Inside Job (7 page)

Demand was high. These new products started to change the whole structure of housing finance. Now, mortgage brokers sourced deals for a new group of “mortgage banks”. The mortgage
banks bought loans from brokers, and held them only until they had enough for Wall Street to securitize. By the mid-1990s, this model dominated the market.

But even in the first several years of their existence, collateralized mortgage obligations produced an interlude of craziness ending in a mini-crisis, in the early 1990s. Though tiny by current
standards, with
estimated losses of $55 billion, it was a warning of the damage that could be inflicted by uncontrolled, or perversely incented, bankers.

There were other dark signs. One was the entry of “hard money lenders” like Beneficial Finance and Household Finance into housing finance. They specialized in high-risk, high-yield
lending, and were aggressive in going after defaulting borrowers. By the end of the 1990s, the high earnings of hard-money housing spin-offs, outfits such as the Money Store, Option One, and New
Century, made them darlings of the stock market. Riskier housing lending, although still a small fraction of the market, was growing.
⁷

High-risk mortgages were extremely profitable, particularly if their risks could be disguised, because they carried high fees and interest rates. They were also perfect for a Ponzi-like bubble,
which would temporarily conceal fraud. If housing prices were rising, then the loans could be paid off by flipping houses or by taking out additional home equity loans, based on the supposed
appreciation of the house.

The gradual rise in high-risk lending exploited the fatal flaw of securitization, namely that it broke the essential link between credit
decisions
and subsequent credit
risk and
consequences
. If people pumped out bad loans just to sell them, trouble would eventually follow, but it would be
other
people’s trouble. In principle, one could adjust for this,
for example by requiring sellers of loans to accept a fraction of subsequent losses. But nobody did that; in fact, compensation practices were moving in the opposite direction, and fast.

Securitization spread from high-quality mortgages to so-called subprime mortgages, and also to other classes of loans. Wall Street started securitizing portfolios of credit card receivables, car
loans, student tuition loans, commercial property loans, and bank loans used to finance leveraged corporate buyouts. Initially, again, only high-quality loans were used; but, again, quality
declined steadily over time.

At the same time, the securitization food chain became ever more complex and opaque. Its growth and increasing complexity caused a gradual, disguised rise in system-wide leverage and risk. Many
buyers of securitized products were hedge funds and other highly leveraged,
unregulated “shadow banking” entities. Securitized mortgage products were increasingly
insured by specialized (“monoline”) insurance companies and/or via credit default swaps, a market dominated by a London-based unit of AIG (AIG Financial Products). These were
unregulated derivatives that generated potentially huge payments in the event of credit downgrades or defaults. But nobody knew the total size or distribution of these risks.

During the same period, the increasing criminality and systemic danger of finance was showing itself, even as the industry successfully pressed for more deregulation. The most visible signs were
the Internet bubble, the huge frauds at WorldCom and Enron, the Asian financial crisis, and the implosion of Long-Term Capital Management (LTCM), which at the time was the world’s largest
hedge fund.

The Internet revolution was very real, and certainly justified a sharp spike in venture capital investment, start-up activity, and initial public offerings, as well as in the share prices of
established companies well positioned to exploit Internet technology. What actually happened, however, was insane, and went far beyond rationality. Companies with almost no revenues, losing huge
sums of money, and with no plausible way to reach profitability, received enormous equity investments and then went public at extraordinary valuations. The Nasdaq index, a good proxy for technology
stocks, went from under 900 in 1995 to over 4500 in January 2000.

Then the bubble collapsed. Eighteen months later, in mid-2002, the Nasdaq was back down to 1100. Certainly much of the bubble was driven by general public overexcitement, but much of it was also
driven by fraud, on the part of both entrepreneurs and Wall Street. Dozens of Internet companies spent lavishly, paid lavishly, spun half-truths, went public, and then went bankrupt by 2001. Wall
Street firms and their star analysts gave these companies high investment ratings in order to obtain their business, often while privately deriding them as junk.

In addition to start-ups, several established companies, including Enron and WorldCom (which had acquired MCI, a large telecommunications provider), had exploited and thereby contributed to the
stock
frenzy by using accounting fraud and claims of Internet-related innovation. Enron also relied on its political connections, which helped keep regulatory oversight lax.
The company contributed heavily to sympathetic candidates, and one member of its board of directors was Wendy Gramm, who was not only a former chairperson of the Commodity Futures Trading
Commission (CFTC), but also the wife of US senator Phil Gramm of Texas, then chairman of the Senate Banking Committee.

THE CLINTON ADMINISTRATION
became the driver of financial deregulation, with frequent assistance from Alan Greenspan and Congress. The result was a wave
of new laws, regulatory changes, and a sharp deceleration in both civil and criminal law enforcement. Issuance of regulations, monitoring, criminal investigation and prosecution of financial
offences, and tax audits of financial executives declined sharply. Ironically, these deregulatory changes were preceded by the one piece of positive regulatory legislation enacted by Clinton. In
1994 Congress passed and Clinton signed the Home Ownership and Equity Protection Act (HOEPA), intended to curb abuses in the emerging market for high-interest subprime loans, particularly for home
equity lines of credit (HELOCs). The law gave the Federal Reserve Board broad authority to issue regulations covering mortgage industry practices. But Alan Greenspan refused to use the law. In
fact, the Federal Reserve issued no mortgage regulations at all until 2008, which was just a little late, and during the bubble Greenspan made several public statements encouraging use of
“innovative” mortgage products.

Rules against interstate banking were dropped in 1994. The GlassSteagall Act, mandating strict separation between investment banks and commercial banks, was substantially weakened in 1996, and
completely repealed in 1999. Citigroup actually violated the law by acquiring an insurance company and investment bank before Glass-Steagall was repealed; Alan Greenspan gave them a waiver until
the law was
passed. Shortly afterwards, Robert Rubin resigned from the government to become vice chairman of Citigroup, where, over the course of the next decade, he made more
than $120 million.

Then came the fight over derivatives. One of the Clinton administration’s final acts, with strong support from Larry Summers, Alan Greenspan, and Senator Phil Gramm, was a law banning any
regulation of over-the-counter (OTC) derivatives, including all the complex securities that were at the heart of the 2008 crisis. Large sections of the bill were drafted by ISDA, the industry
association for derivatives dealers.
⁸

The total ban on OTC derivatives regulation actually started with a move
towards
regulation. Brooksley Born, chair of the CFTC, had observed the rapidly growing derivatives market and
concluded that it posed significant risks. She initiated a public comment and review process, which immediately triggered ferocious combined opposition from Rubin, Summers, Greenspan, and SEC
chairman Arthur Levitt. Larry Summers telephoned Born, telling her that he had thirteen bankers in his office who were furious, and demanding that Born desist. (The phone call may have been
illegal, since the CFTC is an independent regulatory agency.) Shortly afterwards, the administration introduced legislation to ban all regulation of OTC derivatives, supported heavily by Phil
Gramm.

Remarkably, the deregulation drive was utterly unaffected by a concurrent wave of scandals involving derivatives and other new instruments. A Bankers Trust trading subsidiary, BT Securities,
marketed derivatives in a quite predatory way, usually to hedge against interest rate risk. A simple interest-rate swap for Gibson Greeting Cards on a $30 million debt was constantly tweaked, until
a series of twenty-nine separate “improvements” ended up costing Gibson $23 million. When Gibson finally sued, seven more BT clients came forward with similar claims. Procter &
Gamble said it had lost $195 million; Air Products and Chemicals, $106 million; Sandoz Pharmaceuticals, $50 million. A BT trader reflected—on tape—“Funny business, you know? Lure
people into that calm and then just totally fuck ’em.”
⁹

Nor was the Bankers Trust episode an isolated one. Merrill Lynch coaxed the treasurer of Orange County, California, into a derivatives deal that caused a $1.5 billion loss,
bankrupting the county in 1994. (Merrill and several other banks later were forced to cover more than half the loss.) The centuries-old Barings Bank was destroyed by a rogue trader in Singapore;
Daiwa Bank lost $1 billion on Treasury derivatives; a copper trader cost Sumitomo Bank $2 billion.

Then in September 1998, in the midst of the Asian financial crisis, the hedge fund Long-Term Capital Management collapsed, largely as a result of its derivatives positions. Just days earlier
Alan Greenspan had told Congress that derivatives regulation was unnecessary because “market pricing and counterparty surveillance can be expected to do most of the job of sustaining safety
and soundness.”
¹⁰

LTCM had been founded in 1993 by John Meriwether, a famed trader, along with a glittering array of partners including Myron Scholes and Robert Merton, who received the Nobel Prizes in Economics
for developing the models underlying derivatives pricing. But LTCM had used derivatives to make highly leveraged bets on bonds. When these bets went badly wrong because of the Asian crisis and
Russia’s 2008 sovereign bond default, LTCM found itself with $100 billion in potential losses. The Federal Reserve feared a systemic crisis and organized an emergency rescue involving a dozen
large banks. Forced to defend the rescue, Greenspan testified to Congress:

But that didn’t stop Greenspan from continuing to press for a complete ban on derivatives regulation. And thus, with continued advocacy from Greenspan, the Clinton Treasury Department, and
congressional leaders, Brooksley Born was overruled and the Commodity Futures Modernization Act was passed and signed in late 2000.

Nothing changed Greenspan’s mind. In 2003, at a Chicago investment conference, he said:

After the global financial crisis, the collapse of AIG, and at least $10 trillion in losses, Greenspan finally, barely, admitted that there had been “a flaw” in his
model.
¹³

The Clinton administration also exhibited increasing nakedness in revolving-door hiring. Robert Rubin came to the Clinton administration from Goldman Sachs, and upon resigning as Treasury
secretary in 1999, became vice chairman of Citigroup, whose mergers had been legalized by legislation that he had supported. Laura Tyson, chair of the National Economic Council, joined the board of
Morgan Stanley shortly after leaving the administration. Tom Donilon, the chief of staff of the US State Department, became the chief lobbyist of Fannie Mae shortly after his departure. Franklin
Raines, head of the Office of Management and Budget, became CEO of Fannie Mae, where he became deeply embroiled in its accounting frauds. Michael Froman and David Lipton, two senior economic policy
analysts, went to Citigroup. After serving as Clinton’s final Treasury secretary, Larry Summers became president of Harvard University, while consulting for a major hedge fund, Taconic
Capital. After two no-confidence votes from his faculty, Summers was forced to resign as president of Harvard, at which point he joined another, larger hedge fund, D. E. Shaw, and began giving
speeches to financial institutions that made him millions of dollars per year.

IN PART ENABLED
by deregulation, in part driven by technological change and the increasing capital intensity of highly computerized operations, and in
part to seek greater profits derived from market power, the financial sector consolidated sharply in the 1990s. This consolidation was both horizontal and vertical, and was so extreme that the
financial sector of 2000 was completely unlike that of thirty years before. The only industry segments that remained somewhat fragmented were also largely unregulated—hedge funds that managed
money for the wealthy, venture capital, and, fatefully, the new mortgage lenders in the shadow banking system.

Between 1960 and 2000, the combined capitalization of the ten largest investment banks in the US (of which the largest five dominated the industry) had grown from $1 billion to $179 billion.
Employment by the largest five had quadrupled since 1980 to 205,000 in 2000. This structural consolidation was not confined to investment banking; it affected every segment of the financial sector
and reached across segments via the creation of enormous financial conglomerates. And the main source of this broader consolidation was not the organic growth of the successful; rather, it was
mergers.