This is the second installment of my series on the Occupy Wall Street movement. I promised in the first installment to try and better explain just how the Wall Street schemes worked.
The full story of the economic collapse of 2008 is far too complicated to tell here, but I will do my best to provide a Cliff’s Notes version of the Wall Street con job.
Everyone needs to understand that what Wall Street perpetrated on the American people and the world was perhaps the biggest heist in the history of civilization.
While it is impossible to quantify the exact amount of capital lost, there is no question that trillions of dollars evaporated in this country and across the globe because of these schemes.
As I stated in the first installment, investments in extremely volatile and risky mortgages were at the heart of the collapse.
Much of the financial crisis finds its origins in a mortgage-investment process known as securitization, whereby many different mortgages were lent out by banks and then pooled together and repackaged into investment instruments known as “mortgage-backed securities,” which were then sold off to large investment banks to be resold to their customers.
A mortgage-backed security in and of itself is not necessarily a bad thing. And in the past, there were times when such an investment was not considered incredibly risky.
However, what lead to the financial crisis were investments in “subprime” mortgages.
The subprime mortgage crisis
A subprime mortgage simply refers to a loan made to someone who may have difficulties making payments and are often the result of a low credit score.
Some people have characterized the financial crisis as resulting from the government wanting to put low-income people into homes they couldn’t afford.
It is true that Fannie Mae and Freddie Mac, government-sponsored enterprises that helped create and invested in mortgage-backed securities, contributed significantly to the problem. But this is only one tiny sliver of the story.
It’s one thing to fault someone for taking out a loan on a house he or she might not be able to afford, but it’s an entirely different matter when the lending institutions are actually giving these shady loans out in the first place.
And the reason they were giving out these questionable loans was not because of some altruistic desire to put poor people in houses, but, rather, in the desire to make oodles of money because of the manner in which Wall Street invested in such subprime loans.
In the years leading up to the financial crisis there was an explosion in subprime mortgages. Because investing in mortgage-backed securities quickly became such a lucrative enterprise, banks began to loosen their lending standards.
The Senate Permanent Subcommittee on Investigations released a report in April of this year stating, “The resulting increased demand for mortgage backed securities, joined with Wall Street’s growing appetite for securitization fees, prompted lenders to issue mortgages not only to well qualified borrowers, but also higher risk borrowers.”
In 1994, subprime lending only accounted for about $35 billion or less than five percent of all mortgage loans made, but by 2006, subprime loans totaled over $600 billion and accounted for over 20 percent of all mortgages.
These increases in subprime mortgages also lead to severe increases in predatory lending and mortgage fraud.
As early as 2004, the FBI even took notice of this, and Assistant FBI Director Chris Swecker warned that the problem could be turn into an “epidemic.”
However, while the main instruments at the heart of the collapse were mortgage-backed securities, it was the instruments Wall Street created and used to invest in such securities that caused the most damage — mainly instruments known as derivatives.
A derivative is a contract between two parties in which the value of an investment is “derived” from the value of other assets. It is ostensibly a way to spread the risk of an investment.
During the years leading up to the financial crisis, the derivatives market quadrupled in size.
The Bank for International Settlements estimates the global derivatives market to be at $1.2 quadrillion — yes, you read that correctly. This amount is equivalent to 22 times the GDP of the entire world, though technically this figure represents a notional value, while the actual market value is somewhere closer to $20 trillion.
However, this figure shows how much investing takes place using derivatives, and considering they are not traded on any public exchange, much of the derivatives market goes entirely unregulated.
Also, in 2000, Congress, doing Wall Street’s bidding, passed the Commodity Futures Modernization Act that further deregulated the already mostly-unregulated derivatives market.
(In the next installment of this series, I will get into the collusion between Wall Street and Washington and try to explain better how such things became deregulated.)
In 2002, Warren Buffett referred to derivatives as “financial weapons of mass destruction,” and as “time bombs” that could be “potentially lethal.”
Derivatives can include futures, options, forwards and other such financial jargon, but what we need to focus on are types of what are known as “over-the-counter” derivatives instruments called “collateralized debt obligations” and “credit default swaps.”
Collateralized debt obligations (or CDOs) were one of the main instruments Wall Street used to invest in mortgage-backed securities.
The investment firm Goldman Sachs alone sold $73 billion in “synthetic” CDOs between 2004 and 2007 (synthetic CDOs were CDOs made out of other CDOs… it was some serious Wall Street voodoo shit).
CDOs were instruments that contained these pooled-together mortgage-backed securities (many of which were subprime) along with other assets such as car loans and credit card debt into different levels or “tranches” of investments.
Each tranche offered varying degrees of risk and yields and were given different credit ratings.
A credit rating is a score given to an investment that is supposed to measure the worthiness of the investment and the likelihood of default, with the top rating being “AAA” (indicating a safe investment) and the lowest being a “B” (indicating a junk or toxic investment).
The problem with CDOs was that these tranches were then pooled together and diced up themselves. So, the junk investments were mixed with the safe investments and were then cobbled together into new investments.
This also allowed multiple investments to be made on the same securities. The Financial Crisis Inquiry Commission, a government appointed commission tasked with investigating the causes of the financial crisis, published in their report, “a mortgage on a home in south Florida might become part of dozens of securities owned by hundreds of investors.”
To make matters worse, credit rating agencies such as Moody’s, Standard & Poor’s and Fitch gave ratings to the CDOs, often giving them a score of “AAA.”
This process essentially had the effect of turning junk investments into “AAA” investments.
A rating of “AAA” is supposed to indicate that there is almost no credit risk to the investor whatsoever and is supposed to have a probability of failure of less than one percent.
Credit ratings are taken very seriously in the financial services industry, and most investors rely on them for determining the validity of an investment. Even the SEC has guidelines for investors to rely on these ratings.
So why would the credit ratings agency give “AAA” ratings to investments that were incredibly risky and perhaps even toxic? That’s easy: profit.
Credit ratings agencies are paid fees for providing such ratings, and during the years leading up to the financial crisis, their profits more than quadrupled.
The Senate Permanent Subcommittee on Investigations stated in their report, “ratings agencies weakened their standards as each competed to provide the most favorable rating to win business and greater market share,” … so much for the idea that the industry can be self-regulating.
There is a mountain of evidence to suggest the credit ratings agencies were aware such investments were risky and not worthy of the “AAA” score, but what’s worse is that many on Wall Street were also aware of the risk.
The FCIC report stated, “major financial institutions ineffectively sampled loans they were purchasing to package and sell to investors. They knew a significant percentage of the sampled loans did not meet their own underwriting standards or those of the originators.”
So aware was Wall Street of the risk, in fact, that many began betting against the very CDOs in which they were encouraging others to invest.
Betting against the house
This is where the credit default swaps came into play. A credit default swap basically works similar to an insurance policy that guarantees the credit worthiness of an investment.
However, unlike a traditional insurance policy, unlimited swaps could be taken out on the same investments — and even on investments the swap purchaser didn’t own.
Investment firms such as Goldman Sachs bought billions of dollars in credit default swaps from AIG, a multinational financial insurance corporation, to bet against the same CDOs they were selling to their customers.
This way, when the CDOs failed, Goldman Sachs hoped to still make money.
But because of the unregulated nature of the derivatives market, AIG was not required to set aside the capital to cover such guarantees — and as it turns out, AIG simply didn’t have the funds.
The FCIC report found that credit default swaps “were sold by firms that failed to put up any reserves or initial collateral or to hedge their exposure.”
These practices exponentially magnified the risk for potential financial collapse.
And then, inevitably, the CDOs began to fail.
The bubble bursts
When the people who had originally been given subprime mortgages began to default on their payments, the entire house of cards began to tumble.
People stopped making their mortgage payments, and the market for CDOs simply collapsed.
The rug had suddenly been pulled out from under Wall Street — the bubble had burst, and one by one the largest investment firms in the country began to fall.
In March of 2008, the investment bank Bear Stearns that had sold billions in CDOs to investors was the first to go, being acquired by JPMorgan Chase.
And like a viral contagion, when the collapsing mortgage-backed securities and CDO market took down Bear Stearns, the infection spread across the entirety of Wall Street.
The dominoes finally began to fall.
Fannie Mae and Freddie Mac were the next to crumble, followed by Lehman Brothers, Merrill Lynch and AIG.
The bait-and-switch shell game that Wall Street had built layer upon dizzying layer of deception and fraud went bust… And they mostly got away with it.
In the end, trillions of dollars were lost, the federal government spent billions bailing out the crooks, millions of homes were foreclosed or lost their value, and millions of Americans were unemployed or saw their wages decrease — all in Wall Street’s pursuit of the quick buck in a con game.
There is plenty of blame to be spread around, and every actor played some role in the collapse. But make no mistake about it, Wall Street helped engineer the heist and drove the getaway car, leaving the American people in near-economic ruin to clean up the mess.
But the mess hasn’t been cleaned up, and unless something changes, the new Wall Street swindle is only a matter of time.
W. Paul Smith