I just finished reading the US Senate Permanent Subcommittee on Investigations' report on the 2008 financial crisis:
http://www.ft.com/... (PDF file)
I'm reprinting the report for Red and Black Publishers. The preface I wrote for that edition gives a Readers Digest summary of the 600-page report:
In the first decade of the 21st century, the entire ideology of “free market” and “deregulation” failed spectacularly, as Wall Street melted down and the entire global economy collapsed into the deepest economic disaster since the Great Depression.
It was greed—pure unfettered greed—which produced the collapse.
During the Clinton/Bush era of globalization and deregulation, the banks were flying high. The real estate market in particular was booming; between 1997 and 2006, the average price of a home more than doubled, while interest rates dropped to record lows. To many, it looked as if the good times would never end, and they rushed to cash in. Speculators hurried to buy houses now that they could sell at a profit later when the value went up. Homeowners eagerly took out low-interest second mortgages to finance vacations, cars or other splurges.
Mortgage banks realized that they could make a ton of money by selling mortgages to anyone and everyone, and the criteria for loans became progressively looser using schemes known as “creative financing”. One popular setup was the “Adjustable Rate Morgage” or ARM. This lured people in with attractively low mortgage rates for the first part of the loan period, only to have the interest rate “adjusted” higher later, often to a rate the homeowner could no longer afford. A variation on this was the “balloon payment”, in which payments were made on only half the mortgage, with the second half being due in a single lump sum after just a few years. The most lax loans were “stated income”, in which the bank literally took the word of the homeowner that they had enough income to afford the mortgage, and made no effort to verify any income or even employment. Some banks sold over half their mortgages to people with “stated income” loans. In one memorable case, a prospective homeowner claimed to be a “mariachi band member” with a six-figure income, and the only “documentation” he provided was a photo of himself in his mariachi costume. His mortgage was approved.
And if the creative financing schemes got the homeowner into financial trouble, the bank was always there to “help” with a second mortgage or refinancing. A high proportion of mortgage loans were simply refinances of earlier loans. And some banks even fraudulently paid off appraisers to inflate the value of the home being sold, to bring about a larger loan.
These loans to people with shaky credit ratings were known as “subprime mortgages”. For the banks, any subprime mortgage they could sell was a win-win deal. If the buyer paid it off, great—the bank got money. If the buyer defaulted, the bank could foreclose and, because of the continually rising housing values, then sell the repossessed house for more money than the defaulted mortgage. It was a huge gravy train, every bank wanted to get in on it, and bankers everywhere couldn’t close on enough mortgages fast enough. The banks knew, of course, that a high proportion of these risky subprime mortgages would default, but they didn’t care. All they saw were dollar signs, and they knew that as long as the housing bubble kept swelling, they could always make even more money by repossessing the defaulted mortgages and re-selling the houses or by refinancing the mortgage.
It wasn’t long, of course, before the investment bankers wanted in on the gravy train too. There were tons of money to be made and they were legally barred from making any of it, by Depression-era regulations which separated mortgage banks from investment banks and which limited the amount of leveraged assets that a bank could carry.
So the bankers went to the Clinton and Bush administrations, which obligingly passed two deregulations; the Graham-Leach Act repealed the Glass-Steagall Act that had separated investment banks from mortgage banks since the Great Depression, and the Securities and Exchange Commission relaxed the provisions of the “net capital rule”, which set the amount of debt that any bank was allowed to carry. These regulations had been put into place after the Depression to prevent the repeat of bank failures, caused by high levels of debt from risky stock market or financial investments, that had triggered the 1929 collapse. Their repeal meant that virtually every bank in the country was able to invest freely in subprime mortgage derivatives; the Commodity Futures Modernization Act then deregulated the sale of these derivatives and removed any effective governmental oversight. (Indeed, due to legal loopholes, the second largest initiator of subprime mortgages in the US, New Century, was able to operate virtually free from Federal regulation.)
Now, every financial corporation in the country was at liberty to make money off the housing bubble. The investment banks began offering things called Mortgage-Backed Securities (MBSs) and Collaterized Debt Obligations (CDOs), which were securities packages, sold worldwide in the global financial market, based on the ever-increasing value of the housing mortgages. Although these were quite risky, being based on nothing much more than the hope that the housing bubble would go on forever, the payoffs could be fantastic—many securitized subprime mortgage packages brought in 8 to 10 times as much as government bonds. The risk was downplayed by the financial credit rating agencies who, since their fees depended upon how many ratings they did, obligingly gave the securities “safe” ratings. Investors who did not understand the confusing maze of subrpime derivatives (many CDOs, for instance, were themselves built around the output of other CDOs) simply took the word of the ratings agencies that the AAA ratings meant they were safe investments. For those who did understand the reality behind the securitized mortgages, Wall Street even made money off the potential risk, by selling insurance packages called Credit Default Swaps (CDSs) which protected the security if the subprime loans it was based on failed to perform—allowing enterprising traders to make money by betting that the value of a security would actually fall. In many cases, Wall Street investment banks were placing their own CDS bets against the very same securitized subprime derivatives that they were selling to their own clients. Indeed, investment banks would sometimes set up entire CDOs bundled from failing mortgages, with the express purpose of betting against them. This fact, of course, was never disclosed to the people purchasing the securities, and when they tanked, the investment bank made millions while the investors they had sold the derivatives to were wiped out.
All the while, Washington, permeated with “free market” ideology for decades, did nothing to regulate the new risky financial schemes. The primary regulator for mortgage banks, the Office of Thrift Supervision (OTS), took the position that its client was the banks themselves, not the taxpayers, and took a strictly hands-off approach, even as the banks drove themselves off the financial cliff.
By selling mortgage-based securities, the banks, meanwhile, insulated themselves completely from any risk—if the mortgage defaulted, the cost would now go to whoever had purchased the security, not to the bank that held the mortgage.
The result was a classic bubble, based entirely on the expectation that housing values would continue to climb steadily. The mortgage banks continued selling mortgages to anyone and everyone, as fast as they possibly could. The investment banks and Wall Street hedge funds continued selling MBSs and CDOs based on those mortgages. They all got rich beyond their wildest dreams.
Of course, deep down inside, some of them must have realized that housing values simply could not rise forever and that the bubble would inevitably bust, dragging down not only the housing mortgage market, but the entire huge upside-down-pyramid of derivative securities that depended on it. But their attitude was simple—we’ll worry about that later. Today, there’s lots of money to be made.
Inevitably, the bubble did indeed pop. Housing values declined by over 20%, and people who had borrowed heavily on the value of their house now found themselves unable to keep up. Now, as the default rate climbed, the banks found that they could no longer sell the repossessed houses for more than the mortgage was worth—indeed, they could now not even sell it for the value of the remaining debt. The defaulted mortgages, and all the derivative securities that had been based on them, were now “toxic” and could not be sold. The killer blow came in the summer of 2007, when the ratings agencies, who had until now told everyone that everything was sunny in the land of subprime derivatives, suddenly downgraded nearly 90% of these securities to “junk” level. Almost overnight, billions of dollars in subprime securities became worthless. The payout of Credit Default Swaps to cover them then bankrupted even the largest investment brokers and insurance companies (the total global value of CDSs was estimated at $50 trillion—more than the entire planet’s Gross Domestic Product).
By September 2008, the entire financial house of cards that had been built upon the subprime mortgage industry collapsed utterly. Some of the largest financial companies disappeared into bankruptcy; others, famously dubbed “too big to fail” by the government, were saved only by massive bailouts and by government-brokered mergers with other companies. And despite findings of massive deliberate fraud from top to bottom, virtually nobody went to jail.
This report by the US Senate’s Subcommittee on Investigations, spells out the whole sad story, of how rampant greed and naked self-interest were allowed to take the entire nation—indeed even the entire global economic structure—to the brink of total collapse; how “deregulation” became “license”; how “free market” became “too big to fail”; how gamblers on Wall Street lost billions on risky bets, and how the taxpayers came to bail them out.
Red and Black Publishers