THE 2007-2009 FINANCIAL CRISIS cont'd
Meanwhile, derivatives — financial instruments based on some underlying asset such as mortgages — were a multi-trillion unregulated market and Washington and Wall Street fought hard to keep it that way. 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. Stay tuned for the destruction this eventually caused.
By the end of the 1990s, shiny happy market optimism and 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. Afterward, several regulators launched an investigation into allegations that analysts issued biased opinions in order to increase their investment banking business. A main source of evidence in the investigation were internal e-mails that showed financial analysts privately denouncing stocks they publicly praised.
During the 2000's there were tons of shenanigans going on. Enron Corporation repeatedly used fraudulent accounting practices to hide tens of billions of dollars of debt, a colossal scandal that cost shareholders $11 billion. The Federal National Mortgage Association (Fannie Mae), established by the government to boost the housing market, engaged in what federal officials called “extensive financial fraud” by overstating earnings by around $10.6 billion in order for executives to collect hundreds of millions of dollars in bonuses. CEO Franklin Raines made over $52.8 million in bonuses based on the fraudulent numbers.
The Federal Home Loan Mortgage Corporation (Freddie Mac), also established by the government, paid $125 million to settle charges of fraudulent accounting practices, which involved underreporting earnings by $5 billion.
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. American International Group (AIG) agreed to pay $1.64 billion to settle charges involving improper accounting, manipulated bids, and unethical portfolio practices. 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. UBS paid a fine of $780 million when they were caught helping wealthy Americans evade taxes.
These are all despicable acts to be sure, but it’s hard to get worse than the vile behavior exhibited in the years leading to the 2007-2009 Financial Crisis, the largest financial disaster since the Great Depression. This international catastrophe 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; and a massive crash in the U.S. housing market.
In the end, the United States financial system was only stabilized 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).
Although many intangible consequences of the fiasco cannot be quantified, staff of the Federal Reserve Bank of Dallas "conservatively estimate that 40 to 90 percent of one year's output ($6 trillion to $14 trillion, the equivalent of $50,000 to $120,000 for every U.S. household) was foregone due to the 2007-09 recession." Read the report here.
Not to mention the intangible consequences of things like psychological trauma, skill atrophy from prolonged unemployment, the loss of citizen trust in government institutions and the overall financial system, and the unintended consequences of substantial government intervention.
According to the U.S. Government Accountability Office, "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 recent crisis could range from a few trillion dollars to over $10 trillion." Read the entire report here.
In the years before the crash, many Wall Street banks began to operate far differently than they had in the past. Instead of just making a loan and keeping it on the books, lending became all about loan origination and securitization, which supposedly spread the risk of a loan among hundreds of parties.
During this time, a new lending channel 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, what became crystal clear in the aftermath is that 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.
Meanwhile, Wall Street was busy engineering new, nefarious financial instruments. After all, the possibilities were endless thanks to derivatives being unregulated…thanks President Clinton! The deadliest of these was an extremely complex security called the collateralized debt obligation (CDO). Originally the CDO mirrored a mortgage bond, which aimed to redistribute risk associated with home mortgage lending and make the financial markets more efficient.
In a mortgage bond, thousands of home loans are gathered together and then resold in bits and pieces to investors. The assumption is that it’s extremely unlikely all of the home loans grouped together will repay or default at the same time. This structure depends largely on securitization, with thousands of loans being divided into what are called tranches (generally, the riskiest loans are in the bottom tranche and receive the highest interest rate, whereas the loans in the top tranche are the least risky and receive the lowest interest rate).
In this new world, the CDO gathered one hundred mortgage bonds and used them to create an entirely new pyramid of bonds. The bonds used in this set-up were usually Triple-B-rated bonds, some of the riskiest of the bunch. Not only were these bonds risky, they sometimes weren’t even tied to actual home mortgages. Financial firms soon 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,” short-sellers — pessimists who believed the CDO market would eventually crash and therefore bet against it — happily served as the counter party. This new market made the risk associated with subprime mortgage lending endless.
To make matters far worse, many financial firms borrowed heavily against these securities to increase their returns. This is known as leverage, or using borrowed money as a source of financing. This multiplied the pain exponentially when the market collapsed.
The next little trick is where Wall Street got either really creative or really criminal depending on your take (our take is really criminal). Instead of carrying over the Triple-B-rating to the new tranches, financial firms simply got the low-rated bonds re-rated as Triple-A.
Who in the world would do this for them? Answer: Nationally Recognized Statistical Rating Organizations (NRSROs) named Moody’s, Standard and Poor’s and Fitch Ratings. With just one word from these agencies, the risk of these horrid loans simply disappeared — that is, on paper anyway.
NRSROs are agencies that rate the creditworthiness of a company or a financial product. Because they help investors determine the risk of a security, they are extremely influential in the financial markets. At the time, an epic conflict of interest existed in their 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 arrangement was lucrative for the credit agencies is quite an understatement. When Moody’s went public, its stock multiplied by six and its earnings increased 900%. During the mortgage boom, Moody’s rated $4,700 billion of residential mortgage-backed securities and $736 billion of CDOs in just seven years. Yet over and over they completely missed — or, more accurately, blatantly overlooked — enormous risks being taken by those who paid them huge amounts of money.
Ten years after the crisis, Moody's reached an agreement with the "U.S. Department of Justice and the attorneys general of 21 U.S. states and the District of Columbia to resolve pending and potential civil claims related to credit ratings that Moody’s Investors Service assigned to certain structured finance instruments in the financial crisis era." They 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.
The 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 the stock market dropped 416 points. For the next eighteen months, as hundreds of billions of dollars in mortgage-related investments 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 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.
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 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%, 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.
We don’t mean to pick on Bank of America. 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."