It Takes a Pillage: An Epic Tale of Power, Deceit, and Untold Trillions

by Nomi Prins

  The Second Great Bank Depression took out two of the five major investment banks: the 85 year old Bear Stearns in March 2008 and the 158 year old Lehman Brothers six months later.5 A third, Merrill Lynch, survived with $10 billion of government aid (from which it paid out $3.6 billion in bonuses) in a shotgun merger with Bank of America.6 Goldman Sachs and Morgan Stanley avoided the same fate with an even more cunning move—they each got $10 billion of bailout money and overnight permission from the federal government to become “bank holding companies,” which, as we’ll see, is the financial crisis version of a get-out-of-fail free card. Worse, the Second Great Bank Depression led to the very expensive and largely nontransparent $13 trillion bailout of the financial industry, while leaving the banking and investment structures intact.7

  Wait? More than $13 trillion in the bailout? If you thought this bailout was only about a $700 billion thing called the Troubled Asset Relief Program, which is what the banks, the Treasury Department, and the Federal Reserve want you to believe, you really need this book.

  Of course, a few people and firms have paid the price (aside from the American taxpayer).

  Some companies exist no longer. Lehman Brothers, with a record $4 billion in profits, and Bear Stearns, with a record $2.1 billion in 2006, were dead and gone by 2008.8 And a few scapegoats will head to prison, though they did not create the financial system that condones risk and excess, they merely took advantage of it. But rolling a few heads won’t lead to reform.

  Merely focusing our anger on these minor characters in the multi trillion dollar scheme of things is a deflection from the deeper and very legal bilking that Wall Street and Washington accomplished—which involved a great deal more money than Wall Street produced in the lead up to the crisis, generated in a fraction of the time. The bloodlust reserved for Bernard L. “Bernie” Madoff and the other new villains ultimately only serves to cloak larger systemic crimes: specifically, the $13 trillion that the federal government doled out from the Federal Reserve, the Treasury Department, and the Federal Deposit Insurance Corporation (FDIC) to back the biggest players on Wall Street.9

  As you watch these events play out in this book and in real life, you should keep a couple of points in mind. The first is that this bailout was never meant to help consumers. As we’ll see, if the government wanted to get the money to consumers, it could have given them bailout assistance directly, or at least directed it to banks that were eager to give out or renegotiate loans. Second, for all of the money that we threw at the problem, we still got the worst-case scenario: barely solvent and under regulated institutions. This, in a more concentrated playing field, where bigger firms have more control.

  Finally, there’s no way you and I will make it out of this unscathed. If any money is made from the bailout, Wall Street will not let it end up back in the government till.

  I’m writing about some of these bankers that orchestrated expensive life jackets in a sea of their financial debris, because I used to traverse their world. As a managing director at Goldman Sachs, who was responsible for, among other things, the group that provided credit derivatives analytics, and a senior managing director at Bear, Stearns International (R.I.P.) in charge of the group that provided numbers behind all sorts of securitized deals, I had an upfront and global seat for a lot of the internal politics and power plays that drive the external pillaging.

  The acquisition of power comes through the consolidation of money on Wall Street. You need to have a big appetite for power to be truly successful there. I think that when you live outside this world, it’s hard to understand the motivation to act in ways that seem, and often are, so disconnected from reality. As much as their actions are about hoarding money, their strategy is more about consolidating power and influence. Money is a marker. Power is a drug of choice.

  The Causes of the Crisis

  As we get to know these delightful characters and the institutions that they have run into the ground and recapitalized with our money, we will also put together the pieces of the pillage, the specific acts of economic irresponsibility and borderline illegality that got us into this mess.

  We’ll look closer at the full story in later chapters, but for now there are six primary roots of the crisis, each one related to the other and dangerous in its own right:• risky loans that benefitted lenders over borrowers

  • layered securities consisting of complex combinations of those loans

  • the immense amount of borrowing, or leverage, taken on by the financial system using those loans and securities as collateral

  • the greed for money and positioning that propelled Wall Street titans to extract immense bonuses while they bent the ears and filled the pockets of the politicians who changed the rules to enable institutions to become too big to fail

  • the repeal of the Glass Steagall Act of 1933, which had separated financial institutions into commercial banks (consumer oriented) and investment banks (speculative), plus other acts of deregulation that resulted in an inappropriately structured financial system (covering all types of banks, insurance companies, private equity, and hedge funds) monitored by lax regulators who sided more with Wall Street than Main Street

  These are, of course, not the only reasons why some of us won’t be able to retire until sometime in the twenty second century. The financial industry, after all, prides itself on being painfully complex, so there are endless strands to this story—and, more often than not, they are tangled together in a knotty mess. But we can isolate certain strands that have helped along our unraveling, and particular practices and “products” that have combined to create the perfect financial storm.

  The financial hysteria that surfaced in 2008 started with the fall of the housing market and the barrage of foreclosures that followed. But before the fall came the rise. Once Alan Greenspan finished his 2001- 2003 cycle of interest rate cuts from 6.50 to 1.25 percent, money was so cheap that Wall Street was naturally inclined to take advantage.10

  Homeowners, and their mortgages, provided the means to a profitable end, simply because they were convenient targets. Wall Street pushed lenders. Lenders pushed borrowers. That’s how it worked. Don’t let anyone tell you otherwise. If you can borrow at 1 percent and loan it out at 6 or 8 or 13 percent, you can make money. Even the squirrels in my backyard can make money on that play.

  To Wall Street, individual loans were like carbs. When you’re hungry it doesn’t matter whether you eat doughnuts or pizza or fries, you fill up with what you can easily get at that moment. Loans were easy. If Wall Street didn’t want them, they would not have been issued in massive volumes. Their collapse wouldn’t have triggered an economic crisis. The demand was from the top down, never from the bottom up.

  The more Wall Street could package the loans that Americans took out, the more loans could be extended, and the more the Street profited from reselling the packages to investors. Bernie Madoff might be the single individual associated with the most evil scams, but the legal ones of the banking sector, abetted by the government, eclipsed his crimes.

  Lenders started lending a lot to anyone because Wall Street wizards could spin these loans, good or bad, into new packages, or securities, stamped AAA, or “best,” by rating agencies. The agencies fed these securities through mathematical formulas (based on delusion) that pronounced them completely safe. The agencies got hefty fees for these validations. Wall Street then did two things. First, they borrowed heavily against these “safe securities,” because they could. Then they pawned them off to countless investors—from understaffed state pension funds, to savvy hedge funds, to European insurers—who went on and borrowed even more money against them. That insatiable demand required further supply, which spurred mortgage brokers to push loans to buy homes, which couldn’t be built fast enough to satisfy all of the borrowers. Not without major real estate developers overborrowing, which they did, too, as their stocks quadrupled between 2002 and late 2005.11

  The result? National average home prices skyroc
keted.12 The reckoning that followed began in 2006, when the housing boom slowed.13 People were hurting, but Wall Street was rolling in record amounts of dough.

  Meanwhile, the Fed was raising rates to combat inflation, due in large part to rising oil prices.14 This interest rate policy certainly slowed inflation, but it had unintended consequences that led to the Second Great Bank Depression. As rates rose, so did reset values on adjustable rate mortgages, meaning that people had to cough up more money for their monthly mortgage payments. This led to defaults, foreclosures, and opening up the Pandora’s box of reckless Wall Street practices that trashed the economy. Don’t say Alan Greenspan never did anything for you.

  Inflation also meant that borrowing money was no longer cheap. It would be the least of the Fed’s concerns two years later. Rates on loans for citizens, as well as among Wall Street firms, started to rise. The credit that had slicked the wheels of the economy ceased to flow as freely. There was no slack in the system to make up for the devaluing of the assets used as collateral for credit. Eventually, the system came to a halt.

  With credit harder to come by, buying on credit slowed down. As a result, according to the S&P/Case-Schiller index, the period between fall of 2007 and fall of 2008 registered a 16.5 percent (average) drop in prices.15

  The stock market, always a good inverse indicator of the real economic condition of ordinary people, followed along, with a little lag. At first, the market was oblivious to the plateau and the signs of loan and credit problems that began to percolate for homeowners. The Dow and the S&P 500 reached all time highs of 14,164.53 and 1,565.15, respectively, on October 9, 2007, on news that the Fed would make it even cheaper to borrow money and would cut rates.16 Bonuses for Wall Street in 2007 were concurrently very good; it was the second best year ever for the Street, after 2006.17

  But as we learned in physics class, what goes up must come down. Rates rose from 2.28 to 5.24 percent from the beginning of 2005 to the end of 2006.18 Banks started to feel the pressure from these hikes as much as citizens did. Money wasn’t as cheap for them to lend anymore or to borrow in order to leverage assets, so they tried to increase their production of asset backed securities instead. That led to a frenzy of packaging deteriorating loans and the highest production of what would become known as toxic assets.

  Just eighteen months later, indices were flirting with twelve year lows, with the Dow dropping to 6,763.29 by March 3, 2009, a record 52 percent from its high.19

  The economy functions only if people and institutions can borrow money; we can borrow only if we can put something up as collateral—a tangible asset that acts as a guarantee that the money will be paid back. During the housing boom, nearly any type of asset could be used as collateral to concoct securities. From 2002 to 2006, subprime and other risky home loans were the main form of collateral. The restrictions that could have stopped those loans from being used as collateral to create so much systemic debt, which later introduced so much systemic risk, were ripped apart in 2004 through a dangerous Securities and Exchange Commission rules revision.

  Banks soon found numerous off book hiding places to take on debt without holding extra cash against the debt in case things got bad. Entities called structured investment vehicles (SIV), particularly at the large supermarket commercial banks such as Citigroup, became convenient places to conceal the true health of the bank. SIVs became part of the reason Citigroup had more than a trillion dollars of risky assets off its book.20

  When the assets in SIVs stopped producing income, the SIVs started to default and investors pulled out. As Citigroup and others struggled to back their SIVs with money from other areas in the bank—Get it? On book money to fund off book risk?—Treasury Secretary Henry Paulson was eager to help.

  Toward the end of 2007, he wanted to form a $100 billion fund to bail out the banks.21 This ultimately didn’t happen, but it gave way to a much broader, more costly bank bailout, which included the $700 billion Troubled Asset Relief Program (TARP), as part of the Emergency Economic Stabilization Act (EESA) of 2008.22 SIVs weren’t the only off book way of stockpiling risky assets and borrowing money against them. There were variations, but the names aren’t the point.

  The FDIC was in the uncomfortable role of having to back commercial bank deposits (our deposits), no matter what dumb and risky things banks did with those deposits.23 The agency always had transparency concerns about asset backed securities (ABS), a technology developed by Wall Street in the 1980s that bundled bunches of loans and sold bonds that were constructed using the payments from those loans. But the agency caught on way too late that it didn’t quite have its head around the more complex securities packages. “Standardization and transactional transparency for more exotic forms of securitization, such as structured investment vehicles (SIVs) and collateralized debt obligations (CDOs), remains inadequate,” the FDIC admitted in December 2007.24

  The Borrowing Chain

  Like everything else on Wall Street, the credit crisis is based on reincarnating a lucrative financial gimmick from the past, in this case from the 1980s junk bond era. It was Michael Milken who constructed the first CDO in 1987 at the now-extinct investment bank Drexel Burnham Lambert.25 This CDO was basically a security made up of a bunch of junk bonds. In the late 1990s, the same security was stuffed with high yield (a nice name for junk bonds) and emerging market (Latin American, Pan Asian, and Eastern European) bonds. In 2003, the stuffing was subprime loans.

  After Drexel’s bankruptcy and the implosion of the junk bond market, the use of CDOs went dormant for nearly a decade. But the stuffing, slicing, and dicing of any security that contained credit risk—the possibility that a person or a company might default on payments—into another one reemerged as a highly profitable business in the late 1990s. The stuffing was the emerging market and high-yield bonds. The four years from 2002 to 2006 saw a third wave of stuffing using subprime and otherwise risky mortgages. It was leveraging these subprime backed CDOs to the hilt that became a catastrophe.

  In essence, CDOs are fabricated assets, which means that they are concocted from a little bit of reality and a lot of fakery. They are bonds whose value is backed by loans and promises rendered by a chain of interested parties in finance, from rating agencies that rake in fees every time a new CDO is created to insurance and reinsurance companies. Although the idea sounds absurd, we must remember that financial folks are used to dealing with things that often don’t really exist. So a CDO is just a natural extension of the abstractions inherent to finance. In the late 1990s, the fabricated assets consisting of emerging market and high yield bonds paid higher commissions than any other product, which made pushing them very desirable. My foray into international investment banking began with Bear Stearns in 1993 in London. I ran the European analytics group. Bear Stearns differentiated itself from its more established competitors by concentrating on the more analytically intense products, such as mortgage backed securities, the very first CDO consisting of emerging market bonds in 1996, and high-yield bonds (formerly known as junk bonds) in 1998.

  From 1996 on, it was part of my job to introduce these new CDOs to European companies. I lived and breathed these bizarre concoctions and other securitized products until I left to return to the United States and a job at Goldman Sachs in 2000.

  The CDO market, which was largely dormant for almost a decade after Drexel’s fall, wound up climbing from nearly nothing in 1996 to become a $2 trillion global disaster by 2008.26 Those same types of securities were still the talk of the town except with, as I mentioned, subprime loans as the stuffing. And this time, they would bring outrageous profits for a few short years and then just as fast would help cause the downfall of Bear Stearns, unravel Wall Street, and unleash a global recession. But not before a few people made a lot of money.

  I was one of the lucky ones who had no stock in Bear at the time of their demise (I sold it to support my writing habit), except for a retirement plan that had shriveled down to $3,000. My other remaining connection
was with former colleagues and friends.

  People began e mailing me whom I hadn’t heard from in a decade, as if some close relative had died. A couple of the internal hedge funds at Bear Stearns had undergone explosive growth, based on overleveraging subprime and other risky securities, which were spun into high quality assets and blessed by the various rating agencies. Once demand dried up for these types of securities, their values plummeted. This meant that their value as collateral for borrowing also shrunk. Creditors started to ask for more collateral to be posted to make up for this difference. At the same time, investors were pulling out. The only way to come up with extra money to post as collateral was to sell the assets at bargain prices, which decreased the value of the funds further. The funds were running low on money to pay the borrowing costs, also known as margin calls, they had incurred. In the end, the funds ran out of cash completely and the largely, federally orchestrated demise of Bear Stearns followed. Bear had found itself in a similar situation as the people who couldn’t make their mortgage payments or get new mortgages to make up for that shortfall because of the declining value of their soon to be foreclosed homes.