great Depression. No, the real mendacity is what happens next. The big investment banks found a sure-fire winner. They would buy a bunch of crappy mortgage bonds and securitize them, selling the bonds to investors, making a tidy profit. Investors paid a lot because they believed the bonds were worth a lot, and this is because the credit rating agencies said they were worth a lot. The investment banks were knowingly turning crap into gold, and they made a small fortune doing so. Mortgage bonds are stacked in towers, with the safest stuff on top, and the riskiest stuff on the bottom. The top tier might be rated triple-A and the bottom tier triple-B. The investment banks would strip the bottom tiers of a whole lot of mortgage bonds and create a new asset, a collateralized debt obligation (CDO) made up of the worst of the worst. They would take this pile of triple-B crap to the rating agencies, which would pronounce most of it triple-A. Alchemy in action!
It’s still worse than this. The investment banks knew that the bonds were lousy, and that the credit rating agencies were being fooled. They wanted to milk this as much as they could, and they did. They actively sought out people to short the subprime market (bet against it). To do this, these people needed to buy credit default swaps (CDSs) on the underlying bonds – this is basically an insurance policy that pays out if the bond defaults. Goldman Sachs found that AIG would issue billions of dollars in cheap insurance that it could sell to the short side of the market, earning huge profits as the middleman. And these profits were bigger the worse the underlying bonds, as Goldman could charge a bigger fee. So far, the amount of risk depended on the amount of actual mortgages and actual houses purchased. But that didn’t stop Wall Street. They realized that they could actually create new CDOs not of the mortgage bonds themselves, but out of the CDS bets against these bonds. This is like waving a wand and replicating the underlying mortgage, over and over again, without limit. This sounds insane, but it is exactly what happened. And you can guess the rest – these “synthetic CDOs” were also blessed by the ratings agencies, and sold to investors.
The investment banks knew exactly what they doing. They colluded with the people shorting the market to pick the worst pile of bonds to bet against. They would make a new asset, ex nihilo, from these CDS insurance contracts, and sell them for top dollar – often to pension funds charged with managing people’s life savings. Some of them, such as Deutsche Bank, were actually betting against the bonds at the same time they were pushing them on their customers. Some of them, such as Morgan Stanley, wrote the CDS contracts in such a way that they would pay up if only the most risky loans failed, in effects stacking the deck . And all of them controlled this obscure and non-transparent market, setting their own prices in a way that always seemed to work in their favor.
When it all collapsed, the small band of short-sellers described so vividly by Lewis made a of money. They gambled and won. But here’s the kicker – the investment banks made even more money still. The trader at Morgan Stanley who lost $9 billion in a single day walked away with a severance package worth tens of millions of dollars. The same is true for AIG’s Joe Cassano, who ran his shop with a reign of terror, and ultimately destroyed the company. Ultimately, the taxpayer bailed these people out. The billions owed by AIG on the dodgy insurance sold to Goldman was paid by the taxpayer – at a ridiculous 100 cents on the dollar – and funneled straight into Goldman’s coffers.
This is what ultimately brought down the financial system. Risk had been created and magnified so much that nobody knew where the bodies were buried. Everybody was tainted. This is why the bailouts were necessary. But as the dust settled, we were supposed to rein in the investment banks, to make sure this never happened again. It didn’t happen. The financial industry fought back, and gained a strong ally in the Republican party which still promotes deregulation and buys into the fable about the government being responsible for the crisis. And today, leading Republicans are trying to roll back the financial sector reform bill, which is only a first tepid step in the right direction. They vigorously oppose a consumer protection agency to police the activities of Wall Street and look out for the common man. Simple things like the Volcker rule, which would restrict the speculative behavior of the investment banks, was watered down to appease a lone Republican supporter, Scott Brown. This same Mr. Brown vetoed the bank tax, which would simply have forced the financial institutions to pay back the taxpayers for the bailout – under this myopic ideology, taxes are always and everywhere to be opposed. And the idea of breaking up the banks got almost no support.
This crisis was caused by greed, and this greed sprung primarily from Wall Street. We must make sure that such a crisis never happens again. We must also reduce the incentives for the best and brightest people to seek a career in socially-useless and frequently-immoral activity. Will this happen any time soon? I’m pessimistic. Free markets are always good, you see…