Greed, Lack of Transparency Caused Financial Crisis, Says Greenberger
WASHINGTON—The U.S. economy is slowly making a recovering from a near-collapse and the worst recession since the Great Depression.
But what brought on the subprime mortgage crisis that led to huge financial losses, a decline in wealth for much of the country, a GDP drop of 5 percent for the period from Dec. 2007 to June 2009, and an official unemployment rate that peaked at 10.0 percent in Oct. 2009?
“Very few people understand [what happened],” said University of Maryland Professor Michael Greenberger at the Center for National Policy on Nov. 1. “I firmly believe that the president of the United States doesn’t understand. They don’t understand what went wrong.”
In layman’s terms, Greenberger attempted to explain the essence of how the near collapse of our financial system came about. It’s a story involving new complex financial creations that mask the risks that investors take. The story is also about the role of the federal government—that is, the taxpayers—in rescuing the banks, and the story is ultimately about “criminal” behavior that has eluded prosecution, says Greenberger.
Since 2001, Greenberger has been a professor of the Maryland School of Law. He has frequently been asked to testify before Congressional committees related to financial markets and complex and unregulated financial derivatives. He was director of the Division of Trading and Markets at the Commodity Futures Trading Commission (CFTC), where he served under Chairperson Brooksley Born.
Greenberger was Born’s chief of staff in the late 1990s when they encountered fierce opposition to regulating the multi-trillion-dollar over-the-counter (OTC) derivatives markets whose crash later would be a major factor in bringing on the financial crisis. They wanted these derivatives traded transparently with adequate capital reserves and overseen by a regulator to prevent fraud and manipulation. Bill Clinton’s senior economic policy advisers—Treasury Secretary Robert Rubin, his deputy Lawrence Summers, Fed Chairman Alan Greenspan, and Security Exchange Commission Chairman Arthur Levitt offered vitriolic criticism of Born and the CFTC. Also, the titans in the financial industry and many in Congress were adamantly opposed. Born and Greenberger lost that battle but after the financial meltdown in 2008, the need for regulation and transparency of the derivatives market could not be denied.
$12,000 annual income, $729,000 mortgage
Greenberger began with an illustration which anyone could understand, taken from Michael Lewis’ book, “The Big Short,” about a cherry picker, with an annual salary of $12,000, who actually signed up for a $729,000 mortgage. How could such a thing happen?
There was lots of fraud, robo-signed contracts, and “lying loans,” Greenberger said. Then these mortgages were pooled together as mortgage backed securities.
“[The banks] made these loans that are ridiculous loans—’liar loans’—and immediately they get them off their books and sell them off to another bunch of investors to buy a share in these mortgage backed securities. But it was too easy for those investors to see that they were buying a share in something that said that a cherry picker earning $12,000 a year would pay back a $729,000 mortgage,” said Greenberger.
“So on a nationwide basis they took many more of these mortgage backed securities and packaged them into something called collateralized debt obligation (CDO).” It was made nationwide to give an investor the impression of less risk similar to when one diversifies one’s portfolio.The idea is that the housing market might collapse, say, in Michigan but it was deemed safe that it would continue to rise in Florida or Nevada where it was booming. Of course, that assumption turned out wrong and the entire U.S. housing market bubble burst and collapsed virtually everywhere.
Then the creators of these investments devices divided the investment into pieces, called tranches, which are different levels of risk and interest rates. One can think of the instrument as analogous to investing in various floors of a beach house. The basement which has the greatest likelihood of flooding would be dubbed the high risk investment and would pay out the most in interest. The other extreme would be the “top floor” which was the safest from flooding and would pay less interest.
Economist Mark Zandi wrote about CDOs in his book “Financial Shock,” “First and foremost, the risks inherent in mortgage lending became so widely dispersed that no one was forced to worry about the quality of any single loan.” Zandi adds, “As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility was undermined.”
Next, the people who devised these CDOs went to the credit rating agencies, and paid them to rate the various tranches. The “basement” might get BB- rating while the “top floor” would receive a AAA rating on the theory that the top floor will never be flooded.
“So now you have masked the mortgage to a mortgaged backed security into a collateralized debt obligation, and then you got the further mask of the credit agencies Standard and Poor’s and Moody’s are telling us that these are triple A ratings,” said Greenberger, who is convinced that the rating agencies were paid off.
At the time this happened there were only seven public corporations in the United States that had AAA rating, but there were thousands of these tranches that got AAA rated, Greenberger noted. And nobody is investigating what’s behind these AAA ratings, and that behind them is an investment of whether a cherry picker can pay a $729,000 mortgage.
The plot thickens then when Hank Paulson, CEO of Goldman Sachs (and later Treasury Secretary), who made CDOs a big part of the firm’s business, could see that these investments were going to fail, said Greenberger. He wasn’t alone; others could see the same thing. Just by looking at the percent of mortgage defaults, one could see that the beach house was flooded.
Paulson then asked to buy insurance on some of the tranches that looked like bad bets. Wanting to make a profit on these investments, they devised what are called synthetic CDOs, to bet that the investments would lose value. So, without even owning the tranches, Paulson and many others like him paid one and half to two cents on the dollar as a premium, while the givers of insurance risked 100 cents on the dollar, he says.
Because the law didn’t require the givers of insurance to set aside a capital reserve to cover the debts, we, the taxpayers, ended up paying for the collapse of this market. For example, AIG, a multinational insurance corporation, needed a $185 billion bailout.
“When you generous taxpayers bought AIG, you weren’t really helping the people of AIG, you were really helping the people who bet with AIG,” Greenberger said.
The leading firm who collected on the bets was Goldman Sachs, said Greenberger, who believes they collected $7 billion on this matter.
To compound matters, betting on the tranches was not just a matter of paying the debt once. Greenberger said that the Financial Crisis Inquiry Commission investigations found that certain tranches were bet on nine times to fail.
“That means every time someone didn’t pay their mortgage, the consequences in the real economy were multiplied nine times. If you didn’t have the gambling refusal to pay, you would only had the real losses which would have been dramatically less than the betting losses, and the subprime meltdown would have been much, much less, and probably much easier to rebound from.”
Greenberger faulted the Obama administration for regarding these practices as “immoral, unethical, and reckless,” but won’t go so far as to say they were criminal. No one has been indicted as happened during the Savings and Loan crisis, he says, when 400 were.
At the bottom of these practices is one of ethical conduct.
Greg Smith worked at Goldman Sachs. In March he wrote an Op-Ed in the New York Times that said that the company was “ripping their clients off.” His new book, “Why I Left Goldman Sachs: A Wall Street Story,” was recently released.
He wrote in the Op-Ed, “I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them. If you were an alien from Mars and sat in on one of these meetings, you would believe that a client’s success or progress was not part of the thought process at all.”
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