They’re Gambling with Your Money
WELCOME TO THE internationally acclaimed House of Goldman Sachs. We are proud to be your host at one of the most spectacular casinos in the world. Our well-dressed, highly courteous staff members are some of the most talented and intelligent employees in the business today, as almost all of them have advanced degrees, including some doctorates. They are well trained to help you in every aspect of what you might call gambling. Further, they will make their expertise available to you on any of the hundreds of games we are proud to feature at our exquisite investment casino. Some of the most unusual player opportunities, ranging from exciting “synthetics” to the all-new “exotics,” can be found only here. You can be sure you will always maximize your odds of winning, as our outstanding staff is ready and eager to let you know the probabilities of any game you select.
I see that you are walking to the beautifully appointed gaming room. From the foyer you can see that there are many enticing games in the casino, including some that you’ve never seen before. The players are excited, and the chips on the tables are piled high. You wisely decide to play a game you know and walk over to a beautiful mahogany roulette table. You put a few chips down, and the handsome and expensively dressed croupier drops the tiny silver ball. After he spins the wheel around, it lands in a green slot. Knowing that green is normally a 1-in-37 chance, you decide to play red, which should give you almost fifty-fifty odds of doubling your money. The dealer drops the ball, which, after circling the wheel again, lands on green. You know the probabilities of that are exceptionally small. So you continue to play red. But to your amazement green comes up on eight of the first ten spins.
Astounded at this enormous run of luck that defies all probabilities, you put your entire stake on green. The croupier removes it and puts the chips back in front of you. You look up and ask why. He politely says, “I’m sorry, sir, green is not allowed to be played against the house.”
An old-timer standing behind you watching the action says, “That’s a heck of a wheel, son. The casino spent years making alterations to it.” He goes on to tell you that it took masterful financial engineers to get it just so. The first attempts resulted in the ball’s landing on green only a few times in every ten times it was spun. But with intense work by outstanding financial engineers, the number of times the ball landed on green kept going up. Now it’s eight of every ten times the ball is dropped, which is exactly what the house targeted.
“Since it pays thirty-five to one, it makes a bundle for the casino. There are dozens of other games that pay off for the house just as well. If you walk down the Strip, you’ll see the casinos of Morgan Stanley, Credit Suisse, Citigroup, and a dozen others just as nice. Lehman and Bear Stearns also had great places; it’s too bad they burned down,” he finishes.
You wisely decide to leave but wonder how it is that a casino is allowed to have such odds in its favor. In Las Vegas, it would be shut down in less than an hour. In the Old West, the proprietors would immediately have been strung up for high-handed cheating. But on Wall Street it wins rave reviews. And you can’t go to the government regulators because you know they work with the casinos.
This story is, of course, total fiction. We all know investment banks and banks don’t own casinos—at least not directly. The details, too, are not literally true. So, as you read on, any similarities you may deduce are simply a matter of coincidence.
Or, then again, are they?
Singing the Bailout Blues“How could the U.S., the strongest country on earth, put itself into this horrific situation?” I wrote in Forbes shortly after the $700 billion Troubled Asset Relief Program (TARP) was passed by Congress in late 2008. “I wince at the $700 billion bailout,” I continued. “It was a necessary evil, but it doesn’t make me feel good as an investor.” The article went on to describe what we knew back then had caused the worst financial crisis in history.1
The public is still very perturbed about the financial bailout, as well as the high levels of unemployment the financial crisis has caused. Further resentment has been stoked because millions of people have been forced out of their homes. Many Americans are furious that virtually all of the perpetrators of these financial acts are walking off not with prison sentences but with severance payments up to a hundred million dollars. The final and possibly bitterest blow is that the financial executives who almost brought down our economy received seven- and eight-figure bonuses for what they did. The rise of the Tea Party and the sweep of the House of Representatives by Republicans in November 2010 showed quite clearly that voters are unhappy with the slow progress of both constructive change and job creation. Is popular opinion close to the truth on what actually happened, or is it out of whack with the facts?
Three congressional committees (which were surprisingly bipartisan) subpoenaed hundreds of thousands of e-mails and took voluminous testimony. Prior to the hearings, few explanations were forthcoming from the Fed and the Treasury about the banks and investment bankers who received the bailouts. But thanks to the congressional committees’ thorough work, we know much more today.
What we have learned is at times shocking. Bankers were enormously deceitful to the public, and their greed was on a par with almost any in our history. Yes, Congress has taken actions to prevent a recurrence of some of the folly, but all too many questions remain. In order to highlight possible causes of future crises, let’s take a quick look at what we’ve learned.
First we’ll look at the roles played by the Federal Reserve under its current and previous chairman, as well as by senior administration officials through the previous two administrations and the present one. We’ll then move on to the banks, investment banking firms, and other key players. No one group can be singled out for causing the financial crisis or the Great Recession. As most of us know, they were caused by a powerful confluence of factors, almost a perfect storm. What many people don’t know was the degree of incompetence and misguided ideology, as well as the powerful role played by little-known special-interest groups and the intensity of greed displayed by so many, all of which were critical elements.
The solutions to these serious problems are certainly beyond the scope of this book, but an understanding of the insidious effects they inflict should prove helpful to us as investors in understanding the problems we must continue to cope with for some time.
Mr. ChairmanMay I introduce you to one of the major economic powers in U.S. history? No, he wasn’t a political figure such as FDR or Ronald Reagan, but he was reverently called “the Oracle” by many thousands for the brilliant economic moves people thought he had made, which they believed had saved not only the U.S. economy but businesses globally. I’m referring, of course, to Dr. Alan Greenspan. He holds a Ph.D. in economics and served as chairman of the Federal Reserve of the United States from 1987 to 2006. For Wall Street, he was the closest thing to a Delphic oracle that investors had ever seen.
During his tenure as Fed chairman, he appears to have been strongly driven by ideology. As many know, Greenspan is a disciple of Ayn Rand, the author of Atlas Shrugged and one of the prime intellectuals from whom libertarianism took its ideas. In his late twenties, Greenspan fell into the Objectivist movement, dominated by Rand, which favored free markets and opposed strong government, and he contributed several essays to her book Capitalism: The Unknown Ideal. He was even a strong advocate of the gold standard and in his earlier years would have denied the power of the Fed to increase or reduce the money supply. Through the years he remained close to Ayn Rand and was a strong believer in deregulation. She and his mother were present as the witnesses when President Reagan swore him in as the chairman of the Federal Reserve in the summer of 1987.
In his prepolitical years, his philosophy was relatively simple: regulation bad, free enterprise good. He went so far as to state on Meet the Press that antitrust laws should be abolished. Not only did he want to cast out the New Deal in its entirety; he even wanted to undo the Republican president Theodore Roosevelt’s trust-busting work in the early twentieth century. His perspective is encapsulated well in this quote from a speech he gave to the American Bankers Association in 1996: “If banks were unregulated, they would take on any amount of risk they wished, and the market would rate their liabilities and price them accordingly.”2 Simple, yes; naive, yes; and to a large degree successful. So successful, in fact, that the deregulation of the banks played a major role in their blowing up both themselves and the economy a little over a decade later. The complexity, scale, and interdependence of modern banks were never considered by the man who led the Fed for twenty years.
Greenspan appears to be an advocate of the much earlier form of free enterprise, the laissez-faire of the 1830s and 1840s. Back then, all the fundamentals he would like to see in the current world were functioning. What his almost zealous idealism seems to overlook was that it was anything but a perfect time. Most people lived in enormous poverty. Fifty to 60 percent of the English population suffered from malnutrition. Child labor was widespread, and most people worked a seven-day week. “Don’t come in Sunday, don’t come in Monday” was a sign industrialists often posted on British factory doors. Debtors’ prisons dotted the country. Several major riots took place in manufacturing cities and London, protesting the terrible conditions, while Wellington, “the Iron Duke,” who won the Battle of Waterloo, was prime minister. Ironically, had Greenspan lived in those halcyon times, his chances of achieving the success he did would have been almost nil, because major positions went to the upper class. At heart he is a man of the early nineteenth century.
Fortunately for him, he was born much later and achieved enormous success. Greenspan at his pinnacle was widely considered to be the most able central banker who ever walked the face of the earth. He was a financial savior, affectionately called “the Prophet” or “the Oracle,” whose understanding of evolving financial and economic problems and his adept handling of them as they arose led, most believed, to a world of peace and prosperity.
Every statement or speech he gave was a news event and was immediately flashed to financial markets globally. No economic forum was considered important if he did not speak or attend. His portrait sold for as much as $150,400,3 and a dinner with him went for $250,000.4 More important, he had the ear of every president of the United States from Ronald Reagan to George W. Bush, as well as most congressmen and senators, whether Democrats or Republicans, almost since his appointment as chairman of the Fed.
Wall Street speculated on what he would say prior to his every major appearance before Congress. His speeches were often televised live, and their content was distributed to the media before the actual delivery of the talk. Greenspan’s speeches and statements were convoluted and difficult to decipher, although every word was studied by tens of thousands.
To me his statements not only were difficult to decode but often seemed to contradict previous ones he had made. When I mentioned this to other money managers I knew or when I wrote about his lack of clarity in my Forbes column, I was told that this was the way a major chairman of the Fed should present himself. Others said that this was the way an oracle should speak. Greenspan told Bob Woodward, the noted journalist and political author, that he wanted to keep the financial community off balance by doing this so it never fully understood his course of action. He called it “constructive ambiguity.”5
If his speeches were opaque, his actions as Fed chairman for almost twenty years certainly were not. And it was those actions that played an important role in the worst financial crisis in history. What is striking was that although his decisions on key matters were consistent, predictable, and repeated numerous times, few Fed watchers caught on to the pattern.
Greenspan did not want outside regulation by governmental agencies at any level, and he did not want the Fed to carry out many of its assigned responsibilities to regulate banks and other financial institutions or to provide the consumer protection it was mandated to give. He had an unshakable belief that companies, regardless of their size, industry, or circumstances, would, in their own self-interest, regulate themselves well. His belief in self-regulation colored most of his major actions over the almost twenty years he was chairman.
Greenspan was instrumental, along with Treasury Secretary Robert Rubin and Lawrence Summers, a powerful, politically connected Harvard economist, who would later become secretary of the Treasury, in repealing the Glass-Steagall Act under the Bill Clinton administration. The act, which restricted the power of commercial banks to compete with investment banks and significantly curtailed the amount of risk they could take, had by and large worked successfully to that time. The roots of the repeal came out of Greenspan’s Federal Reserve, which in the late 1980s began reinterpreting Glass-Steagall in a series of actions that slowly increased the banks’ abilities to expand into other activities.6
Enormous decisions that affected the welfare and livelihoods of most Americans were made by the ranking Fed and Treasury policy makers and were based on their personal ideologies, which were often far removed from those of the electorate.
Were It That SimpleGreenspan was also the “leading proponent of the deregulation of derivatives.”7 There were an ample number of knowledgeable people who were concerned that this deregulation would cause a serious drop in the safeguards on their use in the last year of the Clinton administration. Among the opponents was the former head of the Commodity Futures Trading Commission (CFTC), Brooksley Born. She attempted to have derivatives regulated, including the extremely complex and lethal credit default swaps, which sank AIG and came close to sinking dozens of other financial institutions and hedge funds. Born was met by enormous opposition from Secretary of the Treasury Robert Rubin, Lawrence Summers, and, oh yes, Alan Greenspan, all of whom, on April 21, 1998, took turns trying to talk her out of her position.8 One account indicates that Summers’s discussion was—to be charitable—very assertive. Born’s stand resulted in her being forced out of the Clinton administration.9
Rubin and Summers, with the strong support of Greenspan, pushed through the Commodity Futures Modernization Act of 2000, which Clinton signed into law in his last month in office. The impact on markets resulting from the nonregulation of these toxic derivatives was enormous. President Clinton told ABC News in April 2009, when asked about the advice he had received from Secretary Rubin and his handpicked successor, Summers, “On derivatives, yeah, I think they were wrong and I think I was wrong to take it.”10
Numerous warnings by highly knowledgeable financial types were given about the destructive power of derivatives years before the meltdown. George Soros, the hedge fund manager who “broke the Bank of England” with his shrewd currency trades, avoids using such contracts, “because we don’t really understand how they work.”11 Felix Rohatyn, who saved New York City from going bankrupt in the 1970s, described derivatives as potential “hydrogen bombs.” Warren Buffett presciently observed, five years before the 2007–2008 crash, that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”12 Those warnings, like so many others, were ignored.
From 1990 and for the next four years, the Fed cut rates sharply. Easier access to credit and rapid advances in financial technology led to explosive growth in the over-the-counter derivatives markets, which reached $25 trillion in notional value by 1995 and increased tenfold to 2005.
Alan Greenspan took an active role in lessening the regulation of derivatives and did not see any cause for alarm, consistent with his unwavering philosophy that the derivatives markets were unregulated and therefore must be good. Even after derivative scandals sent shock waves through the market in the mid-1990s and derivative counterparties lost billions of dollars, Greenspan continued to press for greater deregulation of them. His policy never changed. In 2003, he testified to the Senate Banking Committee, “We think it would be a mistake” to more deeply regulate the contracts.13 During the 2008 crash, in a speech at Georgetown University, Greenspan said that the problem was not the derivatives but the people using them—who got “greedy.”25 He was contradicted by Frank Partnoy, a law professor at the University of San Diego and an expert on derivatives and financial regulation, who said, “Clearly, derivatives are a centerpiece of the crisis.”14
The consistency and obstinacy of Greenspan’s push to deregulation in the face of failure after failure of his policies are remarkable. So, as we run quickly through a number of other major policy decisions that contributed to the magnitude of the financial crisis, an important question we should ask is whether the Fed’s powers ought to be curtailed after the damage it has caused the economy.
As obstinate as Chairman Greenspan was about derivatives, he was even more so about not taking any action to curb the excesses of the housing bubble.
The subprime problems did not begin in 2004–2005. Rather, they go back almost a decade to the passage of the Tax Reform Act of 1986, which allowed the deduction of interest on a primary residence and one other home.15 This made the cost of subprime mortgages cheaper than consumer loans, on which interest could not be deducted. A major new market was opened for people who could not get conventional mortgages because of low credit scores. Credit was now available, but at higher interest rates, and numerous financial companies, aka loan sharks, flocked into what looked like a very profitable new business.
By 1997, questionable accounting, higher-than-projected arrears, and defaults made it apparent that the industry had underpriced its loans and was floundering. Of the top ten originators of new mortgages in 1996, only one remained in 2000. Did the credit-rating agencies, the Federal Reserve, the regulators, and the banks remember this dismal performance? They did not, as we all painfully know. Only a year later, subprime demand roared ahead again and housing prices had turned up sharply. The housing bubble had started.
The Subprime BallAfter the 1996–2000 high-tech bubble collapsed, the Federal Reserve, under Chairman Greenspan, lowered interest rates significantly and a very easy monetary policy was established to cushion the enormous market losses, estimated at over $7 trillion, that investors had taken after the 2000–2002 crash. The Fed feared those losses might severely curtail consumer and to a lesser extent business spending, pushing the nation into a recession. To prevent this outcome, the Fed funds rate was dropped from 61/2 percent in mid-2000 to 1 percent in mid-2003 in thirteen consecutive steps as the high-tech bubble disintegrated. Long-term Treasury rates fell from 7 percent to 41/2 percent.16
After the 2000–2002 high-tech bubble collapsed, people realized that although many had lost heavily in the market, housing, usually accounting for by far the greatest portion of their net worth, was not only intact but moving steadily higher. Beginning in 2002, an enormous housing boom was triggered whose excesses, as we’ll see, were the prime cause of both the near-destruction of the global financial system and the worst economic climate since the 1930s.
Twelve and a half trillion dollars’ worth of new-home originations was completed between 2002 and 2007. Risky subprime originations shot up far more than conventional mortgages, increasing from 6.6 percent of total mortgages in 2002 to a whopping 21.7 percent in 2006.17 The subprime industry had hit a grand slam!
However, as is so often the case in the financial sector, the truth is not found in the glossy pages of a self-congratulatory annual or quarterly report but squirreled away in the footnotes buried deep in the back pages, where, it is hoped, they will never be found.
The Casino Has a Grand New GameMortgages were now available for buyers with only the most limited incomes and financial resources, housing prices soared, and buyers were lining up to get a part of the action. The mortgage companies and real estate investment trusts (REITs), along with banks and investment bankers, the major originators of subprime mortgages, were aware that they now had an opportunity that comes maybe once in a generation, and they were quick to exploit it.
Enormous incentives were paid to subprime marketers to encourage sales. Many mortgage bankers (a glorified name for a primarily unscrupulous bunch of mortgage sellers whose ethics make most used-car salesmen appear highly principled) made a million dollars or more a year as well as lavish perks. The merchandise they sold smelled worse than fish left unrefrigerated for days.
The object for the mortgage lenders was to make it easy for borrowers with little or no income or even without jobs to buy homes, by loosening the underwriting standards in the subprimes and Alt A’s*86 enough so that anyone could buy. Quality was of little concern. Everything they bought was immediately packaged with pools of other similar mortgages and sold to hungry clients.
Oh yes, bankers from Citibank, Bank of America, and Wachovia to Goldman Sachs, Morgan Stanley, Lehman Brothers, and Bear Stearns were all major players in the game. They not only bought mortgages from mortgage bankers but aggressively acquired the mortgage banks themselves; vertical integration meant even greater profits.*87
The bonds were then rated by a credit-rating agency such as Moody’s, Standard & Poor’s, or Fitch. Normally they were given a credit rating that was, as we’ll see, far too high for the quality of the mortgage pool rated. The higher the ratings the banks could get from the rating agencies, the more salable the mortgages were. Nobody cared to look under the hood to see what the collateral really was. It was just merchandise that had to go quickly. And it did, by the hundreds of billions of dollars.
If you’ve got the stomach, we’ll quickly look under the hood. What we see is a variety of products, almost all guaranteed to be major losers for buyers. Let’s take a quick peek into a mortgage broker’s or originator’s office. He has all kinds of goodies to offer the mortgagees to get their business.
“Over here we have the Ninjas, and they’re going fast,” he might say. “What is a Ninja?” somebody asks. “Well, actually, it’s an acronym the sales folk use for this class of mortgage. It stands for mortgages where the buyer has no income, no job, and no assets. But don’t worry, the housing market is sizzling and prices will go higher, so you are well protected,” the mortgage broker might answer.
“Over there,” another salesman might continue, “we’re having a special on negative amortization mortgages. Ninja buyers really like this product.” What’s that in English? Again, simple! The buyer doesn’t have to pay any interest on the mortgages for two or three years and gets to move into the home of his choice immediately. At the end of three years he owes about 140 percent of the original price because of the high interest charged, but no banks or mortgage bankers care. They unload the mortgages like hot potatoes to their institutional buyers. It all goes down as profit to them and means big commissions today for some, multimillion-dollar bonuses at year-end for others.
Who’s going to lend $200,000 to a Ninja buyer who will have to repay about $280,000 in three years and doesn’t have a dime? In retrospect, the answer is once again simple—we did, as taxpayers paying off the bank bailout.
Next we come to the largest section of the subprime salesroom, featuring the adjustable-rate mortgage, or ARM. Normally customers were lured in with a low teaser rate as bait. Two very popular adjustable-rate mortgages were the 2-28 and the 3-27. The 2-28 gave the mortgagee a low fixed rate of 2 percent for two years and an 11 or 12 percent rate for the next twenty-eight. The 3-27 gave the buyer a 3 percent rate for three years and a 10 to 12 percent rate for the next twenty-seven. Adjustable-rate mortgages were very popular, accounting for 80 percent of all subprime originations in 2005, or more than 1.7 million mortgages, and 70 percent of originations through the entire 2000–2007 boom.18
Chairman Greenspan gave subprimes the Fed seal of approval, stating that they were often cheaper than fixed-rate mortgages. Because a conventional fixed-rate mortgage has much lower indirect and hidden charges than a subprime mortgage and the cost to maturity might be 6 percent rather than 10 percent or higher for a subprime mortgage, I don’t quite catch his math.
Again, we are just skimming the surface of the subprime and Alt-A universe, but I hope you now have an idea now of what was under the hood. Many of the buyers of subprime loans were decent people. They were taken in by glib salesmen who often specialized in minorities, elderly people, and those who simply could not understand the lengthy and complex mortgage documents they signed. The FBI and local authorities, as well as the courts, have processed thousands of cases from such victims. Angelo Mozilo, the well-coiffed, Brioni-suited, perpetually tanned former CEO of Countrywide Financial and the largest subprime lender, settled with the SEC for $67.5 million for fraud in October 2010.19
Sure, there were speculators and hucksters among those taking out these mortgagees, but if someone has a chance to make big returns with little down in a rising market, doing so isn’t much different from using cheap margin to buy stocks. And the sellers, if they so chose, had highly sophisticated methods to check buyers’ credit and ability to meet payments of both interest and the principal when due—but that was rarely done. From the beginning the subprime industry was fatally flawed. Many people could not even afford the initial “teaser” rates of 2 percent or 3 percent, let alone the quadruple or quintuple rates after twenty-four or thirty-six months. The concept was doomed to fail, and it did.
Where Were the Fed and the Regulators?It is disturbing that one individual can exert the influence that Alan Greenspan did during his twenty years at the helm.
The Oracle left us with a remarkable record during his tenure as chairman of the Fed. Two of the most serious financial crashes in U.S. history, in 1987 and 2000–2002, took place while he headed the Federal Reserve.*88 He was also at the helm and played a major role in the real estate bubble from 2002 to 2006, stepping down not long before the largest crash since 1929 and the worst financial crisis in Western history. No other chairman in Fed history has had more than one market debacle during his tenure. The great majority have had none.
Why didn’t the Oracle or Ben Bernanke, his successor at the Fed, and other senior Fed officers see the mortgage problems that the national and local press wrote about repeatedly, starting in 2006? Why did they not realize there was a problem until months after the housing market had already turned down?
Nobel laureate Paul Krugman and Pulitzer Prize winner Gretchen Morgenson repeatedly detailed various aspects of the subprime problem dating back to 2006. Possibly Greenspan found The New York Times too liberal for him; after all, he is a professed libertarian. But the issues were also covered in The Wall Street Journal, and state governments around the country were taking steps to ban some of the worst practices of the mortgage originators. Greenspan admitted back in the fall of 2007 that he did not see the subprime crisis coming, more than ten months after it began.20 Skimpy regulation practices appear to have been encouraged by the Federal Reserve. And even when Greenspan finally saw the crisis was about to hit, the Fed took no measures to halt some of the most blatant lending practices. In fact, around that time, it took steps to block North Carolina and other states from taking action against federally chartered banks using poor mortgage practices.
As far back as 2000, Greenspan rejected a proposal by Fed Governor Edward Gramlich to have the Fed examine the lending practices not just of the banks but of subprime lenders. Gramlich frequently spoke out about the dangers of the latter’s sales practices. An expert in the subprime area who realized the major danger that the subprime market would blow up, he pushed hard for greater regulation and spoke to Greenspan about the necessity for it. But mortals don’t often defeat gods. Gramlich, one of the real heroes of the period, published a book entitled Subprime Mortgages: America’s Latest Boom and Bust that strongly warned about those dangers shortly before he died of leukemia in 2007. In 2008, when asked about his failure to perceive the dangers, Greenspan merely said, “I turned out to be wrong, much to my surprise and chagrin.”21 That is scant recompense for the many millions of Americans who suffered from both the crisis and its aftermath.
Greenspan had the authority to control these lending practices under a law passed by Congress in 1994, the Home Ownership and Equity Protection Act (HOEPA), but his antiregulation beliefs were so strong that he was adamant in refusing to do so.
The Fed chairman in 2005 and then his successor, Ben Bernanke, in 2006 completely missed the opportunity to have the Fed take the strong measures necessary to puncture the bubble.22 Worse, the Fed’s refusal to act encouraged practices that led to the victimization of hundreds of thousands of subprime borrowers and a large number of institutional lenders. The Fed was reactive, not proactive, through almost the entire collapse.
By the time the Fed realized the enormity of the problem, it was far too late. In 2007, even after the bubble was already imploding, both Greenspan and Bernanke continued to issue reassuring statements that all was well. Bernanke said in late March 2007, “At this juncture . . . the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”23 Three months before the collapse of Lehman Brothers, he stated, “The danger that the economy has fallen into a ‘substantial downturn’ appears to have waned.”24
How did Greenspan and, to a somewhat lesser extent, Bernanke make blunders of this magnitude? According to Daniel Kahneman, one of the most revealing moments of the 2007–2008 economic meltdown came at a congressional hearing in 2009, when Greenspan admitted that his theory of the world was mistaken. He expected and believed that financial firms would protect their interests, because they are rational companies and the markets are rational, so they would not take risks that would threaten their very existence. Where he went wrong, according to Kahneman, was that there was a huge gulf in the goals between the firms and their managers’ (their agents’) interests. The firm takes the long view of profitability over time. The agents take a much shorter-term view, basing decisions on possible promotions, large salaries, and bonuses. As we saw, the executives did not commit suicide by taking such risks. They walked away unscathed. It was the corporations they managed that were crippled or committed suicide.
A close friend of Kahneman, Nassim Taleb, author of the financial bestseller The Black Swan, put it in these words: “People are simply unwilling to accept the fact that they are actually taking huge risks . . . Alan Greenspan, the former chairman of the Federal Reserve . . . was driving a bus full of children with his eyes closed while he was in office.”25
Not only were the Fed’s actions totally inappropriate to meet the crisis, but with the Fed’s hand on the pulse of the economy and with the severe liquidity crisis having already cut deeply into the nation’s financial arteries for almost eighteen months, it seemed totally unaware of the forthcoming collapse in September 2008.
Whether the Fed has too much power is a controversial topic. But it certainly appears that the power it has was not used in an appropriate manner during the liquidity crisis and the Great Recession. According to statements by knowledgeable central bankers, including Chairman Bernanke, the Fed also did not use it well during the Great Depression, but at a Fed meeting in Jackson Hole several years before the 2007–2008 meltdown, Bernanke implied that the Fed’s methods were now too sophisticated ever to allow a devastating financial crisis to happen again.
Ironically, Congress and the Obama administration gave the Fed even greater supervisory authority in the Financial Reform Act of 2010.
Could such episodes happen again? It’s possible. Bernanke did continue Greenspan’s policies until it was far too late. Although he said in late 2010 that we needed more regulation, his statements were quite different in early 2007. I don’t think Bernanke is another Greenspan, or that he will continue to pursue Greenspan’s policies. But what will the next chameleon who becomes chairman do? There is little or nothing to restrain an ideologue who favors libertarianism at one extreme, or socialism at the other, from influencing monetary policy.
Next let’s briefly look at another outcome of the Fed and the previous two administrations’ support of the destructive non-exchange-traded derivatives, as well as the excess leniency in regulation of the banks in the post-Glass-Steagall environment, which allowed banks and investment bankers to take enormous advantage of the system before bringing themselves and the financial system to the brink of collapse.
Gaming the SystemEarlier in the chapter, we glanced briefly at the credit-rating agencies (CRAs), Standard & Poor’s, Moody’s, and Fitch, and noted that their credit ratings on mortgage-backed securities were far too high. The CRAs had come through the 1929 crash and the Great Depression unscathed, and their ratings through those difficult times had been rock solid. They gained increasing respect over time. Investors relied on them to accurately assess the credit of the company securities they rated, and their decisions were almost universally accepted.
Why, then, did they blemish reputations built up over more than a hundred years? The answer is the same as the one the notorious bank robber Willy Sutton gave in the 1930s when a reporter asked him why he robbed banks: “That’s where the money is, stupid.”26
The three top credit-rating agencies became enormously prosperous, not unlike the mortgage lenders earlier in this chapter. From 2002 to 2007, their revenues more than doubled, from less than $3 billion to over $6 billion. Most of the rapidly increasing revenues came from rating complex financial instruments.
All of the securities sold by banks and investment bankers needed high ratings to sell. Moody’s and S&P each issued thousands of AAA credit ratings on subprime mortgage products near the height of the subprime bubble. As Senator Phil Angelides, the chairman of the Financial Crisis Inquiry Commission investigating the credit-rating agencies, said, “Moody’s did very well. The investors who relied on Moody’s ratings did not fare so well. From 2000 through 2007, Moody’s slapped its coveted Triple-A rating on 42,625 residential mortgage backed securities. Moody’s was a Triple-A factory. In 2006 alone, Moody’s gave 9,029 mortgage-backed securities a Triple-A rating.”27
Standard & Poor’s ran neck and neck. By comparison, only a handful of AAA ratings were given to the strongest U.S. corporations or foreign governments, whose creditworthiness was light-years above that of subprime.
The ratings were a very lucrative business for the credit-rating agencies, costing upward of $50,000 for plain-vanilla slices to $1 million or more for supercomplex, multilayered collateralized debt obligations (CDOs).*89
The dollar signs were spinning. Moody’s gross revenues from residential mortgage-backed securities (RMBS) and CDOs increased from $61 million in 2002 to more than $208 million in 2006. From 1998 to 2007, its revenues from rating complex financial instruments grew by a stunning 523 percent.28 S&P’s annual revenues from ratings more than doubled from $517 million in 2002 to $1.16 billion in 2007. During the 2002–2007 period, its structured finance revenues, a good part of which came from CDOs, more than tripled, increasing from $184 million in 2002 to $561 million in 2007.
Interestingly, after the collapse of thousands of AAA subprime rated issues that led to the worst financial crisis since the Great Depression, Standard & Poor’s on August 30, 2011, gave a AAA rating to another subprime borrower. This after it downgraded U.S. Treasuries in the previous month.
Rating agency stock prices tripled or quadrupled, on average, in the 2000–2007 period, while Moody’s stock was up more than sixfold. But there would be a terrible price to pay. Like Dr. Faustus, the rating agencies had sold their souls to the Devil.
The banks and investment bankers had a large and growing market for residential mortgage-backed securities, which if sliced and diced properly would give them major underwriting profits from a clientele that could not get enough of the right stuff, which consisted of high ratings from the credit-rating agencies as well as higher yields than they could obtain from non-mortgage-backed bonds or other paper. The bankers found the solution early in the decade: cut the quality of the AAA, AA, and A product, yet retain the same high investment-grade ratings. That was essential for buyers, many of whom could, by law, buy only investment-grade securities.
This solution was not unlike that used by more questionable bars, which water down their Glenfiddich single malts or other good brands, serving them from the original bottles, or by drug dealers who cut their product. The pivotal point was the cooperation of the CRAs. Dozens of underwriters with some of the Street’s largest investment bankers, including Merrill Lynch, Citigroup, UBS, Bank of America, Wachovia, Goldman Sachs, Credit Suisse, RBS, Lehman Brothers, and Bear Stearns, had years of experience working with the credit-rating agencies on RMBSs, more specifically subprime. They persuaded the CRAs to go along, using finesse and threats to take their business elsewhere. From that point on, it was a turkey shoot—or, more accurately, a client shoot.
Armed with the best credit ratings money could buy, the bankers sold the toxic mortgages to unsuspecting clients. The product gave the bankers the best of all possible worlds: both significantly higher yields, since a good part of the merchandise was junk, with very high credit ratings. Sales soared into the hundreds of billions of dollars, and the bankers’ margins on the business were in the stratosphere.
But the antics only started there. Once the bankers had the high credit ratings in hand, they were able to sell all sorts of complex paper, such as CDOs and structured investment vehicles (SIVs) to their clients. From 2003 to 2006, the demand was almost insatiable; where else could an insurance company, bank or hedge fund, or CDO get a yield like this with a top credit rating? By selling notes and other credit instruments, CDOs, SIVs, and hedge funds leveraged themselves up thirty to thirty-five times the amount of their capital invested, as we saw in chapter 5. Their clients saw consistent returns of up to 15 percent annually or even higher.
The bankers, however, were not happy with the billions of dollars they were making. With a little ingenuity and a lot of inside knowledge of the toxic assets they were selling, they could do even better. More complex derivatives were devised, which the traders dubbed “exotics” and “synthetics,” thanks to the work that Robert Rubin, Larry Summers, and Chairman Greenspan had done in pushing through the Commodity Futures Modernization Act of 2000.
Exotics were extremely complex derivatives normally written by a banker who wanted to short certain toxic assets, knowing that the odds were heavily on his side that they would go down in flames. Synthetics allowed a banker to short the worst toxic assets he could find, not once but many times the size of the poor-quality issue itself, by simply replicating these horrific mortgage portfolios. Replication was simple, since there were no rules to follow. All that was needed was the financial details and the composition of the pool of mortgages and the monthly return it provided. The odds for the short sellers of toxic junk were now almost as great as those for the house in our mythical casino. What’s more, the payoffs were in the billions rather than in thousands of greenbacks from the players in the casino.
Although there were many players, Goldman Sachs was the superstar, according to the findings and e-mails that were released publicly by the various Senate and House committees investigating the crash and meltdown. Goldman’s research in finding the worst groups of subprime or Alt-A mortgages in the marketplace was outstanding. It could then short them to its clients or other buyers, making a killing when they dropped. To get the maximum odds, it wanted to discover not only the poorest issuers of this junk—and there were dozens of them—but the absolutely worst issues each had put out.
To do this, its analysts scoured through every series of mortgages of each bad issuer with a high credit rating. Overall, their detailed research covered thousands of individual series of mortgages. Which of each poor issuer’s mortgages, for example, had the worst “Ninja” series, combined with a high rate of negative amortization or other debilitating options, to give Goldman a strong possibility of higher default rates, regardless of how high a credit rating they had been assigned? Dozens of other tools were used by Goldman’s highly sophisticated multimillion-dollar-plus research and trading teams. All were out to bag their regular clients or any other potential victim who showed enough life to sign a derivative contract. Goldman was not alone; many of the banks noted above played an identical game, but unquestionably this firm was the champ.
One of its biggest wins was AIG. Goldman and a syndicate of bankers bought credit default swaps, which effectively resulted in their shorting mainly AAA-rated but very poor quality subprime mortgages to AIG, the buyer. The giant insurance company’s losses were so huge that it was on the brink of bankruptcy. The New York Fed, then under Timothy Geithner, stepped in and paid the syndicate of banks 100 cents on the dollar, or $62 billion in all.*90 The inspector general of TARP, Neil Barofsky, stated that the Fed, using taxpayers’ money, had overpaid Goldman and the rest of the syndicate by tens of billions of dollars, but that is another story.*91
Goldman was bearish on the subprime market and watched it begin to turn down in the fall of 2006. The company wanted to get out of its remaining inventory quickly. The market for subprime was becoming increasingly illiquid, and the sale of its inventory would be difficult and probably go at a sizable discount. What to do? Easy: sell to its own clients. As Table 15-1 shows, Goldman sold six issues totaling $6.5 billion, all from its own inventory, to clients. The six new issues of subprime mortgage pools were quickly brought to market in late 2006 and early 2007. Five had AAA ratings on 70 percent to 80 percent of the overall issue.
Goldman knew that the ratings would collapse because of the poor quality of the holdings, since it had been instrumental in getting high ratings on many of them from the rating agencies and had researched them all thoroughly. The largest issue was Hudson Mezzanine, which, although subprime, contained 72 percent of supposedly AAA mortgages. The issue dropped more than 50 percent in less than a year, and Goldman made major money on its sale, while its clients lost a big chunk of their own investment.
In early 2007, as the subprime market began to crumble, Goldman moved quickly to increase the sale of its toxic inventory to clients. Hudson Mezzanine was followed by two more deals, Anderson Mezzanine 2007-1 and Timberwolf 1. In total these two underwritings raised $1.3 billion. What did the clients buy in the “synthetic” packages? Naturally, more of the lethal inventory that Goldman wanted to bail out of. “Boy, that Timberwof [sic] was one shitty deal,” wrote Thomas Montag, formerly the cohead of the global securities business at Goldman, according to the Levin subcommittee.29 To sell it, the head of Goldman’s Mortgage Department, Daniel Sparks, sent out a mass e-mail promising its sales force “ginormous credits” for disposing of these tainted securities.
The Hudson Mezzanine 2006-1 deal was rated AAA, the highest credit rating that Moody’s gives, although it had a major slug of subprime instruments in it. The subprimes were quickly downgraded, and investors lost the majority of their capital, as Table 15-1 shows. Look at row 3, which shows the highest credit rating for the issues in early April 2010, prior to their being sold to Goldman clients. Of the six issues, all of which contained sizable AAA portions, credit ratings had been entirely withdrawn by Moody’s for two, Hudson Mezzanine and Timberwolf 1. Three others, Long Beach Mortgage Trust 2006-A, Anderson Mezzanine, and Abacus 2007-AC1, were lowered to low junk ratings; only GSAMP 2007-FMI, although downgraded significantly to Baa2 by Moody’s, was just barely above junk status. Finally, the underwritings were downgraded very quickly by the credit agencies, the average time being remarkably short—six months.
Obviously, given Goldman’s sterling record for integrity in the recent past, it would be hard for any of us not to accept the statements of Goldman’s CEO, Lloyd Blankfein, made at the various congressional committee hearings, that Goldman had not been using its formidable research and marketing clout to its benefit against that of its clients. It would be even harder not to accept that a good part of the $11 billion in bonuses Goldman paid out for its 2008 year in early 2009 could not have come from its subprime businesses. Blankfein testified to the committees that the firm had lost money there.*92 Where it had come from was never quite answered.
Subsequently, in mid-2011, Blankfein and other officers hired criminal attorneys when the United States began a probe of matters raised by the Senate’s Permanent Subcommittee on Investigations. The subcommittee report accused Goldman Sachs of misleading clients about complex mortgage-related investments. The subcommittee chairman, Senator Carl Levin, also alleged that Blankfein had misled Congress.30 Other lawsuits have been filed on a number of highly rated issues Goldman sold or shorted to its clients from its inventory in this period. The odds played by Goldman short selling to its own clients seem above those of the hypothetical casino in the chapter’s opening paragraph.
Goldman Sachs was not the only investment bank that was flagged by the House and Senate subcommittees in the 2010 hearings for this type of trading. Investigations are also being carried out at the time of this writing on Morgan Stanley and Citigroup. Goldman has also made a large settlement with the SEC entailing a payment of $300 million as a fine and $250 million as restitution to the institutional investors involved.
Not only did Goldman and probably many other banks not share the information about those investments with their clients, as was their fiduciary responsibility, but, as we have seen, they actually sold those securities to the clients. Though doing so may not be have been illegal, it certainly seems to have been a breach of ethics that is unforgivable to most. Just as bad, the firm and many others sold tens of billions of dollars’ worth of low-quality mortgage-backed securities to their clients in new underwritings when they believed the subprime market was on the verge of collapse. An underwriter has the fiduciary obligation both to provide his clients with his views on the state of the market and to sell them securities he believes are very solid. Goldman and many other firms did neither.
Ironically, in the financial panic beginning in September 2008, there was a run by investors on their assets at Goldman Sachs and Morgan Stanley. The firms were saved only because the Fed transformed them into banks and extended major credit to them, as it was also forced to do with Citigroup. The bailout provided more capital to many of the major domestic banks involved as well. Most of the banks that had been instrumental in causing the crash came out whole, while all too many Americans suffered badly.
Are there lessons here for you as an investor? I think there are several. First, the banks resisted financial reform at every step, in spite of the bailout and the damage they caused. Financial reform will help, but, as noted, it’s not perfect; nor has the SEC taken aggressive steps on the matter of conflict of interest—and this seems surprising when it is all over smaller investment firms for even minor technical infractions.
You should stay away from complex products offered by investment firms and banks. If you stick to contrarian strategies, you will be much better off over time. Also, with products not regulated by the SEC, take underwriting ethics with a grain of salt regardless of what you buy. The underwriters at banks and investment banks certainly do.
