Summary
Highlights
In 2011, protests like Occupy Wall Street erupted in response to the financial crisis. Americans expressed widespread anger that Wall Street was bailed out while Main Street suffered from job losses, foreclosures, and declining home values. Critics argued that massive illegality had occurred, yet few were held criminally accountable. Bankers, however, claimed that a strong economy required healthy financial services and that 'hammering' banks would lead to further recession, while expressing regret for past mistakes without fully explaining the complex financial instruments at the heart of the crisis.
The origins of the financial crisis can be traced back to a 1994 JP Morgan retreat in Boca Raton. Young bankers, including Blythe Masters, sought ways to reduce banking risk. This led to the development of credit default swaps (CDS), a derivative that insures loans against default, initially used to offload risk from corporate loans like Exxon's. This innovation allowed banks to circumvent capital requirements, freeing up capital for more business and making credit more readily available. The initial intent was to make the financial system safer.
JP Morgan expanded CDS to bundles of debt, using tranches to offer different risk levels to investors. Eventually, synthetic CDOs emerged, allowing bets on portfolios not even owned by the bank. This created an unregulated, opaque market with huge profits for banks. Despite warnings from figures like Brooksley Born of the Commodity Futures Trading Commission, who advocated for transparency and regulation to prevent a financial crisis, powerful financial institutions lobbied against oversight. Alan Greenspan, then Fed Chairman, supported deregulation, believing markets would self-correct. Legislation pushed by banking interests, including the repeal of Glass-Steagall, ensured derivatives remained in the shadows, leading to their explosive growth.
Credit default swaps were soon applied to portfolios of consumer credit risk, particularly mortgages, with a focus on subprime debt. Wall Street found immense profit in securitizing these mortgages, bundling them into CDOs and selling them to investors, often aided by favorable ratings from agencies. This fueled a housing boom, especially in fast-growing states like Georgia. Former Governor Roy Barnes fought against predatory lending practices that characterized much of the subprime market, but the pushback from the mortgage lobby led to the weakening of protective laws. Banks increasingly packaged high-risk subprime debt into CDOs, using credit default swaps to supposedly improve their ratings.
While JP Morgan expressed caution regarding mortgage data and risk, other banks aggressively sold subprime CDOs globally, particularly to naive German Landesbanks like IKB. By 2005, the credit default swap market was in the trillions and doubling annually. Many top bank executives and regulators failed to understand the complex instruments, allowing some banks to unknowingly accumulate massive risk. Synthetic CDOs allowed investors to bet repeatedly on the performance of underlying mortgages, regardless of direct ownership, akin to gambling. Despite warnings from individuals like Wells Fargo CEO Dick Kovacevich, who dubbed the situation 'toxic waste' and a 'bubble,' most bankers dismissed concerns, believing housing prices would never fall significantly.
The housing bubble began to burst in late 2006, leading to a wave of defaults. By 2007-2008, smart money knew the game was over, and banks tried to offload their toxic assets. Goldman Sachs, however, notably profited by betting against its own clients through credit default swaps, leading to a settlement with the SEC for misleading marketing. In July 2007, IKB became the first bank to fail due to its subprime exposure. The crisis escalated, revealing that many large financial institutions, like Citigroup, didn't fully comprehend their own risks, creating a 'boomerang effect' where offloaded risks returned. The true systemic danger lay in credit default swaps; AIG's $440 billion in CDS obligations, undisclosed to other market participants, caused a run on the insurance giant. The lack of transparency meant no one knew the true extent of interconnected risk, leading to the financial nuclear holocaust of September 2008, when Lehman Brothers collapsed and AIG required an $85 billion bailout.
The original goal of reducing risk through credit derivatives mutated into a 'Frankenstein monster' that spun out of control, creating a terrifying and unprecedented financial crisis. Many within the market, including those who helped create it, expressed deep disappointment and a sense of betrayal. The crisis, unlike previous economic downturns, was self-inflicted by a few institutions that failed to manage risk. The devastating fallout is still felt on Main Street, particularly in areas like Georgia, the 'ground zero' of the subprime crisis. Neighborhoods are plagued by vacant and abandoned properties, often owned by anonymous, globally dispersed investors through securitized pools, leaving local communities to pay the price for Wall Street's greed.