Inside Job

by Charles Ferguson

  Nothing changed Greenspan’s mind. In 2003, at a Chicago investment conference, he said:

  Critics of derivatives often raise the specter of the failure of one dealer imposing debilitating losses on its counterparties, including other dealers, yielding a chain of defaults. However, derivative markets participants seem keenly aware of the counterparty credit risks associated with derivatives and take various measures to mitigate those risks.12

  After the global financial crisis, the collapse of AIG, and at least $10 trillion in losses, Greenspan finally, barely, admitted that there had been “a flaw” in his model.13

  The Clinton administration also exhibited increasing nakedness in revolving-door hiring. Robert Rubin came to the Clinton administration from Goldman Sachs, and upon resigning as Treasury secretary in 1999, became vice chairman of Citigroup, whose mergers had been legalized by legislation that he had supported. Laura Tyson, chair of the National Economic Council, joined the board of Morgan Stanley shortly after leaving the administration. Tom Donilon, the chief of staff of the US State Department, became the chief lobbyist of Fannie Mae shortly after his departure. Franklin Raines, head of the Office of Management and Budget, became CEO of Fannie Mae, where he became deeply embroiled in its accounting frauds. Michael Froman and David Lipton, two senior economic policy analysts, went to Citigroup. After serving as Clinton’s final Treasury secretary, Larry Summers became president of Harvard University, while consulting for a major hedge fund, Taconic Capital. After two no-confidence votes from his faculty, Summers was forced to resign as president of Harvard, at which point he joined another, larger hedge fund, D. E. Shaw, and began giving speeches to financial institutions that made him millions of dollars per year.

  Structural Consolidation

  IN PART ENABLED by deregulation, in part driven by technological change and the increasing capital intensity of highly computerized operations, and in part to seek greater profits derived from market power, the financial sector consolidated sharply in the 1990s. This consolidation was both horizontal and vertical, and was so extreme that the financial sector of 2000 was completely unlike that of thirty years before. The only industry segments that remained somewhat fragmented were also largely unregulated—hedge funds that managed money for the wealthy, venture capital, and, fatefully, the new mortgage lenders in the shadow banking system.

  Between 1960 and 2000, the combined capitalization of the ten largest investment banks in the US (of which the largest five dominated the industry) had grown from $1 billion to $179 billion. Employment by the largest five had quadrupled since 1980 to 205,000 in 2000. This structural consolidation was not confined to investment banking; it affected every segment of the financial sector and reached across segments via the creation of enormous financial conglomerates. And the main source of this broader consolidation was not the organic growth of the successful; rather, it was mergers.

  In 1997 Morgan Stanley merged with Dean Witter, one of the largest remaining retail brokerage firms. In 1998 Nationsbank acquired Bank of America, at that time the largest bank merger in history. In the same year, however, Citigroup acquired Travelers, which was itself the result of many mergers and acquisitions, including Travelers Insurance, Primerica, and the investment banks Salomon Brothers, Shearson Lehman, and Smith Barney. This created the largest financial services firm in the world. As mentioned earlier, the merger violated the Glass-Steagall Act, and when Glass-Steagall was repealed the following year, the new law was sometimes derisively called the Citigroup Relief Act. Then in 2000, JPMorgan merged with Chase Manhattan to form JPMorgan Chase, which as of 2011 is the world’s largest financial services firm. Dozens of smaller investment banks, commercial banks, brokerages, insurance companies, and other specialized firms also merged with or were acquired by the large financial conglomerates and leading investment banks. Even the mutual fund industry consolidated; in 2000, for example, Alliance Capital acquired Sanford Bernstein, resulting in a combined entity that managed $470 billion.

  By the time George W. Bush took office, every major industry segment and financial market was dominated by an oligopoly of large firms. By 2000 investment banking was dominated by five firms: Merrill Lynch, Goldman Sachs, Morgan Stanley, Lehman Brothers, and Bear Stearns. Most other investment banking activity was housed in the investment banking subsidiaries of enormous financial conglomerates—the three Americans (Citigroup, JPMorgan Chase, and Bank of America), plus a few Europeans such as Deutsche Bank, UBS, and Credit Suisse. Securities insurance was dominated by two monoline firms, MBIA and Ambac, plus AIG, the world’s largest insurance company. Securities rating was dominated by three firms (Moody’s, Standard & Poor’s, and Fitch); Moody’s alone held about 40 percent of the total market. By 2000 five accounting firms dominated the market for corporate auditing. (After the collapse of Enron led to the prosecution and dissolution of Arthur Andersen, five became four.) Five banks, led by JPMorgan Chase and Goldman Sachs, controlled 90 percent of all global derivatives trading. The consumer credit card market was overwhelmingly dominated by Visa, MasterCard, and American Express. NationsBank/Bank of America, Citigroup, and JPMorgan Chase dominated interstate banking. Asset management was increasingly dominated by large firms as well—Fidelity, Vanguard, Alliance Capital, BlackRock, Pimco, Putnam, and a handful of others. (These are enormous firms; in 2011, BlackRock managed $3.6 trillion; Fidelity managed $1.5 trillion.)

  Not only was the financial sector highly concentrated, but it was increasingly collusive. The major firms did compete with one another, but they also cooperated extensively—in business, for example, through securities syndication, but also in lobbying and political action through industry associations, and through shared use of lobbying firms, law firms, and academic experts.

  Incentives

  THE LAST MAJOR development in financial services during the 1990s was its progressive internal corruption. By the time the Bush administration took office, incentives had turned pervasively toxic.

  Although the details varied by industry segment and individual profession, the direction was remarkably consistent. Prior to 1971 only private partnerships were allowed to join the New York Stock Exchange, ensuring that investment banks and bankers had the long time horizons and caution associated with partnership money that could only be withdrawn upon retirement. But in 1971 the New York Stock Exchange changed the rule, investment banks started going public, and bankers’ incentives started to shift towards annual bonuses and stock options. In principle, it would have been possible to replicate the earlier incentives; for example, by having very long vesting and holding periods for stock. But this was never done, and by 2000 the majority of investment banking compensation was in annual bonuses, mostly cash. Even the stock options rarely required more than five years’ vesting. Equally important, the former requirement that senior bankers place the majority of their own money at risk was abandoned.

  Several major developments corrupted the structural incentives of firms relative to their customers. One major factor was the securitization food chain. Mortgage lenders no longer needed to care about whether mortgages would be repaid, because they sold them almost instantly to investment banks, which in turn sold them to various structured investment vehicles or to suckers (i.e., customers). In order to generate loans with higher sales prices, the lenders started paying mortgage brokers “yield spread premiums”, which were effectively bribes for pushing borrowers into the most expensive loans possible.

  The investment banks didn’t care about selling trash to their customers for several reasons. First, the former model of relationship banking was largely gone. Second, fee structures carried no penalties for selling junk; the banks and bankers didn’t share in any subsequent customer losses. Third, bankers’ compensation was overwhelmingly dominated by annual bonuses, which were driven by that year’s transaction revenues, so traders and salesmen didn’t care what happened later.

  The ratings process was corrupted by the shift from buyer to issuer payment, by pe
rsonnel turnover, and by the rise of ratings “consulting”. As late as the 1970s, rating agencies were paid by the buyers of the securities they rated, not by the investment banks that created and sold the securities. But that started to change, and by 2000 all three of the major rating agencies were paid to rate new securities almost entirely by the large investment banks that issued them. Since there were only a handful of these issuers, the rating agencies were very cooperative. But conflicts of interest went even further. The rating agencies also rated the debt of the banks themselves, a crucial indicator of the banks’ stability. But since downgrading a bank would, again, infuriate a major customer, it was never done. Indeed, the rating agencies started consulting to the banks, receiving huge fees for advising how to construct a security such that it would receive a high rating. At the individual level, things were even ickier. Rating agencies paid substantially less than investment banks, so employees of rating agencies tried hard to please the bankers they dealt with, in hopes of getting a job at the bank. Many did.

  The securities insurance companies, especially AIG Financial Products, compensated their employees just like investment bankersannual cash bonuses based on the year’s transactions. So, again, they had every incentive to sell insurance, either literal insurance or credit default swaps, in order to get their bonuses. Losses five years later would be the company’s problem.

  Incentives among the ultimate buyers of securities were dangerous as well. In the case of hedge funds, compensation at the firm level was so-called 2 and 20: clients were charged fees of 2 percent per year of assets managed, and the fund kept 20 percent of all gains, computed annually. However, the fund did not participate in losses, so fund managers were incented to take risks. The same was true, to a lesser extent, of other larger institutional investors such as pension funds and mutual funds. They too were compensated annually based on performance, and they too were rewarded for gains but not punished for losses. This incented them to “reach for yield”, and made them far less attentive to long-term risks. For example, they started to trust ratings uncritically, rather than examine risks independently.

  And finally, there were the external incentives supplied by the regulatory and policy environment. It was the Clinton administration that first signalled, decisively, that it was suspending enforcement of the law when it came to the financial sector and even to individuals with substantial financial assets. In addition to supporting legislation—such as the repeal of Glass-Steagall—that permitted previously illegal activities, the government stopped enforcing the laws that existed. When Alan Greenspan refused to issue mortgage regulations under HOEPA, nobody complained. When the Internet bubble spawned huge amounts of extremely obvious fraud, nobody investigated and nobody was prosecuted. America was now an open city.

  And then George W. Bush became president. He was not elected, and to a significant extent the American people therefore cannot be blamed for what happened afterwards. Bush lost by over 500,000 votes, and almost certainly lost the state of Florida, so he should have lost the electoral college as well. But through a well-orchestrated public relations and legal campaign, a Florida recount was avoided and the Supreme Court handed George W. Bush the White House by a 5 to 4 decision.

  With the changes of the 1990s, the conditions for a financial disaster were fully in place. Bush’s ascent to the presidency was just the final nail in the coffin.

  CHAPTER 3

  * * *

  THE BUBBLE, PART ONE: BORROWING AND LENDING IN THE 2000s

  THE DOT-COM STOCK MARKET bubble peaked in the winter of 2000. Its inevitable collapse was worsened by the 9/11 terrorist attacks; and yet the resulting recession was short and mild. There were two reasons for this.

  First, the Bush administration embarked on a campaign of massive deficit spending. The government employed tax cuts, particularly for the wealthy, and sharply higher spending, particularly for the military—for the war in Afghanistan, the invasion and occupation of Iraq, and counterterrorism and intelligence efforts. And second, Federal Reserve chairman Alan Greenspan aggressively reduced interest rates. Greenspan cut rates from 6.5 percent at the peak of the Internet bubble all the way down to 1 percent by July 2003, the lowest in fifty years.1

  The recovery, however, was an anaemic one, even if you took it at face value. And the real problem was that you couldn’t take it at face value. What followed, in fact, was a remarkable alliance of financial sector greed and political calculation. The recovery of the 2000s was fake, driven almost entirely by unsustainable behaviour: massive tax cuts and national deficits, the housing bubble, and consumer spending enabled only by borrowing. While the real economy did continue to benefit from Internet-driven productivity gains, the US was simultaneously falling behind many other nations in the underlying educational, infrastructural, and systemic determinants of national competitiveness. America’s manufacturing sector was quietly decimated. Moreover, most of the benefits of America’s productivity gains were now appropriated by the top 1 percent of the population, not by the broader workforce—a major change from prior generations. As a result, during the 2000s, even during the bubble, real wage levels for average Americans stagnated or fell, and on a net basis very few jobs were created. Gains from the fake economy and the (real) Internet revolution were offset by massive job losses both in manufacturing (including information technology products) and in services functions susceptible to outsourcing or automation.

  A Marriage of Convenience Produces a Bubble

  GIVEN THESE STRUCTURAL problems, a fake recovery driven by a financial bubble was very politically convenient. Most of the growth in consumer spending during the 2000s was driven by the bubble. As house prices rose, homeowners could borrow more against the supposedly higher value of their homes; and by spending the proceeds of their borrowing, they both pumped up the general economy and also perpetuated the housing bubble itself, as borrowed cash was used to finance further home purchases (for second homes, rental properties, etc.).

  In fact, much of the 2000s-era subprime lending wasn’t about increasing home ownership at all. Fewer than 10 percent of subprime loans financed a first home purchase.2 Many subprime loans issued during the bubble were devices to take money out of a home, to refinance a prior mortgage, or to buy a second home. Some of the loans were for personal consumption (televisions, holidays, cars, home improvements); some were for trading up to a more expensive home; many were speculation driven by the bubble, for the purpose of flipping houses repeatedly; and many more were frauds perpetrated against borrowers, who were tricked into deceptive, overly expensive loans.

  But all of them contributed to the bubble. As a result the CaseShiller US National Home Price Index doubled between 2000 and 2006, the largest and fastest increase in history.3

  Greenspan’s rate cuts undoubtedly helped start the bubble. Most people borrow heavily to buy a house, and the amount of house they can afford is driven by monthly mortgage payments, which in turn are heavily affected by interest rates. As a result of Greenspan’s rate cuts, prime mortgage rates fell by 3 percentage points from 2000 to 2003. Assuming standard fixed-rate mortgage terms, the same monthly debt service that supported a $180,000 home in 2000 would support a $245,000 home in 2003, a 36 percent increase.4 Not surprisingly, between 2000 and 2003, the Case-Shiller US National Home Price Index went up more than a third.5 So, yes, interest rates were relevant. But they don’t even come close to explaining that doubling of housing prices during the bubble, which continued even after US Federal Reserve Chairman Ben Bernanke started raising rates again.

  Over the next four and a half years, from 2003 through mid-2007, America’s financial sector churned out some $3 trillion in often fraudulent mortgage-backed securities (MBSs) and even more exotic, risky, and/or fraudulent derivatives tied to those securities. The home loans underlying these securities were mostly sourced through a new breed of largely unregulated mortgage banks, as well as by several leading commercial banks. Investment banks, some of which were subsidi
aries of the larger banking conglomerates (e.g., JPMorgan Chase, Citigroup, Deutsche Bank), bought these mortgages and packaged them into structured investment products—mortgage-backed securities and collateralized debt obligations (CDOs). These were rated by the evercooperative rating agencies, insured through either the monoline bond insurance companies or AIG’s credit default swaps, and then sold to pension funds, insurance companies, mutual funds, hedge funds, foreign banks, and many others—even, often, to the asset management arms of the same banking conglomerates that had created them.

  More than half of the increase in lending volume during the bubble was accounted for by subprime, Alt-A, Option-ARM, and other highrisk or predatory loans (see Glossary).

  An astonishingly large share of these loans and the resultant securities were defective. The borrowers were people under financial pressure, people who were speculating, people committing fraud, and/or people who were being defrauded (a major category, discussed below). And whatever the reason for the defects in the loans, they were pushed all the way through the securitization chain with no regard for quality control—indeed, with negative quality control, due to intense pressure to find high-yield loans regardless of risk, and to cover up the risks that existed. Some of it was mere sloppiness, but much of it was conscious and deliberate. There was massive fraud. The deception was so enormous and so obvious that senior management frequently must have known, and indeed there is growing evidence that in many cases they approved or even directed it. And if some of them didn’t know, then the enormity of their negligence would be nearly as criminal as pure fraud. It wasn’t subtle, and we shall see it was discussed widely and explicitly within the companies involved. Moreover, there is clear evidence that many CEOs and senior executives lied to their investors, auditors, regulators, and the public, both during the bubble and afterwards, as their firms started to collapse.