The Aftermath of The Bursted Bubble

THE AFTERMATH OF DEREGULATION

By Steve Thomsen

September 15^th, 2008. AKA, the day the whole financial world went into cardiac arrest. This was the day when all transactions stopped, several financial companies were pronounced officially dead, and the DOW Jones Industrial dropped 700 points in a single day. This was the day known as the Great Collapse. And in it, all of America feared for the future of our financial security.

In my previous post I described how the new securitization system had been put into place to secure mortgage, credit card, and student loan payments. These financial products, known as derivatives, gave birth to investments like Collateralized Debt Obligations (CDOs), Collateralized Mortgage Obligations (CMOs), and one final product to ensure your financial products from going bad called Credit Default Swaps (CDSs). I also went over the ways these products were used to lump lousy mortgages into lump sum products that were sold as AAA rated investments. As mentioned, this picture got ugly. So ugly, in fact, that it completely stopped the market on that fateful day in September. Here’s how it was abused:

By 2006, the mortgage market was already raising eyebrows. Allan Sloan, the editor in chief of Fortune Magazine, wrote a column entitled “House of Junk.” The article was very critical on the real estate products hitting the market. These CMOs that were being offered to investors, he wrote, were comprised of mortgages that the owners had lass than 5% on in many cases. Basically, even though they were sold as solid investments, he was realizing that they consisted almost entirely of sub-prime loans. And sub-prime meant the owner could walk away from his house for basically any reason. After all, he had almost no money in it. So why should he care?

More troubling still, a third of all mortgages that made up these CMO derivatives had defaulted. The products were going to go bad. It wasn’t a question of “if.” It was a question of “when.” And WHEN these products went bad, it would be much bigger than simply drying out payments for investors: it would also mean that everyone who had an insurance policy on these products would ALSO need to be paid out for the CMOs defaulting. And, as mentioned, a lot of these products were leveraged FAR beyond a single person insuring their house. Often times, dozens or even hundreds of investors would buy insurance policies against these houses going bad. They didn’t even own the house. They were just placing HUGE bets against the real estate market.

So imagine this: your house burns down. You have insurance on the house, so you’re not worried. But fifty other people ALSO insured your house against burning down. So now the loss isn’t just for one house: it’s for fifty. And everyone who has insured themselves against your house burning down now has a vested interest in the house burning. You can see why certain people would want to see this house burn.

The biggest company to abuse the bets against the mortgage market was, hands down, Goldman Sachs. Goldman, since heading off to the races to create as many CDOs and CMOs as possible, had sold as many mortgages as they could possible sell. They practically gave them away so they could create more securities to sell to investors. They knew the mortgages were basically crap. They also knew that the mortgages would default and the securities, consequentially, would go bad. But this market was making them tons of money. So they doubled down on it, working with lenders like Wakovia to make as many piece-of-crap financial products disguised as AAA investments as possible.

But Goldman Sachs took it one step further: they started buying MASSIVE amounts of Credit Default Swaps to insure themselves against the very financial products they were selling. They would sell thousands of mortgages, lump them into securities, and then buy CDSs on the securities as soon as they sold them to other customers. Is this making your head hurt yet? That’s exactly why it worked: because it’s literally too boring to pay too close attention to. But, as mentioned, the securitization chain is where all the bodies are buried in this story.

In 2006, George W Bush appointed the CEO of Goldman Sachs, Henry Paulson, to be the US Treasury Secretary. Paulson, along with Greenspan and Summers, is often known as one of the key players to the financial disaster. Paulson was a complex character: he was business savvy, but not a straight Gordon Gecko. Still, some of the policies he was the chief advocate of were directly related to the collapse. So his appointment to the treasury is crucial to the story and indeed history.

One of the policies he lobbied for was for the banks to be able to leverage their borrowed money in numbers much higher than the amount of reserve capital the banks actually had. So the bank could potentially loan $100 billion while it only had $15 billion in reserve. This obviously went against the golden rule of living within your means, but according to Paulson, these were deals negotiated by professionals. So they should be allowed to make risky bets.

The other was to leave the Credit Default Swap market unregulated. This was a market that should have been regulated from day one simply because of the volatile nature of the products. In typical insurance policies, you can only insure yourself for something you own. In the world of financial products, you don’t need to own a product to buy insurance. Not only that, but you can insure yourself for several times the amount of the actual financial product by buying multiple CDSs on your product. This was a VERY dangerous system because if anything went wrong, the blowback would be deadly.

AIG was the primary supplier of Credit Default Swaps. And since it was a largely unregulated market, Goldman Sachs went big with it. Their former CEO was now in one of the highest offices in the country and their piece-of-crap products were so heavily insured that if (or, more accurately, WHEN) the products defaulted, they would be owed a vast sum of money. The number was in the billions. Needless to say, Goldman Sachs had a very vested interest in blowing up the world.

Some other major mortgage lenders included Countrywide, who’s CEO at the time was Angelo Mozello. Angello became enormously wealthy during the bubble, and left the scene of the crime with over $200 million. Robert Steele, the CEO of Wakovia, got out of his failed company with millions as well, and eventually chaired the board of Wells Fargo bank. And Bank of America’s Ken Lewis went on to make over $9 million during the worst year of the bubble (2008). Eventually, we’ll talk about the key point that the reason this behavior continues to this day is because none of these people have gone to jail.

The time bomb was set. The players had already established their positions. Any day, enough mortgages will have gone bad that a full-blown atom bomb of fiscal carnage would unleash upon the world. Goldman Sachs had set their pieces. Lehman Brothers and Bear Stearns were busy creating their mortgage messes, but hadn’t counted on Goldman’s boldness. And AIG had an unexpected payday in it’s future, the magnitude of which would ultimately equal $85 billion (!!) It was the closest thing we’d get to seeing the apocalypse in our lifetime. And what’s strangest of all, some people still don’t even know that it happened.

Next week, we’ll go over this grand fireworks show that blew our economy to hell and back. And we’ll go over how the culprits who nearly destroyed the world were rewarded for their bad behavior. All this, next week on “Corporate Welfare.”