To this day, very little in the way of regulation reform has been passed. It seems as though this disaster has just blown over, and Washington thinks it will not likely happen again. No top executive from the firms that caused the global recession has been put on trial or has admitted to any wrongdoing. None of the billions of dollars in compensation that were handed out before or after the crisis has been stripped or attempted to be stripped. Essentially, the greatest Ponzi scheme in the history of the world took place, and not one person has been held liable.
Editor’s Note: This is the second in a two-part series exploring the causes and outcomes of the 2008 financial crisis. See Part I here.
Ten years ago, in order to get a loan, you had to put a down payment of 20 percent if you had an average credit rating. Mortgages are long-term investments lasting from 15-30 years, and lenders don’t like to have too many investments, considering how long mortgages took to mature. They only want investments that they know will follow through, and the 20 percent down payment creates equity and lowers the risk, since the borrower now has a 20 percent stake in the asset and can’t simply pick up and walk out.
Then came the securitization of these mortgages, which created mortgage-backed securities (MBS). Essentially, lenders would sell all of their mortgages to an investment bank which would bundle the mortgages with other securities, like car loans and student loans, and splits them up into three main groups, called “trenches”, by the amount of risk they carried; this created what is known as a Collateral Debt Obligations (CDO). Investment banks then paid rating agencies like Moody, Standards and Poors, and Fitch to rate those CDO investments. Top investments in the first trench, which carry very little risk, are rated AAA. Then comes the second trench, which usually carries anywhere from B+ to C+. Finally, the lowest trench carries the most risk. Once the investments were rated, they were then sold to investors like pension funds, retirement funds, and the Average Joe. In that way, lenders and investment firms make quick cash, and the investors who purchased the CDO get monthly cash flows from the mortgage but also hold all the risk.
CDOs risk to the investment firms was limited to the length of time the firm held the CDO before selling it. Since the AAA ratings were considered very safe, they would be bought off very quickly by pension funds and others looking for a safe bet. The CDOs in the lower trench, which were few in numbers, since no one gave out risky loans, were also sold quickly, because they yielded very high interest rates. So it was the middle-rated obligations which had trouble selling. But CDOs allowed the firms to lend out more money, considering they would be selling the CDO shortly after. So the firms began to lower their credit standards, giving much riskier loans in order to make quick cash. At the same time, they were lobbying the SEC to lift the leverage limit on bank lending, which it did in 2004.
Leverage refers to the amount of money the bank has loaned out compared to the amount it possesses in liquid cash. Let’s say a bank has 100,000 dollars in liquid cash and has loaned out 400,000; that bank has a leverage of 4:1. Lifting the leverage limit would mean the banks would essentially be able to loan out much more than they could actually cover, essentially leaving them insolvent.
The banks began pushing out loans no matter how risky the investment, because of the quick cash they were making. Previously if you wanted a loan, you needed a credit score of 620 and a down payment of 20 percent in order to be considered a viable option; now banks were settling for scores in the 500s and no money down, so houses had absolutely no equity. People with minimum wage jobs were getting half-million-dollar loans with the help of banks falsifying records in order for them to get approved. No one cared, because they were making huge commission checks and bonuses. They began fishing for subprime loans, because they fetched the highest interest rate. Now since the market was being really flooded with these subprime loans, the investment firms knew that no investor would touch what was essentially garbage, so they began bundling those subprime loans with prime loans and had the rating agencies re-rate them as AAA investments. So now investors were fooled into buying extremely risky loans that were disguised as loans with little to no risk; at the same time, these investments were paying out subprime interest rates which were shockingly high for an AAA investment, an offer most couldn’t refuse.
The investment firms knew CDOs were risky investments, and they had billions in unsold investments. So in order to keep from losing money, when the CDOs defaulted, they went to AGI and began purchasing a complex derivative called a Credit Default Swap (CDS). Basically it’s an insurance policy to which the investment banks would pay a premium to AIG, and in turn AIG would cover any losses from the CDOs. This was all done through a small division of AIG called AIG Financial Products, which was headed by Joe Cassano. Cassano apparently didn’t realize the risk or never planned on actually following through with the agreement in case of a default. Either way, AIG’s top executives didn’t question his motives, and why would they? They were making billions of dollars for the company, and their compensations were off the charts. Cassano himself made off with 315 million dollars in compensation, none of which was recollected, and he is not being prosecuted.
The difference between insurance and the CDS derivative is that anyone could pay AIG a premium every month to insure against the CDO’s default. If I own a car, I can go to an insurance company and get it insured. Then let’s say the car gets stolen. I would get money as compensation for my stolen car. But if it was a derivative, you could also be insured against my car being stolen, so if my car is stolen, not only will I get compensated, but so will you. It’s an absolutely mind boggling concept, and that is why it should be regulated.
By the time the homeowners’ ARMs kicked in, interest rates had skyrocketed, and they were unable to pay their mortgages and began to default on their loans. Once this started to happen, the investment firms (at the head of which was Goldman Sachs) raided AGI for compensation and made billions. These are securities which were specifically designed by these investment banks to fail! So in the end, the homeowner loses his home and investors lose their life savings and retirement funds, while the firms and their executives made away with load of cash. But AIG only had so much money to give, and soon it started to feel the pinch. Goldman was again at the head of the pack in demanding that AIG fork over the money it owed. Even with the government pleading with Goldman to easy off a little, it were very head strong in its pursuit of AIG, as if they had some sort of agenda, e.g. perhaps they wanted AIG to fail because they knew the government would step in and pay them what they asked.
Investment banks started losing money quickly due to their own investment in the CDO they hadn’t sold off, stock prices began to plummet, and chaos was imminent. First domino to fall was Bear Sterns, follows soon after by Fannie Mae and Freddie Mac. So the government was forced to step in, acquiring AIG and negotiating with investment firms like Goldman Sachs to pay off AIGs debts, which totaled 61 billion dollars. Shortly after, the government passed a bill that would give a staggering 700 billion dollars to the financial sector in hopes of stabilizing the market. The top nine banks received a total compensation of 125 billion dollars. Goldman got ten billion on top of what it had already received for the AIG CDO compensation, and another 13 billion after AIG’s bailout. So essentially these firms were rewarded billion of dollars for scamming US taxpayers out of their homes, retirement funds, and life savings. They made off with billions of dollars, and we are left picking up the pieces.
To this day, very little in the way of regulation reform has been passed. It seems as though this disaster has just blown over, and Washington thinks it will not likely happen again. No top executive from the firms that caused the global recession has been put on trial or has admitted to any wrongdoing. None of the billions of dollars in compensation that were handed out before or after the crisis has been stripped or attempted to be stripped. Essentially, the greatest Ponzi scheme in the history of the world took place, and not one person has been held liable.
For further information, see the book Griftopia by Matt Taibbi and the documentary film Inside Job.
