For a long time I have admired the PBS series Frontline for its outstanding reporting. On May 1, the program aired the second-half of a huge four-hour documentary on the origins the Great Recession entitled Money, Power, and Wall Street. The situation obsessed me and my blog posts back in 2008 – 2009. Economically, nothing compares to it in my lifetime. In this post I will attempt to summarize this superb four-part Frontline.
Wall Street is the largest sector of the American economy. It is almost double the size of America's manufacturing sector. Ultimately, the 2008 financial crisis and resulting Great Recession cost the world economy $11 trillion dollars. This is how it happened.
It all started at a ritzy weekend resort in Boca Raton, FL in 1994. A group of young bankers from JPMorgan, were celebrating the success of the company's derivative portfolios. Young, very bright minds, partying a bit and meeting in small conference rooms hatched a new idea.
These young people were struggling with the age-old problem of how to manage Risk. Out of these discussions came the idea of Credit Default Swaps, a derivative that ensured a loan against default, a novel idea. Up to this point derivatives had always involved speculation about the future value of some tangible commodity like corn, coal, or beef.
The JPMorgan whiz kids came up with the idea to use derivatives to manage their bank loan risks. Banks are required to set aside a certain percentage of capital in reserve for every loan they make in order to ensure that if a certain number of loans default they will be able to cover the loses. But, what if banks could find another way to cover potential losses without setting aside their own capital? The banks would then have more capital to lend. Beyond this, however, the derivatives themselves were wildly profitable.
Credit derivatives were born. Banks could loan more capital instead of keeping it in reserve while spreading risks around in an innovative way. In 1994, one of JPMorgan’s whiz kids, Blythe Masters, brokered the world’s first Credit Default Swap with Exxon. By 1998, JPMorgan had hired Terri Duhon to package whole segments of loan portfolios from multiple companies and offer them. The idea mushroomed. JPMorgan’s profits soared and its competitors soon followed suit.
By now derivatives became bets on any and all portfolios whether the banks owned them or not. Credit risk itself became no different from the risk of a season's worth of corn or the coal in a mine in West Virginia. Credit became a commodity, thereby making banking history.
This fueled a worldwide credit boom. Ironically, just as large banking institutions were attempting to reduce risk through new kinds of derivatives, public officials in Washington saw the workings of these new financial instruments as creating greater risk overall. Most famously, Brooksley Born in 1998 attempted to alert congress to the dangers and sought to regulate these Swaps and derivatives. The Banks lobbied hard against this. The Banks won. Legislation was passed by congress and signed into law by President Bill Clinton to repeal the depression-era Glass-Steagall Act, thus opening the way for Banks to market and sell derivatives without any public accountability whatsoever. Citigroup led the charge to repel the Act.
The result was an explosion in Credit Default Swaps beyond commercial credit risk into consumer credit risk with emphasis on home mortgages. In places with rapidly growing housing markets, like Georgia, predatory lending practices emerged. In 2002, Governor Roy Barnes managed to pass legislation putting limits on aggressive mortgage lending practices. The mortgage lobby heavily funded his political opponents and got the law overturned when Barnes failed to win re-election.
Home sales skyrocketed. Swaps grew exponentially. Credit innovation continued with the emergence of Synthetic CDOs. Investors could now bet on derivatives based not on mortgages themselves but on other derivatives. Derivatives on derivatives on derivatives. Terri Dohan, one of the innovators of the Swap system, began to hesitate about the amount of growth and the resulting tower of risk that was amassing. Ultimately, she encouraged JPMorgan to reduce its exposure and limit its protfolio to only certain kinds of Swaps. The derivatives had evolved into something that she had not originally anticipated.
Subprime mortgages fed the growing hunger for Swaps and CDOs. By 2005, many trillions of dollars were involved and the amount started to double every year. It was a global phenomenon led, of course, by the United States. Conditions became such that neither the bankers nor the legislators of the countries involved even understood how these swaps in conjunction with subprime lending worked. The understanding of risk virtually vanished as the housing market continued to grow at a record pace.
Around $36 billion in bonus money was being doled out to the top managers of the derivative market. But, in meetings with the Federal Reserve some bankers like Wells Fargo CEO Richard Kovacevich warned of “toxic assets” and “building a bubble.” They remained in the minority, however. His fellow bankers disagreed with that assessment, telling the Fed everything looked fine.
The Frontline correspondent asked Terri Duhon pointblank why did everyone keep going when it became clear to her that JPMorgan should reduce its exposure to Swaps and CDOs. She replied: “Umm…the…I mean…look…very simply, there are certainly some investors, some banks, some borrowers who are a bit greedier than they should be.”
When it became more obvious that the derivatives market was nearing a climax, Goldman Sachs took a particularly aggressive position. A congressional investigation later revealed that the bank packaged toxic mortgages into CDOs and then sold them to foreign banks and municipalities while the bank used Swaps to bet against their own customers. As things began to unravel, when the housing bubble burst, Goldman Sachs made money off of other banks that had invested in their CDOs. Banks in Germany became the first to fail.
By 2008, things were going terribly wrong but, due to the lack of public disclosure, almost no one knew it yet. Suddenly, massive numbers of mortgages were in default and those holding Swaps had to pay up. If they could. Insurance giant AIG was on the hook for $440 billion in Swaps. Effectively, there was a “run” on AIG. Too much money was coming due too quickly.
Blythe Masters: “It was a very scary time. We were in totally new territory and the notion that Lehman Brothers could be filing for bankruptcy and AIG could be at risk of the same fate was absolutely unprecedented. And thinking through the implications of that for the health of not just the US economy but the world, I mean it wasn’t really conceivable to do that. I couldn’t get my mind around it.”
Terri Duhon: “We never saw it coming. We never saw that coming. And I was disappointed. Hugely disappointed. I was part of a market that I believed was doing the right thing. Maybe I was idealistic, maybe I was young, maybe I didn’t fully appreciate where we were going, but there was a whole system going on…of people who maybe were turning a blind eye, maybe were…you know just…I don’t know…it is frustrating to see. Certainly.”
Richard Kovacevich: “It shouldn’t have happened. Most of our financial crises in the past have been due to some macroeconomic event. Oil disruption. War. This was caused by a few institutions – about 20 – who, in my opinion, lost all credibility relative to managing their risk and the sad thing is it should never have happened. The management should have stopped it before it got big and people were suffering.”
A financial meltdown occurred unlike anything since the Great Depression. Bear Sterns, heavily into subprime mortgages, ran out of cash first. The corporation called Wall Street lawyer Rodgin Cohen, who called the president of the New York Federal Reserve, Timothy Geithner that same day. By 1AM the next morning Geithner had a Fed team inside Bear Sterns looking at the books.
This is the first time anyone outside the banking industry saw hard data of the systemic magnitude of exposure of financial markets to Swaps. Until this moment everything had been shrouded thanks to the repel of Glass-Steagall and the laissaz-faire regulatory climate and, of course, to human greed.
If Bear Sterns failed on their Swap obligations it would impact trillions of dollars in other banks all over the world. Geithner was shocked and immediately concluded that Bear Sterns was “too big to fail.” By 4AM Geithner called Federal Reserve chairman Ben Bernanke. The next morning George W. Bush’s Treasury Secretary, Hank Paulson, was briefed by Bernanke.
Ultimately, Paulson and Bernanke worked out a deal where the US Government would oversee the sale of assets from Bear Sterns to JPMorgan. The Fed paid JPMorgan $30 billion to ensure the sale. Paulson felt this would be a one-time event. He was wrong. No one still understood either the magnitude of exposure to or the consequences of Swaps and CDOs.
Next came Lehman Brothers, the world’s fourth largest investment bank. In the fall of 2008 this firm was shelling out over $250 billion a day just to remain in business. It was a panic situation. Only this time Paulson, who initially opposed getting the government involved with Bear Sterns, decided that “moral hazard” trumped the situation. If you take away all risk of failure then it will only lead to ridiculous risk-taking and the free market loses its inherent ability to regulate itself.
Late on a Friday afternoon in mid-September Paulson summoned all the major banking CEO’s to the Federal Reserve Bank branch in New York and told them that this time the government would not step in. The CEO’s were told to figure the mess out on their own. Lehman Brothers was allowed to fail. Yet, by“saving” Bear Sterns but not “saving” Lehman Brothers the government unintentionally sent mixed signals. Credit markets worldwide froze. The stock market crashed.
Many Lehman Brothers investors were insured against bankruptcy by AIG. Suddenly, AIG was obligated to pay huge sums of money that it was not leveraged to compensate. Once again, no government or Fed official saw this coming. Once again, decisions were being made in “real-time” as facts were being discovered. AIG was only days away from complete collapse.
Geithner knew the consequences of an AIG collapse would dwarf those of Lehman Brothers. He argued that the government had to step in this time. Paulson, against his principles of moral hazard, agreed to go along. $180 Billion would flow to Wall Street’s largest banks in order to cover AIG’s exposure. The stock market continued in freefall.
By now Ben Bernanke understood the magnitude of the problem and proposed to the Bush administration a massive bailout of Wall Street in order to stop playing catch-up to the situation. Bernanke wanted to get control before things got completely out of hand. There was a risk of a full-blown depression.
Paulson agreed to go to congress and address the situation. By coincidence, Speaker of the House Nancy Pelosi put in a call to Paulson to request that congressional leadership be briefed on the AIG situation the next morning. Paulson replied to Pelosi that “tomorrow morning will be too late.” An emergency meeting was held late that afternoon involving senior legislators from both political parties in the House and the Senate. Both the Fed Chairman and the Treasury Secretary reported to the group that if they did not act immediately the financial system of the entire world would melt down in a matter of days.
Paulson requested $700 Billion to unfreeze the financial markets, to get banks willing to transact with other banks again. Conservative republicans revolted. The bill became stuck in congress, unable to move. The markets were plunging. Suddenly, presidential politics intervened. 2008 was, of course, and election year. Senator Barack Obama was facing Senator John McCain in the presidential race. McCain out-of-the-blue announced he was suspending his campaign to return to Washington to address the situation. He called upon President Bush to summon senior leadership including McCain and Obama for a meeting on the crisis.
What McCain did not know is that Obama had Wall Street insiders keeping him informed of the situation all along. Obama was prepared to address the issues far beyond the understanding of McCain. In the meeting it showed. McCain fumbled with a few note cards, Obama took command with facts and forceful recommendations. Others began to argue among themselves. Bush left the meeting after it became obvious that he had lost control of it. Before he exited, however, he turned to Speaker Pelosi and whispered: “You guys are going to miss me.” McCain ended up looking like a bumbling fool.
In the end, by a vote of 263-171, Paulson got his $700 Billion known as TARP. Paulson immediately convened a meeting with the largest bank CEOs. Paulson divided about $125 billion among these banks in exchange for partial government ownership of the banks. This was issued as an ultimatum. The CEOs had to sign agreements to accept the infusion of cash before they left the room. It was hoped this massive injection would unfreeze the financial markets and get the global economy moving again.
As long as my post has been to this point, it is only half the story, covering Part One and Part Two of the documentary. For the sake of space I will more briefly highlight the second half. Part Three examines how the newly-elected Obama Administration dealt with the mess. Specifically, how Obama was simultaneously attempting to cast the bankers in public as "fat cats" yet privately attempting to get them on board in addressing the crisis.
As Obama took office Citigroup was failing. Wall Street was definitely in the grips of systemic contagion. Obama chose Tim Geithner as his Secretary of the Treasury and Larry Summers as his National Economic Advisor. His economic team had to hit the ground running. In the early days, Geithner came off as unpolished. He flubbed his major speech laying out the Administration's policy for dealing with the crisis. It was his first appearance ever on television.
Meanwhile, Larry Summers became a fierce advocate for the total reform of Wall Street. He wanted to split-up the major banks and to investigate select banking officials for possible criminal charges. Geithner, so novice in his public dealings, remained an expert behind the scenes and in private meetings. He stood up to Summers and argued that now was not the time to press for reforms. The situation could be better addressed with government stress tests of specific banks.
Obama ultimately sided with Geithner. He had always had Wall Street connections for information and wanted to build a consensus with the bankers to face the crisis. But that cooperation never came about. The bankers had dodged a bullet. Wall Street was essentially left intact.
Meanwhile, the Tea Party emerged partially in reaction to the Obama Administration's continuation of Bush policy to bailout the banks which, of course, was originally the brainchild of Federal Reserve Chairman Ben Bernanke. The 2010 elections were partially a revolt against the actions of the Fed in favor of keeping large banks afloat.
The implementation of the stress tests took some time and every major bank was subject to direct government audits and scrutiny. Geithner, more proficient in public now, proclaimed that the results of the stress test brought "an unprecedented level of transparency and clarity to the nation's banking system."
The 19 largest banks in the nation were declared healthy and could repay their government loans. Geithner was viewed as something of a hero for standing firm against Summers and advocating the "right" approach to the crisis. Before long, the banking industry was back to making respectable, if subdued, profits again.
But this profitability only fueled the rage of the Tea Party. While business seemed to return to usual on Wall Street, Main Street continued to suffer under the aftereffects of the Great Recession. And it wasn't only the conservatives that were pissed off. The emergence of the Occupy Wall Street ultimately indicated the anger toward the large banking industry and all that it supported was spilling across the political spectrum.
Part Four presents the actual workings of how the banks priced, packaged, and sold the Swaps and CDOs. Four successful individual bankers are interviewed throughout the program, giving details of how they worked while only vaguely answering questions about their personal involvements. At the time of their employment, mostly from late 2007 on, some of them were making up to $10 million a year as banking "star traders.”
The derivatives were mostly packaged in the US and mostly sold from large banks both on Wall Street and in London to municipalities and other foreign banks. In 2004, Goldman Sachs sold the largest sovereign debt deal in history with a unique Swap to Greece. It was a complex instrument that was intentionally deceptive. Greece did not realize that they had locked themselves into high interest rate debt in the long run.
In 2011 Jefferson County, Alabama became the largest municipal bankruptcy in history due to dealings with Swaps. Several similar stories are told in the episode from Italy, Spain, other municipalities and other banks worldwide.
One of the basic tenets of the Glass-Steagall Act, repealed in 1999 by President Clinton with strong bi-partisan support, was to partition Commercial Banks and Investment Banks. The new environment created by the repeal made the mixing of loans, other forms of credit, and derivatives possible.
The origins and resilience of the Occupy Wall Street movement is discussed in another segment. That group is slowly coming around to pushing, along with other parties, for passage of the Volker Rule which would effectively re-establish the partition that once separated investment bankers from commercial lenders. But, as Frontline notes in several interviews, there is absolutely no momentum on the part of financial institutions nor political willpower on the part of the legislators to separate the two types of banks again.
Wall Street culture remains largely the same today as it was before the crisis. It is a culture unto itself, distinctive within both America and the world. Since 2007 the five largest banks in the US have grown larger. These five corporate entities control assets equaling 56% of the American economy.
OK. So this is a very long post. But it is actually a very short summary of everything covered in this excellent four-hour documentary, with plenty of interesting online extras offered. Complete unedited interviews. Financial industry reporting. Well worth watching if you want to delve deeper into this most unprecedented worldwide social, political, and economic story – still unfolding today.