Inadequately regulated banking systems experience severe boom and bust cycles, where the enormous risks taken during the boom times inevitably lead to tremendous losses during the busts. From the early 1800s until 1929, the U.S. financial system experienced banking panics every five to ten years. These events culminated in the disastrous collapse of U.S. stock market prices on October 29, 1929 – Black Tuesday – which signaled the beginning of the Great Depression.

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After the Wall Street Crash of 1929, tight regulations were put into place to prevent another catastrophe. These included the formation of the Securities and Exchange Commission and the enactment of the Banking Act of 1933, commonly known as the Glass-Steagall Act. Glass-Steagall prevented banks from engaging in risky investment banking activities and prohibited any one institution from acting as any combination of an investment bank, commercial bank or insurance company. After these firewalls were established, the U.S. enjoyed over 40 years of economic growth without one major financial crisis.

 

​Over time, many of the significant protections that were put into place between traditional commercial banking, investment banking and brokerage industries were systematically dismantled. Meanwhile, banks were required to keep fewer cash reserves on hand and the government, banks and rating agencies all lowered their mortgage standards to entice more Americans to purchase homes. 

           

Financial deregulation was a bipartisan endeavor.

 

In the late 1970s, savings and loans (S&Ls) – cooperative financial institutions that accept deposits and make mortgage, auto and other personal loans to its members – were in crisis, hit hard by high interest rates and inflation. One issue was that, although interest rates at that time spiked as high as 21.5 percent, S&Ls could only offer a 5.25 percent interest rate, a number established by the government. To help S&Ls compete, Congress passed – and President Jimmy Carter signed into law – the Depository Institutions Deregulation and Monetary Control Act, which gave S&Ls broader authority and phased out limits on what S&Ls and banks could pay out for consumer deposits. 

 

​Although the S&L crisis was in full swing when President Ronald Reagan took office, he signed the Garn-St. Germain Depository Institutions Act, which only accelerated S&L deregulation. In fact, this action basically deregulated S&Ls entirely. Of the bill, President Reagan said, “This bill is the most important legislation for financial institutions in the last 50 years…All in all, I think we hit the jackpot.” 

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Yeah, Reagan hit the jackpot all right! S&Ls were now freer than ever to make riskier investments with depositors’ money. Essentially, S&Ls were now allowed to operate like banks without being regulated like them. Because there was little oversight, fraud – think falsified loans, illegal conspiracies, and straight-up embezzlement – spiraled out of control. In the end, over 1,100 bankers were prosecuted by the U.S. Justice Department in response to the S&L scandal and, unsurprisingly, many imploded.  Ultimately, 1,043 savings and loans failed at a cost of $124 billion to the American taxpayer.

 

​Even still, President Bill Clinton doubled down on financial deregulation. In 1998 Citicorp, a commercial bank holding company and Travelers Group, an insurance company, merged to form Citigroup. Citigroup instantly became the largest financial services company in the world combining banking, securities and insurance services. However, the merger violated the Glass-Steagall Act. 

 

​No worries whatsoever! Congress simply passed – and President Clinton signed into law – the Financial Services Modernization Act, commonly known as the Gramm-Leach-Bliley Act. Although Glass-Steagall had been diminished over the years, it was completely gutted with this legislation that allowed commercial banks, investment banks, securities firms and insurance companies to consolidate. In the absence of Glass-Steagall, financial institutions could grow larger, become more entangled and take far greater risks… and boy did they ever!​ The financial sector soon consolidated into just a few huge firms, any one of them so large and interconnected that their individual failure would threaten the entire system. In other words, they became too big to fail.

 

​While all this was going on, derivatives – financial instruments based on some underlying asset like mortgages – were a multi-trillion-dollar market, and Washington and Wall Street didn’t like that they were being “constrained” by all those nasty regulations. So, in December 2000, Congress passed – and President Clinton signed into law – the Commodities Futures Modernization Act, which prevented the Commodity Futures Trading Commission from regulating almost all over-the-counter derivative contracts.

 

​By the end of the 1990s, shiny happy market optimism and stacks of venture capitalist cash had fueled a massive bubble in Internet stocks. By 2001, the dot-com bubble burst losing over $8 trillion in paper and actual wealth. ​During the early 2000s there were tons of shenanigans going on. Enron Corporation, for example, repeatedly used fraudulent accounting practices to hide tens of billions of dollars of debt, a colossal scandal that resulted in 25,000 lost jobs, multiple criminal convictions, and a $11 billion financial loss for Enron’s shareholders.​ A Senate investigation found that Riggs Bank laundered money for former Chilean dictator Augusto Pinochet, helping him conceal millions of dollars in assets from international authorities; UBS paid a fine of $780 million when they were caught helping wealthy Americans evade taxes; and Credit Suisse paid a $536 million fine to settle claims it violated U.S. sanctions by helping other countries launder hundreds of millions of dollars through American banks. They even facilitated transactions for Iran’s Atomic Energy Organization and the Aerospace Industries Organization, both of which were proliferators of weapons of mass destruction.

 

​This is all bad behavior to be sure, but it’s hard to get worse than the despicable behavior that was exhibited before, during and after the 2007-2009 Financial Crisis, by far the largest financial disaster since the Great Depression. This international disaster resulted in the collapse of large financial institutions; the government takeover of Fannie Mae, Freddie Mac and the nation’s largest insurance company; an astronomical government intervention; a massive crash in the U.S. housing market; the loss of millions of jobs and trillions in household wealth; and millions of shattered dreams.

 

​A 2013 report from the U.S. Government Accountability Office said that “the 2007-2009 Financial Crisis has been associated with large economic losses and increased fiscal challenges. Studies estimating the losses of financial crises based on lost output (value of goods and services not produced) suggest losses associated with the crisis could range from a few trillion dollars to over $10 trillion.” A report from the Federal Reserve Bank of Dallas that same year was even worse. Their researchers estimated, “conservatively,” that “$6 trillion to $14 trillion – or the equivalent of $50,000 to $120,000 for every U.S. household – was foregone due to the 2007-09 recession.”

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Many additional but intangible consequences that can’t be precisely measured – but that made an enormous impact on Americans during that time – include psychological trauma, skill atrophy from prolonged unemployment, and the loss of citizen trust in government institutions and the overall financial system, which will likely stick around for our entire lifetimes. In the end, the United States financial system was stabilized only through significant injections of taxpayer capital, together with additional guarantees and lending facilities provided by the Federal Reserve, the Department of the Treasury, and the Federal Deposit Insurance Corporation (FDIC).

 

So, how in the heck did this happen?

 

The stage for the 2007-2009 financial meltdown was set in 1995 by President Bill Clinton, who was determined to increase the rate of home ownership to an all-time high of 67.5 percent within five years. This would produce 8 million new homeowners! Yay!

To help him reach this goal, President Clinton unveiled a list of 100 specific actions – what he called the National Homeownership Strategy – that he was convinced would achieve his mission but “not cost taxpayers one extra cent.”

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On its face, this seems like a really nice thing for President Clinton to do. At a minimum, it would make people forget about Monica Lewinsky for a few minutes. But what Bill Clinton failed to realize – or just decided to willfully ignore – was that, to create 8 million new homeowners, mortgage-lending standards would have to be slashed. I mean, like severely slashed. Like slashed and burned slashed. This – together with the fact that the possibilities were now endless given derivatives were unregulated, which we also have President Clinton to thank for – led to financial institutions creating nefarious, toxic mortgage structures that ignored even the slightest attempt at establishing credit worthiness and were so complicated that people applying for a home loan could not possibly understand them. Even Warren Buffett, the world’s savviest investor who called these new financial instruments “time bombs, both for the parties that deal in them and the economic system,” admitted to not understanding them.

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It certainly didn’t help matters that, in addition to being incredibly complicated, financial analysts were muddying the waters even more by issuing dishonest opinions to increase their investment banking business. A main source of evidence in a post-crisis investigation of this phenomenon were internal e-mails that showed financial analysts privately denouncing stocks they publicly praised.

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The deadliest of these new products was an extremely complex security called the collateralized debt obligation (CDO). Originally the CDO mirrored a mortgage bond, which sought to redistribute risk associated with home mortgage lending and make the financial markets more efficient. In a mortgage bond, thousands of home loans were gathered and then resold in bits and pieces to investors. The assumption was that, since it was extremely unlikely all the home loans grouped together would repay or default at the same time, this spread the risk of a loan among hundreds of parties. This redistribution of risk was achieved through something called securitization, where thousands of home loans were divided into what are called tranches (generally, the riskiest loans were in the bottom tranche and received the highest interest rate, whereas the loans in the top tranche were the least risky and received the lowest interest rate).

 

​In this new world, however, the CDO gathered not individual home loans, but entire mortgage bonds and used those to create an entirely new pyramid of bonds. A big red flag was that the bonds used in this set-up were typically Triple-B-rated bonds, some of the riskiest of the bunch. To make matters far worse when the day of reckoning finally arrived: Not only were these bonds risky, at times they weren’t even tied to actual home mortgages. Financial firms quickly discovered they didn’t need an actual home loan as the origination. Like Vegas, they only needed someone to take the other side of their bet. In these “synthetic CDOs,” as they were called, short-sellers – or pessimists who believed the CDO market would eventually crash and therefore bet against it – happily served as the counterparty. Synthetic CDOs essentially made the risk associated with subprime mortgage lending endless.

 

​Another factor that multiplied the pain exponentially when the day of reckoning arrived was that many financial firms borrowed heavily against these securities to increase their returns. This is known as leverage (i.e., using borrowed money as a source of financing), and Wall Street made it an artform. From 1978 to 2007, the amount of debt held by the financial sector skyrocketed from $3 trillion to $36 trillion, more than doubling as a share of gross domestic product.

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But all these realizations came much later, of course. Getting back to the story, the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) – government-sponsored enterprises (GSEs) established in 1938 and 1970, respectively, to boost the national housing market – were right there to help accomplish President Clinton’s dreams. At one point during this mess, they had a combined mortgage exposure of $5 trillion … and they both engaged in what federal officials called “extensive financial fraud.”​ 

 

It was eventually discovered that Freddie Mac underreported earnings by $5 billion and Fannie Mae by $10.6 billion. Fannie Mae CEO Franklin Raines made over $52.8 million in bonuses based on the fraudulent numbers. Raines eventually agreed to return $24.7 million, but not before Fannie Mae spent over $99 million to defend him and two other executives against multiple lawsuits. Fannie Mae and Freddie Mac were able to get away with this deceptive behavior for so long because, for years, they had used their outsized political power to defend against even the most benign regulation and oversight. Among other coercive tactics, they spent $164 million between 1999 and 2008 to lobby Congress.

 

During this time, a new lending channel also emerged. This “shadow” banking system consisted of non-depository banks and other financial entities such as investment banks, hedge funds, money market funds and insurers. Enormous amounts of risk were moved from the more regulated parts of the banking system to this shadow system, where there was little oversight and low capital requirements. 

 

​The risk involved in these transactions was generally considered caveat emptor, the Latin term for let the buyer beware. The thinking was that the parties involved in these deals were sophisticated and well-funded and therefore didn’t need to be saved from themselves (however, as we learned the hard way, losses sustained in the shadow banking system weren’t limited to the parties that made the deals. In truth, no one was isolated from the destruction).

 

​This next little trick is where people got either really creative or really criminal depending on your take (our take is they got really criminal). Remember when we said that the bonds in the new pyramid were typically Triple-B-rated bonds, some of the riskiest of the bunch? Well, this pesky little fact didn’t matter a bit to the Wall Street guys who, instead of carrying over the Triple-B-rating to the new pyramid, simply got the low-rated bonds re-rated as Triple-A. 

 

You’re probably asking, “How did they get away with doing that?” “Who in the world would do that for them?” Answer:  Nationally Recognized Statistical Rating Organizations (NRSROs) named Moody’s, Standard & Poor’s and Fitch Ratings (NRSROs are agencies that rate the creditworthiness of a company or a financial product). With just one word from these agencies, the risk of these horrid loans simply disappeared. That is, on paper anyway.

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Because NRSROs help investors determine the risks of securities, they are extremely influential in the financial markets. During the financial crisis, an epic conflict of interest existed in the NRSRO model. For years, investors paid the bill for the risk assessments given by the rating agencies, but this changed over time. Eventually the issuers of the securities were responsible for paying for their own ratings.

 

​To say this compromised arrangement was lucrative for the credit agencies is a huge understatement. When Moody’s went public in 2000, its stock multiplied by six and its earnings increased 900 percent. The Financial Crisis Inquiry Commission – created to examine the causes of the 2007-2009 economic crisis – revealed that “from 2000 to 2007, Moody’s rated nearly 45,000 mortgage-related securities as triple-A. This compares with six private-sector companies in the United States that carried this coveted rating in early 2010. In 2006 alone, Moody’s put its triple-A stamp of approval on 30 mortgage-related securities every working day. The results were disastrous: 83 percent of the mortgage securities rated triple-A that year ultimately were downgraded.”

 

The Commission ultimately concluded there was a significant breakdown at Moody’s – “including the flawed computer models, the pressure from financial firms that paid for the ratings, the relentless drive for market share, the lack of resources to do the job despite record profits, and the absence of meaningful public oversight” – and that “without the active participation of the rating agencies, the market for mortgage-related securities could not have been what it became.”

 

Ten years after the crisis, Moody’s finally reached an agreement with the U.S. Department of Justice and the attorneys general of 21 U.S. states and the District of Columbia for its conduct during the crisis. Moody’s agreed to pay a $437.5 million civil penalty to the Department of Justice and $426.3 million to the participating states and the District of Columbia. Standard & Poor’s reached a $1.375 billion settlement with the DOJ and several states for defrauding investors by inflating ratings ($687.5 million goes to the Justice Department and $687.5 million to 19 states and the District of Columbia).

 

​The entire house of cards finally came crashing down on February 27, 2007, when Freddie Mac announced it would no longer buy the riskiest subprime mortgages and, as a result, the stock market dropped 416 points. For the next eighteen months, as trillions of dollars in stock value vanished, government regulators made desperate attempts to contain a widespread virus that ultimately metastasized into a global financial panic. 

 

The total cost of the government intervention wasn’t revealed until years later, when Bloomberg LP won a court case against the U.S. Federal Reserve and a group of the largest U.S. banks. As a result, the Federal Reserve was forced to release 29,000 pages of documents under the Freedom of Information Act.

 

Because the level of the Fed’s financial commitment had been such a closely held secret, citizens, shareholders and even the U.S. Congress had been unaware of the full scale of the financial rescue – which enabled many of the distressed banks to hide the magnitude of their fiscal predicament. For example, on November 26, 2008, Bank of America CEO Kenneth Lewis sent a letter to shareholders that said the bank was “one of the strongest and most stable major banks in the world.” However, at the time his bank owed the Federal Reserve $86 billion. In just one day alone – December 5, 2008 – the Federal Reserve loaned the still deeply troubled banks a combined $1.2 trillion. 

 

​But as the dust settled and Americans learned more about the backroom negotiations between the government and Wall Street, public outrage grew. AIG’s initial $85 billion support from taxpayers eventually grew to $182 billion. It was discovered that shortly after their rescue, millions of dollars in bonuses had been paid to AIG executives. To add insult to injury, less than a week after the government committed the initial funds, AIG executives attended a retreat at a luxury resort and spa. AIG paid over $440,000 for the event. 

 

​Just before his firm’s liquidity crisis, Merrill Lynch CEO John Thain spent $1.22 million of company money redecorating his office (he spent $35,115 on his toilet!).  It was also discovered that Merrill had paid its employees billions of dollars in bonuses right before their sale to Bank of America was finalized. Also, before the deal officially closed, Merrill’s trading losses increased to $15.31 billion, and the firm had to take additional write-downs on its weakening assets. ​However, none of these game-changing developments were made public before the merger was approved by the shareholders of both companies. When Bank of America made these disclosures after the deal closed, the bank’s stock fell by more than 60 percent, equaling a market value loss of over $50 billion.

 

​The Securities and Exchange Commission (SEC) sued Bank of America for allegedly concealing huge losses at Merrill Lynch to ensure that shareholders would approve the merger. The suit was settled for $150 million, although the judge himself said the agreement was “half-baked justice at best.” Shareholders also sued Bank of America. That case was settled for $2.43 billion.

 

​In August of 2013, the Justice Department finally sued Bank of America, but not because of the Merrill Lynch deal. Bank of America stood accused of lying to investors in the years leading to the financial crisis and defrauding them by vastly minimizing the risks of $850 million in securities. The suit claims that then-CEO Kenneth Lewis referred to the wholesale mortgages his firm was actively selling as “toxic waste.” One year later, Bank of America agreed to a settlement of $16.65 billion. Bank of America has paid a total of $76.1 billion in fines.

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In August of 2013, JP Morgan Chase finally admitted that the firm faced criminal and civil investigations into whether the firm sold sketchy mortgage securities in the years before the crisis. JP Morgan Chase has paid a total of $43.7 billion in fines. Citigroup $19 billion; Deutsche Bank $14 billion; Wells Fargo $11.8 billion; RBS $10.1 billion; BNP Paribas $9.3 billion; Credit Suisse $9.1 billion; Morgan Stanley $8.6 billion; Goldman Sachs $7.7 billion; and UBS $6.5 billion.

 

​All in, banks have been fined $243 billion from the fall-out of the 2007-2009 Financial Crisis. But as Market Watch reminds us, “It’s important to note that the banks don’t just send a check for their fines to federal and state governments. Many times, they get credit by making loans and supporting debt restructuring. For example, a Goldman Sachs commitment for $1.8 billion of loan forgiveness and financing for affordable housing was considered as part of a $5.1 billion ‘fine’ the bank had to pay.”