Inside Job

by Charles Ferguson

  By the summer of 1987, stock indices had racked up years of spectacular gains, signs of a bubble were everywhere, and institutional managers were nervous. But financial innovation was there to help, with a marvellous new product called “portfolio insurance”. The idea was this: if a fund manager was worried that the market would fall, he could limit his losses by selling stock-index futures (a form of financial derivative). If the market suddenly plunged, losses would be covered by the futures you sold.

  Executing such a strategy was impossible for a mere human being, but two University of California at Berkeley finance professors, Hayne Leland and Mark Rubinstein, developed software that would trade automatically. A portfolio manager could pick a desired price floor, and the computers took it from there. Futures selling would be minimal if the portfolio was performing well, but would accelerate as markets fell. Fund managers loved the idea; by the autumn of 1987 some $100 billion of stock portfolios were “insured”, and the professors had made a fortune.

  There was just one little problem. If this strategy was generally adopted, it would have exactly the opposite effect from the one intended, because any substantial market fall would automatically generate a huge burst of futures selling. And a sudden wave of selling in the futures market would almost surely trigger panicky selling in the stock market—which could trigger more futures selling, and so on.

  And that’s more or less what happened. The effect was worsened by the fact that the stock market was in New York while the futures market was in Chicago, and the computer links between them were extremely primitive.

  It started on Wednesday, 14 October 1987, but the real carnage hit on the following Monday, 19 October, forever dubbed Black Monday. The stock market fell 23 percent, the largest one-day percentage drop in history.6 The markets eventually stabilized, with the help of a flood of new money from Alan Greenspan’s Federal Reserve—one of the first appearances of what Wall Street came to call the “Greenspan Put”. Get into whatever trouble you may, Uncle Alan will bail you out.

  The episode was a clear warning of the inherent dangers of financial “innovation”. Professors Leland and Rubinstein were obviously extremely clever men, as were the bankers using their tools. Some of them had to know that if enough people were using this “insurance”, any sizeable downturn would trigger large-scale selling and thereby cause the very event they were supposedly trying to prevent. Credit default swaps and other financial derivatives often carry similar risks. Their use therefore requires regulation—particularly disclosure of positions to a regulator who can look across the whole market, and limitations on the total level of risk. But derivatives were too profitable for Wall Street, which instead pushed in precisely the opposite direction.

  Deregulation Triumphant: The Clinton Administration

  THE 1990S WERE, it turns out, the best of times and the worst of times. The economic outlook entering the 1990s was extremely gloomy. In the late 1980s the LBO-takeover–stock market bubble deflated, and long-term economic problems began to bite, once again.

  But in the end, America’s economic performance in the 1990s was superb. The reason was the Internet revolution, together with venture capital and start-up systems. Starting with the invention of the World Wide Web in 1990, Internet-based innovation and entrepreneurship generated sharply higher economy-wide productivity growth for the first time since the 1960s. Even though the Internet was globally available and the World Wide Web had been invented in Europe, America spawned every major Internet company—Amazon, eBay, Yahoo, Google, Craigslist, Facebook—and thousands of smaller ones. Clinton administration policy helped by privatizing the Internet in 1995, reforming parts of the telecommunications sector, and taking antitrust action against Microsoft.

  At the same time, however, the Clinton government created the regulatory environment that gave us the financial bubble and crisis of the 2000s. As president, Bill Clinton let the financial sector run wild. Economic and regulatory policy was taken over by the industry’s designated drivers—Robert Rubin, Larry Summers, and Alan Greenspan. It was during this period that America’s financial sector assumed its current form—highly concentrated, sometimes criminal, and systemically dangerous. Its growing fraudulence even affected the Internet industry, via a stock market bubble that Wall Street deliberately inflated. The pervasive level of fraud in “dot-com” stocks was nakedly obvious to everyone in the industry (including, at that time, me), but the Clinton government did nothing about it. For the first time, investment bankers were given clear signals that they could behave as they wished.

  Equally dangerous, however, were several other developments in the US financial sector during the 1990s. The first was far-reaching deregulation, in both law and practice, championed by the Clinton government, Congress, and the Federal Reserve. The second was the structural concentration of the industry, much of which would have been illegal without the deregulatory measures. With astonishing speed, the financial sector’s major components—commercial banking, investment banking, brokerage, trading, rating, securities insurance, derivatives—consolidated sharply into tight oligopolies of gigantic firms, which often cooperated with each other, particularly in lobbying and politics.

  The third change in the industry was the rise of the “securitization food chain”, an elaborate industrywide supply chain for generating mortgages, selling them to investment banks, and packaging them into “structured” investments for sale to pension funds, hedge funds, and other institutional investors. The result was an extremely complex, opaque process that integrated nearly every segment of the financial system.

  The fourth change in financial services was growth in unregulated, “innovative” financial instruments. Once again enabled by continued deregulation, the industry invented clever new things like credit default swaps, collateralized debt obligations, and “synthetic” mortgage securities.

  In principle, these changes created major efficiencies; but they also made the entire system more fragile, interdependent, and extremely vulnerable to both fraud and systemic crises.

  But the final change in the financial sector was the most fatal. By the end of the 1990s, at every level of the system and at every step in the securitization food chain, all of the players—from lenders to investment banks to rating agencies to pension funds, from mortgage brokers to traders to fund managers to CEOs to boards of directors—were compensated heavily in cash, based on short-term gains (often as short as the last transaction), with built-in conflicts of interest, and with no penalties for causing losses. Almost nobody was risking their own money. In short, nobody had an incentive to behave ethically and prudently. By the time George W. Bush took office, the explosives had been planted; all it took was for someone to light the fuse.

  Taming Mortgages but Creating a Monster

  IT ALL BEGAN with a clever, sane idea: the mortgage-backed security. In order to allow S&Ls to lend more money, banks could buy mortgages from S&Ls—which would give the S&Ls immediate cash—and then the bank would package the mortgages into securities, which it would sell to investors.

  In 1983 Larry Fink and his investment banking team at First Boston invented the CMO, or collateralized mortgage obligation. (Fink is now CEO of BlackRock, the big investment manager.) Fink’s innovation was that his CMOs were sliced into several distinct classes, or “tranches”, with different credit ratings and yields. The top tranche had first claim on cash flows from the mortgages, while the bottom tranche absorbed the brunt of prepayment and default risk.

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

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

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

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

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

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

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

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

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

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

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

  The Next Wave of Financial Deregulation

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

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

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

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

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

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

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

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

  Had the failure of LTCM triggered seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own.11

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