Financial Implosion

Chapter 6

Financial Implosion: The Subprime Mortgage Meltdown

 

Decades of flawed policies culminated in the bursting of America’s real estate bubble, a massive financial meltdown, recession and stagnation. Globalism, deindustrialization, misguided trade policies, regulatory failure, mass third world immigration and the diversity cult propelled the economy to its inevitable destination. Before we proceed to an analysis of the great implosion, the following section places the recent crisis into perspective with a brief outline of the history of financial cycles, panics and asset bubbles.

 

Panics, Bubbles and Business Cycles

 

There is an inevitable yin and yang in human economic affairs. In primitive societies there was the cycle of famine and plenty, lean years and fat years. With the rise of civilization and its economic surplus there began the cycles due to trade and accumulation; these cycles were magnified once the natural barter economies were replaced by money economies.

 

One well-attested early example of a business cycle occurred in Italy In the late 2^nd century BC when there was a large increase in gold and silver. This prompted a vast expansion of commerce and investment in Gaul and in Rome’s Eastern provinces. This period of easy money ended with the Social War of 90 BC and the bankruptcy of the state.[1] The first general financial collapse in early modern times occurred in 1557. The immediate cause of the crash was the decision by King Philip of Spain to suspend payments on his short term debts. The great financial center of Antwerp was devastated and a number of major German merchant bankers were ruined.[2]

 

Early Asset Bubbles and Pyramid Schemes

 

In 1636 Holland experienced a trading frenzy in tulip bulbs as prices of all types reached stratospheric levels. Demand came from members of all classes of society most of whom lacked any expertise regarding the intricacies of tulip varieties and cultivation. The speculative fever was exacerbated by the existence of an early forward market which turned tulip trading into a year-long activity. Holland had legislative restrictions on margin trading but the informal tulip market escaped regulatory oversight. The growing demand was met by the sale of common tulip varieties in a way quite similar to the recent dot.com bubble where stocks became interchangeable in the minds of investors.[3] Investment banker Richard Bookstaber sums up the factors underlying the tulip mania:

 

The seeds of the tulip mania may have been the unattainable lure of fashionable and rare tulips, combined with the newly accepted practice of substituting more common bulbs to meet that appetite. But the mania reached full bloom only with the innovation of forward contracts and the leverage these contracts afforded, which allowed traders to buy and sell commodities they did not own, had no intention of owning, and indeed did not even have the money to purchase outright.[4]

 

The bubble abruptly burst in February 1637 with the collapse of tulip bulb contract prices and a general country-wide economic recession.  

 

In 1716 Scottish financial theoretician John Law arrived in France where he established a bank with the ability to issue deposit notes repayable at a constant amount of specie; in 1719 Law’s bank became the state bank. Its notes were convertible into coin, given specific maturity dates, were interest bearing and were acceptable for payment in full of taxes. Heartened by the bank’s apparent success the French government permitted Law to charter the Mississippi Company which was eventually merged into the Bank; many French rentiers exchanged their rentes for Mississippi Stock. Although Law was given even more power and became a virtual financial dictator, the Company share price began to falter in 1720 as a result of large investors cashing in their holdings. The end came when the French currency collapsed in the foreign exchange markets; his system being in a state of collapse Law was sent into exile.

 

The South Sea Bubble, occurring at the same time as Law’s scheme, was another famous early stock exchange bubble. The South Sea Company was founded in 1711 by Tory directors opposed to the Whig controlled Bank of England. The company’s alleged purpose was to establish a monopoly of trade with South America and the Pacific. This government backed scheme employed some of Law’s tactics in an effort to persuade shareholders in the Bank of England to surrender their stock for shares in a semi-official trading company, the South Sea Company. Many investors were under the illusion characteristic of financial pyramids that sales of shares were a form of profit. In fact the pledged subscriptions exceeded the country’s national income. Following a proposal to underwrite all of England’s debt by exchanging treasury annuities for Company stock a massive speculative boom was unleashed.  Toward the end of 1720 the bubble burst with losses to all but a select group of inside shareholders. The financial chaos that followed unleashed so much distrust of the corporate structure that the Bubble Act was passed requiring that all corporations be specifically authorized by act of Parliament; the Act remained in effect for a century afterward. Another result was that financial power passed to the Bank of England. Isaac Newton famously said of the affair that he “could predict the motion of the heavens but not the madness of the people.”

 

Business Cycles in Britain and America

 

Britain was the capitalist economy par excellence. As such it has experienced a long history characterized by growth followed by depression and financial panic. Americans imbibed the capitalist spirit of their British forebears although, as we have seen in Chapter 2, with considerably more trade protection. Both economies were quite intertwined and were also generally affected by business cycles and financial crises elsewhere.

 

In Britain at the dawn of the industrial revolution the business cycle was generated by the interaction between cycles of new construction and agricultural output. Periods of enhanced building combined with good harvests were years of prosperity; a lapse in construction along with poor harvests resulted in depression. War could sometimes be an economic stimulus. The war with France from 1756 to 1763 led to a wave of maritime construction and iron production.[5] There was a banking crisis in 1772 resulting in many bank failures and the bankruptcy of merchants and manufacturers holding bank notes. This along with the first stirrings of revolution in America resulted in depression in 1775.

 

The years from 1791 to 1793 saw financial crises in Britain, Europe and the newly independent United States. In 1791 speculation over the new U.S. debt repayment plan was rife. Foreign investors, Amsterdam bankers in particular, entered the American debt market en masse. However, in February 1792 European investors, nervous at the outbreak of war between Britain and France began to withdraw their capital resulting in the first Wall Street crash in March. Treasury Secretary Hamilton, despite much criticism, managed to stabilize the market through the purchase of government bonds. At the same time in Britain the war resulted in hoarding and a severe cash crunch; in the following year Britain experienced a large number of bank failures.

 

The end, as well as the inception, of war could also precipitate a financial crisis. Between 1814 and 1816 there was another series of British bank failures due to a slackening of demand and unemployment resulting from demobilization. Poor harvests then tipped the British economy into depression. At the same time the United States also experienced a cycle of boom and bust. A surge in demand for American agricultural produce created an outburst of land speculation in the South and West. By 1818 the substantial increase in supply led to steeply declining prices at the same time as the Bank of the United States began a policy of credit contraction. The resulting depression was accompanied by a bank panic in 1819. Britain in 1825 experienced another wave of speculation followed by a period of correction with rising interest rates followed by falling prices and a general depression.

 

The 1830s were once again a period of land and commodity speculation in the United States. This resulted in heavy borrowing from England by states and corporations and heavy reliance on short term credit. The Bank of England became anxious owing to the consequent flow of specie from England to America. By 1837 the Bank of England stopped discounting bills for the U.S. trade and British banks ceased to provide additional funding. Thus the credit markets collapsed and panic ensued. Another contributing factor was the end of the Bank of the United States which had previously operated to stabilize the markets. Two years later a decline in the price of cotton led to prolonged depression. The panic and depression of the late 1830s were the result of a large asset bubble.  “The difference between 1837 and 1839 was that the former panic had centered around temporary maladjustments in internal monetary affairs and external influences, while these monetary and external influences in the later period were combined with the real effects of a decade of uninhibited expansion of productive capacity which necessarily entailed a long period of readjustment.”[6]

 

The 1840s witnessed a great railroad building boom in Britain followed by a crisis in 1847 and chaos in the European financial markets as a result of the 1848 revolutions. Britain experienced a short crisis in 1851 and another in 1853 as a result of the Crimean War. Inflation resulting from the discovery of gold in 1849 caused a series of bubbles in commodities, railroad construction and stocks; much of this speculation was centered in the London financial markets. All of these events laid the groundwork for the great worldwide crisis of 1857. The United States was severely impacted in the crisis owing to the events in London. The drain of specie to the Far East during and after the Crimean War led to strenuous efforts by the French to recoup specie from Britain.  The result was that British banks diverted capital into their domestic market which put increasing strains on the New York money market and U.S. banks. Speculation on railroads was another factor causing dislocations in the U.S. financial markets. The immediate cause precipitating the U.S. crisis was the failure of Ohio Life Insurance and Trust Company due to speculation in railroad securities by its New York agent. Security prices fell, banks suspended specie redemptions and there was a run on the major New York banks by their correspondent banks throughout the country. The panic was ultimately dampened by the actions of the recently formed New York Clearing House that had been founded earlier in the decade. While the depression was followed by a period of prosperity in Britain, America was mired in depression for the next three years.

 

Economic historian T. S. Ashton notes a common factor underlying many of these early panics and depressions:

 

Some bankers used the money of depositors for their own trading or for speculative purposes. Some were slow to learn what has been called the first law of banking – how to distinguish between a bill and a mortgage – and when as often happened, there was a sudden demand for cash they found themselves with assets locked up in long-terms loans.[7]

 

Such speculation on the part of banks and other financial intermediaries were to characterize subsequent bubbles and panics. Indeed, even today many have not learned that first law of banking as shown by the repeal of Glass Steagall as well as the actions of the major banks and giant insurance company AIG in recent decades.

 

In 1866 the failure of a leading London discount firm led to a “black Friday” financial panic. Seven years later in 1873 speculation and overexpansion and defaults in the railroad sector led to crashes on the New York and London exchanges. The crisis caused a number of bank runs and affected non-bank financial firms with subsequent effects on other nations such as Germany. In early 1884 owing to a decline in American business and the increased issuance of notes backed by silver, European investors began to sell their American securities. A leading New York brokerage firm and two large banks failed.  The panic was contained when the New York Clearing House again organized a rescue. In 1893 there was another financial panic related to U.S. specie policy. Fearing that gold payments could not be maintained by the government, Americans and foreigners sold assets and accumulated gold. Deflation, rising interest rates and unemployment resulted.

 

The year 1907 witnessed a major crisis. The recent San Francisco earthquake had drained the reserves of insurance companies. There was, as in past financial crises, a railroad involvement. Railroads were unable to raise sufficient long-term capital to build equipment needed to transport a large increase in agricultural output. The London banks then refused to provide any additional short term credit draining the reserves of both local and New York banks. Knickerbocker Trust, a major New York financial company failed; other firms followed putting great pressure on the Clearing House banks. Trust companies, such as Knickerbocker were organized to handle investment funds. They also expanded into life insurance, deposit taking and short term loans; these trusts were at the heart of the financial crises in 1857 and 1873 as well as that of 1907. The crisis was finally dampened when J.P. Morgan and the New York Clearing House organized a rescue. One result of the panic was the Aldrich-Vreeland Act of 1908 which attempted to deal with the over-issue of bank notes and to augment bank solvency. The creation of the Federal Reserve by legislation in 1914 followed in the footsteps of Aldrich-Vreeland. The Fed was designed as an alternative to a European style central bank.

 

The panics of the late nineteenth century and of 1907 were due to various factors. Bad loans, speculation, malfeasance or rumors would all play a part. When banks cut lending or depositors suffered losses an economic downturn would follow.  In the U.S. there existed a financial panic generator. There was a natural business cycle resulting from seasonal variations in the demand for cash and credit in agriculture. Country banks would withdraw their deposits from city banks to meet these seasonal agricultural needs; these deposits had previously found their way to the New York City banks. When the peak in a business cycle overlapped that of the agricultural cycle the New York banks would experience a liquidity crisis as they were unable to meet the demands of their commercial clients and the country banks; their deposits drained away. This started a cycle of bank runs, business failures, securities markets crashes and a general credit contraction.[8]

 

In 1914 there was a financial panic as European investors began selling their holdings of American securities with the advent of war thereby draining U.S. gold supplies. Stock prices collapsed and the New York Stock Exchange was forced to close on July 31. Banks were unable to call in their loans to brokers, exchange rates fluctuated wildly and currency hoarding resulted. Cooperation between the Treasury and the newly formed Federal Reserve stabilized the situation and the war eventually led to a boom in the U.S. economy with a tripling of American exports between 1914 and 1918.

 

The Great Depression

 

The signature event of the modern economy was the Great Depression. The booming 1920s was marked by irrational exuberance in both the domestic and foreign securities markets. Domestically the U.S. economy was characterized by a boom and merger wave with a rapid growth in holding companies and in leverage. Other innovations in financial structure included investment trusts trading large blocks of stock and  security affiliates which were investment banks organized by a commercial bank to underwrite and market securities. These institutions were subject to manipulation and caused a great increase in market volatility. Another destabilizing characteristic of securities markets was the expansion of call loans; New York banks and brokers made large amounts of such loans to corporations. Despite many warnings there was also much speculation in foreign securities on the part of over enthusiastic investors and banks. Prefiguring the later loan debacle of the 1980s, U.S. investors doubled their holdings of Latin American securities during the 1920s.

 

The boom was, of course, followed by depression.  Even before the stock market crash there was a downturn of industrial production in the summer of 1929; retail sales followed down in the autumn. Stock prices peaked on September 3, 1929. The Bank of England joined by other European central banks increased their discount rates draining funds from New York. With stocks held on thin margins a selling panic occurred on October 24 followed by a massive selloff on October 29. The result was a severe credit crisis, bank panics, gold drains and worldwide depression. The following three years saw numerous bank runs and failures; those banks remaining drastically cut lending to protect their reserves. The Fed, under the sway of the gold standard and the real bills doctrine, which states that credit should only be provided for loans which directly increased production, failed to pump enough liquidity into the economy. The Federal Reserve met the dollar devaluation and consequent export of gold by raising interest rates. Furthermore In 1936, the Fed fearful of the rise in commodity prices doubled bank reserve requirements. By the fall of 1937 the fear of inflation abated but a new recession settled in.

These deflationary policies on the part of the Fed have, in hindsight, been severely criticized as exacerbating the downturn. “But it is unreasonable to expect that inexperienced central bankers, operating without adequate legal power and without strong government support, could by their policy within their own country counteract the effects of a long war which had involved all the industrial nations and destroyed their former financial relationships.”[9]

 

The malfunction of the financial sector was accompanied by revelations of malfeasance on the part of many prominent financial leaders. The president of National City Bank was found guilty of tax evasion; the president of Chase Bank was discovered to have been engaged in stock manipulation, the head of a large group of holding companies was accused of fraud. A major Swedish industrialist was found to have engaged in massive accounting fraud; his activities had been enabled by a respectable Boston investment bank.[10] Thus, the events of eighty years ago have close parallels to those of the contemporary great crash.

 

Legislation was soon passed to curb such abuses. The best known of these was the Glass-Steagall Act which widened the authority of the Federal Reserve to curb bank speculation; it also authorized the Fed to set margin requirements, outlawed interest on demand deposits and authorized setting the interest rate on time deposits. It also required the separation of investment and commercial banking. An immediate result was that J.P. Morgan chose to specialize in commercial banking and spun off its investment banking business into a new company, Morgan Stanley. Another provision of Glass-Steagall established the Federal Deposit Insurance Corporation. In 1935 there was additional legislation which further strengthened the position of the Federal Reserve.

  

Post-Depression

 

The Great Depression finally met its end with World War Two; however there were two mild recessions in 1958 and 1960. The postwar U.S. government pledged to abolish the business cycle. The promise was renewed when during the Great Society “business was assured that never again would even the smallest recession be permitted. And many believed just this. There seemed to be no more risk.”[11] However, by 1966 there was severe pressure on the money markets with recessions following in 1969 and 1973. The years 1974 to 1975 saw negative growth with unemployment averaging 8.5%. Tax cuts and monetary expansion helped to end the recession but at the cost of massive inflation and an insignificant reduction in the unemployment rate. During 1978 under that new regime of stagflation the rate of inflation reached 9% and interest rates soared. Robert Samuelson asserts, regarding the no depression pledge, that at “first the performance matched the promise.” However as time passed “complications arose; there were desperate attempts to retrieve the original promise – mainly through wage and price controls.”[12] And as one part of its new social contract the government sought to expand the housing market by providing cheap mortgages for the masses. The following passages from Homer and Sylla summarize the postwar mortgage initiative:

 

In the post-World War II era, U.S. government credit was extended to eliminate the risk from a wide variety of private credit instruments, many in the form of mortgages. A number of federal agencies bought mortgages, and those agencies resold their own paper or guaranteed the mortgages and sold them publicly. The mortgage market with this aid, was able to absorb a disproportionate volume of the total savings of the country.      

                                                                       ……….

As the mortgage market came more nearly to resemble the bond market … rates were no longer as stable relative to bond rates as they once were … the time pattern of mortgage rates was almost the same as that of bond yields.[13]

 

One drawback to the new initiative was that lenders were no longer as familiar with the mortgages and borrowers as they were previously. The separation of the ultimate lender from the mortgage borrower increased vastly owing to the affirmative housing policies of the 90s with disastrous consequences.

Prelude to Disaster: Recent Financial Crises

 

As we have seen the last few decades of the twentieth century witnessed explosive growth in financial innovation. This was accompanied by the increasing dominance of the financial sector in the U.S. economy. Rescues of major banks and other financial companies occurred as the authorities sought to avert major crises. There were also a series of asset bubbles occurring in the 1980s and 1990s: real estate and stocks in Japan and in Scandinavia in the late 80s, the Asian crisis in the mid-90s and U.S. dot com stocks in the late 90s. These were followed by, worst of all, the subprime crisis in the new century.

 

Over this period the U.S. was the leader in financial innovation and these inventions attracted capital from abroad. One of these innovations whose abuse was to prove so troublesome was in real estate securitization. During the mid-80s there was a flood of collateralized mortgage obligations. Such securitization was not without precedent; there were six periods between 1870 and 1940 in which mortgage securitization was attempted but quickly dropped.[14] Of course, the credit craze of the 80s went beyond mortgages; there were also highly leveraged corporate mergers and buyouts. Following the dot com burst, the Wall Street financial engineers eyed the rising real estate prices as a way of obtaining higher yields through ever more complex securitized products. The total amount of asset backed securities of all types exploded in the ten years following the mid-90s. In addition to mortgages there were credit card receivables, student loans, equipment leases, manufacturing loans and auto loans. In theory these securitized receivables provided a more efficient allocation of capital and diversification. In practice such innovation, as we have seen in the preceding chapter, required an efficient and well-considered regulatory framework in order to be kept on track. And the regulatory agencies along with the chief regulator, Fed Chairman Greenspan, were not up to the task. The Chairman’s performance in this respect was at best mediocre as noted by many financial experts. Peter Schiff speaking of Greenspan asserted that “America’s apparent prosperity is nothing but an illusion built on the phony foundation of inflated asset values and consumer debt.” Stephen Roach was even blunter noting that Greenspan “will leave behind a record foreign deficit and a generation of Americans with little savings and mountains of debt.”[15] However the responsibility can’t all be put on Greenspan; the subprime catastrophe was the inevitable result of policies that have been pursued for over forty years.

 

As previously noted the 1980s witnessed an explosion of financial and computer innovation. These had many benefits for increasing liquidity and safety through hedging and efficient funds management. However, along with lower interest rates on borrowed money they also served Wall Street’s increasing propensity for risk. There was no effective regulation in place for the new derivatives. The futures markets were still primarily self-regulating and the CFTC was not yet securely established. It was assumed, incorrectly, that the banks’ internal risk management was sufficient to protect against serious problems. However, the greed factor came into play as rogue traders began to take larger and more profitable risks; betting on interest rate swings moved risk taking on the Street to a whole new level.

 

The Latin American Debt Crisis

 

In the early 1980s there occurred a Third World debt crisis centered in Latin America. Beginning in the 1970s and continuing into the following decade the oil producing countries accumulated a massive current account surplus of almost $200 billion with over $60 billion in the form of Eurocurrency deposits. Given the prospect of continued high oil prices U.S. banks were eager to recycle these large sums. The Mexican government, buoyed by its own prospective oil revenues to increase spending, was an eager borrower. Other Latin American countries were also encouraged to take part; by 1982 commercial bank loans to Latin America mushroomed to over $300 billion from virtually zero just a few years before.

 

However, the 1981 recession ultimately caused the demand for oil to plummet; Mexico was severely affected and borrowed even more. By the summer of 1982 foreign credit lines began to dry up. In August 1983 Mexican authorities announced that Mexico had run out of reserves and would default on some $80 billion in loans. A sudden reluctance of banks to lend then produced a cascade of problems in fifteen other Latin American countries most notably Argentina and Brazil; the U.S. banking system entered a crisis. A committee set up by the Federal Reserve, the IMF and other central banks established a cooperative framework between the large banks and the various debtor governments resolving the debt crisis.

 

Junk Bonds and Bad Loans

 

The 1980s were a time of Wall Street financial invention, exuberant lending and aggressive expansion of bank balance sheets. With the fall of interest rates in 1983 pension plans and insurance companies seeking higher yields expanded their investments into Wall Street’s newly devised mortgage backed securities. Junk bonds were another financial growth sector which like mortgage bonds resulted from the new Volcker policy of lower interest rates. High-yield junk bonds were the weapon of choice for corporate takeover artists. “The funny money of the junk bond market overshadowed … the bubble-making funny money being churned out on the mortgage desks of the big firms.”[16] Led by financiers such as investment banker Michael Milken and arbitrageur Ivan Boesky, corporate raiders utilized such bonds in attempted leveraged buyouts of a number of prominent corporations. However, fraud and abuse was rampant in these activities and by the end of the decade takeover specialist firm Drexel Burnham Lambert was liquidated. The collapse of Drexel in 1990 was a harbinger of the many Wall Street failures of the following decades.

 

Banks were also caught up in various calamities caused by bad loans and speculation.  In 1984 Continental Illinois Bank a company which, unlike Drexel, was too big to fail, was seized by the federal authorities. The Savings and Loan sector was another victim of speculative excess and inept regulation.  Liberalized regulations encouraged speculative commercial real estate lending which impelled a collapse requiring a massive taxpayer bailout of the industry.

 

Securitization

 

In retrospect the most important innovation of the 80s was mortgage securitization.  This appeared to be a win for all parties involved. By removing loans from their balance sheets banks were able to make still more loans. Wall Street firms made more profit by packaging and holding these securities. Final investors had higher returns and consumers could borrow more easily. However the new system of securitization also separated the ultimate lenders from the local borrowers; lenders, in contrast to the traditional mortgage lending system, were ill-equipped to monitor their borrowers’ financial health.

 

Mortgage securities began in 1970 with the charter given by Congress to GNMA to buy mortgages from banks so as to spur home lending. In 1977 Wall Street expanded the concept of securitization by packaging mortgages into a bond for Bank of America. Within a few years the CMO was born as Wall Street financial engineers figured out how to divide these securities into tranches based on risk with the safest tranche triple-A rated. The ratings agencies were induced to rate these new securities highly because of the diversity of the underlying mortgages. Freddie Mac was the first of the Street’s clients to make use of this new device. Advances in computer hardware and software facilitated the creation of new securitized variations using other forms of consumer credit such as car loans and credit card receivables.

 

Securitization grew rapidly when the fall in interest rates induced investors into searching for higher yield alternatives. Wall Street also looked for new ways of generating more income and found an answer in the famous carry trade. Low interest rates on borrowed money and the high rates on the mortgage backed securities led the Wall Street firms to hold these on their books. Of course, such high leverage would lead to large losses with an increase in short term rates. Securitization may have started innocently enough but its ultimate abuse in combination with government housing policy resulted in financial disaster.

 

The 1987 Market Crash

 

The two culminating financial crises of the 1980s were the end of the Japanese bubble and the stock market crash of 1987. The factors behind the great Japanese financial bubble and its collapse were described by one international banking expert as follows:

 

Although several factors played a role in the development of the great bubble in Japanese real estate and stocks, the major one was undoubtedly the rapid growth in the nation’s money supply that had started by the mid-1980s. This growth was mainly driven by large-scale interventions by the Bank of Japan to limit the appreciation of the yen in the foreign-exchange markets. Given the huge production capacity that had been built up in Japan during the preceding years, massive export volumes were necessary to keep the profitability of these factories at minimally acceptable levels.[17]

 

The U.S. real estate bubble that began a decade after the Japanese was also fueled by an expansive monetary policy. In this case it was not due to a desire to spur exports by keeping the dollar cheap; as we have seen the U.S. political and financial leadership was singularly unconcerned about protecting American trade. The expansion of real estate ownership was encouraged and subsidized via Federal housing policy leading to rapidly rising prices and accompanying speculation.

 

However, the best remembered crisis of the 80s was the great stock market crash of October 1987. This crash was the result of new financial instruments and techniques combined with advances in computing. Traders used the new contracts such as the S&P 500 index futures contract to hedge and arbitrage against falling stock prices and rising interest rates. This resulted in an increase in volatility particularly on ‘triple witching’ days when options, futures and options on futures all expired on the same day. Another financial innovation in the form of portfolio insurance was an additional factor. Feedback from the S&P futures exchange to the stock market created a stampede as portfolio managers sold S&P futures causing futures prices to drop precipitously. This caused still more selling in a positive feedback loop as portfolio insurance programs generated still more sell orders in the futures market. One participant described this failure of portfolio insurance as follows:

 

Many institutional portfolio managers sold stock index futures short, hoping to hedge their portfolio values.  … However, the strategy did not work on October 19, 1987. The futures markets saw a constant flow of sell orders on that day and the arbitrageurs picked up the signals and continued to sell stock. Portfolio insurance failed its test in the first bear market encountered since its creation in 1985.[18]

 

Hedging, arbitrage and portfolio insurance techniques relied heavily on program trading. This computer assisted trading which took the form of rapid programmed trade executions magnified these price swings and thereby destabilized the market. Furthermore this “combination of speed and complexity would be the source of many future crises.”[19] One such recent occurrence was the ‘Flash Crash’ of May 6, 2010 when the Dow Jones fell about one thousand points in a matter of minutes; high frequency trading was the major cause. On October 6, 2012 a similar flash crash occurred on the Mumbai India stock exchange. It should be noted that the 1987 crash did not last long and did not bring down the entire economy in contrast to the recent subprime mortgage meltdown. The latter was not the result of a sudden spike in volatility caused by program trading, interconnected markets and a herd mentality. It was rather the result of a slow financial tectonic buildup which finally imploded.

 

Legacy of the 80s

 

Even at that time some of the most astute observers such as Henry Kaufman had misgivings as to the ultimate effects of the 1980s financial developments. Kaufman noted how in a fully deregulated financial system losses, failures and bankruptcy are the ultimate rebalancing forces in the market; however as deregulation has proceeded these have not been allowed to take effect. Large debtors and financial institutions have not been permitted to fail. “Think of the pressure that households will bring to bear on the federal government someday, when rates on adjustable-rate mortgages and floating-rate consumer loans are driven to lofty levels and the debt burden of the household-consumer sector preempts a large slice of personal income.”[20] Kaufman’s premonition was to be proven painfully correct two decades later.

 

The “decade of greed”, the 1980s, set the stage for the meeting of financial engineering and social engineering in the Clinton 90s. It would be a good guess that had the social engineers not forced their projects on the mortgage/banking/financial system the resulting bubbles would have been much smaller with less systemic risk and more easily contained as were the failures of the 80s and the later LTCM crisis. It was social engineering that dropped the nuke; by itself greed would have caused a smaller and more manageable collapse.

 

Post 1990

 

The trends in finance set in motion during the 1980s continued with increased momentum after 1990. The surge in the economy beginning in the early 1980s and continuing into the 2000s was fueled by consumer spending. Periodically the various bubbles created by monetary easing and consumer spending would pop and the economy would sink. The finance sector was subjected to cycles of productive invention followed by reckless speculation.  “The cycle usually starts with some worldwide innovation, say securitization, venture capital or LBOs. This leads to imitation, which is generally good because it creates competition and improvement. Finally, there’s a speculative binge. Crowd psychology takes charge; the quest for quick profits overwhelms underlying economics.”[21] Securitization, computerized trading systems, complex investment strategies and the international mobility of capital resulted in massive changes in the structure of finance and explosive growth in the large financial companies.

 

In the 1990s as securitization continued its growth much lending occurred outside of banks. Following the LTCM debacle (see below) the large Wall Street firms expanded their holdings of securities on their books for extended periods of time financed by the carry trade. In the 1990s default risk began to surpass prepayment risk as the major concern for holders of mortgage securities. One solution was the invention of the CDO, a self-diversified security; a bond consisting of bonds whereby the risk of default in mortgages is offset by credit card receivables and other high yield securities. Wall Street became enamored by such structured finance which combined computer modeling with geographic and income diversity of borrowers and a variety of loan categories.

 

To be sure securitization was just one of an array of innovative financial techniques first pioneered in the 80s which assumed increasing importance in subsequent years. The real story of finance during the 90s was in the derivatives markets.  “The decade became known for the rogue trader and investment managers easily deceived by their investment bankers.”[22] Regulators were bewildered by the number and variety of swaps and options, the rise of financial engineering in fixed income, new trading strategies and the increasing international scope of the markets. Wall Street, joined by insurance companies such as AIG, created ever more exotic instruments such as futures on air pollution, shipping rates, major market indices and interest rate swaps. The major banks also entered the arena and despite the 1988 BIS regulations the system was continually evaded by rogue traders. “Large-scale money center banks routinely had hundreds of billions of dollars of contingent liabilities on their books as a result of swaps.  These amounts often dwarfed the banks’ combined capital and assets.”[23] These new instruments were traded opaquely via computer links and were subject to the sudden drastic changes known as black swans but more mathematically described as the ‘fat tails’ problem. In the early 90s credit derivatives were valued at $11 trillion and reached almost $100 trillion at decade’s end.[24]

 

 

 

1994 Bond Market Crash

 

In the mid-1990s a series of problems afflicted the fixed income markets.  The most notable and ominous for the future was the first great mortgage securities crisis of 1994. In the process of securitization mortgages were cut into Principal Only (PO) and Interest Only (IO) components. In 1994, when the Fed raised interest rates the market for mortgage-backed securities crashed; Salomon Brothers lost over $100 million on IO securities. This occurred shortly after Salomon and a number of other firms ran into trouble playing the Japanese convertibles market; Salomon had managed to hedge its way out of that crisis without major losses. Other firms impacted included the big three Wall Street producers and sellers of mortgage-backed securities: Kidder Peabody, Bear Stearns, and Lehman brothers. All three firms as well as many smaller ones took big hits during that 1994 mortgage backed securities meltdown. Kidder was also reeling from an obscure pyramid structure of trades devised by a young rogue trader. These unfortunate lapses in risk management led to Kidder's parent company, GE, selling off the venerable old firm to Paine Webber. In 1995 another venerable old company, the British firm Barings Brothers also met its demise due to the activities of another rogue trader. Another victim of the mid-decade crisis was Orange County whose treasurer lost almost $2 billion in a repurchase agreement.

 

1997 Asian Crisis

 

The Asian crisis of 1997 started in Thailand with the financial collapse of the Thai baht and quickly spread as Southeast Asia and Japan saw slumping currencies and devalued stock assets. The countries most affected were Indonesia, South Korea and Thailand although much of East Asia also experienced a loss of confidence and slumping demand. All of the East Asian countries shared a similar economic model which involved  close relationships between government, industry, banks and labor as well as export oriented economies. The actions of both domestic regulators and the IMF in having banks sell off assets to meet capital requirements caused the crisis to spread to those countries in which these assets were held. The consequent fall in asset prices reduced the banks’ capital even more and sparked increased volatility in a vicious cycle of further asset liquidations.

 

The relatively advanced industrial economy of South Korea was badly affected by the 1997 crisis. This was distinguished from previous crises in that it was managed in the interests of the financial rentier class instead of those of the industrial capitalists.[25] This was eerily similar to the way that ten years later the U.S. subprime meltdown was to be managed in the interests of the financial class rather than in the interests of business in general. In fact during the U.S. mortgage meltdown it was a segment of the financial class consisting of large banks and certain Wall Street executives that were favored while business in general; particularly small business experienced diminished prospects.

 

Rise of the Hedge Funds and the Collapse of LTCM

 

The 90s saw the rise to power of the ‘traders’ on the Street and the rise of the hedge funds which are investment partnerships having few investors with large minimum investments. Hedge funds were not so much engaged in ‘hedging’ as they were in highly leveraged speculation with massive risk exposures relying heavily on computer modeling. One such fund was Long-Term Capital Management founded in 1993 by former Salomon executives and traders. In 1998 the Asian crisis combined with the Russian default and currency devaluation to undermine LTCM’s strategy of selling short Treasuries while going long on bonds from developing countries. When these yields failed to converge there was a flight to quality in favor of Treasury securities. Major houses such as Lehman and Merrill were severely impacted as the Street’s dependence on short term repo funding backfired. In September 1998 John Meriwether the CEO of LTCM announced that his hedge fund was on the verge of default. The imminent failure of LTCM and its smaller epigones threatened to collapse the entire financial system as creditors and investors on the Street began to panic.

 

Despite its extraordinary collection of leading quantitative financial analysts the models used at LTCM were flawed. Their widely used VAR (value at risk) technique did not deal with low probability events and their analysis assumed that the differential between Treasury and other securities would converge to historical levels. The models also could not take into account the actions of rival market participants who seeing that LTCM needed to unload its positions traded against it while those who might have provided LTCM needed liquidity refused to do so.

 

Hedge fund manager Richard Bookstaber analyzes the systemic nature of the LTCM collapse and similar market liquidity failures. Complexity and tight coupling means that components of a process are critically interdependent with no room for error or time for adjustment. In the markets this arises from a nonstop information flow and the perpetual demand for instant liquidity, particularly in the case of derivatives, in highly leveraged markets. In the case of LTCM a minor loss required the company to liquidate positions to meet margin calls. This caused a downward cascade when prices fell causing the portfolio as a whole to lose value. Thus there were still further demands for cash followed by yet more liquidation.[26] And as was to occur with the chain of events at the height of the subprime meltdown such tight coupling threatened the entire financial structure.

 

Only coordination of all of the major market participants by the Fed was able to unlink such tight coupling. And the Fed swung into action as Greenspan, deciding that LTCM was too big to fail, put together a bailout package. It was, no doubt the jeopardy to the omnipresent Goldman Sachs, a major counterparty which had a large exposure in the event of an LTCM default that helped impel Greenspan and his colleagues to action. Once the immediate crisis was resolved Greenspan further calmed the Street by lowering interest rates and business as usual soon resumed as Wall Street borrowed money cheaply. However with the ‘too big to fail’ reassurance once more put in place Wall Street lost another opportunity to learn a valuable lesson. Therefore after the LTCM debacle there was no corrective effect other than a brief respite from risk taking and leverage. Hedge funds resumed their growth with assets managed increasing from $500 billion to almost $2 trillion between 2000 and 2007 exclusive of hedge-fund like trading subsidiaries and proprietary funds at the large banks and on Wall Street.

 

While these events were unfolding LTCM’s progenitor, Salomon Brothers involvement in the proposed British Telecom – MCI merger led to losses of over $100 million. With the Asian crisis costing the firm another $60 million, Salomon was sold to Travelers Group in 1997 putting an end to the once prestigious pioneering risk taker’s independent existence.

 

Tech bubble

 

Between late 1997 and the early part of 2000 falling interest rates led to a binge of stock purchasing. Tech stocks were particularly affected rising to levels totally out of proportion with historical valuations. Yahoo, for example, was selling at over 2 thousand times earnings. China.com a small dot com serving the Chinese market doubled in price in November 1999 when the WTO and China came to an agreement. StockGeneration.com was the ultimate bucket shop, a pyramid scheme allowing participants to purchase an array of virtual stocks. Beginning with the last quarter of 1999 through early 2000 there were over $200 billion worth of dot com IPO issuances. Irrational enthusiasm combined with a shortage of shares in internet companies and reports from analysts at investment banks hungry for IPO fees fueled the bubble. “The Internet fervor was led by a self-reinforcing and self-financing hype machine.”[27]

 

The Unfortunate Legacy of the 90s

 

It is clear that the events of the decade of the 90s, as well as those of the 80s, left some unfortunate precedents which came to a painful climax in the first decade of the new millennium. Bookstaber points to the structural risk inherent in the new innovations of the 80s and 90s which began as attempts to improve the financial markets.[28] It is true that the lessons drawn from the 1990s failures of Orange County, Barings, Kidder, UBS, LTCM etc. induced Wall Street to put into place risk managers and risk management committees. However, such attempts to deal with structural risk might have prevented the 1987 and LTCM crashes but were insufficient to halt the subprime mortgage meltdown.

 

The Enron scandal, revealed in October 2001 which eventually led to the bankruptcy of Enron and the downfall of the prestigious accounting firm Arthur Andersen was symptomatic of continuing problems with the large banks and investment houses. Enron resulted from the non-transparency of a complex business model, unethical practices and audit failure. However, these practices were aided and abetted by such large banks and Wall Street firms as Citigroup, Bank of America and, of course, Goldman Sachs. Citi, in particular provided the off-balance sheet structures and creative loan transactions that were used by Enron executives.

 

One additional legacy of this time period that persists is the resentment that exists over large payouts to executives whether or not it is warranted by performance. The losses on Wall Street from their failure to exercise due diligence may have cost CEOs their jobs but not their elaborate golden parachutes. Given that their failures have weakened the economy such rewards are neither economically nor morally justified.[29]

 

Engineering an Economic Meltdown

 

There is much ruin in the economy of a great nation and much blame to be attached to those who, although perhaps inadvertently, engineered such ruin. Two negative emotions are proverbially said to explain Wall Street; fear and greed. And as explained already, the ever-present greed machine has operated with renewed vigor since 1980. Excessive risk taking was increasingly rewarded especially with other people’s money. The Street was busy contriving increasingly esoteric bonds, derivatives and structured finance to make up for a decline in its traditional brokerage business. There was also a turn to ‘predatory lending’ on the part of the mortgage finance industry. However, these activities were made as a response to the desires of Washington politicians and bureaucrats. Indeed the “social engineers on Pennsylvania Avenue ran amok far more than the financial engineers on Wall Street.”[30]

 

It was government that pushed Fannie Mae and Freddie Mac to issue massive amounts of debt to expand home ownership. Initiating this policy was the Clinton administration, great believers in public-private partnerships as a means of wealth redistribution, who pushed Fannie and Freddie into increasing their holdings of subprime debt. But while they left a poison pill, it was the supposedly conservative Bush administration that eagerly swallowed it. In the year 2000 just before the HUD subprime goal hike, Fannie and Freddie held few subprime mortgages; eight years later one quarter of their assets consisted of subprime and other risky loans. And it was also government who rewarded the more eager ‘predators’ while penalizing the more cautious banks.

 

To be sure the actions of the political class reflected the long decline in social standards that began in the 1960s. The old American culture of opportunity and individualism was replaced by one of group rights, tribalism and affirmative action. These one time student radicals now advocated the partnership of government and business which included banking and finance. They had come to the conclusion that a Soviet-style central control economy does not work. Instead they modeled their thinking after that of Mussolini and the current Chinese regime whereby a well remunerated corporate elite would run the economy so as to achieve the specified social objectives of the government. Nor was it only academics, politicians and bureaucrats who pushed the new affirmative action ideology. As we have seen it was not simply greed that motivated the Street; it was greed mixed with a genuine dose of ‘social compassion’. Of course, the eagerness of the mortgage suppliers was initiated by Federal housing policy and its attendant coercion which altered the whole atmosphere of the mortgage market. As in the case of obtaining cheap labor by advocating open borders and increased immigration it was always good to make a fortune by appearing to have a social conscience.

 

It was the financial engineers who devised the means by which money could be made while the risk accompanying a social conscience could be diversified. That was the technique of securitization which allowed the risk of subprime lending to be passed from mortgage wholesalers to Wall Street and then on to final investors; banks could then make even more such loans. Thus, at the behest of Washington lenders were able to extend subprime loans on absurd terms to large numbers of risky borrowers. The loans were then pooled into securities which were rated triple A by accommodating rating agencies and sold to final investors.  Moreover, the securitization of mortgages now included both private obligations as well as government guaranteed securities. These increasingly complex securities were structured by sophisticated computer models. They were filled with increasingly risky mortgages with higher rates of interest for investors who were anxious to obtain higher yields. In that way a considerable amount of toxic assets found their way into numerous portfolios worldwide. The process was enabled by Federal Reserve rate cuts; mortgage and asset backed securities more than doubled between 2000 and 2006. Low quality subprime and non-standard mortgage originations dominated this increase.

 

The explosion of mortgage debt interacted with a forty year trend whereby private consumption expenditures have increased greatly at the expense of savings. Household debt in general has also exploded as a percent of disposable income over the last few decades. Foreign lenders used their trade surplus to finance this massive increase in U.S. borrowing. Hence there is a direct connection between the housing bubble, subprime mortgage lending, expansionary monetary policies and the enormous trade deficit.

 

Furthermore, none of this could have occurred in the absence of a number of delusions afflicting politicians, economists, banks and Wall Street. Home ownership was now regarded, not as a reward for saving but as an entitlement. It was also imagined that real estate values would continue to go up indefinitely. Many economists and financial firms assumed that immigration and rising global prosperity would fuel the real estate market for the foreseeable future. The big banks and Wall Street firms joined politicians and regulators in wishful and unsophisticated thinking. Financial management, seemingly so shrewd and sell-interested, showed little understanding of the most elementary principles of complex systems, risk or fat-tailed distributions. And like observers on a beach hypnotized by receding waters just before a tidal wave they walked straight into catastrophe. 

 

The Social Engineers

 

In the 1960s American liberalism took a quantum leap beyond providing equal justice under law, a safety net for the deserving poor and government responsibility for economic intervention so as to promote gainful full employment. The new liberal imperative included implicit highly intrusive new anti-discrimination regulations, as well as wholesale demographic shifts in pursuit of increased ‘diversity’. There were also forms of reparations for an ever expanding list of victimized groups with affirmative action being one of these. Ultimately an anti-discrimination and affirmative action initiative, combined with the assertion of a ‘right’ to home-ownership, culminated in new Federal housing finance regulations.

 

Community Reinvestment Act

 

In 1977 Congress passed the Community Reinvestment Act to reduce discriminatory credit practices against low-income neighborhoods. Banking institutions were examined by federal regulatory agencies and rated with respect to their actions against such redlining. These ratings were then to be taken into consideration during the approval process for mergers, acquisitions and the opening of new branches. The law, supposedly provides that CRA lending should be undertaken safely so as not to bring about losses to the bank.

 

The Act was implemented in a restrained manner until the advent of the Clinton administration. By 1995 the CRA regulations were substantially revised to focus less on procedures and more on actual results. The ultimate effect, as later acknowledged by CRA proponent Larry Lindsey was that credit standards were downgraded.[31] The CRA and the actions of the Clinton administration set the stage for the subprime meltdown years later. Through securitization encouraged by the administration the secondary market was also impacted. Greenspan in 2008 acknowledged the critical role that CRA loan securitizations had on magnifying the ultimate credit implosion. HUD also set targets for the purchase of CRA loans by Fannie and Freddie. Mortgage companies although not formally covered by the CRA were also encouraged or pressured to undertake more risky lending. A Federal Reserve study also found that CRA examiners gave more importance to flexibility in lending than they did to management of risk. Banks with the lowest safety ratings often had the highest CRA ratings; only 29% of CRA loans were profitable.[32]

 

Boston Fed Study

 

In October 1992 a study by economist Alicia Munnell of the Federal Reserve Bank of Boston purported to show that race was a major factor in mortgage approval by banks with black and other minority applicants being rejected for mortgages at a higher rate than white applicants. The following year the Federal Reserve citing the Munnell report issued a booklet with new guidelines on combatting mortgage discrimination. Among other guidelines the booklet recommended that job turnover and a lack of credit history should not be negative factors in assessing mortgage applications. Both the Fed and the American Bankers Association followed up with instructional videos for member banks.

 

A guide issued by the Federal Reserve Bank of Boston itself typifies these educational initiatives. Asserting the familiar civil rights slogan that cultural separation perpetuates social biases the authors write:

 

While the banking industry is not expected to cure the nation’s social and racial ills, lenders do have a specific legal responsibility to ensure that negative perceptions, attitudes, and prejudices do not systematically affect the fair and even–handed distribution of credit in our society. Fair lending must be an integral part of a financial institution’s business plan. … Management of financial institutions must establish a corporate culture in which fair lending and serving minority markets are seen to contribute to shareholder value and are rewarded. [33]

 

The guide provides detailed recommendations and instructions to financial institutions which hit all of the fashionable liberal platitudes arising over the last five decades. Multiculturalism is to be advanced by requiring cultural diversity in the hiring of employees. Once a sufficiently multicultural workforce exists, an affirmative action program is to be put in place as management reviews promotion practices to ensure that there are no real or even perceived biases limiting the advancement of minorities. Sensitivity training should be required so that employees will treat customers with due respect and in a friendly manner. Employees should be trained to “accept and appreciate racial and ethnic diversity”. Since “certain cultures encourage people to ‘pay as you go’ and avoid debt” the lack of a credit history should not be seen as a negative factor in evaluating mortgage applications.

 

Furthermore, they recommend that Fannie Mae and Freddie Mac accept new valid income sources to include part–time and seasonal work, second jobs, retirement income, alimony, child support, unemployment benefits and even welfare payments. In addition those institutions bundling loans for securitization should also modify their guidelines to conform to those of Fannie and Freddie. The booklet explicitly endorses the use of statistical analysis to determine if race or ethnicity has affected lending decisions. The authors go so far as to encourage lenders to entrap sellers and realtors through the use of paired individuals who assume similar characteristics other than race so that charges of discrimination can be filed.[34] Such initiatives pressuring all financial institutions, bank and non-bank, involved in mortgage lending were advanced by government and regulatory authorities.  Thus the frequently heard assertion that the mortgage meltdown was caused by the new inventions of predatory lenders can be discarded; such predatory lending as existed was encouraged and enabled by regulators and government bureaucrats.

 

The Boston Fed study was not without its critics who noted that Munnell dismissed the importance of a number of critical variables including applicant net worth, credit and employment history, other debt owed and various technical loan factors. One critic was economist Raphael Bostic at the Federal Reserve Board of Governors itself.  He concluded from his alternate regression specification that the claim that non-economic discrimination is a general phenomenon is refuted. He found that minority applicants fare worse regarding assessment on debt-to-income ratio requirements but fare better when it involves loan-to-value ratio requirements and that the factor of race declines as the ratio of debt-to-income decreases and as the loan-to-value ratio decreases. He found that statistically significant racial differences were not observed for wealthy applicants or for those applicants with ‘clean’ credit histories. However, the average minority applicant who does not have a completely clean credit history is rejected significantly more often than a similar white applicant. Even so he emphasizes “that these observed racial differences in decision outcomes do not necessarily imply that discrimination is currently present in the lending market. … These differences in the implied default and prepayment risk formulas could reflect several economic phenomena. Finally, a more complete and, if possible, mathematical understanding of how lenders consider specific economic variables in making accept/reject decisions is needed.”[35]

 

One more complete mathematical understanding which was much more devastating to the Munnell thesis was provided by economists Theodore Day and Stan Liebowitz. Their detailed examination of the data used in the study show that these are plagued with inconsistencies rendering the conclusions of the authors suspect. Day and Liebowitz warn, accurately as it turns out, that the “currently fashionable ‘flexible' underwriting standards of mortgage lenders may have the unintended consequences of increasing defaults for the 'beneficiaries' of these policies.” They also note that the Boston Fed researchers seem to have been unaware of these inconsistencies at the time of the study.[36] It is of course possible that in pursuit of diversity the Boston Fed economists deliberately ignored these errors.

 

Day and Liebowitz’ “reworking of the data provides no evidence for the conclusion that banks systematically discriminate against minority groups.” They provide a number of examples of flawed data in the Boston study. These include numerous observations where imputed interest rates were absurdly high or low. They found forty four mortgages that were impossibly classified as both rejections while being sold in the secondary market. There is also an indication of data fudging since 41 out of these 44 mortgages were applications from minorities.  In addition there were at least 5 mortgage applications with an applicant having a net worth of less than negative one million dollars and at least 27 mortgage applicants who would need more than ten years to pay off their debt incurred prior to the mortgage. The Boston researchers responded that negative net worth would not necessarily preclude receiving a loan when the value of human capital is taken into account; these might represent physicians with very large assets and even larger liabilities. Day and Liebowitz, however, point out that these negative net worth figures are in the millions of dollars far exceeding the cost even of medical school while the reported incomes appear to be far too low for doctors. They ask the pertinent question: “Does common sense and intuition have no role in economic analysis?”[37]

 

Day and Liebowitz also question the Boston researchers’ analysis of the loan-to-value ratio. The researchers acknowledge that high loan to value ratios raise the probability of mortgage denial but contend that such applicants must obtain private mortgage insurance. Day and Liebowitz, however, observe that almost half of the high loan to value applicants failed to apply for mortgage insurance and yet most of them were approved. In addition twenty out of fifty five applications with loan-to-value ratios greater than 100% were approved. Another important variable used in the regression equation was the expense to income ratio. The data here was also of questionable quality since there were hundreds of cases where the calculated ratio disagreed with the reported ratio.[38]

 

In 2002 researcher Robert Cotterman evaluated some recent research on mortgage discrimination for HUD. He discussed logit models (see Appendix 6) of mortgage default concluding that while some show that blacks have statistically significantly lower log odds of default than do whites thus supporting the hypothesis of racial discrimination, others are statistically significant in the opposite direction. A series of papers by Berkovec, Canner, Gabriel, and Hannan in the mid-1990s provide evidence that is inconsistent with that of the Boston Fed study; their results show that mortgage discrimination does not exist.[39]

 

Despite its shortcomings and ambiguities as pointed out by other researchers, the Boston Fed study was eagerly seized upon by the champions of diversity and affirmative action in government and the media. Lawrence Lindsay summed up the attitude which was prevalent even among some who acknowledged the study’s defects: "The study may be imperfect, but it remains a landmark study that sheds an important light onto the issue of potential discrimination in lending."[40] The Boston study almost immediately exerted tremendous influence on public policy. The Clinton administration breathed new life into the Community Reinvestment Act as they forced banks to lend to the poor and minorities. HUD Secretary Cisneros, along with the Treasury Department and the Federal Deposit Insurance Corporation, pressured banks to make mortgages more affordable.  Fannie and Freddie were persuaded to set aside 42% of their guarantees to low income and minority borrowers; under Cuomo’s tenure that goal was increased to 50%. The FHA also ramped up its insurance of such mortgages while the Justice Department under Attorney General Reno increased the pressure on banks with a new anti-redlining initiative.

 

At a later time, following in the footsteps of Wall Street, Fannie and Freddie began carrying subprime debt on their own books. Some officials at the Treasury and Federal Reserve began to express great concerns for the soundness of the debt issued by the agencies. Another one of those expressing concern was the chief risk officer at Freddie who was fired for his trouble.[41] Bank spokesmen were conspicuously silent as these events unfolded. Overwhelmed by the currents of political correctness, fear and white guilt which afflicted all other institutions of society, the bankers attempted, not always successfully, to mollify the bureaucrats or buy off the community organizers. 

 

The lower standards soon spread beyond the supposedly discriminated against minorities to encompass the entire mortgage industry. The targeted pool expanded to include NINJA loans for anyone with no income, no job, and no assets, and of course no credit history. And, as will be seen below, Wall Street began to profit greatly from fees and from mortgage securitizations under the housing bubble that was set in motion by the government, the Fed and the agencies.  One financial commentator observes that with “every major financial lobbying group advising members to go along with the slacker standards, the seeds of the mortgage crisis were planted far and wide. To question the new rules was to run the risk of being branded a racist. Shunning them might invite a regulatory crackdown.”[42] Economists Day and Liebowitz at that time issued this ominous warning which proved to be true some ten years later:  “It will be ironic and unfortunate if minority applicants wind up paying a very heavy price for a misguided policy based on badly mangled data.”[43]

 

Affirmative Mortgages

 

So it came to pass that the traditional vaunted prudence of mortgage lenders was discarded and the era of affirmative mortgages began. The Clinton administration attacked alleged discrimination with a number of policy initiatives. An executive order strengthened anti-redlining regulations, numerical targets were set for Black neighborhoods, banks were mandated to employ flexible underwriting standards and additional bank examiners were appointed specifically to enforce the CRA. Fannie and Freddie were required to purchase risky loans thereby freeing the banks to continue to provide more risky loans. By 2000 HUD Secretary Cuomo increased their subprime quota to 50%. In 1995 the agencies were authorized to purchase mortgage backed securities which enabled Wall Street to take the plunge into subprime securitization. New mortgage dealers such as Countrywide thrived under the new subprime regime.

 

Benevolence and compassion were not the only forces behind the new initiative. Greed, cronyism and cold political calculation prevailed. HUD Secretary Cuomo opened the door to abuse by providing sweetheart regulations to private mortgage interests. Brokers, bankers and securities dealers under the guise of racial and social justice induced the Secretary to reject the imposition of new reporting requirements on the GSEs. Community organizer groups such as the recently discredited ACORN also pushed Cuomo to force the agencies into providing more affordable and riskier loans. HUD also enlisted the FHA into the new homeownership crusade which ultimately increased its delinquency rate; some borrowers were even able to buy a home without any money up front. HUD also accepted Fannie's many rules on the predatory practice of prepayment penalties. The final rules allowed the GSEs to count these loans toward the HUD lending goals. Borrowers were thus bound to pay these exorbitant charges to extricate themselves from ‘mortgages gone bad’. Cuomo notably failed to take action against the controversial yield spread premiums (YSP) beloved of the mortgage finance industry. These are payments to brokers based on the ‘spread’ between the high interest rate that brokers persuade unwary borrowers to accept and the par or going rate they would ordinarily have to pay.[44] YSPs were a perfect example of the collaboration between the greed and diversity machines allowing do-gooders to do quite well while feeling very righteous.

 

HUD was joined by the Department of Justice as Attorney General Reno’s Federal prosecutors filed suits against ‘racist’ banks and mortgage lenders often resulting in costly fines and settlements. To fend off the eager prosecutors and to mollify ACORN and other community organizers the banks had to open money-losing branches in supposedly underserved areas, pledge billions in loans and incur high legal and insurance costs. The ABA even suggested guidelines, helpfully endorsed by Greenspan, for flexible inner city and race-based lending to keep the Justice Department and the community organizers at bay. Among these community organizers in Chicago was a youthful disciple of Saul Alinsky by the name of Obama.[45]

 

Before long Reno extended her anti-racist crusade to include Native American borrowers who had default rates second only to Blacks. Even those claiming some remote Indian ancestry now found it much easier to qualify for loans.[46] This served as a precedent for the Bush policy of using mortgages to build support among still another ‘victimized’ minority, Hispanic immigrants. Political considerations also required that in order to maintain this affirmative action for Blacks the general standards would have to be lowered for all borrowers including Whites; such was the inevitable result of the Federal mucking about with affirmative housing.

 

By the year 2000 the mortgage industry had adopted en-masse the ‘flexible’ standards pushed by the Clintonites of whom it can be said: “They may have boxed up their Birkenstocks and cut their hair” but they “are no less radical than they were in the 1960s. This gang of coat and tie radicals has snuck behind ‘enemy lines,’ infiltrating the Washington ‘establishment’ they once railed against, to redistribute your hard-earned money in the name of ‘economic justice’. … Bad actors with bad ideas make bad policy.”[47] However, it was not just bureaucrats and politicians; the long march through the institutions included executives in the universities, the media and even the corporations including those on Wall Street.

 

The banks adapted to the new regime and carried on with business by increasing their CRA commitments and agreements. Chase, for example, increased its CRA lending commitments to facilitate its merger with Chemical. Banks also adapted by writing off the resulting losses from such lending and by following Wall Street into the subprime securitization market. The funds utilized for this new subprime lending was diverted from the more useful activities of strengthening the financial positions of the banks or of lending to the many small and medium sized businesses  who could not get the needed capital to expand or even to survive.

 

The result of the downgrading of standards for mortgage eligibility was a sudden increase in Black mortgage borrowing in the mid-1990s which pushed the general homeownership rate to record levels resulting in the great bubble in housing prices. The bubble created by this loosening of standards affected the entire housing market.  Many supposed subprime predatory lending victims, were, in fact veteran homeowners with impaired credit and much debt who used their subprime refinance loans as an ATM machine to support their level of consumption.[48] Also many first-time homeowners bought more housing than they could afford resulting in default and a refinancing and repackaging of the property. Clinton appointed cronies to the boards of Fannie and Freddie to insure that the affordable housing policy would continue after the end of his administration. And the Clinton HUD objectives succeeded all too well; in 1998 57% of black mortgage applicants were denied, by 2004 that was down to 27%.[49]

 

Indeed Fannie and Freddie continued their explosive growth in subprime investments well into the Bush administration. They developed product lines more favorable to low income borrowers, expanded into the somewhat higher grade "alt-a" market, making alternative products easily available to borrowers with better credit histories than subprime borrowers, but who were unwilling to provide full documentation to their prospective lenders. By 2008 the agencies held or guaranteed half of the subprime and low quality loans that were the source of the financial meltdown. The subsequent activities of the two most powerful affirmative mortgage promoters were not without irony. As New York State Attorney General, Cuomo who pushed the banks into the subprime market in the first place, now prosecuted Bank of America along with others for misleading shareholders regarding the very losses that resulted from those risky loans. In June 2007 just before the meltdown began Clinton boasted of his vigorous enforcement of the CRA. Soon thereafter he blamed everyone else, Bush, the Fed and Wall Street for the resulting calamity.[50]

 

Bush and the Hispanics

 

The ‘compassionate conservative’ Bush administration continued the Clinton housing initiative and added some enhancements of their own. “Perhaps the only domestic issue George Bush and Bill Clinton were in complete agreement about was maximizing home ownership, each trying to lay claim to a record percentage of homeowners, and both describing their efforts as a boon to blacks and Hispanics. HUD, Fannie, and Freddie were their instruments, and, as is now apparent, the more unsavory the means, the greater the growth.”[51] CRA loan commitments were negligible from the onset of the Act in 1977 until the Clinton administration and exploded with the HUD initiatives of 1995. The growth continued under the Bush first term; subprime loans went from two to twenty percent of new home mortgages. Bush set a goal for over five million additional minority homeowners by 2010 and bank CRA pledges increased from $1.85 trillion in 2002 to $4.20 trillion in 2004.[52] In 2004 the HUD goals for Fannie and Freddie were increased. Their holdings of subprime paper increased by over $400 billion from 2004 to 2006 and tripled over the course of the second Bush term. The Justice Department under Bush was somewhat less zealous than it was under Reno but continued to pursue alleged mortgage discrimination violations.

 

Nothing better illustrates the convergence of mass immigration, affirmative action and the disastrous housing bubble than the initiative to provide affordable mortgages for Hispanic immigrants. This initiative began in the Clinton administration and was, by no means limited to legal immigrants. In 1995 Clinton ordered the IRS to issue Individual Taxpayer Identification Numbers (ITINs) to immigrants without social security numbers. Mortgage lenders, pressured by Hispanic activists, accepted these along with Matricula Consular cards opening up the market for illegal aliens. Former Clinton HUD Secretary Cisneros was active in these endeavors advising Hispanic subprime lobbyists and becoming a member of the board of Hannie Mae, the Hispanic National Mortgage Association whose objective was to securitize packages of such questionable loans. Mortgage standards and criteria were also adjusted downward to accommodate the new borrowers.  In some instances multiple households were allowed to pool their incomes to qualify for mortgages.[53] Hispanic lawmakers were instrumental in the new housing initiative and Hispanic mortgage lenders, brokers, real estate agents, and construction companies profited greatly from the new easy credit environment. With a combination of numerous illegal borrowers and Hispanic mortgage profiteers none of the usual watchdogs expressed any interest in reports of predatory lending abuses in those days. The Congressional Hispanic Caucus continued this work along with industry and community groups and La Raza to ensure that "by the end of the decade Latinos will share equally in the American Dream of homeownership."[54] And they found a new partner in the Bush administration.

 

Bush and his chief strategist Karl Rove had always shown a particular fondness for Hispanic immigrants. And they both shared the naïve belief that Hispanics could be won over to the Republican Party. One of their endeavors to that effect was ‘comprehensive immigration reform’ and amnesty for illegal immigrants. Another was a housing push for Hispanics. They operated on the assumption that Hispanic immigrants having ‘family values’ were natural Republicans and that home ownership would enhance this proclivity. The strategy never won a majority of Hispanic votes for the Republicans but at least it got Rove an invitation to the La Raza annual convention in 2006. Bush and Rove’s ‘compassionate conservative’ beliefs, however, appeared to transcend political considerations. Columnist Steve Sailer expressed it as follows: “under the Bush Administration, the American Dream isn't just for Americans.”[55]

 

Bush and new HUD secretary Mel Martinez continued the anti-redlining and affordable mortgage policies of Clinton, Reno and Cuomo with an initiative labeled the American Dream Partnership. Their American Dream Payment Assistance Fund subsidized mortgage payments for minorities and for Hispanic immigrant home buyers in particular. ‘Dream’ has apparently become a required term for programs that pander to Hispanics, e.g. the Dream Act. Martinez recruited Freddie and Fannie to invest hundreds of billions of dollars in Hispanic home ownership.

 

The Bush Administration’s compassionate conservative concern for Hispanic immigrants appeared to pay off; at least at first. The percent of Hispanic home ownership grew from 40% at the start of the Clinton administration in 1992 to 46% in 2000 and reached a peak of almost 50% at the end of the Bush administration in 2008.[56]  Between 2000 and 2007 Hispanic home ownership increased from 4.1 million to 6.1 million. Total subprime home loans to Hispanics were $19 billion in 2004 and peaked at some $73 billion two years later.[57] It is not surprising that when housing finally crashed it was the heavy Hispanic immigrant states of California, Nevada and Florida that were hit the hardest by foreclosures.

 

Consequences of Affirmative Housing

 

Once the damage was done economic researchers and commentators turned their attention to an analysis of the causes and results of the housing debacle. Two economists at the Federal Reserve Bank of San Francisco in a 2008 report found that FICO scores make a significant difference in mortgage foreclosure rates.  FICO, an acronym for creators of the measure, the Fair Isaac Corporation, takes payment history, level of indebtedness, types of credit used and credit history length and runs these through a mathematical model. Borrowers with low FICO scores are more likely to default on a mortgage and the researchers also found that race has an independent effect even after controlling for FICO; Black borrowers in particular were over three times more likely to default than White borrowers. Also loans located in low-income neighborhoods were 2.7 times more likely to be in foreclosure than those in upper-income tracts and the risk declines in proportion to average neighborhood income. They did, however, find that loans made by CRA regulated lenders were only about half as likely to go into foreclosure as those made by non-regulated lenders.[58] This particular finding is hardly surprising since one would expect more tightly regulated institutions, i.e. banks, to have fewer problems. Considering that the San Francisco Fed and its researchers tend to be favorably disposed to the CRA these findings were quite telling.

 

One effect of the low income housing push was to force banks to hold portfolios of bad loans.  To protect themselves lenders attempted to increase their mortgage associated processing fees. In effect this amounts to charging higher rates of interest for these riskier loans. Many states passed predatory lending laws to curb such practices. In normal circumstances such price controls would result in shortages; but in this case the banks were forced by government to continue making these loans. Thus the banks were forced to absorb the losses thereby contributing to the bankruptcy of many mortgage lenders. In addition many borrowers could only obtain such loans by taking out adjustable rate mortgages. Such mortgages then largely fueled the subprime meltdown.[59]

 

In 2005 and 2006 subprime lending peaked with minorities getting almost 60% of those mortgages. In 2007, the bubble began to deflate as it dawned on lenders that many of the recipients would never earn enough to pay them back. Furthermore as a result of the Bush-Rove strategy the housing bubble was most pronounced in those areas with large Hispanic populations. In the heavily Hispanic counties of Greater Los Angeles minorities had obtained almost 80% of subprime mortgage money disbursed in 2006. According to the Wall Street Journal in those counties where Hispanics account for more than one quarter of the population the foreclosure rate reached 6.7 homes per 1,000 residents between 2006 and 2009 compared with 4.6 per 1,000 residents in all counties.[60] By August 2008, California with twelve percent of the national population, accounted for 29 percent of foreclosures. Heavily Hispanic California, Nevada, Arizona and Florida with 21 percent of the U.S. population accounted for half of all foreclosures. However it must be pointed out that many defaults in those four states were a result of white speculators who purchased homes with the intention of renting them out to recent Hispanic immigrant laborers. Other properties were purchased by whites fleeing those areas where public schools were overwhelmed by the children of illegal immigrants.[61] In addition there was another area with high default rates which had comparatively few immigrants; this was the Rustbelt which had long been losing jobs sacrificed on the altar of ‘free trade’.

 

Fraud was an inevitable accompaniment to such ill-considered and zealous government policies. Economist Ed Rubenstein points out an example in Colorado where:

 

A ring of mortgage brokers, realtors, appraisers, and loan officers in local banks recruited hundreds of illegal immigrants to act as “straw buyers,” the lowest players in the FHA mortgage fraud game. The illegals were supplied with stolen identities, including driver’s licenses, Social Security cards, and income tax returns. Some were given green cards of legal immigrants. What couldn’t be stolen was forged. The false documents enabled the illegal immigrant straw buyers to “buy” homes they had no intention of living in. The seller—usually a real estate speculator—had usually just purchased the property at a much lower price. The speculator and his accomplices—bank officers, appraisers, loan officers, and real estate attorneys—fraudulently qualified their illegal immigrant recruits to purchase properties at inflated prices.[62]

 

Similar illegal house flipping schemes reportedly occurred in a number of other states. Moreover, with the FHA being rather lax in document checking it has been estimated that more than 200,000 illegal Hispanic immigrants have qualified for FHA loans. [63] Rubenstein also notes one consequence of the interaction between Federal housing and immigration policy that elicits little or no concern among the government and media elite:

 

Individuals who do not live in urban areas, who are not minorities or illegal immigrants, have a tougher time finding mortgage money because of the FHA’s efforts on behalf of those groups. The fiscal impact of FHA is also felt by individuals who own property in neighborhoods beset by mortgage fraud. First, there is a distortion of the local real estate market with an artificial boom of properties doubling in value. Then these homes suddenly go into foreclosure or are abandoned or used as crack houses. Some neighborhoods struggle for years to recover from this economic dislocation. Property values go down. Local governments and school districts are plagued by declining property tax revenues.[64]

 

Financial columnist Arnold Ahlert summarizes the fraud, injustice and deception of the diversity housing push and subsequent crash. He also notes that the ultimate cost of solving the subprime problem will most likely be imposed on the ordinary innocent American citizen:

 

Letting the government officials off the hook for pursuing ridiculous housing schemes that had no basis in fiscal reality? Outrageous. Letting bankers off the hook after years of making improper loans, providing false documentation in order to foreclose, and having them pay a relatively miniscule fine as a settlement? Outrageous. Allowing homeowners who’ve stopped paying mortgages to go on living in their homes while millions of other Americans struggle to make their own payments, often for no other reason than maintaining their integrity? Outrageous. Government-sponsored bailouts with money we don’t have for either, or both, sides? Absolutely, mind-numbingly outrageous. ^[65]

 

Government was the chief mover behind the mortgage meltdown. Indeed one Financial Crisis Inquiry commissioner calculated that at least two thirds of the risky mortgages were accounted for by Fannie and Freddie holdings and guarantees, direct holdings of the FHA or those private holdings which were required by HUD to meet the goals of the CRA while the remaining fraction of risky loans were issued privately by Wall Street.[66] Nevertheless Wall Street’s participation and mortgage related financial innovations were important. According to Chairman Greenspan the “evidence suggests that this market evolved in a manner which if there were no securitization, it would have been a much smaller problem and, indeed very unlikely to have taken on the dimensions that it did.”[67] The following section explores the role played by the financial community in the crisis.

 

The Financial Engineers

 

It was, in fact, the financial engineers on Wall Street that made it possible for the social engineers in Washington to carry out their schemes. The Washington-Wall Street axis was particularly active during the mid-1990s. While the social engineers in the Clinton administration were hatching their mortgage schemes the financial engineers on the Street were developing new financial techniques allowing subprime mortgages to become widespread. The CMO gave rise to the CDO which bundled together assets such as credit card receivables along with mortgages. These were designed to distribute risk among tranches so as to satisfy the risk preferences of various investors. Shortly afterward financial engineering pushed the process still further, “bundling the securities sold by the mortgage pools into securities pools, and selling tranched claims against them … The lesser quality securities were pooled and further securities issued against them to get more AAA bonds. Thus, were born CDO … CDO squared and so on. Over 95 percent of securities thus generated were rated A and above, and 80 percent rated AAA.”[68] Thus the CDO gave way to the so-called CDO squared in which a firm would sell an interest in a pool of CDOs. In the middle of the next decade all varieties of asset backed securities exceeded $1 trillion in total.

 

Spreading the Risk

 

In the past lenders held their residential mortgages until maturity. But with the advent of securitization mortgage originators sell these on the secondary market with risk being passed up the line to the final lenders. Securitization has turned the mortgage market into one large national market with a resulting reduction in borrowers’ interest costs and an increase in yields to lenders. With localized markets interest rates differed by locality; with a national market they have become more uniform.[69]

 

However, there is one major obstacle to such broadening of the market; the lender must go through a complicated legal process in the event of default. Investors thus focused on default risk for which the obvious solution is insurance which was provided by private companies and even more reassuringly by government agencies. The FHA and the VA guarantee mortgages, GNMA guarantees pools of a mortgage originator and, of course, Fannie Mae and Freddie Mac purchase and pool mortgages. But there were other risks ignored by final investors. Liquidity risk was the inability to get out of a position quickly and interest rate risk could adversely affect the value of the investment. Under the new system of securitization and contingent liabilities these risks became less visible and the old techniques of financial prudence broke down under this regime of complex financial engineering. In addition, the rating agencies failed in their responsibility of accurately modeling and assessing these new securities. The systemic risk and the high correlations (see below) endemic in these instruments were simply ignored.  In addition as financial economist Johan Van Overtveldt observes:

 

Since a general expectation of ever-rising house prices in the United States had already seriously distorted the incentives for originators of low-quality mortgage loans, the fact that securitization allowed them to quickly unload the risks associated with these mortgage loans made their behavior even more predatory. Since compensation for many participants in the securitization chain came in the form of upfront origination fees, it was hardly surprising that the originate-to-distribute model of mortgage loans, as opposed to the traditional originate-to-hold model, went completely off the rails under the forces of adverse incentives.[70]

 

 

Risk Mismanagement

 

A decade before the Federal government embarked on its ill-fated adventure of encouraging subprime mortgages one of the Street’s leading economists warned of the dangers of securitization. Henry Kaufman observed that with the loosening of the bond between the mortgage originator and the borrower along with the illusion of liquidity on the part of the security holders the “new risk management techniques do not reduce, and may even increase, credit risk.”[71] Far from taking his warning to heart the powers that be on Wall Street embarked on the course of devising even more opaque methods of risk transfer.

 

One of the new instruments devised was the credit default swap. This is an insurance policy on a corporate bond for the purpose of hedging against the risk of default. A CDS enables a bank with concerns about the financial condition of a long-standing client to protect itself without alienating the client. However speculators eventually made use of these instruments as a method of taking a short position in the bond. Credit default swaps were soon the hedging instrument of choice for collateralized mortgage obligations and its offspring the CDO. A variant called the pay as you go CDS was invented by Deutsche Bank and Goldman Sachs which made payments to the purchaser in an incremental fashion as borrowers defaulted.[72] The most important underwriter of credit default swaps was AIG Financial Products group which began in the late 80s following the LTCM debacle. Goldman Sachs was also in the business as the broker standing between the insurance seller and the insurance buyer. Credit default swaps facilitated the rating agencies awarding of triple-A status to CMOs thereby enabling the market to grow. However, unbeknownst to the management of AIG there was a large exposure potential to writing these swaps which was soon to be realized; by 2006 AIG had an $80 billion exposure.

 

Opaque and Complex

 

To prevent the mortgage market from running out of steam the financial engineers continued to turn out new instruments. “In the process, Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO.  … The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America. For Wall Street it was a machine that turned lead into gold.”[73] Of course, in addition to the lower middle class were many of the impoverished beneficiaries of the Federal agencies. The ordinary CDO was soon joined by this ‘synthetic’ CDO which uses credit derivatives to create single tranche CDOs. Goldman Sachs could, for example, pick 100 different triple-B mortgage bonds and create a CDS on each one. The CDO, consisting of a bundle of CDSs, was shopped for ratings to one of the ratings agencies. The innocents at the rating agency, lacking their own valuation model would, accommodatingly use that of Goldman Sachs and give this beast a high rating. The other innocents at AIG accepted this rating and wrote the CDSs.[74] Ultimately Goldman did develop considerable exposure to an AIG default; but Goldman’s management did have the foresight to establish enough influence to have AIG bailed out thereby saving themselves in the process.

 

Finally there was the CDO-squared; a CDO that invests in other CDOs. These were often loaded with the most toxic leftover parts of the original CDO pool. These magical new securities facilitated further transfer of risk. The original goal of the mortgage security innovation was to make the market more efficient. Now, by hiding the risk, these increasingly complex securities made the market less efficient. The financial engineers of Wall Street assumed that these subprime mortgage bonds were uncorrelated with other, e.g. geographic, variables. One bond heavily concentrated in one state was assumed to have the same default characteristics as a bond heavily concentrated in another state.[75] Thus a tenet of modern portfolio theory with its emphasis on diversified, i.e. uncorrelated holdings was violated. 

 

Financial derivatives and the re-packaging of CDO securities presumably made possible the construction of any desired cash flow and risk profile. But the underlying stochastic volatilities made it impossible to accurately measure the true underlying risks. Accounting rules allowed firms to value their securities based on financial models in a procedure known as mark to model. However the models could be tampered with to hide losses. Quantitative risk management attempts to measure risk by calculating the sensitivities of the elements on the balance sheet to turbulent market conditions. These include the price risk of a bond portfolio caused by random movements in the risk free yield over time (delta risk), the inability of a linear instrument to fully hedge for random changes in the yield (gamma risk) and the change in the volatility of the yield (vega risk). It is necessary to measure the effects of extreme movements in all of these risk factors.[76] As we have seen the Value at Risk (VAR) a portfolio risk measurement technique was the method of choice for assessing these risks. However VAR and similar techniques did not take into account ‘black swan’ events and ‘fat-tailed’ distributions.

 

Mortgages and mortgage backed securities added to the difficulty of hedging for risks. Economists Karl Case and Robert Shiller noted in 1996 that the owner of a portfolio of mortgages in effect holds a portfolio of options with different strike prices; thus there is no natural way to hedge using options.[77] The subsequent development of the Credit Default Swap, a type of insurance policy, was an attempt to deal with this. Case and Shiller highlight a factor that accelerated the mortgage meltdown and was probably not taken into account by the models and the regulators, namely that default losses will rise nonlinearly and faster than the fall in house prices.

 

Because of the nonlinear relationship between actual losses and house prices, even regionally diversified mortgage portfolios are exposed to potentially catastrophic risk from sharp regional price drops.  … One way of dealing with mortgage is securitization, but securitization simply transfers the risks directly to mortgage-backed securities holders. Non-agency investor worries, particularly about California, have led to demands for credit enhancement of mortgage-backed securities via a ‘super-senior’ structure, in which classes of securities are set aside to bear any default losses ahead of more senior protected paper. … Experience has shown that even regionally diversified portfolios can suffer catastrophic losses when large regions suffer significant price declines.[78]

 

They anticipated the origin of CDO tranches. Thus while regulators and bank management in the 90s were oblivious there were economists with misgivings who flew warning flags back then. Case and Shiller delivered a most prescient caution and one that was published in a Fannie Mae sponsored journal. But the agencies and regulatory authorities such as the Federal Reserve were too busy pushing ill-designed research that worsened the problem instead of using their research resources to investigate such potentially catastrophic risks. Thus, by 2005 and 2006 the risks inherent in toxic CDOs became a major problem.

 

The increasing interdependence and tight coupling of the financial markets magnified the effects of the crisis by allowing even relatively small events to cause large disruptions. Modern complexity theory explains many aspects of recent financial crises. The theory asserts that systems self-organize to a critical level whereby even small events trigger large cascades. Furthermore such complexity is characterized by power law distributions as opposed to the assumed normal distribution; these are characterized by fat tails and by nonstationarity where the future distribution of outcomes is not identical to the present distribution. Such nonstationarity was characteristic of both the Long Term Capital Management failure and the 2008 mortgage meltdown.[79] Thus the increased complexity of the financial markets is yet another cause of the ‘fat tails’ and ‘black swan’ phenomena.

 

An example of such financial systemic risk would be that the “failure of one counterparty to meet the terms of its contract … may threaten the solvency of its counterparty. The threat would be significant in a situation in which many counterparties, hit by a severe macroeconomic shock like a sudden large drop in asset prices, are unable to fulfill their obligations. In the extreme, this development could set off a domino effect of defaults that could trigger a financial panic or collapse.”[80] Moreover, a complex systems view indicates that capital adequacy regulations and liquidity creation may be procyclical by expanding leverage during booms and contracting it in downturns.[81]

 

Central banks require much additional analysis and research on such complicated systemic problems. In 2005 a trader at Deutsche Bank engaged a quantitative analyst to produce a study on the effect of home price changes on subprime mortgages. The output of the simulations showed that home prices did not have to collapse to drive the value of mortgage bonds to zero; they simply had to stop rising so fast.[82] There was, of course no reason that regulators such as the FRBNY could not have been doing similar analyses at even earlier times. Such would have provided an early warning of the impending meltdown.

 

The Calm Before the Storm

 

The economic ship sailed on for some time in seemingly calm waters oblivious of the storm and the iceberg waiting just beyond the horizon.  Fueled by easy money and the apparent endless appetite of foreign investors for American debt the housing bubble continued to stimulate the hollowed out U.S. economy. Wall Street continued to reap the profits of its financial innovations and speculations. There were warnings raised by some but these economic Cassandras were ignored.

 

The Great Housing Bubble

 

Appendix 6B shows the growth of mortgages in the U.S. by source: commercial bank, agency etc. Note the almost parabolic growth path beginning in the mid-1990s until an abrupt slowdown in 2008.  The real estate bubble accompanied and survived the great dot-com bubble. The bubble was encouraged by the government’s home-ownership policies, by innovations in financial engineering including the securitization of mortgage loans and the rise of Structured Investment Vehicles. The exuberant optimism of investors and home buyers was accompanied by a loosening of regulatory oversight. Chairman Greenspan himself commented in his memoirs that while he recognized the increased financial risk of subprime borrowing and subsidized home ownership he believed that “the benefits of broadened home ownership are worth the risk. Protection of property rights, so critical to a market economy, requires a critical mass of owners to sustain political support.”[83] Greenspan thus echoed the Bush administration belief in the social and political benefits to be derived from lax mortgage policies. Not willing to curb massive Hispanic immigration as a source of cheap labor he, like members of the Bush administration, offered them this bribe in return for votes. Needless to say the strategy didn’t work. Indeed, “it is highly questionable whether the benefit of broadened home ownership sufficiently compensates for the costs brought about by the subprime meltdown and the subsequent financial crisis: recession, job loss, financial distress, debt overburden, and ironically, reduced home ownership due to foreclosures.  … Intelligent regulatory interventions could have substantially reduced the outstanding amounts of subprime lending.”[84]

 

Michael Lewis notes how in the ‘sand’ states: California, Florida, Nevada and Arizona, which were hardest hit once the housing bubble burst, there was a particular taste for lending huge sums of money to poor immigrants. He cites reports of low wage immigrants from South America and the Caribbean buying townhouses; and even multiple townhouses as the market value of the first one rose. “The housing blogs of southern California teemed with stories of financial abuses made possible” by 30 year adjustable rate mortgages. “In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.”[85] What he fails to mention is that these were a byproduct of the Federal pressure starting with the Clinton administration and then picked up by the Bush administration to buy the Hispanic vote.

 

The FICO scores of borrowers were critical for evaluating risk on the part of both lenders and the rating agencies. These ranging from 300 to 850 were designed as a measure of borrower creditworthiness. However, they didn’t account for the borrower’s income and could be rigged. The rating agencies simply asked for an average FICO score from loan packagers. However, it was the variance and not the average that was of importance since those with low scores were almost certain to default; thus the number with low scores was the critical piece of information. Wall Street packagers were able to combine loans in such a way as to exploit that. In addition, immigrants had artificially high FICO scores since never having taken out a loan, they had never defaulted. This put a premium on finding immigrant borrowers. “The Mexican harvested strawberries; Wall Street harvested his FICO score.”[86]

 

Federal Reserve policy was a great contributor to the housing bubble.  The low interest rate policy pursued by the Fed and pushed by both Greenspan and Bernanke  fueled the bubble. However there was indeed a very real fear in the early 2000s that the U.S. was in danger of sliding into a Japanese style prolonged deflation. It was the Federal Reserve mishandling of its regulatory powers that was less excusable. Greenspan along with his deputies Bernanke and Geithner and Treasury Secretary Paulson did not pay sufficient attention to warnings regarding the subprime market. They failed to use their substantial regulatory powers or to exercise moral suasion. Krugman notes that the “real sin, both of the Fed and the Bush administration, was the failure to exercise adult supervision over markets running wild.”[87] Economists with divergent ideological views echo Krugman’s assertion. Martin Eakes from the Center for Responsible Lending maintains that the “Federal Reserve could have stopped this problem dead in its tracks, if the Fed had done its job, we would not have a foreclosure crisis in virtually every community across America.” Desmond Lachman of the American Enterprise Institute notes that Greenspan “chose to forego the regulatory authority vested in the Fed over the U.S. financial system. In particular, he chose not to exercise his authority under the Home Ownership Equity Protection Act to rein in the non-bank mortgage loan originators, which were mainly responsible for originating and distributing subprime mortgages.”[88]

 

The role of the housing agencies has already been discussed at length. Fannie and Freddie’s plunge into the subprime securities market was their most important contribution to the subprime crisis. Their purchases of subprime securities steadily increased from some $38 billion in 2002, to $279 billion in 2006.[89] By holding such large amounts on their books and by taking large positions in the derivatives markets they went far beyond simply guaranteeing and securitizing mortgages. Wall Street, encouraged by the actions of the agencies plunged even more deeply into the subprime market. Fannie and Freddie were shielded from calls for investigation by their two best friends in Congress, Barney Frank and Chris Dodd. They provided management with extremely generous compensation packages and their congressional friends with large contributions. Even after the financial catastrophe the executives at Fannie and Freddie continued to soak the taxpayers. “Unbelievably, those who caused our national economic turmoil are having the taxpayers pay $160 million for their defense in lawsuits. As The New York Times reported Jan. 24, since the government took over Fannie and Freddie, taxpayers have paid the legal bills of former top executives, lawsuits which accused them of fraud.”[90]

 

Finally, the rating agencies were another enabler of the great housing bubble. Standard and Poor’s ratings classify securities as follows. AAA is the highest rating which indicates a great capacity to pay interest and repay capital. BBB represents an adequate capacity to pay interest and repay principal unless there are adverse economic conditions or greatly changed circumstances.  BB, B, CCC, and C are predominantly speculative in the capacity to repay and are easily swamped if adverse conditions arise. Moody’s has equivalent rating categories. However the models used by the agencies to derive these ratings were riddled with shortcomings with respect to mortgage based securities. The models did not take account of fraudulent loans, loans lacking in documentation or loans for second mortgages. The various tranches were often undeservedly rated triple-A or triple-B. The most overpriced bonds were the most ineptly rated often as a result of the machinations of the Wall Street firms. In conclusion the models were seriously lacking and those who ran them had few modeling skills.[91] Of course the regulatory agencies such as the New York Fed should have been monitoring these models and ratings; they should have known at least as much as the analysts on Wall Street.

 

Wall Street Triumphant

 

The ease with which the Wall Street greed machine manipulated the ratings agencies was just one example of the ascendancy of the big firms. Raters were paid quite well on the volume of business they brought in, even more than by the performance of their ratings. Wall Street manipulators directed their business to the most cooperative ratings analysts; those who gave these dubious mortgage securities, including highly complex collateralized debt obligations, the best ratings. Financial journalist Matt Taibbi gives an example of the ratings manipulators at work.

 

The deal was built on a satanic derivative structure called the CDO-squared. A normal CDO is a giant pool of loans that are chopped up and layered into different "tranches": the prime or AAA level, the BBB or "mezzanine" level, and finally the equity or "toxic waste" level. Banks had no trouble finding investors for the AAA pieces, which involve betting on the safest borrowers in the pool. And there were usually investors willing to make higher-odds bets on the crack addicts and no-documentation immigrants at the potentially lucrative bottom of the pool. But the unsexy BBB parts of the pool were hard to sell, and the banks didn't want to be stuck holding all of these risky pieces. So what did they do? They took all the extra unsold pieces, threw them in a big box, and repeated the original "tranching" process all over again. What originally were all BBB pieces were diced up and divided anew — and, presto, you suddenly had new AAA securities and new toxic-waste securities.[92]

 

Therefore these questionable mortgage backed securities could now be equated in risk to that of Treasury bonds. Having high ratings and the imprimatur of the government-backed agencies, Fannie and Freddie, securities that should have been at junk bond level were now enthusiastically traded on the Street. And it was HUD and the Department of Justice who pressured the banks to make questionable ‘junk’ loans in the first place. The social engineers succeeded in enlisting the financial engineers and the Wall Street greed machine in their cause.

 

Proprietary trading subsidiaries run by traders became a new profit center for the big banks and Wall Street firms. There was an inherent conflict of interest involved as the firms were making bets on the same securities they were marketing to their customers; the various walls and safeguards to keep the businesses separate were never adequate; information inevitably leaked through. In addition board members were not able to exercise effective oversight of these complex risk taking units. Wall Street’s influence had facilitated the repeal of Glass-Steagall which made the need for effective regulation even more important. “Yet instead of enhanced oversight, the new capital rules were met with less regulation, not more. The Fed, which had been the eyes and ears of systemic risk for years, had now abdicated their responsibility to the SEC, which, despite its enhanced powers had no idea what it was doing, its ranks depleted by years of defections of longtime officials to higher-paying jobs on Wall Street.”[93]

 

In 2004, the top investment banks, including Goldman, persuaded the government to create a new, voluntary approach to regulation called Consolidated Supervised Entities; CSE with its small staff was not adequate for its assigned task. As we have seen, Goldman’s political influence transcended administrations.  New disclosure rules that forced the firms to disclose their assets with a breakdown into three levels made it clear that Wall Street firms had fed off the housing bubble. Goldman management fearing that “they were sitting on a time bomb of billions in toxic assets” began to short the subprime market often dumping risky mortgage bonds on their own clients.  By February 2007, Goldman had switched from an exposure of $6 billion on mortgages to shorting some $10 billion against them.[94] During the boom years all of the firms made out quite well; Goldman Sachs was simply the one with the most ‘smarts’.

 

Storm Warnings

 

While Wall Street was basking in the profitable sunlight of the housing bubble there were some who warned of trouble ahead. One who had warned about the impending disaster was economist Nouriel Roubini whose macroeconomic research had shown that “the wages of Americans had stagnated for decades while they were able to build false wealth through borrowing and buying homes.”[95] Roubini was thus one of the few who noted how the U.S. economy, which had been hollowed out for decades, had been deceptively pumped up by the bubble in housing.

 

Greenspan had been oblivious to the effect of his post 911 easy money policy on Wall Street which had created a large increase of risk taking and debt. After slashing rates in 2004, Greenspan became fearful of inflation. He turned down the monetary spigot which then resulted in an increase in mortgage defaults and nervousness on Wall Street regarding CDOs. By early 2006 some well-respected analysts predicted a massive correction. That same year Bernanke expressed concern regarding the inadequacy of the Basel I capital standards in controlling the complexity caused by the growth of structured-investment vehicles and other off balance sheet contrivances. These had enabled the banks to avoid rigid capital requirements and played a major role in the speculative excess.

 

The Great Financial Storm

 

Between 2005 and 2007 Fannie and Freddie endeavored to meet the HUD affordable housing goals despite a tide of rising delinquencies. Analysts on the Street finally began to express reservations regarding the state of the mortgage market. When such anxiety percolated up into the higher reaches of the financial elite the cascade of crisis began.

 

In early 2006, AIG finally suspecting that they were incurring massive risk exited the CDO market. In July 2006 S&P announced that it would change the model evaluating subprime mortgage bonds. Some Wall Street firms realizing that the bonds they had been selling were over-rated frantically moved to sell as many as they could before the new model came out. By the end of 2006 a select number of hedge funds and institutional investors began to invest in credit default swaps as a hedge against their own positions in real-estate related stocks and bonds. Others used them for various complex speculations playing geographical areas against each other, sometimes with disastrous results.[96]

 

Between September 2006 and January 2007 bond traders at Morgan Stanley using their value at risk model purchased $16 billion in triple-A-rated mortgage bonds which ultimately crashed. At a meeting of bank analysts CEO John Mack ultimately confessed that the Morgan Stanley risk management division was caught by “big fat tail risks”. During the fall of 2006 there was a rush out of the subprime market by   J.P. Morgan Chase, Deutsche Bank, Goldman Sachs and Bear Stearns. Citigroup and Merrill, however still had large exposures to subprime securities as a result of their CDO holdings.[97] In early 2007 the respected Grant Interest Rate Observer had a series of articles suggesting that the rating agencies were ignorant of the components of the CDOs that they were rating.[98] The stage was now set for the disastrous year 2007.

 

 

2007: The Storm Breaks

 

In March 2007 British conglomerate HSBC announced the liquidation of its subprime portfolio. In April subprime lender New Century filed for bankruptcy. In July Merrill announced that it had suffered a loss on its trading in mortgage bonds. In the meantime Bear Stearns was on the way to becoming the first major casualty of the breaking crisis. In June Bear announced serious losses in its hedge funds specializing in CDOs.  The rating agencies began to downgrade all types of mortgage backed securities. By late summer Bear faced a funding crisis as the Justice Department began a probe of the collapse of its hedge funds and the usually clueless SEC launched an investigation of its mortgage debt. Of course, an investigation of Fannie and Freddie and their government prodders was not thought necessary. Geithner, Paulson and Bernanke ultimately came to the conclusion that the Bear situation required some kind of government intervention and contrived to have Bear submerged into JP Morgan Chase as a minor subsidiary for a nominal sale price.

 

In July two German banks, IKB and SachsenLB announced substantial losses in the subprime market, victims of the worldwide distribution of toxic U.S. subprime debt. In August American Home Mortgage Investment Corporation filed for bankruptcy; there were also subprime difficulties at French bank BNP Paribas. The world’s central banks including both the European Central Bank and the Federal Reserve made major liquidity infusions into their banking systems to cope with the loss of confidence in securitized products. A liquidity squeeze made the financing of SIVs problematic while a flight to quality in bonds began. At the same time Countrywide announced it would no longer make subprime loans; CEO Mozilo declared the business ‘dead’. Countrywide went into bankruptcy a year later and its assets were acquired by Bank of America.

 

It became increasingly obvious that during the first half of 2007 the “facts on the ground in the housing market diverged further and further from the prices on the bonds and the insurance on the bonds.” The Wall Street firms simply chose to ignore such facts.[99] Merrill’s DV01 duration model had underestimated the fall in prices following the Bear hedge fund problem. In June and July there was a series of large losses and defaults in certain subprime funds including one run by Goldman Sachs. Some of the firms now came to grips with the new reality; Goldman and Morgan began to accurately mark the positions held by their counter-parties.

 

In early September the British mortgage lender Northern Rock requested emergency support from the Bank of England; shortly thereafter Northern Rock was nationalized. The Fed attempted to dampen the growing panic by cutting the fed funds rate by 50 basis points to 4.75%. In the weeks following Citigroup, HSBC, Morgan Stanley, Bank of America, Wachovia, JP Morgan Chase, Bear Stearns, Merrill, Goldman, Washington Mutual, Barclays, Deutsche Bank, UBS, Credit Suisse, Credit Agricole and Mitsubishi Financial all reported a severe decrease in profits. The banks began to curtail lending to business which plunged the economy into recession. Fear spread to the insurance sector and stock prices began to fall. In October the rating agencies drastically downgraded subprime securities. An exodus of Wall Street and bank CEOs began with O’Neal leaving Merrill and Prince leaving Citigroup; both left with large golden parachutes. At the end of the month the Fed cut the fed funds rate further by 25 basis points to 4.5% followed by another cut to 4.25% in December. At the same time the Fed pumped some $50 billion of additional liquidity into the banking system. Toward year’s end the Fed, European Central Bank, Bank of England, Bank of Canada and the Swiss National Bank formulated a joint plan to battle the spreading liquidity crisis.
 

Given the growing international scope of financial markets it was not surprising that U.S. financial companies would seek foreign ‘angels’ to bail them out. In late 2007 Morgan Stanley sold a $5 billion portion to the China Investment Corporation. Charles Gasparino makes the following salient point:

 

So faced with write-downs on mortgage debt that would continue into the new year and a decaying business model, America’s big financial firms scrambled for capital and in doing so, sold out, literally, to capital-rich foreign countries that operated massive investment funds and wanted nothing as much as to own a piece of something as uniquely American as the Wall Street financial system, particularly if they could buy it cheaply. … It didn’t matter that the big firms … were selling themselves to countries whose national interests … don’t always reflect the goals and principles of America. Wall Street needed money and didn’t really care where the money came from.[100]

 

One can picture the bank president in Bedford Falls, with a relieved and obsequious smile on his face as he sells control of his bank to the grasping Mr. Potter. A similarly desperate Citi sold a 4.9% stake to the Abu Dhabi Investment Authority as the Gulf oil sheiks continued to increase their stake in the U.S. financial sector. Saudi prince Alwaleed bin Talal a shareholder in Citigroup “had nearly final say on major management appointments and the firm’s continued embrace of the financial supermarket concept, which clearly wasn’t working.”[101] Merrill also sold a stake to Singapore’s Temasek Holdings and to other interests in the Middle East and Asia. Bear, on the verge of bankruptcy, had unsuccessfully attempted to negotiate a deal with the Chinese. The sell-off of valuable assets was one more consequence of America’s hollowed-out economy with its massive foreign trade deficit.

 

2008: Panic, Bankruptcies and Bailouts

 

In January 2008 Citigroup announced a fourth quarter loss of some $18 billion in mortgage related securities. The source of Citi’s difficulties was the prevailing secrecy in its trading activities; both employees and shareholders had been left in the dark. Citi had a massive off balance sheet exposure to the mortgage market via SIVs; they held some $50 billion in CDOs. In the wake of the Citigroup revelations yields widened and the Street could no longer raise financing for their heavy borrowing. Secrecy and a lack of proper monitoring prevailed throughout the financial community. Societe Generale announced accumulated losses of $7 billion due to the activities of a single trader. With an increasing panic in the markets the Federal Reserve cut the fed funds rate twice over a two week period down to 3%.

 

In February trouble in the banking sector continued; Credit Suisse announced a loss of almost $3 billion on structured credit positions. Economist Nouriel Roubini warned of a systemic financial meltdown. In the meantime with the credit crisis in housing spreading beyond the subprime sector and an impending recession Congress approved a rescue package of $168 billion including tax relief for taxpayers and tax breaks for business. The following month Carlyle Capital defaulted on $16.6 billion of its debt. At the same time Bear Stearns advised the Fed of its significant liquidity deterioration. The Fed induced JP Morgan Chase to provide Bear with emergency funding and to take it over for a sweetheart price of $2 per share. This provoked a firestorm from Bear shareholders leading to JP Morgan having to increase its bid to $10 per share. The Fed continued with its attempts at supporting the banks. They announced a $40 billion increase in lending facilities for banks, followed by a $200 billion securities lending facility. They also cut the fed funds rate again by 75 basis points to 2.25%. The markets rallied in April after these Fed rate cuts. Also helping the markets was the resolution of the Bear failure followed by the Fed providing still more liquidity by lending $200 billion in Treasuries from its new lending facility to bond dealers. However, the exuberance was dampened as new write-downs were announced by Citigroup, Merrill, Royal Bank of Scotland, Bank of America and JP Morgan Chase.

 

The troubles resumed in the summer. In July IndyMac, a California based bank with heavy exposure in mortgages, failed and was taken over by the FDIC. In August the Danish government rescued Roskilde Bank, a large lender in property-related loans. In the meantime nerves were shattered by further predictions from Nouriel Roubini. Above all it was now Fannie Mae and Freddie Mac’s turn on the financial grill. In July concerns regarding their financial condition escalated; it became clear that Freddie and Fannie would also need bailouts. The Federal Reserve Board quickly granted the New York Fed the authority to keep them afloat. For over a decade the agencies were prodded by the likes of Cisneros, Cuomo, Frank and Dodd “to insure and guarantee increasingly risky loans to satisfy the political goal of making sure everyone in the country who wanted a home could get one”; as a result “both Fannie and Freddie were dying.”[102] In September Fannie and Freddie were formally nationalized.

 

It was now Lehman’s turn on the stage. By May its condition had markedly deteriorated and following in the footsteps of Morgan Stanley, Citigroup, Bear and Merrill, Lehman’s management sought for a foreign white knight to bail them out. However they failed to persuade the Korea Development Bank and Mexican billionaire Carlos Slim to take a stake in the company. By late summer with the banks having virtually ceased to lend and with the shorts embarked on a feeding frenzy Lehman’s troubles became acute; on September 9 Lehman’s shares plunged 45%. Lehman needed to roll over $100 billion a month in financing with no willing lenders and with its bad assets having increased from $30 to $80 billion. On September 12 Paulson and Geithner called an emergency meeting of all Wall Street firm CEOs at the New York Fed’s fortress-like headquarters. Lehman CEO Fuld proposed that the government bail out Lehman as it had previously bailed out LTCM and Bear. However Lehman was condemned to file for bankruptcy liquidation and a mass selling of assets spread globally as Lehman began to unwind its positions. Lehman’s bankruptcy had one significant result. It showed that fighting against moral hazard may add fuel to a financial panic and systemic implosion and unfortunately reinforced the position of the Treasury and Fed that from now on important institutions must be saved.[103]

 

Following the Lehman Brothers bankruptcy it was Merrill Lynch’s turn on the chopping block. Merrill CEO John Thain attempted to find his own Middle East white knight in the Kuwait Investment Authority. Ultimately Bank of America took over and absorbed Merrill Lynch. That deal was almost aborted when BOA CEO Ken Lewis discovered just how much debt Merrill had incurred. His threat to abandon the deal elicited warnings from Paulson and Bernanke that the Fed had the authority to remove him and his directors from office. The following January TARP funds were used to give BOA $20 billion and protect it from possible losses due to Merrill’s toxic assets.

 

The subsequent impending collapse of insurance giant AIG surprised both Paulson and Geithner who had been assured by the NYS insurance commissioner that AIG was sound.  The Treasury and the Federal Reserve now backtracked on their claim that they had no authority to rescue private nonbank firms as in the case of Lehman. Now, as the financial markets went into a freeze they were prepared to come to AIG’s rescue. The Federal Reserve announced that it would lend $85 billion to AIG, to pay off its losses on subprime credit default swaps. It was no surprise that one of the biggest beneficiaries of the Fed action was Goldman Sachs which had an exposure of some $20 billion in the event of an AIG default.  Bernanke’s actions had apparently been prompted by advisers which included Goldman’s Lloyd Blankfein. Under their prodding he found a loophole in the Federal Reserve Act which allowed the Fed to give AIG funds it needed to avoid bankruptcy. In exchange the Fed took an almost 80% stake effectively wiping out AIG’s shareholders.[104] Thus while the stockholders of AIG lost out Goldman was saved from the negative consequences of an AIG insolvency. And the money AIG owed to Goldman was completely paid off by the taxpayer.

 

By this time the ineptitude of the regulatory agencies was obvious to all. Both the SEC and the Fed had been clueless as to the fact that the Street and the banks would need billions of dollars more in capital if the losses due to their risky assets continued. The Fed had long since missed the fact that when Glass-Steagall was repealed it enabled Citi to mix its risky mortgage bond trading with its depositors’ funds. The SEC lost all credibility as a regulator especially with those it was charged to regulate. In the current crisis its dysfunction had reached new heights and the lack of understanding of the causes of the crisis on the part of its chairman Cox who also attended the September 12 crisis meeting was on full display.[105] The SEC had already become the “laughingstock of the regulatory world” for having declared the soon to collapse Bear well capitalized. Now they proceeded to investigate the very short sellers who had been warning about the condition of Bear and Lehman.[106]

 

On September 15 the Dow dropped 500 points. There was a flight to quality with only Treasuries being bought. The lending market closed down; even high rated companies could no longer borrow. All markets were now affected including that for non-mortgage backed securities and money market funds. There was fear that the value of all assets would fall to zero. Paulson responded with a proposal for an asset buy-back program of nearly a trillion dollars to bail out Wall Street. The Fed accepted the application of the last two independent investment banks, Goldman Sachs and Morgan Stanley to convert into banks in order to access the Fed credit facilities. Despite its new status as a bank Goldman still required a cash infusion from Warren Buffett; Mitsubishi Financial did likewise to Morgan Stanley. Wall Street as it had existed with its risk taking culture was now over. “Without trust, without lenders and investors believing that they could lend a dollar and get that dollar back in a few days, Wall Street, for all intents and purposes, was finished in its current form.”[107]

 

In late September Washington Mutual collapsed and was taken over by JP Morgan Chase. Another banking giant, Wachovia was also undergoing a severe crisis. Citigroup and Wells Fargo competed for the right to acquire Wachovia’s assets. Citigroup was set to take over Wachovia when Wells Fargo came in with a better offer. After a period of legal wrangling all parties, including the FDIC and the Federal Reserve, agreed to the Wells acquisition on October 12. At this time Lehman’s failure began to seriously impact the European banks. French and Belgian banking authorities had to inject capital into Dexia which had large subprime losses through its U.S. subsidiary. The German authorities likewise had to rescue Hypo Real Estate. Iceland had to nationalize its major banks and seek help from the IMF; Irish authorities also had to act to guarantee Ireland’s troubled banking system.

 

In early October the Troubled Asset Relief Program (TARP) was signed into law. With the passage of TARP, Paulson “abandoned his promised strategy and instead essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs, and a few others unnaturally selected for survival.”[108] Paulson’s strategy shifted from one of purchasing toxic assets to one of direct government investments. To prevent bank runs all big banks could become recipients of government money in exchange for convertible preferred stock. However, some bankers who were not in great financial stress denounced the plan and opposed direct government involvement in the banks. The Federal Reserve also doubled the size of its planned loans and created a new special-purpose vehicle for buying commercial paper. The liquidity crisis continued to spread in Europe and elsewhere abroad. On October 8 Prime Minister Brown announced a rescue plan for Britain’s major banks. The financial crisis also spread to Asia, Latin America, Eastern Europe and Africa. On October 29 the Fed lent $30 billion to the central banks of Brazil, Mexico, South Korea and Singapore.

 

The worry now was that there would be a complete collapse of the entire financial system resulting in a world-wide depression. As the U.S. election approached one beneficiary of the crisis was Barack Obama. With his trademark “cool demeanor” Obama received a boost as Americans searched for a responsible leader. It was a supreme irony that the person most representative of the forces that for fifty years had laid the groundwork for this economic destruction was the one that U.S. voters turned to for the solution. In the weeks following the election Paulson arranged a further bailout of the teetering Citigroup as he injected a further $20 billion to bring the lending total up to $45 billion. The American taxpayer was now the largest shareholder in one of the world’s largest and worst run banks in return for preferred shares with no voting rights.[109] In the meantime Citi ended the experiment begun by Sandy Weil by divesting its non-bank assets.

 

The effects of the great recession lingered long after the financial meltdown.  The politicians and social engineers responsible were never held to account and the same was true for the leaders of the financial institutions. “The people in a position to resolve the financial crisis were, of course, the very same people who had failed to foresee it”. These were Henry Paulson, Tim Geithner, Ben Bernanke, Lloyd Blankfein, John Mack, Vikram Pandit etc. “A few Wall Street CEOs had been fired … but most remained in their jobs, and … became important characters operating behind the closed doors … With them were a handful of government officials who should have known a lot more about what Wall Street firms were doing, back when they were doing it.”[110]

 

Aftermath

 

For several decades Wall Street made out quite well implementing the housing programs designed by progressive social engineers and big government. The result was the worst economic crisis since the 1930s; stagnation has been in effect ever since. While the U.S. taxpayer was required to ante up the funds to bail out banks and the Street, few if any of the politicians, bureaucrats or financiers responsible were ever called to account or forced to disgorge any part of their gains. Business as usual for the surviving financial entities and the Washington politicians prevailed with the ‘too big to fail’ viewpoint even more entrenched. Although a number of solutions were proposed it was the flawed Dodd Frank bill that was put into effect.

 

The peak of the crisis passed but nevertheless many economists foresaw a long period of stagnation. With billions in taxpayer funds the banking system was stabilized but the overall economy did not turn around. Contributing to the dolorous economic climate was uncertainty regarding government policy, and the Obama agenda in particular. Business pursued the defensive strategy of hoarding cash and not increasing hiring. There was also a factor inhibiting any significant bank lending; it is likely that banks are content to ride the yield curve since a large amount of lending involves the prospect of large losses. Adding to the woe was fear of China and the other U.S. creditors; should they be unwilling to roll over their debt or should they demand higher interest rates the result would be a further great recession.

 

Return to Business as Usual

 

With interest rates pushing zero the banks found the carry trade to be quite profitable and some risky trades were also once more possible. Also contributing to renewed profitability was the relief they experienced of no longer being weighed down by holdings of toxic assets. Troubled Citi and Bank of America returned to profitability and Goldman, as usual, made out very well with the resumption of trading.  There was still one more weight taken off of the minds of bank and Wall Street executives. “By 2009 the financial crisis had become so acute that Treasury Secretary Timothy Geithner discouraged criminal investigations of the large nonprime lenders.”[111]

 

Moreover, under the new administration the Washington social engineers were once again able to resume their activities. The Obama administration has  re-ignited the 90s crusade against the banks with the current attorney general once again warning bankers that it is illegal to discriminate based on the source  of a credit seekers income. CRA lobbyists are also pressuring the administration to strong-arm banks to provide the same affirmative action for vendor contracts and minority jobs. In addition they propose bringing all corporations in America under the same tests for racial discrimination.  The Justice Department is also seeking to have lenders delete bad credit histories of minorities and immigrants.[112]

 

To implement this renewed affirmative housing policy the Justice Department has a new division, called the Fair Lending Unit, consisting of lawyers, economists and statisticians.  The department has so far succeeded in intimidating lenders fearful of being branded racists into providing more than $20 million in set-asides raised through out-of-court settlements. To protect themselves from government harassment banks must now implement costly fair-lending internal monitoring divisions. These collect proxy data, based on guesswork regarding neighborhood patterns or gender and racial classification of names, in an attempt to determine if the applicant falls into one of the ‘protected classes’.[113] One financial commentator aptly remarks on the likely consequences of the renewed trend in affirmative finance:

 

Before long, the number one industry in America may be the shakedown industry itself – the afterbirth of a decades-long obsession with multiculturalism and diversity. With each new race-based government regulation, the race racket becomes more lucrative, attracting more parasites to the host.[114]

 

Thus, escaping being held to account, the ‘social engineers’ joined the surviving Wall Street firms in returning to business as usual.

 

Winners and Losers

 

The financial meltdown and recession had its winners and losers. An obvious set of winners were those banks and Wall Street firms who, after years of extraordinary profits and stratospheric compensation packages, were now recipients of taxpayer largesse. Taxpayers and workers who had to bear the cost of bailouts and economic stagnation were obvious losers.

 

The original TARP fund of $700 billion was followed in early 2009 by the Federal Reserve buying subprime mortgages directly from the banks. The bad investments made by banks were transferred to taxpayers. The biggest beneficiaries included Citigroup, Bank of America, JP Morgan Chase and Wells Fargo. Nor was it only American banks that received these subsidies. Swiss-based UBS and Britain's Barclays, the Korean Development Bank owned by the South Korean government, the French BNP Paribas, the German Deutsche Bank, the Edinburgh-based Royal Bank of Scotland, Germany’s Hypo Real Estate Holding, Belgian Dexia SA and Paris based Societe Generale SA were also beneficiaries. Another Fed program allowed investment banks for the first time to borrow directly from the Fed; beneficiaries included Goldman Sachs and Morgan Stanley. All of these banks received many billions of dollars’ worth of loans and subsidies. Moreover financial companies were not the only recipients of such funds.  

 

The Fed's efforts to prop up the financial sector reached across a broad spectrum of the economy, benefiting stalwarts of American industry including General Electric and Caterpillar and household-name companies such as Verizon, Harley-Davidson and Toyota. The central bank's aid programs also supported U.S. subsidiaries of banks based in East Asia, Europe and Canada while rescuing money-market mutual funds held by millions of Americans.[115]

 

Altogether the effort by the Federal Reserve to ward off total depression included lending banks and other companies over $1 trillion of public money.

 

Underlying these initiatives is the ‘too big to fail’ imperative. Arnold Ahlert summarizes its history as applied to the financial industry.

 

It was a status quo where “too big to fail” had been institutionalized long before this particular crisis took hold. In 1984, faced with the failure of Continental Illinois, a large commercial bank, the government not only engineered a rescue, but extended FDIC insurance to both the bank depositors and all its other lenders, including those whose accounts exceeded FDIC limits, as well as global bondholders. In 1998, Long-Term Capital Management, a hedge fund whose financial excesses had many major Wall Street firms on the hook, was rescued by the Federal Reserve with funding from its member banks. Thus, long before the government-engineered housing crisis that led to the debacle of 2008 took hold, the pattern of “privatizing profits and socializing losses” had been established.[116]

 

The Obama administration continued ‘too big to fail’ even extending it to include industries such as automobiles. There were continued subsidies for Wall Street risk taking. The attitude of the administration was illustrated by remarks made when the Safe Banking Act of 2010 was introduced which would have placed limits on the leverage and size of financial institutions. The Financial Stability Board sent a letter to Congress touting the “stability of large banks” and citing the “irreparable economic harm to the growth and job-creating capacity of the U.S. economy” if the bill were passed. Geithner told one of the bill’s sponsors, Senator Ted Kaufman, that the issue was “too complex for Congress and that people who know the markets should handle these decisions.”[117]

 

The amounts lent by the Federal Reserve to those banks ‘too big to fail’ were truly impressive. In 2008, despite its self-proclaimed strength and stability Bank of America owed the Federal Reserve some $86 billion. Jamie Dimon, JP Morgan Chase CEO, claimed his firm’s borrowing of $48 billion in February 2009 from the Fed’s Term Auction Facility came “at the request of the Federal Reserve to help motivate others to use the system,” even though the bank’s total borrowings were nearly twice its cash holdings. Furthermore, by that time Federal Reserve loan guarantees amounted to some $7.77 trillion.[118]

 

Executives at the bailed out firms must also be reckoned as being among the ranks of the winners. There were no givebacks or curbs on the pay of the top financial executives. The CEOs of these firms created a system which rewarded risk without penalizing losses. A real penalty would provide that those who ordered or approved such risky behavior would be required to return their massive salaries, bonuses and golden parachutes – “hitting the risk takers where they will feel it the most is the only way to make sure those who feel the urge to bet the ranch, whether on the CDO market or the next wonderful investment to come out of Wall Street, think twice.”[119] There were also those who profited directly from the financial calamity. A mystery investor or hedge fund reportedly made a bet of almost $1 billion that the U.S. would lose its AAA credit rating. Rumor had it that billionaire investor and Democrat patron George Soros, was in some way involved.[120]

 

Where there are winners there must also be losers. Small business was deprived of bank loans while paying more taxes. Workers, over half of whom find employment in small business also suffered as jobs were lost and fewer workers were hired. The American middle class of course suffered along with workers. All in all the Great Recession cost some $14 trillion in lost wealth as American household net worth dropped from $64.4 trillion in the second quarter of 2007 to $50.4 trillion in 2009; a loss of some $46,000 per capita.[121]

 

Financial Reform

 

It has been suggested that the ‘too big to fail’ philosophy by removing fear from the largest financial companies has upset the balance between fear and greed. The real disciplining force needed is the willingness to let institutions fail regardless of their size. One obvious solution was proffered by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City. He wants to simply “reduce the scope and size of banks, combined with legislatively mandated debt-to-equity requirements.” He notes that the largest financial institutions have grown to their present size as a result of the government subsidies they received because they were too big to fail. “Therefore, diminishing their size and scope, thereby reducing or removing this subsidy and the competitive advantage it provides, would restore competitive balance to our economic system.”[122]

 

A series of reforms regarding the operations of the Federal Reserve was suggested by economist Jane D’Arista. She proposes a system of rules and regulatory limits covering not only commercial banks but also unregulated nonbank financial firms such as hedge funds and private equity firms, the so-called shadow banking system. She has also come to the conclusion that the Fed is once again “pursuing wrongheaded theory, blinded by similar political biases and obsolete doctrine.”[123] Of course some of this political blindness is a result of the bias toward liberalism which is entrenched both in the government and at the Federal Reserve.

 

Even before Wall Street embarked on its risky new ventures prominent financial economist Henry Kaufman recommended increased public disclosure by financial institutions concerning their many off-balance sheet items and contingencies. He also advocated appropriate capital requirements as a means for cutting back on the unprecedented growth of debt which began at that time. Such a policy would provide better cushioning for creditors. To regulate increasing securitization institutions should also be required to record assets at the lower of cost or liquidation value. Regulators should be more knowledgeable than the credit agencies and should develop credit rating systems for their institutions; these should be disclosed publicly. Financial weakness would be remedied more quickly with disclosed official credit ratings. There should also be established a national board of overseers for financial institutions which would provide an integrated overview, provide uniform accounting standards, improve reporting procedures and require fuller disclosure of information for directors, trustees and the public. It would consist of members from the Fed, supervisory agencies and knowledgeable private individuals.[124] Kaufman apparently would not have thought much about the mark to model valuation of assets commonly employed. To carry out his program, however, the regulatory agencies would have needed to develop higher levels of expertise than they were in fact willing to do.

 

 Some students of the markets advocate that regulation be carried out on an international basis. This would be an extension of agreements commencing with the Basel accords of 1988. These provided for the adoption of capital adequacy criteria coordinated by standards established by international committees and sanctioned by international soft law. The Basel accords were followed by further efforts at international regulation. The Mexican bond crisis of 1994 and the Russian bond crisis and Asian instability of 1998 led to the creation under the G7 of the Financial Stability Forum and the World Bank-IMF Financial Sector Assessment Program.[125] Given the U.S. experience with such international bodies, e.g. the WTO, enhanced international regulations may be a bad idea. Indeed the student of the Federal Reserve William Greider contends that the Basel accords did not restrain lending and created a new vulnerability for banking. The rules turned out to be pro-cyclical magnifying the crisis by destroying bank capital as a result of the mounting losses on market securities.[126]

 

The most immediate cause of the crisis, the open-ended extension of mortgage financing, has also received attention. Some economists, quite logically, advocate ending the idea of making home ownership independent of the ability to pay. Others advocate ending Fannie and Freddie altogether or at least splitting the mortgage giants up into smaller private companies. It has been proposed that the CRA be repealed lest it encourage future administrations to use it again to allocate credit to favored groups. As explained already that eventuality now appears to be happening once again. Some believe that it would be enough for the government to be open about subsidizing housing and not use stealth regulations or mandates to do so. However, the dissenting member of the Angelides Commission, Peter Wallison warns that if “the government gets back in the business of distorting the private markets” to stimulate housing growth another financial crisis is sure to result.[127]

 

Dodd-Frank

 

However, the remedy ultimately settled on in Washington was the problematic Dodd-Frank bill. Ben Bernanke expressed two basic goals that any reform package should aspire to. The ideal would be for prudential supervision and regulation addressing the problem of moral hazard and ensuring that financial institutions manage their liquidity so as to prevent a crisis. Regulations for capital adequacy should also be countercyclical so that institutions increase capital coverage during booms and decrease it at times of credit weakness. Furthermore:

 

The crisis should not lead to abandonment of the basic principles of competition and free-market economics … It’s not possible for all people, at all times, to make the right decisions. Innovations and progress have inherent ups and downs, excesses and abuses, and booms and busts. … Even taking into account the extreme severity of the present financial crisis, it would be a grave mistake to confine financial markets in an over-stringent regulatory straitjacket.[128]

 

Thus, despite its shortcomings the role of modern finance as an engine of economic growth should be recognized. The consequences of the too big to fail philosophy should also be dealt with as part of any reform as should the role of the large housing agencies. Dodd-Frank unfortunately fails to meet these criteria.

 

Dodd-Frank failed to put a definitive end to the philosophy of ‘too big to fail’ and its inherent moral hazard. Big banks will thus continue to take big risks inviting another major financial crisis. The new ‘financial stability oversight council’ will make sure that big firms get special treatment as regulators embed themselves within the large firms to supervise risk taking. In cases where liquidation becomes necessary these same regulators will resolve it “outside of the traditional bankruptcy process” giving special consideration to counterparties and select classes of regulators.[129] Given the history of regulatory capture explained in a prior chapter such new regulatory initiatives do not seem very promising.

 

Furthermore it will be left to the discretion of the regulators as to which companies will get this special treatment. Those who shout the loudest, and have the resources to make themselves heard, regarding the dire financial effects of their default are the ones who will expect and will get future bailouts. Certain types of investments also will be in line for future bailouts. Those firms whose default would impact minority or underserved communities are more likely to receive special consideration. Favoritism will also be harmful to the economy. “The free marketplace can’t determine, for example, that banks should be smaller, if the government keeps rewarding lending to big banks. … More attention to discretionary regulation — officials deciding what’s risky and what’s not, according to Dodd-Franks’ prescription — means less regulatory attention to the kind of rules the financial system needs.” In addition the new ban on bank deposits for speculation “still allows for such trading in Fannie Mae securities”.[130] The supposedly all inclusive Dodd-Frank legislation excludes doing anything effective regarding Fannie and Freddie.

 

Moreover, the recent policies of the Obama administration and the Fed illustrate the favoritism shown to the select few.  The Fed has been pumping trillions of dollars at almost zero interest rates into Wall Street in addition to hundreds of billions in bailouts.  And Wall Street thrives on selling the enormous debt that government is now incurring. Although Dodd-Frank left big Wall Street and the big banks untouched the same was not the case for the small community banks that must bear the brunt of the very regulations that the large firms have the influence and resources to evade.

 

Dodd-Frank continues the differential treatment as regards large and small banks that existed long before the financial meltdown. With almost four thousand pages of rules smaller banks are hard put to manage their operations under such a flood of regulation. Banks are required to retain a portion of the risk of loans that they originate and later sell to other parties; a particular burden for small banks. They are required to hold more capital and capital is restricted to little other than shareholder interest and retained earnings making it difficult to find new shareholder investors. Banks that provide municipalities with traditional banking services are subject to additional registration and oversight; a burden on both banks and small communities. New derivatives rules make it particularly expensive for small banks to offset their risks. The new rules will also drain as much as $50 billion from the earnings and capital of the industry. All in all, fewer loans will be made resulting in slower job growth and a weaker economy.[131]

 

With the new financial reforms “the same bureaucrats who hadn’t seen any of the most recent market collapses coming, including the big one in 2008, would be determining which businesses got loans and which didn’t.”[132] With at least 400 separate rules affecting virtually the entire financial sector bureaucrats would have more say in the allocation of capital than ever before. Many of Dodd-Frank’s provisions are completely unrelated to the financial crisis. It was instead specifically designed to expand the size and scope of government including new powers granted to the Consumer Financial Protection Bureau. It also expands government authority to seize control of firms designated as failing with only limited judicial review. There are capital requirements and proprietary trading restrictions but also, strangely enough, rules for such items as living wills. Many of these ambitious provisions means that service fees will rise and there will be less money available for productive lending.[133] Dodd-Frank rightly directs regulators to be wary of the ratings agencies. However, the regulators embedded within the individual firms are likely to suffer from the same group think that previously afflicted the rating agencies, Wall Street management and regulators in the years before the crisis.[134]  Finally it is telling that the very same regulators who failed to keep Corzine from losing his customers’ money will be in charge of the new regulatory regime.

 

Furthermore, Dodd-Frank has the potential to adversely affect employment. There are direct effects on financial industry employment. Banks are reportedly looking at outsourcing as a way to pay for the costs of doing business imposed by the new regulation. While reducing jobs in the home office, Goldman Sachs has been quietly shifting jobs to Singapore and India.  JP Morgan chief Jamie Dimon has loudly complained about the prolonged uncertainty regarding the Dodd-Frank regulations while, along with Citi, BOA, Morgan Stanley and Goldman he has outsourced jobs abroad. It can be said that Dodd-Frank has dumped tons of new rules on the banks which have little or nothing to do with the type of risks leading up to the crisis.[135] Capital will be diverted from more productive businesses with a direct effect on employment. Indeed, businesses as well as financial institutions will most likely wait and see how the Dodd-Frank regulations play out before adding new employees.

 

The new reform also has the potential to help re-ignite the very social engineering that was the ultimate cause of the mortgage crisis. Dodd-Frank echoes the Obama administration plans to toughen testing standards for CRA lending and to include standards for non-bank financial institutions. These standards are designed to insure that the underserved have favorable access to mortgage financing. The legislation provides for a data collection system to monitor small business loans to minorities and to provide bank examiners with a tool for enforcing CRA provisions. There is also a scheme to socialize small business loans to minorities and a Federal Insurance Office to make sure that minorities are being offered affordable premiums. There is also a new Consumer Financial Protection Bureau which, among other things, will investigate racism and promote fair lending. Of course it will be ordinary middle-class customers and borrowers who will have to bear the cost of the increased defaults resulting from these policies.  In addition, there may be unpredictable systemic effects as was true of the affirmative mortgage initiatives that led to the financial meltdown.[136] And, of course, one should not count on regulators like New York Fed and the SEC to warn about these in time.

 

Affirmative action will also be injected into all financial transactions with an impact on economic growth.Another affirmative action bureaucracy will be created as government agencies are required to set up minority inclusion divisions for their own employees and for their contractors. Even the financial regulatory agencies will have de facto race hiring quotas imposed on them. Such an effort is, of course, not needed.[137] The various agencies were quite proactive in making sure that protected groups were hired and advanced even above more qualified and experienced employees. That is yet another reason they were so ill-equipped to detect the financial crisis in its early stages.

 

Some Specific Provisions of Dodd-Frank

 

Some of the provisions, for better or worse, of the Dodd-Frank legislation are outlined in the following.[138] Dodd Frank, of course, has a number of provisions directly affecting financial regulation. The legislation adopts the Volcker Rule which prohibits banks, bank affiliates and holding companies from engaging in proprietary trading or investing in and sponsoring hedge funds and private equity funds. Nonbank financial institutions supervised by the Fed will also have restrictions on proprietary trading and investing in hedge funds and private equity funds. These provisions go beyond the old Glass-Steagall rule which simply kept bank customers money from being intermingled with such risky trading. The provisions appear to be too open-ended and open to interpretation and, thus, to favoritism.

 

Swaps are a particular concern. A code of conduct is established for all registered swap dealers and major swap participants. When acting as counterparties or when advising a swap entity dealers and participants are enjoined to ascertain that the other parties have been well advised regarding the intricacies and risks of such transactions. These broad and ambiguous regulations do not appear to take account of the fact that not all swap contracts are that dangerous; more focus should be placed on instruments such as Credit Default Swaps. 

 

Regulators are required to consider the potential benefits and costs for financial institutions and consumers of any proposed regulation so as to prevent any undue regulatory burden. There should also be coordination and consultation among the various agencies before a proposed regulation is issued. A new Consumer Financial Protection Bureau (CFPB) was created with primary responsibility for regulating consumer protection regarding financial products and services. There is a provision to protect small business from being unintentionally regulated by the CFPB; regulators may exclude businesses that meet certain standards. Such regulatory interpretation, however, may create a big loophole for favoritism and special treatment.

 

One provision of Dodd-Frank is a tacit admission that the regulatory apparatus already existing has failed.  The new Office of Financial Research within the Treasury is to be staffed with a highly sophisticated staff of economists, accountants, lawyers, former supervisors, and other specialists to support the Financial Stability Oversight Council’s work by collecting financial data and conducting economic analysis. This is precisely the sort of technical expertise that, as we have seen, the Fed and regulatory agencies have neglected to foster. The Council, however, is chaired by the Treasury Secretary and includes the Federal Reserve Board, SEC, CFTC, OCC, FDIC, the new Consumer Financial Protection Bureau, and state banking, insurance, and securities regulators. These are, for the most part, the same crew that had previously failed to warn of or prevent the crisis.

 

Some worthwhile parts of the bill involve providing for increased transparency; something that should have previously been done by the Fed and the regulatory agencies. The Office of Financial Research and member agencies will collect and analyze data to identify and monitor emerging risks to the economy and make this information available to the public and to Congress. There are also requirements for the Federal Reserve to disclose counterparties and information regarding its emergency lending, discount window operations, and open market transactions on an on-going basis. Another provision requires that the ratings companies disclose their methodologies and their ratings track record.

 

There are additional mandates targeting the ratings agencies. An attempt is made to curb the conflict of interest that may occur when a rating agency employee goes to work for an underwriter of a security or money market instrument subject to a rating by that agency. It requires that a report be sent to the SEC when certain employees of the agency obtain employment at a company that the agency has rated in the previous twelve months. It would of course have also been useful if there were similar mandates for regulators, government officials, Congress and Congressional staff. One other provision allows Investors to bring legal action against a ratings agency for a knowing or reckless failure to conduct a reasonable investigation or to obtain analysis from an independent source regarding the securities it has rated. The agencies will now be subject to “expert liability” testimony. Hence, new business is directed to one of the Democrats’ favorite special interests; the trial lawyers.

 

Minimum capital requirements standards at least equal to the standards already in effect are established. The Council is authorized to impose a 15 to 1 leverage requirement on a company that in their view constitutes a grave threat to the financial system. There are also financial safeguards added regarding swaps to ensure that dealers and participants have adequate financial resources to meet their obligations. Regulators have the authority to impose capital and margin requirements on major swap participants. Such new regulator discretion for the swap market are good in theory provided they don’t conflict with existing obligations under the Basel accords and don’t end up riddled with favoritism and loopholes.

 

An attempt is made to reform ‘bailout’ procedures. Most large financial companies that fail are expected to be resolved through the bankruptcy process. The Treasury Secretary must approve any new Federal Reserve lending program and sufficient collateral is supposedly required. The FDIC can guarantee the debt of insured banks with the approval of the Treasury Secretary. Thus, ‘too big to fail’ continues in a slightly altered form.

 

There are provisions for reforming mortgage lending. Financial incentives that encourage lenders to steer borrowers into more costly loans, including "yield spread premiums”, are prohibited. These are also worthwhile provisions of the law, although it is difficult to see how they can be put into effect without curbing lending to low-income borrowers. Other mortgage provisions are a return to business as usual; social engineering, slush funds, favoritism and affirmative action. An Office of Housing Counseling is established within HUD to boost homeownership. A Neighborhood Stabilization Program provides funding to States and localities to rehabilitate, redevelop, and reuse abandoned and foreclosed properties. Bridge loans are given to qualified unemployed homeowners with reasonable prospects for reemployment. HUD is also authorized to provide legal assistance to low-income homeowners and tenants impacted by mortgage foreclosures.

 

And no financial reform legislation is complete without a plethora of new affirmative action. The FDIC, Federal Reserve, HUD and FTC, among other agencies are to “oversee the enforcement of federal laws intended to ensure the fair, equitable and nondiscriminatory access to credit for individuals and communities.” A new Office of Minority and Women Inclusion is established which will “among other things, address employment and contracting diversity matters. The offices will coordinate technical assistance to minority-owned and women-owned businesses and seek diversity in the workforce of the regulators.”  Another new agency is the Federal Insurance Office which “will gather information about the insurance industry, including access to affordable insurance products by minorities, low- and moderate-income persons and underserved communities.” There is one worthwhile, although clearly secondary, function of the new office. It “will also monitor the insurance industry for systemic risk purposes.” Finally a Bureau of Consumer Financial Protection is established within the Federal Reserve System to assume responsibility for overseeing most consumer protection laws and to curb unfair, deceptive and abusive practices.

 

Furthermore, Congressional legislation is not complete without all sorts of provisions irrelevant to the problem to be addressed.  There is a clause allowing consumers free access to their credit score if such score negatively affects them financially or with respect to employment. There are a number of provisions regarding natural resources. Those engaged in the commercial development of oil, natural gas, or minerals are to include information in their reports regarding payments made to the U.S. or other governments with regard to such development. There are provisions related to the illicit trade in minerals in areas of conflict between armed groups. The Democratic Republic of Congo is of specific concern; manufacturers who use minerals originating in that nation are required to file reports with the SEC and must “exercise due diligence on the source and chain of custody of the materials and the products manufactured.” One has to wonder why such provisions, whatever their merits might be, were bundled in a financial reform and regulation bill.

 

The American Bankers Association has a useful summary of the unintended consequences and ‘collateral damage’ likely to result from Dodd-Frank:

 

Implementation of the Act will require literally dozens of new mandatory and discretionary rulemakings by numerous Federal regulatory agencies over the next several years.  As a result, bankers are likely to be faced with thousands of new pages of regulations not to mention increased litigation risk.  In addition, while most of the provisions contained in the Act are effective essentially immediately upon enactment, many have delayed effective dates.[139] 

 

Timeline to Disaster: Chronology of Events Resulting in the Financial Meltdown

 

The following is a chronology of the important underlying factors whose ultimate and inevitable result was the great financial collapse, recession and stagnation. While not ‘all-inclusive’ it highlights many of the important milestones of American economic decline over the last few decades and also those events immediately leading to the financial crisis of 2008.

 

1961-1972: Major civil rights legislation, Vietnam War, baby boomers enter college, rise of New Left; long march through the institutions begins.

 

March 1961: President Kennedy signs an Executive Order requiring that government employers take affirmative action to ensure that applicants are employed, and employees are treated equally, without regard to their race, creed, color, or national origin.

 

October 1962: Kennedy Trade Expansion Act provides for a round of tariff cuts.

 

September 1965: President Johnson signs an Executive Order affirming the Federal Government's commitment to promote equal employment opportunity through a positive and continuing program in each department and agency.

 

October 3, 1965: President Johnson signs immigration legislation repealing the national origins quota system thereby setting the stage for mass chain migration.

 

1970: Philadelphia Plan implemented - Nixon’s Labor Department requires Philadelphia companies to meet hiring goals using strict quotas and timetables.

 

1971: President Nixon signs an Executive Order coordinating the participation of Federal departments and agencies in an increased minority enterprise effort; Griggs vs. Duke Power case banned employment tests and educational requirements unless they could be shown to be necessary for a particular job.

 

1977: Congress passes the Community Reinvestment Act to reduce discriminatory credit practices.

 

March 1979: The United States and the People's Republic of China formally establish embassies; a bilateral trade agreement was signed which was followed in 1980 with agreements on maritime affairs, civil aviation links, and textile matters.

 

1980s: Rise of mortgage securitization; financial industry collapse and bailouts; rise of ‘too big to fail’ philosophy.

 

March 1980: Refugee Act repealed the limitations which had previously favored only refugees fleeing communism and authorizing federal assistance for the resettlement of refugees.

 

August 1983: Mexican/ Latin American debt crisis begins.

 

1984: Continental Illinois Bank seized by federal authorities.

 

Late 1980s: Peak of Savings and Loan sector collapse.

 

1986: The FIRE sector (finance, insurance, and real estate) proportion of GDP rises above that of manufacturing.

 

November 6, 1986: Immigration Reform and Control Act signed implementing amnesty for illegal immigrants ultimately encouraging a larger wave of illegal immigration.

 

October 1987: Stock market crash.

 

1989: Creation of the Resolution Trust Corporation to resolve S&L crisis.

 

1990: Collapse of Drexel Burnham Lambert.

 

November 29, 1990: Immigration bill signed into law providing for an increase in total immigration under an overall flexible cap and a permanent provision for a diversity lottery for immigrants from underrepresented countries.

 

1992: Boston Fed report - lead author Munnell; Democrat Congress authorizes HUD to set Fannie and Freddie minority lending targets.

 

1993: Clinton overhauls CRA redlining regulations, begins probe of financial institutions with poor minority lending records and hires Munnell at Treasury; Democrat Congress requires Fannie and Freddie to review their underwriting guidelines; Boston Fed with approval of Greenspan issues new lending guidelines.

 

February 26, 1993: First World Trade Center bombing carried out by Muslim terrorists here under lax immigration and visa policies.

 

1993-1995: Attorney General Reno proceeds with prosecutions of, and encouragement of private suits against, banks.

 

1994: President’s Fair Housing Council established; Countrywide Financial signs agreement with HUD to relax underwriting standards and set numerical targets; Mortgage Bankers Association signs agreement with HUD for more flexible standards; federal regulators begin to reject bank applications for charter changes on the grounds of poor CRA grades;  first major mortgage securities crisis.

 

January 1, 1994: North American Free Trade Agreement (NAFTA) came into effect; NAFTA became model for subsequent U.S. trade agreements.

 

January 1994: Clinton reaffirms support for Reno’ efforts and cites Boston Fed study; he issues executive order increasing HUD’s fair-housing powers.

 

January 1, 1995: World Trade Organization (WTO) set up to replace the General Agreement on Tariffs and Trade but with much broader scope.

 

April 1995: New CRA rules setting numerical targets for poor neighborhoods; banks required to pass compliance tests in return for being able to merge and avoid penalties.

 

1995: HUD gives agencies still higher targets; authorizes them to purchase MBS’s including those containing sub-primes.

 

1996 Clinton orders IRS to issue ITINs to foreigners not eligible for SSNs.

 

September 30, 1996: Illegal Immigration Reform and Immigrant Responsibility Act signed with the aim of adopting stronger penalties against illegal immigration.

 

1997: Asian financial crisis; Salomon Brothers sold to Travelers Group; CRA regulations fully implemented; Freddie and Bear Stearns securitize first offering of CRA mortgages; Fannie launches CRA Portfolio Initiative.

 

1997-2000: Tech stock bubble and collapse.

 

1998: Fannie rolls out high risk loan program; HUD raises affordable lending bar.

 

September 1998: LTCM failure and bailout.

 

1999: HUD reviews racial discrimination embedded in Fannie and Freddie computerized underwriting systems.

 

2000: Banks begin accepting ITIN numbers from mortgage applicants; HUD sets still higher affordable housing mandates for the agencies.

 

2001: Franklin Raines announces the American Dream Commitment, Fannie’s decade long $2 trillion plan to lend to the underserved.

 

September 11, 2001: Arab terrorists, many admitted under expedited visa programs, use hijacked planes to destroy World Trade Center and damage Pentagon.

 

December 2001: China formally joins the WTO.

 

2001-2004: Fannie and Freddie purchase some $300 billion in subprime mortgage securities to meet HUD mandates.

 

2001-2006: Eight additional free trade agreements enacted.

 

2002: Bush pledges to help expand minority, especially Hispanic immigrant, homeownership.

 

2003: Bush signs American Dream Down Payment act with $200 million a year to help minority borrowers.

 

2004: HUD proposes that Fannie and Freddie adjust underwriting standards and raise affordable housing goals for new immigrant households.

 

2005: While HUD attempts to move up affordable housing goals, Fannie and Freddie are forced to cut back due to rising delinquencies.

 

2006-2007: Fannie tries once again to meet HUD goals by making over $350 billion in subprime lending.

 

February 8, 2007: HSBC Holdings experiences a decline in profits due to its U.S. subprime portfolio’s increase in bad debts.

 

April 2007: Subprime lender New Century files for bankruptcy.

 

June 2007: Bear Stearns announces serious losses in hedge funds specializing in CDOs; S&P and Moody begin downgrading mortgage backed securities.

 

July 2007: Countrywide announces it would no longer make subprime loans – CEO Mozilo declares the business ‘dead’; IKB and SachsenLB, two German banks, announce substantial losses in the subprime market; questions raised about Citi trading activities.

 

August 2007: American Home Mortgage Investment Corporation files for bankruptcy; subprime difficulties at French bank BNP Paribas; Bear faces a funding crisis as the Justice Department and SEC begin probe; widening of yields as the Street could not easily raise financing from their usual sources;

CDOs plummet; Merrill’s model DV01 is shown to have serious flaws – CEO O’Neal now faces opposition by a coalition of former and current executives. 

 

August 9, 2007: ECB and Fed make major liquidity infusions; spread between LIBOR and overnight index rate and that between Treasury bonds and corporate bonds surge.

 

September 7, 2007: British mortgage lender Northern Rock requests emergency support from the BOE - it is subsequently nationalized.

 

September 18, 2007: Fed cuts fed funds rate by 50 bp to 4.75% followed by Citigroup, HSBC, Morgan Stanley, Bank of America, Wachovia, JP Morgan Chase, Bear Stearns, Merrill, Goldman, Washington Mutual, Barclays, Deutsche Bank, UBS, Credit Suisse, Credit Agricole, Mitsubishi Financial reporting severe cuts in profits.

 

October 2007: Rating agencies drastically downgrade subprime securities; exodus of CEOs begins as O’Neal leaves Merrill and Prince leaves Citigroup with golden parachutes; banks curtail lending to business plunging the economy into recession.

 

October 31, 2007: Fed cuts fed funds rate further by 25 bp to 4.5%; fear now spreads to insurance sector.

 

November 15, 2007: Fed pumps additional $47 billion liquidity into the banking system.

 

December 11, 2007: Fed cuts fed funds rate again by 25 bp to 4.25%; stock prices fall sharply.

 

December 12, 2007: The Fed, ECB, BOE, Bank of Canada and Swiss National Bank announce a joint plan to battle the liquidity crisis.

 

2008: HUD affirmative lending target for the agencies reaches 56%.

 

January 2008: Bear’s attempt at a joint Chinese venture falls through - shares fall to lowest level in 4 years.

 

January 11, 2008: Bank of America announces offer to buy Countrywide.

 

January 15, 2008: Citigroup announces a fourth quarter loss including $18 billion in mortgage related securities.

 

January 21, 2008: Fed cuts fed funds rate again by 75 bp to 3.5%; turmoil in the markets.

 

January 24, 2008: Societe Generale announces accumulated losses of $7 billion in the account of one trader.

 

January 30, 2008: Fed cuts fed funds rate again by 50 bp to 3%.

 

March 2008: Imminent collapse of Bear - Geithner, Paulson and Bernanke come to the conclusion that the resulting systemic risk requires government intervention.

 

March 7, 2008: Fed announces a $40 billion increase in lending facilities for banks, followed by a $200 billion securities lending facility.

 

March 11, 2008: Goldman expresses public concern about Bear Stearns creditworthiness.

 

March 12, 2008: Carlyle Capital defaults on $16.6 billion of its debt.

 

March 13, 2008: Bear advises Fed that it has experienced significant liquidity deterioration.

 

March 14, 2008: Fed induces JP Morgan Chase to provide Bear with $30 billion emergency funds with the Fed assuming the credit risk.

 

March 18, 2008: Fed cuts fed funds rate again by 75 bp to 2.25%.

 

April 2008: New write-downs announced by Citigroup, Merrill, Royal Bank of Scotland, Bank of America and JP Morgan Chase; markets rally after the Bear situation is resolved; Fannie and Freddie have their capital requirements lowered to shore up the housing market.

 

May 2008: Lehman’s management searches for a white knight to bail them out but fail to persuade the Korea Development Bank and Mexican billionaire Carlos Slim.

 

May 29, 2008: Bear is acquired by JP Morgan Chase as a minor subsidiary for a bargain price.

 

June 25, 2008: BOA acquires Countrywide.

 

July 2008: Concerns about the condition of Fannie Mae and Freddie Mac escalate - the Treasury asks Congress for authority to bail them out and the Federal Reserve Board grants the New York Fed the authority to keep them afloat.

 

July 12, 2008: IndyMac, a California based bank with heavy exposure in mortgages, fails.

 

August 2008: The Danish government rescues Roskilde Bank, a large lender in property-related loans; markets rattled by predictions of doom by Nouriel Roubini; John Thain the new CEO of Merrill seeks Middle East investors to bail out the firm; Lehman’s troubles become acute. 

 

September 2008: Shorts begin feeding on Lehman.

 

September 7, 2008: Fannie and Freddie put into a government run conservatorship.

 

September 9, 2008: Lehman’s shares plunge 45%.

 

September 12, 2008: Credit Default Swaps on Lehman, Merrill and even Goldman and Morgan Stanley increase rapidly; AIG’s financial condition severely deteriorates; at FRBNY Paulson and Geithner call an emergency meeting of all Wall Street firm heads - Lehman condemned to file for bankruptcy while BOA is slated to absorb Merrill.

 

Week of September 15, 2008: That Monday the Dow drops 500 points; mass selling of assets spreads globally as Lehman begins to unwind its positions; flight to quality into Treasury securities begins; near run on money market funds; worry now is that there would be a complete collapse of the entire financial system resulting in a mass world-wide depression with the value of all assets falling to zero; Bank of America completes takeover of Merrill Lynch; Lehman files for bankruptcy; Fed gives AIG a loan of $85 billion - soon afterward an additional loan of $38 billion was provided; on Thursday Paulson drafts a document asking for nearly a trillion dollars to bail out the Street.

 

September 21, 2008: The Fed allows the last two investment banks, Goldman Sachs and Morgan Stanley to convert into banks bringing them into the Fed credit facilities; Warren Buffett injects equity capital into Goldman and Mitsubishi Financial does likewise to Morgan Stanley; Wall Street as it had existed is over.

 

September 24, 2008: Washington Mutual collapses and is taken over by JP Morgan Chase; European banks hard hit by the failure of Lehman - French and Belgian banking authorities have to inject capital into Dexia, German authorities have to rescue Hypo Real Estate, Iceland has to nationalize its major banks and seek help from the IMF and Ireland also has to act to save its banking system.

 

October 2008: with the crisis getting even worse, Paulson changed his strategy from one of purchasing toxic assets to one of direct government investments; financial crisis spreads to Asia, Latin America, Eastern Europe and Africa.

 

October 6, 2008: The Fed doubles the size of its planned loans, creates new special-purpose vehicle for buying commercial paper and begins to pay interest on bank reserves.

 

October 8, 2008: PM Brown announces a major rescue plan for Britain’s large banks.

 

October 12, 2008: Wells Fargo takes over Wachovia.

 

October 29, 2008: The Fed lends $30 billion to the central banks of Brazil, Mexico, South Korea and Singapore.

 

November 2008: In the weeks following the election Paulson arranges a further bailout of the teetering Citigroup injecting a further $20 billion to bring the lending up to $45 billion; Citi begins the spinning off of its nonbank components.

 

January 16, 2009: After complaints by BOA CEO Ken Lewis a plan was put into effect to give BOA $20 billion from TARP to protect it from possible losses on $118 billion of Merrill’s toxic assets.

 

 

---

[1] Homer and Sylla, A History of Interest Rates, p. 47.

[2] Macdonald, A Free Nation Deep in Debt, p. 128.

[3] Bookstaber, A Demon of Our Own Design, pp. 175-76.

[4] Ibid, p. 177.

[5] Ashton, The Industrial Revolution, p. 72.

[6] North, Economic Growth of the United States 1790-1860, pp. 201-202.

[7] Ashton, The Industrial Revolution, p, 72.

[8] Ratner, Soltow and Sylla, Evolution of the American Economy, pp. 364-65.

[9] Myers, A Financial History of the United States, pp. 306-7.

[10] Ibid, pp. 312-13.

[11] Homer and Sylla, A History of Interest Rates, p. 379

[12] Samuelson, The Great Inflation and its Aftermath, p. 50.

[13] Homer and Sylla, A History of Interest Rates, pp. 419-24.

[14] Van Overtveldt, Bernanke’s Test, p. 223.

[15] Ibid, pp. 52-3.

[16] Gasparino, The Sellout, p. 60.

[17] Van Overtveldt, Bernanke’s Test, p. 82.

[18] Geisst, Wheels of Fortune. p. 268.

[19] Bookstaber, A Demon of Our Own Design, p. 31.

[20] Kaufman, Interest Rates, the Markets and the New Financial World, p. 46.

[21] Samuelson, The Great Inflation and its Aftermath, p. 197.

[22] Geisst, Wheels of Fortune, p. 299.

[23] Ibid, p. 303.

[24] See previous chapter: Movers, Shakers and Regulators for the role of regulators, BIS guidelines and ‘fat tails’.

[25] Ha-Joon Chang and Chul-Gyue Yoo, The Triumph of the Rentiers? in Eatwell and Taylor, International Capital Markets, p. 370.

[26] Bookstaber, A Demon of Our Own Design, pp. 144-45.

[27] Ibid, p. 172.

[28] Ibid, p. 5.

[29] Samuelson, The Great Inflation and its Aftermath, pp. 205-6.

[30] Sperry, The Great American Bank Robbery, p. 203.

[31] Sperry, The Great American Bank Robbery, p. 194.

[32] Ibid, pp. 190-95.

[33] Federal Reserve Bank of Boston, “Closing The Gap: A Guide To Equal Opportunity Lending”, http://www.bos.frb.org/commdev/closing-the-gap/closingt.pdf, p. 6.

[34] Ibid, pp. 7-24.

[35] Raphael Bostic, “The Role of Race in Mortgage Lending: Revisiting the Boston Fed Study”, Federal Reserve Board of Governors, December, 1996.

[36] Theodore Day and Stan Liebowitz, “Mortgage Lending to Minorities: Where's The Bias?” Economic Inquiry, January 1998, pp. 1-7.

[37] Ibid, pp. 32-33.

[38] Ibid, pp. 33-34.

[39] Robert Cotterman, “New Evidence on the Relationship Between Race and Mortgage Default: The Importance of Credit History Data”, Unicon Research Corporation. May 23, 2002.

[40] Day and Liebowitz, p. 25.

[41] Gasparino, The Sellout, p. 414.

[42] Sperry, The Great American Bank Robbery, p. 57.

[43] Day and Liebowitz, p. 25.

[44] Wayne Barrett, “How the youngest Housing and Urban Development secretary in history gave birth to the mortgage crisis”, August 5, 2008.

[45] Sperry, The Great American Bank Robbery, pp. 21-38.

[46] Ibid, p. 22.

[47] Ibid, pp. 105-6.

[48] Ibid, pp. 176-7.

[49] Ibid, p. 135.

[50] Ibid, p. 11.

[51] Barrett, “How the youngest Housing and Urban Development secretary in history gave birth to the mortgage crisis”.

[52] Steve Sailer, “The Minority Mortgage Meltdown (cont.): Charting The CRA Crackup”, February 15, 2009.

[53] Sperry, The Great American Bank Robbery, p. 182.

[54] Susan Schmidt and Maurice Tamman, "Housing Push for Hispanics Spawns Wave of Foreclosures", Wall Street Journal, January 4, 2009.

[55] Steve Sailer, “Karl Rove—Architect Of The Minority Mortgage Meltdown”, September 28, 2008.

[56] Sperry, The Great American Bank Robbery, p. 228.

[57] Schmidt and Tamman, "Housing Push for Hispanics Spawns Wave of Foreclosures".

[58] Elizabeth Laderman and Carolina Reid, “Lending in Low- and Moderate-Income Neighborhoods in California: The Performance of CRA Lending During the Subprime Meltdown”, Federal Reserve Bank of San Francisco, November 26, 2008, pp. 12-14.

[59] Thomas DiLorenzo, “The Government-Created Subprime Mortgage Meltdown”, http://www.lewrockwell.com/dilorenzo/dilorenzo125.html.

[60] Schmidt and Tamman, "Housing Push for Hispanics Spawns Wave of Foreclosures".

[61] Sailer, “Karl Rove—Architect Of The Minority Mortgage Meltdown”.

[62] Rubenstein, “What Price Mass Immigration?”, p. 131.

[63] Ibid, p. 132.

[64] Ibid, p. 133.

[65] Arnold Ahlert, Housing Market Outrage, August 30, 2011, http://frontpagemag.com/2011/08/30/.

[66] Sperry, The Great American Bank Robbery, p. 86.

[67] Ibid, p. 191.

[68] Van Overtveldt, Bernanke’s Test, p. 228.

[69] Livingston, Money and Capital Markets, p. 328.

[70] Van Overtveldt, Bernanke’s Test, p. 229.

[71] Kaufman, Interest Rates, the Markets and the New Financial World, p. 89.

[72] Lewis, The Big Short, p. 49.

[73] Ibid, p. 73.

[74] Ibid, pp. 76-77.

[75] Ibid, p. 74.

[76] Salih Neftci, Synthetic Assets, Risk Management, and Imperfection in Eatwell and Taylor, International Capital Markets, pp. 443-45.

[77 Karl Case and Robert Shiller, “Mortgage Default Risk and Real Estate Prices” in Journal of Housing Research 1996, p. 244.

[78] Ibid, pp. 248-49.

[79] Scott Page, Understanding Complexity, The Teaching Company, pp. 39-43.

[80] “Introduction” in Financial Derivatives, Federal Reserve Bank of Atlanta, p. xii.

[81] Van Overtveldt, Bernanke’s Test, p. 243.

[82] Lewis, The Big Short, p. 80.

[83] Van Overtveldt, Bernanke’s Test, p. 93.

[84] Ibid, p. 95.

[85] Lewis, The Big Short, pp. 97 -98.

[86] Ibid, pp. 99-100.

[87] Van Overtveldt, Bernanke’s Test, pp. 152-53

[88] Ibid, p. 91.

[89] Sperry, The Great American Bank Robbery, p. 15.

[90] Tait Trussell,  “Paying for Greed”,  Feb 7th, 2011,

 http://frontpagemag.com/2011/02/07/paying-for-greed/

[91] Lewis, The Big Short, pp. 98-101.

[92] Matt Taibbi “The People vs. Goldman Sachs” Rolling Stone, May 26, 2011.

[93] Gasparino, The Sellout, p. 199.

[94] Taibbi “The People vs. Goldman Sachs”

[95] Gasparino, The Sellout, p. 239.

[96] Lewis, The Big Short, p. 104.

[97] Ibid, pp. 206-218.

[98] Ibid, p. 177.

[99] Ibid, p. 194.

[100] Gasparino, The Sellout,  p. 321.

[101] Ibid, p. 307.

[102] Ibid, p. 412.

[103] Ibid, p. 457.

[104] Ibid, p. 466.

[105] Ibid, p. 442.

[106] Ibid, p. 411.

[107] Ibid, p. 461.

[108] Lewis, The Big Short, p. 260.

[109] Gasparino, The Sellout, p. 482.

[110] Lewis, The Big Short, p. 260.

[111] William Black,  “Why CEOs Avoided Getting Busted in Meltdown” May 10, 2011,

Bloomberg Opinion.

[112] Sperry, The Great American Bank Robbery, pp. 25-42.

[113] Arnold Ahlert , “Back in the Sub-Prime Mortgage Habit” July 13, 2011, FrontPageMag.com.

[114] Sperry, The Great American Bank Robbery, p. 208.

[115] Jia Lynn Yang, Neil Irwin and David S. Hilzenrath, “Fed aid in financial crisis went beyond U.S. banks to industry, foreign firms” http://www.washingtonpost.com, Thursday, December 2, 2010.

[116] Arnold Ahlert , “A Bailout Monstrosity” November 29, 2011,

http://frontpagemag.com/2011/11/29/a-bailout-monstrosity/

[117] Ibid

[118] Ibid

[119] Gasparino, The Sellout, p. 497.

[120] By Mark Duell, “Who 'made $10bn on 10/1 bet that U.S. credit rating would be downgraded'?” August 9, 2011

http://www.dailymail.co.uk/news/article-2023809/Did-George-Soros-win-10-1-return-S-Ps-US-credit-rating-downgrade.html#ixzz1UXw4Cwxw.

[121] Sperry, The Great American Bank Robbery, p. 234.

[122] Arnold Ahlert, “Lessons from the Economic Wreck-covery”, frontpagemag.com, July 12, 2011.

[123] William Greider, “Fixing the Fed”, The Nation, March 30, 2009.

[124] Kaufman, Interest Rates, the Markets and the New Financial World, pp. 48-60.

[125] Eatwell and Taylor, “A World Financial Authority” in Eatwell and Taylor, International Capital Markets, p. 20.

[126] William Greider, “Fixing the Fed”, p. 21.

[127] Sperry, The Great American Bank Robbery, pp. 213-22.

[128] Van Overtveldt, Bernanke’s Test, pp. 244-45.

[129] Nicole Gelinas, “Americans Should Fear Dodd-Frank, Not Free Markets” Investor’s Business Daily, December 13, 2011.

[130] Ibid

[131] “Cumulative Weight of New Regulations Rests Heavily On Community Banks and their Communities”, http://www.aba.com/aba/documents/DFA/DFA_CBBurden_072111.pdf, July 2011

[132] Gasparino, Bought and Paid For, p. 227.

[133] Arnold Ahlert, “Obama’s Regulatory Cliff Draws Near”, http://frontpagemag.com, December 27, 2012.

[134] Gelinas, “Americans Should Fear Dodd-Frank, Not Free Markets”.

[135] Charles Gasparino, “How Wall St. 'fixes' kill jobs”, New York Post, September 14, 2011.

[136] Sperry, The Great American Bank Robbery, pp. 98-103.

[137] Ibid, p. 99.

[138] http://banking.senate.gov/public//_files/070110_ Dodd_Frank_Wall_Street_Reform

      _comprehensive_summary_Final.pdf. and http://www.aba.com/RegReform/RR_ExecSummary.htm.

 [139] http://www.aba.com/RegReform/RR_ExecSummary.htm, Dodd-Frank Wall Street Reform and Consumer Protection Act, Executive Summary.