Flashcards in Inside Job Deck (4):
This crisis was not an accident. It was caused by an out-of-control industry. Since the 1980s, the rise of the U.S. financial sector has led to a series of increasingly severe financial crises. Each crisis has caused more damage, while the industry has made more and more money.
After the Great Depression, the US had 40 years of economic growth, without a single financial crisis. The financial industry was tightly regulated. Most regular banks were local businesses, and they were prohibited from speculating with depositors' savings. Investment banks, which handled stock and bond trading, were small, private partnerships.
In the 1980s, the financial industry exploded. The investment banks went public, giving them huge amounts of stockholder money. People on Wall Street started getting rich.
The Reagan administration, supported by economists and financial lobbyists, started a 30-year period of financial deregulation.
By the late 1990s, the financial sector had consolidated into a few gigantic firms, each of them so large that their failure could threaten the whole system. The Clinton administration helped them grow even larger.
In 1933, in the wake of the 1929 stock market crash and the Great Depression, the Glass-Steagall Act (GSA) was introduced. This act separated investment and commercial banking activities. At the time, "improper banking activity," or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors' money.
The limitations of the GSA on the banking sector sparked a debate over how much restriction is healthy for the industry. Many argued that allowing banks to diversify in moderation offers the banking industry the potential to reduce risk.
Consequently, in 1999, Congress passed the Gramm-Leach-Bliley Act, which overturned Glass-Steagall. It cleared the way for future mergers and eliminated the GSA restrictions against affiliations between commercial and investment banks.
With the passing of the Gramm-Leach-Bliley bill, commercial banks went back to getting involved in risky investments to boost profits. The additional risk-taking, in particular, subprime lending, led to the 2008 financial crisis.
Beginning in the 1990s, deregulation and advances in technology led to an explosion of complex financial products, called derivatives. Economists and bankers claimed they made markets safer. But instead, they made them unstable.
Using derivatives, bankers could gamble on virtually anything. They could bet on the rise or fall of oil prices, the bankruptcy of a company; even the weather. By the late 1990s, derivatives were a 50-trillion-dollar unregulated market.
In December of 2000, Congress passed the Commodity Futures Modernization Act. Written with the help of financial-industry lobbyists, it banned the regulation of derivatives.
In 2001, the U.S. financial sector was vastly more profitable, concentrated, and powerful than ever before. Dominating this industry were five investment banks, two financial conglomerates, three securities-insurance companies and three rating agencies.
Linking them all together was the securitization food chain, a new system which connected trillions of dollars in mortgages and other loans with investors all over the world.
In the old system, when a homeowner paid their mortgage every month, the money went to their local lender. And since mortgages took decades to repay, lenders were careful.
In the new system, lenders sold the mortgages to investment banks. The investment banks combined thousands of mortgages and other loans — including car loans, student loans, and credit-card debt — to create complex derivatives, called collateralized debt obligations, or CDOs. The investment banks then sold the CDOs to investors.
Now, when homeowners paid their mortgages, the money went to investors all over the world.
The investment banks paid rating agencies to evaluate the CDOs, and many of them were given a AAA rating, which is the highest possible investment grade. This made CDOs popular with retirement funds, which could only purchase highly rated securities.
This system was a ticking time bomb. Lenders didn't care anymore about whether a borrower could repay, so they started making riskier loans. The investment banks didn't care, either; the more CDOs they sold, the higher their profits. And the rating agencies, which were paid by the investment banks, had no liability if their ratings of CDOs proved wrong.
In the early 2000s, there was a huge increase in the riskiest loans, called subprime. But when thousands of subprime loans were combined to create CDOs, many of them still received AAA ratings.
Suddenly, hundreds of billions of dollars a year were flowing through the securitization chain. Since anyone could get a mortgage, home purchases and housing prices skyrocketed. The result was the biggest financial bubble in history.
During the bubble, the investment banks were borrowing heavily, to buy more loans, and create more CDOs.
The ratio between borrowed money and the banks' own money was called leverage. The more the banks borrowed, the higher their leverage.
In 2004, Henry Paulson, the CEO of Goldman Sachs, helped lobby the Securities and Exchange Commission to relax limits on leverage, allowing the banks to sharply increase their borrowing.
There was another ticking time bomb in the financial system: AIG, the world's largest insurance company, was selling huge quantities of derivatives, called credit default swaps.
For investors who owned CDOs, credit default swaps worked like an insurance policy. An investor who purchased a credit default swap paid AIG a quarterly premium. If the CDO went bad, AIG promised to pay the investor for their losses.
But unlike regular insurance, speculators could also buy credit default swaps from AIG in order to bet against CDOs they didn't own.
In insurance, you can only insure something you own. Let's say you and I own a house. I can only insure that house once. The derivatives universe essentially enables anybody to actually insure that house. So you could insure that; somebody else could do that. So 50 people might insure my house. So what happens is, if my house burns down, now the number of losses in the system becomes proportionately larger.
Since credit default swaps were unregulated, AIG didn't have to put aside any money to cover potential losses. Instead, AIG paid its employees huge cash bonuses as soon as contracts were signed. But if the CDOs later went bad, AIG would be on the hook.
AIG's Financial Products Division in London issued 500 billion dollars worth of credit default swaps during the bubble, many of them for CDOs backed by subprime mortgages.
Goldman Sachs bought at least 22 billion dollars of credit default swaps from AIG. It was so much that Goldman realised that AIG itself might go bankrupt; so they spent 150 million dollars insuring themselves against AIG's potential collapse.
Then, in 2007, Goldman went even further. They started selling CDOs specifically designed so that the more money their customers lost, the more money Goldman Sachs made.
The three rating agencies — Moody's, S and P, and Fitch — made billions of dollars giving high ratings to risky securities. Moody's, the largest rating agency, quadrupled its profits between 2000 and 2007.
In March of 2008, the investment bank Bear Stearns ran out of cash, and was acquired for two dollars a share by JP Morgan Chase. The deal was backed by 30 billion dollars in emergency guarantees from the Federal Reserve.
On September 7th, 2008, Henry Paulson announced the federal takeover of Fannie Mae and Freddie Mac, two giant mortgage lenders on the brink of collapse.
Two days later, Lehman Brothers announced record losses of 3.2 billion dollars, and its stock collapsed.