THE PRICE OF WALL STREET'S SECRETS

Abstract

The paper discusses the events leading to the Great Recession, which was fueled by the subprime mortgage crisis, and in this context discusses the importance of accountability and oversight of matters in the financial sector. The paper finds that the crisis in 2008 could have been mitigated on multiple counts, and was brought about due to the blatantly criminal negligence of the top executives in Wall Street, as well as the help they received from the Federal Government.

PICTURE CREDIT: CNBC

"Lehman Files for Bankruptcy; Merrill Is Sold," said the headlines of the New York Times on September 14th, 2008.{1} The world was taken aback at the unabated collapse of the American financial sector, and before they knew it, the economic downturn was at their doorstep too. While more and more people across the world became homeless and poorer, Wall Street, the origin of this crisis, and the Federal government had no explanation. When asked at a press conference, Henry Paulson, then the treasury secretary, said that he had inherited this crisis, and it was not entirely of his making.{2} We will explore how he was both absolutely correct and decidedly wrong.

Let me paint you a picture. A young couple immigrating from Puerto Rico would love to own a home in America. Fortunately for them, they were in America in 2005, when houses were ridiculously expensive, but housing loans were ridiculously cheap, because of what bankers called "adjustable-rate mortgages". This was America between 2004 and 2006, characterised by the bullish nature of the financial markets, which manifested itself in low housing prices. Home ownership and property prices continued to rise rapidly until 2005.

Home prices began to decrease in early 2006.{9} Many Americans suffered as a result of this. Their properties were worth less than what they had paid for them. They couldn't sell their houses since they owed money to their lenders. If they had adjustable-rate mortgages, their payments were increasing as the value of their homes decreased. The most vulnerable subprime borrowers, like immigrants, were trapped in mortgages they couldn't afford to begin with.

From the beginning of 2007, one after another, subprime lenders began declaring bankruptcy. More than 25 subprime lenders failed between February and March. New Century Financial, which dealt especially in subprime lending, declared bankruptcy in April and fired half of its workers. Bear Stearns had suspended acceptances of redemptions in two of its hedge funds by June, causing Merrill Lynch to take $800 million in assets from the funds. By August 2007, it was clear that the financial markets were incapable of resolving the subprime crisis, and that the issues were affecting those well beyond the borders of the United States. The interbank market, which keeps money moving across the world, was entirely frozen, owing largely to the fear of the unknown. Due to a liquidity crisis, Northern Rock was forced to seek emergency capital from the Bank of England.

In October 2007, Swiss Bank UBS became the first large bank to declare losses on subprime-related investments, totalling a whopping $3.4 billion. The Federal Reserve and other central banks would take concerted action in the coming months to lend billions of dollars in loans to global credit markets, which were coming to a standstill as asset values collapsed. Meanwhile, financial institutions battled to determine the value of billions of dollars in now-toxic mortgage-backed securities in their portfolios. Bear Stearns, a Wall Street stalwart since 1923, failed in March 2008 and was bought out by JPMorgan Chase for pennies on the dollar.

By July of 2008, the devastation had extended throughout the banking industry. IndyMac Bank became one of the biggest banks to collapse in the United States, and the country's two largest housing financiers, Fannie Mae and Freddie Mac, were taken over by the federal government due to their solvency issues. However, the September bankruptcy of the legendary Wall Street bank Lehman Brothers was the largest in US history, and it became symbolic of the destruction brought by the global financial meltdown for many. That same month, global markets were nosediving, with major US indices suffering some of their largest losses on record. The Federal Reserve, the Treasury Department, the White House, and Congress all scrambled to come up with a comprehensive plan to halt the bleeding and restore morale in the markets.

The US government provided a cumulative credit bailout of $1,488 billion to the investment banks implicated. In fact, Henry Paulson, the US Treasury Secretary at the time, insisted on paying a dollar for a dollar in most situations, particularly in the rescue of AIG, a company that held large amounts of Goldman Sachs' credit swaps against mortgage-backed bonds. Interestingly, he had previously worked at Goldman Sachs as the Wall Street giant's CEO. This fact perfectly lays the foundation of what the rest of the paper discusses: the implicit moral corruption undertaken by the financial sector and the gains it made from doing so. Through this paper I also explore how financial institutions and the executives running these firms bear little to no consequences for making atrocious amounts of money at the expense of ordinary people.

In order to understand the extent of damage the financial sector, spearheaded by Wall Street, has caused in the wake of financialisation, that is, as Luiz Carlos Bresser-Pereira defined it in his paper "The Global Financial Crisis And A New Capitalism," a "distorted financial arrangement based on the creation of artificial financial wealth," we must discuss what prompted the rapid financialisation of the American economy and the events that led to the Great Recession.

The Events Leading Up to the 2008 Crash

In the year 1981, under the presidency of Ronald Reagan, began the new era of financial policy-making, which is famously known as Reaganomics. While it received this name from the erstwhile president, its most noteworthy advocate was the then Treasury Secretary, Donald Regan, ex-CEO of Merryl Lynch. Regan spearheaded a 30-year-long programme called deregulation, which included significant tax cuts for businesses and less oversight from governmental institutions. One such change was allowing investment banks to go public, which led to an unimaginable increase in their valuations, as well as their share of common depositors’ money. This began a movement towards financial neoliberalism, involving riskier bets on the part of financial institutions with the investors’ money. Not too long after, in 1984, many savings and loan firms made risky investments with depositors’ money, and the rough aftermath of the losses that ensued went on till the end of the decade. Many S&L firms went under, costing the American taxpayers $124 billion, and many people their life’s savings.

This ordeal was met with uproar, and investigations into the dealings of these firms began.

The Lincoln Savings and Loans Association, founded by Charles Keatings, is one such example.In 1985, when there were some indications of the upcoming crisis not boding well for the firm, the economist Alan Greenspan wrote a letter to the regulators saying that he found nothing in Lincoln’s books that said that there was any risk in allowing it to continue making investments with depositors’ money, and found Keatings business management to be "sound". Keating reportedly paid Greenspan $40,000 for his study of Lincoln’s accounts. Come 1990, Keating was convicted in both state and federal courts of several counts of fraud, conspiracy, and racketeering, while Alan Greenspan was made Chairman of America’s central bank, the Federal Reserve, by Ronald Reagan 3 years prior to this, and continued to be reappointed by the following four presidents.

In 1995, Bill Clinton appointed Robert Rubin, ex Goldman Sachs associate, and Larry Summers, Harvard Economics Professor, as Treasury Secretaries. The two played an instrumental role in exacerbating the work of Donald Regan, which they did alongside Alan Greenspan. The extent of their influence on the White house and the legislative branch was on display when the Gramm-Leach-Bliley Act was signed into law in 1999. In 1998, Citicorp and travellers merged to become the largest financial services company, violating the Glass-Steagall act. The erstwhile Glass-Steagall Act, brought about after the Great Depression, did not allow banks with large deposit holdings to conduct risky investment activities with said depositor money. Greenspan gave the new Citigroup a year’s exemption, and within that year, on Summers’ and Rubins’ insistence, the congress passed Gramm-Leach-Bliley act, which overturned the Glass-Steagall act, and cleared the way for future mergers. Robert Rubin later joined Citigroup as a member of its board and went on to make 126 million dollars through his commitments at Citigroup.

The Great Recession was not the first crisis brought about due to the deliberate mismanagement of the financial sector. In the late 90s, investment banks generated an internet stock bubble that burst in 2001, costing approximately $5 trillion in investment losses. According to reports by the New York attorney general, investment banks' ratings on internet companies differed significantly from their true opinions on the same.For example, a stock that had the highest rating was labelled as trash by one of the company's analysts. Investment banks were essentially enticing customers to invest in stocks that they knew would fail. When they were sued, the investment banks paid a total of $1.4 billion in settlement and agreed to "change their ways". This is but one example. Investment banks and similar firms have often been caught defrauding customers, laundering money, bribing government officials, and engaging in other blatantly criminal acts. Nonetheless, they were only required to pay a "penalty" without admitting any wrongdoing, fire a few employees, and go about their business as usual.

As usual, it started with noble intentions. In order to deal with the deflation of the dot-com bubble and a slew of corporate accounting scandals, the Federal Reserve reduced the federal fund rate from 6.5 percent in May 2000 to 1 percent in 2003. The objective was to stimulate economic growth by making money available to firms and consumers at low interest rates. As a result of the low mortgage rates, property values began to rise. Even subprime borrowers, or those with little or no credit history, were able to fulfil their dream of owning a home. The banks then marketed the loans to Wall Street banks, which bundled them into so-called low-risk financial products like mortgage-backed securities and collateralized debt (CDOs). Soon after, a sizable secondary market for creating and marketing subprime loans developed.

In order to encourage increased risk-taking among banks, the Securities and Exchange Commission (SEC) lowered the net capital requirements for five investment banks in October 2004: Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley. As a result, they were able to leverage their initial investments by up to 30 or even 40 times. This implies that these banks created artificial wealth by borrowing up to 30 to 40 times more money than they held with them, and the risks they took were calculated with the sum total of the actual wealth and the artificial wealth, which in the case of the recession, totalled a colossal $1 Trillion dollars in investment losses alone.

Who Saw It Coming?

As we have now discovered, there were multiple points over the span of 2 decades that indicated that the practices of the financial sector would put the economy in harm’s way. There were some who foresaw this disaster One such person was Raghuram Rajan, ex-governor of the Reserve Bank of India. As early as 2005, at the peak of the housing boom in America, Rajan presented a paper titled "Has Financial Development Made the World Riskier?" at the Federal Reserve's annual Jackson Hole conference, in front of the stalwarts of neoliberalism in banking, Alan Greenspan and Larry Summers.

Rajan brought up many points in his paper, including the rapid financialisation of economies with large chunks of it left unsupervised. But the interesting point in his paper, a viewpoint not brought up at the time, was to do with incentives. He wrote,

"My main concern has to do with incentives." Any form of intermediation introduces a layer of management between the investor and the investment. A key question is how aligned are the incentives of managers with investors, and what distortions are created by misalignment. I will argue in this paper that the changes in the financial sector have altered managerial incentives, which in turn have altered the nature of risks undertaken by the system, with some potential for distortions." {5}

In essence, Rajan took issue with the recklessness with which the so-called safe loans were given out, and more importantly, the fact that such behaviour was incentivised. He was, in only a couple of years, proved right, unfortunately. While these same mid-level managers lost their jobs when their banks went under, the executives still sat on their millions.

They were not the only ones who made money at this time. Some who foresaw the financial meltdown viewed it as an opportunity to make money. Three such stories were recounted in the movie, "The Big Short," which was used as the primary source for this paper. ‘The Big Short’ is a film, directed by Adam McKay and written by McKay and Charles Randolph, which chronicles the real lives of a few men who saw the 2008 financial crisis coming, and made money at a great cost. It is based on Michael Lewis' 2010 book ‘The Big Short: Inside the Doomsday Machine’, on how the housing bubble triggered the 2008 financial catastrophe.

The movie is notable for using unorthodox approaches to illustrate financial concepts. It includes cameos by Margot Robbie, Anthony Bourdain, Selena Gomez, and Richard Thaler, who break the fourth wall to discuss subjects like subprime mortgages and synthetic collateralized debt obligations (CDOs). This made complex financial concepts more accessible to larger audiences and helped spread awareness about the implicit corruption of the system that people trusted their life savings to. The film consists of three stories that run parallelly and are ultimately connected by their discoveries of innate corruption in the American financial system, which was responsible for the housing bubble that emerged in America in 2005.

The first story involves Michael Burry, an unconventional hedge fund manager, who discovered in 2005 that the US housing market was based on high-risk subprime loans. He advocated the creation of a credit default swap market, which would allow him to short mortgage-backed assets. Major banks accepted his long-term bet, which was worth more than $1 billion, but he had to pay high monthly premiums for them. As a result, the investors in his hedge fund, particularly Mr. Lawrence Fields, were enraged by his decision. Burry limits withdrawals due to his discomfort about the situation, resulting in Fields suing him. Ultimately, the market falls, and his fund's value climbs by 489 %, resulting in a total profit of approximately $2.69 billion, with Fields alone earning $489 million.

The second narrative chronicles the discoveries of FrontPoint Partners hedge fund manager Mark Baum (based on Steve Eisman), who is forced to buy swaps from Jared Vennett (based on Greg Lippmann) owing to his disdain for banks' ethics. The FrontPoint team discovers that mortgage brokers profit by selling their mortgage transactions to Wall Street banks, which pay greater margins for riskier mortgages. As these loans began to fail in early 2007, CDO prices surged and rating agencies refused to reduce the bond ratings. Baum then learns of conflicts of interest and corruption among credit rating firms from a friend at Standard & Poor's. Vennett invites the team to the American Securitization Forum in Las Vegas, where Baum learns from a CDO manager that the market for insuring mortgage bonds, which include "synthetic CDOs" , are bets in favour of the faulty mortgage bonds, and is significantly larger than the market for the mortgage loans themselves. This horrifies Baum, who realised the entire world economy is about to collapse. Despite holding on to his swaps until the last possible moment, FrontPoint walks away with $1 billion after selling to Morgan Stanley.

The final narrative follows young investors Charlie Geller, and Jamie Shipley, who discover a marketing presentation by Vennett on a coffee table in the lobby of a large investment bank. They solicit the help of Ben Rickert, a former securities trader in Singapore to meet the capital level for an ISDA Master Agreement and purchase these credit swaps. When bond and CDO prices climb despite failures, Geller suspects banks of defrauding investors. The trio also attend the American Securitization Forum, where they find that the SEC does not have any procedures in place to supervise mortgage-backed securities activities. They are able to make more money than Burry and Baum by shorting better-rated AA mortgage securities. They eventually transform their $30 million investment into a $80 million investment, but their trust in the system is damaged when Ben informs them of the serious ramifications for the general population.

Finally, there was one more group of people who knew-the executives of investment banks. While Biljana Adebambo, Paul Brockman, and Xuemin Yan write in their paper "Anticipating the 2007–2008 Financial Crisis: Who Knew What and When Did They Know It?" that "Our results add considerable weight to the argument that the financial crisis was more a case of flawed judgement than flawed incentives," the evidence from the entire progression of events dating from 1980 suggests that it is a little more complicated than that. This is exemplified by what Goldman Sachs did between 2005 and 2009. During the peak of trade in mortgage-backed securities, they sold more than $3 billion worth of these assets as "safe investments," in spite of knowing the real quality of the mortgages they were based upon. Yet, in 2007, with the advent of credit swaps against these same securities, they essentially ensured themselves against the imminent meltdown of the entire financial system by buying swaps worth $3 billion from AIG. With AIG near insolvency, the government took it over and ensured Goldman Sachs got every penny. Conveniently, the Treasury secretary was Henry Paulson at that time, ex Sachs CEO. Simultaneously, Joseph Cassano, the head of AIG Financial Products Division, which dealt with the sale and purchase of financial derivatives like mortgage-backed securities and credit swaps, made $315 million.

If this is not incriminating enough, Joseph St.Denis’s ordeal confirms their prior knowledge. AIG auditors raised alarm about the sorry state affairs of the firm’s books in 2007, but were immediately shut down by the top executives, and were barred from further investigation of AIGFP’s accounts. One of the auditors was Joseph St.Denis, who after being repeatedly blocked by Cassano in his attempts to bring the issues with AIGFP’s practices to the fore, resigned in frustration. At the time that the infamous Lehman Bank’s collapse took place, its CEO and Chairman Richard Fuld owned 6 aircrafts and one helicopter. These are just a few of the prominent examples of blatant disregard top executives of these banks had for the destruction their decisions brought to the lives of millions.

Consequences

PICTURE CREDIT: USA TODAY

While millions lost their life savings and pension funds as a result of the housing bubble, the bankers on Wall Street left with insane amounts of money. The recession extrapolated this effect and further thinned out America's middle class. Today, America has the worst GINI index, or inequality index, among developed nations, with 41.1. This implies that America’s top 1% earns 40 times the income of the bottom 90%. {6}

In an increasingly globalised world, these American banks took their financial management culture to many other countries across the globe. So the failure of these American banks led to a domino effect failure in other countries. Iceland, for example, was a country with a GDP of 13 million dollars and a bank debt of 100 million dollars in 2008.{2} Smaller, developing countries suffered in other ways. Mexico’s food insecurity rose as a result of the crisis. In fact, global food prices shot up, leaving millions of people to starve. How did food prices go up globally? When large financial crises hit banks in a country, the purchasing power of individuals, as well as of the country as a whole, reduces. More often than not, the currency of a country devalues because of it too. Crises like this involve recessions, and in Mexico’s case, its economy shrank by 6.7% in 2009. A recession is characterised by inflation of goods and services, including food.

The findings of the paper entitled ‘the Impact Of The 2008 Financial Crisis On Food Security And Food Expenditures In Mexico: A Disproportionate Effect On The Vulnerable’ indicate that households that were more susceptible before the financial crisis saw a worsening effect in terms of food insecurity as a result of the crisis. The findings agreed with both measures of food security, one based on self-reported experience and the other on food spending.This was the primary cause of food insecurity in Mexico, caused by a few men in Wall Street. {3}

Conclusion

There are a few lessons that can be drawn from the unfortunate events that unfolded between 2007 and 2009.

-Incentivizing The Right Behaviour

Those who worked within the financial industry were incentivised to generate volumes of loans rather than focus on giving loans only to those who could pay them back.

By allowing investment banks to advertise financial products on the basis of ratings given by private agencies, whose entire business model depended on giving reasonable ratings to the investment firms’ undertakings, regulatory authorities incentivised and allowed the legalisation of institutional looting. By looking the other way when investment banks shorted the same mortgage bonds they invested in on behalf of their depositors as "safe" investments, regulatory authorities further incentivised the fraud that took place. Last but not least, by constantly bailing out these financial institutions after the criminal abandon with which they invested in unsafe undertakings with depositors’ money, the government of America and those at the Federal Reserve like Alan Greenspan have incentivised this behaviour, which is guaranteed to churn out one economic crisis after another.

-Regulation and oversight are key.

The Great Recession could have been avoided if regulations had continued to be in place, and proper institutional oversight was in place. The SEC Division of Risk Management was, during the height of the bubble, cut down to one member. By systematically making regulatory authorities toothless, the financial industry, by lobbying such actions with the government, brought about a cardiac arrest of the whole economies across the world, simply for disgustingly large amounts of profit to be split among the top executives at these banks. For example: At the time that Lehman Brothers filed for bankruptcy, its CEO owned 6 planes and one helicopter.

-Choosing Sustainable Growth Over Leapfrogging Growth

Instead of trying to leapfrog our way through growth, governments must reign in industry’s bullish tendencies and try to maintain a sustainable growth model. Financial and economic growth work on the same principle that blood sugar in the body does. When a diabetic person consumes sugary items or simple carbohydrates, all the energy from those foods is immediately supplied to the bloodstream. Since the person is diabetic, they are not able to synthesise enough energy from other foods to maintain that level. Hence, there is a sudden and sustained drop in blood sugar levels, which is harmful for the person in question. When faced with such a problem, a diabetic has two options: continue to consume simple carbs and sugary foods, and supply sugar directly to the bloodstream in the event of a blood sugar drop, or change their lifestyle to avoid such rapid and tumultuous changes in blood sugar levels.While the former will lead to adverse effects, including a shorter lifespan for the person in question, the latter is a sustainable model. Similarly, rather than focusing on leapfrogging growth that involves blatant disregard for simple microeconomic principles, a slower but sustainable growth model will be effective.

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