The global economic crisis of 2008 cost tens of millions of people their savings, their jobs, and their homes.
Iceland population: 320,000, GDP: $13 billion, Bank losses:$100 billion
Iceland is a stable democracy with a high standard of living and until recently extremely low unemployment and government debt.
In 2000, Iceland's government began a broad policy of deregulation that would have disastrous consequences. First for the environmentand then for the economy. They started by allowing multinational corporations like Alcoa to build giant aluminum-smelting plants and exploit Iceland's geothermal and hydroelectric energy sources.
At the same time, the government privatized Iceland's three largest banks. The result was one of the purest experiments in financial deregulation ever conducted. In a five year period, these three tiny banks which had never operated outside of Iceland borrowed 120 billion dollars, 10 times the size of Iceland's economy. The bankers showered money on themselves, each other and their friends.
Iceland's bubble gave rise to people like Jon Asgeir Johannesson. He borrowed billions to buy up high end businnesesin London. He also bought a pinstriped private jet, a 40 million dollar yacht and a Manhattan penthouse.
When Iceland's banks collapsed at the end of 2008, unemployment tripled in six months. A lot of people lost their savings. Government regulators who should've been protecting the citizens of Iceland had done nothing. One-third of iceland's financial regulators went to work for the banks.
"when you think you can create something out of nothing it's difficult to resist", Prime minister of Singapore Lee Hsien Loong.
September 15,2008 - Lehman brothers, one of the most venerable and biggest investment banks was forced to declare itself bankrupt. Another Merrill Lynch was forced to sell itself today. And the collapse of the world's largest insurance company, AIG triggered a global crisis. The result was a global recession which cost the world tens of trillions of dollars rendered 30 million people unemployed and double the national debt of the United States.
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.
Part 1: How we got here
After the great depression, the U.S. had 40 years of economic growth without a single financial crisis. The financial industry was tightly regulated. Most local banks were local businesses prohibited from speculating with depositors' savings. Investment banks, which handled stock and bond trading were small, private partnerships.
In 1980s, the financial industry exploded. The investment banks went public, giving them huge amounts of stockholder money. People on Wall Street started getting rich.
In 1981, President Ronald Reagan chose as Treasury secretary the CEO of the investment bank Merrill Lynch, Donald Regan. The Reagan administration supported by economists and financial lobbyists started a 30 year period of financial deregulation. In 1982, the Reagan administration deregulated savings-and-loan companies allowing them to make risky investments with depositors' money. By the end of the decade,hundreds of savings-and-loan companies had failed. This crisis cost taxpayers $124 billion and cost many people their life savings.
Thousands of executives went to jail for looting their companies. One of the most extreme cases was Charles Keating. In 1985, when federal regulators began investigating him Keating hired an economist named Alan Greenspan. In this letter to regulators, Greenspan praised Keating's sound business plans and expertise and said he saw no risk in allowing Keating to invest customers' money. Keating reportedly paid Greenspan $40,000. Keating went to prison shortly afterwards. As for Alan Greenspan, Reagan appointed him chairman of America's central bank. The federal reserve Greenspan was reappointed by Presidents Clinton and George W.Bush.
During the Clinton administration, deregulation continued under Greenspan and Treasury secretaries Robert Rubin, the former CEOof the investment bank Goldman Sachs and Larry Summers, a Harvard economics professor.
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. And the Clinton administration helped them grow even larger.
In 1998, Citicorp and Travelers merged to form Citigroup, the largest financial services company in the world. The merger violated the Glass-Steagall Act a law passed after the Great Depression which preventing banks with consumer deposits from engaging in risky investment banking activities.
In 1999, at the urging of Summers and Rubin Congress passed the Gramm-Leach-Bliley Act known to some as the Citigroup Relief Act. It overturned Glass-Steagall and cleared the way for future mergers.
Robert Rubin would later make $126 million as Vice Chairman of Citigroup.
An appropriate metaphor is the oil tankers. They are very big and therefore you have to put in compartments to prevent the sloshing around of oil from capsizing the boat. The design of the boat has to take that into account. And after the Depression, the regulations actually introduced these very watertight compartments. And deregulation has led to the end of compartmentalization.
The next crisis came at the end of the 90s. The investment banks fueled a massive bubble in Internet stocks which was followed by a crash in 2001 that caused $5 trillion in investment losses.
The Securities and Exchange Commission, the federal agency created during the Depression to regulate investment banking had done nothing. Eliot Spitzer's (Governor2007-2008, Attorney General NY) investigation revealed the investment banks promoted Internet companies they knew would fail. Stock analysts were being paid based on how much business they brought in. What they said publicly was quite different from what they said privately.
In December 2002, 10 investment banks settled the case for a total of $1.4 billion and promised to change their ways.
Bear Stearns -$80 million, Credit Suisse $200 million, Deutsche Bank $80 million, JP Morgan $80 million, Lehman brothers $80 million, Merrill Lynch $200 million, Morgan Stanley $125 million, UBS $80 million, Goldman Sachs $110 million, Citigroup $400 million.
Since deregulation began, the world's biggest financial firms have been caught laundering money, defrauding customers and cooking their books again and again.
Credit Suisse helped fun el money for Iran's nuclear program and for Iran's Aerospace Industries Organization which builds ballistic missiles. The bank was fined $536 million. Citibank helped funnel $100 million of drug money out of Mexico. When UBS was caught helping wealthy Americans evade taxes they refused to cooperate with the U.S. government. Citibank, JP Morgan and Merrill Lynch helped Enron conceal fraud: fined $385 million.
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 market 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 1998, someone tried to regulate them. Brooksley Born graduated first in her class at Stanford Law School and was the first woman to edit a major Law review. After running the derivatives practice at Arnold&Porter Born was appointed by Clinton to chair the Commodity Futures Trading Commission which oversaw the derivatives market.
In May of 1998, the CFTC issued proposal to regulate derivatives. Clinton's Treasury Department had an immediate response. 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.
By the time GeorgeW.Bush took office in 2001 the U.S.financial sector was vastly more profitable, concentrated and powerful than ever before. Dominating this industry were five investment banks: Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch, Bear Stearns. Two financial conglomerates: Citigroup, JP Morgan. Three securities insurance: AIG, MBIA, AMBAC. Three rating agencies: Moody's, Standard& Poor's and Fitch. And 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 mortgages to investment banks. The investment banks combined thousands of mortgages and 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 triple A 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 were a huge increase in the riskiest loans, called subprime. When thousands of subprime loans were combined to create CDOs many of them still received triple-A ratings.
Part 2: The Bubble (2001-2007)
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.
The Securities and Exchange Commission conducted no major investigations of the investment banks during the bubble.
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 SEC to relax limits on leverage allowing the banks to sharply increase their borrowing.
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. 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.
Goldman Sachs sold at least $3.1 billion worth of these toxic CDOs in the first half of 2006. The CEO of Goldman Sachs at this time was Henry Paulson the highest paid CEO on Wall Street. In May 2006, Henry Paulson was nominated to be the Secretary of the Treasury. Paulson had to sell his $485 million of Goldman stock when he went to worm for the government but because of the law passed by the first President Bush he didn't have to pay any taxes on it. It saved him $50 million.
By late 2006, Goldman had taken things a step further. It didn't just sell toxic CDOs it started betting against them at the same time it was telling customers that they were high quality investments. By purchasing credit default swaps from AIG Goldman could bet against CDOs it didn't own and get paid when the CDOs failed. Goldman Sachs bought at least $22 billion of credit default swaps from AIG. It was so much that Goldman realized that AIG itself might go bankrupt. So they spent $150 million 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.
Goldman Sachs, John Paulson and Morgan Stanley weren't alone. The hedge funds Tricadia and Magnetar made billions against CDOs they had designed with Merrill Lynch, JP Morgan and Lehman Brothers. The CDOs were sold to customers as "safe" investments.
Part 3: The crisis
As early as 2004, the FBI was already warning about an epidemic of mortgage fraud. They reported inflated appraisals, doctored loan documentation and other fraudulent activity, In 2005, the IMf's chief economist Raghuram Rajan warned that dangerous incentives could lead to a crisis. Then came Nouriel Roubini's warnings in 2006. Allan Sloan's articles in Fortune Magazine and the Washington Post in 2007 and repeated warning from the IMF.
By 2008, home foreclosures were skyrocketing and the securitization food chain imploded. Lenders could no longer sell their loans to the investment banks. And as the loan went bad,dozens of lenders failed.
The market for CDOs collapsed leaving investment banks holding hundreds of billions of dollars in loans, CDOs and real estates they couldn't sell.
In March 2008, the investment bank Bear Stearns ran out of cash and was acquired $2 a share by JP Morgan Chase. The deal was backed by $30 billion in emergency guarantees from the Federal Reserve.
On September 7th, 2008 Henry Paulson announced the federal takeover of Fannie Mae and Freddie Mac, giant lenders on the brink of collapse.
Two days later, Lehman Brothers announced record losses of $3,2 billion and it's stock collapsed. On September 12th Lehman Brothers had run out of cash and the entire investment-banking I dusty was sinking fast. The stability of the global financial system was in jeopardy.
On September 17th, AIG is taken over by the government. One day later, Paulson and Bernanke ask Congress for $700 billion to bail out the banks. When AIG was bailed out, the owners of its credit default swaps the most prominent of which was Goldman Sachs were paid $61 billion the next day. Paulson, Bernanke and Tim Geithner forced AIG to pay 100 cents on the dollar rather than negotiate lower prices. Eventually the AIG bailout cost taxpayers over $150 billion.
On October 4th, 2008 President Bush signs a 700-billion-dollar bailout bill. But world stock market continue to fall amid fears that a global recession is now underway. Unemployment in the U.S. And Europe rises to 10 percent. The recession accelerates and spreads globally.
By December of 2008, General Motors and Chrysler are facing bankruptcy. And as U.S. Consumers cut back on spending, Chinese manufacturers see sales plummet. Over 10 million migrant workers in China lose their jobs.
Part 4; Accountability
The men who destroyed their own companies and plunged the world into crisis walked away from the wreckage with their fortunes intact. The top five executives at Lehman Brothers made over a billion dollars between 2000 and 2007. And when the firm went bankrupt, they got to keep all the money.
In March of 2008, AIG's financial products division lost $11 billion. Instead of being fired, Joseph Cassano, head of AIGFP was kept as a consultant for a million dollars a month.
In the U.S., the banks are now bigger, more powerful and more concentrated than ever before. JP Morgan took over first Bear Stearns and then WaMu. Bank of America took over Countrywide and Merrill Lynch. Wells Fargo took over Wachovia.
Between 1998 to 2008, the financial industry spent over $5 billion on lobbying and campaign contributions, and since the crisis, they're spending even more money. The financial industry also exerts its influence in a more subtle way, one that most Americans don't know about. it has corrupted the study of economics itself.
Deregulation had tremendous financial and intellectual support because people argued it for their own benefit. The economics profession was the main source of that illusion. Many prominent academics quietly make fortunes while helping the financial industry shape public debate and government policy. The Analysis Group, Charles River Associates, Compass Lexecon and the Law and Economics Consulting Group manage a multimillion dollar industry that provides academic experts for hire.
When the financial crisis struck before the 2008 election, Barack Obama pointed to Wall Street greed and regulatory failure as examples of the need for change in America. But when finally enacted in mid 2010, the administration's financial reforms were weak. And in some critical areas, including the rating agencies, lobbying and compensation nothing significant was even proposed. "it's a Wall Street government"
In 2009, as unemployment hit the highest level in 17 years Morgan Stanley paid its employees over $14 billion and Goldman Sachs paid out over $16 billion. In 2010 bonuses were even higher. Why would a financial engineer be paid higher than a real engineer? A real engineer build bridges, a financial engineer build dreams. And when those dreams turn out to be a nightmare, other people pay for it.
For decades, the American financial system was stable and safe. But then something changed. The financial industry turned its back on society corrupted our political system and plunged the world economy into crisis. At enormous cost, we've avoided disaster and are recovering. But the men and institutions that caused the crisis are still in power and that needs to change. They will tell us that we need them and that what they do is too complicated for us to understand. They will tell us it wont happen again. They will spend billion fighting reform. It won't be easy. But some things are worth fighting for.
Reference: "Inside Job"
