I keep hearing how "complicated" this present financial crisis is, and while formulaically that may be true - and certainly the implications as well any potential responses will be very complicated - at its heart it doesn't seem all that complicated to me. It was just a bunch of people who went looking for free money and when the time came to pay up, they tried to hide it, and when that didn't work they tried to hide it some more. It was a chain and a system of denial where when the shit finally hit the fan this week everybody went scurrying for the protection of the government.
So I went looking for people who could explain the present global financial crisis to me this week and this is some of what I found:
(You can read the transcript - here.)
The documentary does very good job of tracing the entire process; beginning with people like former homeowner Clarence Nathan:
It’s a no-income verification loan. They don't do that. It's almost like you pass a guy in the street and say: lend me 540,000 dollars? He says, what do you do? Hey, I got a job. OK. It seems that casual even though there are a lot of papers that get filled out and stuff flies all over with the faxed and emails. Essentially, that's ... that the process.
I wouldn't have loaned me the money. And nobody that I
know would have loaned me the money. I know guys who are criminals who
wouldn't loan me that and they break your knee-caps. I don’t know why the
bank did it. I’m serious ... 540 thousand dollars to a person w/bad credit.
And then without ever meeting him face to face Clarence is eventually hooked up with a guy like Mike Francis - former Executive Director at Morgan Stanley on the residential trading desk. Adam Davidson explains:
Mike was one link in a chain that connected the global pool of money to its new favorite investment, these residential mortgages, the US housing market, and guys like Clarence Nathan. Think how attractive a mortgage loan is to that 70 trillion dollar pool of money. Remember, they're desperate to get any kind of interest return. They want to beat that miserable 1 percent interest Greenspan is offering them. And here are these homeowners, they're paying 5, 7, 9 percent to borrow money from some bank. So what if the global pool could get in on that action? There are problems. Individual mortgages are too big a hassle for the global pool of money. They don't wanna get mixed up with actual people and their catastrophic health problems or debilitating divorces, and all the reasons which might stop them from paying their mortgages. So what Mike and his peers on Wall Street did, was to figure out how to give the global pool of money all the benefits of a mortgage – basically higher yield - without the hassle or the risk. So picture the whole chain. You have Clarence. He gets a mortgage from a broker. The broker sells the mortgage to a small bank, the small bank sells the mortgage to a guy like Mike at a big investment firm on Wall Street. Then Mike takes a few thousand mortgages he’s bought this way, he puts them in one big pile. Now he’s got thousands of mortgage checks coming to him every month. It’s a huge monthly stream of money, which is expected to come in for the next thirty years, the life of a mortgage. And he then sells shares of that monthly income to investors. Those shares are called mortgage backed securities. And the 70 trillion dollar global pool of money loved them.
Mike Francis: it was unbelievable. We almost couldn’t produce enough to keep the appetite of the investors happy. More people wanted bonds than we could actually produce. That was our difficult task, was trying to produce enough. They would call and ask “Do you have any more fixed rate? What have you got? What’s coming?” From our standpoint it's like, there's a guy out there with a lot of money. We gotta find a way to be his sole provider of bonds to fill his appetite. And his appetite’s massive.
Alex Blumberg: To be fair, they knew there were risks. But investors have a system to assess those risks. They’re these special companies. Credit rating agencies. Moody’s, Standard & Poor’s, Fitch. Their job, their main job, is to assess risk for Wall Street and the global pool of money. They rate every kind of bond according to its risk. Triple A is the safest, then there’s double A, single A, all the way down to single B and below. And that’s all most investors look at - the letter grade. They trust the credit rating agencies. And these agencies blessed most of these mortgage-backed securities. Gave them AAA ratings - which means they were considered as safe as a US government bond. This was the magic of this whole system. You could take a pool of thousands of risky mortgages, and create a security that was called money-good, as safe as any investment out there. At least that's what people thought. But now we know those agencies relied on the wrong data. That same historic data that had nothing to do with these new kinds of mortgages.
Adam Davidson: And then things got even worse. The thing that took this problem and turned it into a crisis was something else that was new, something called a Collateralized Debt Obligation. A CDO. And that brings us back to the guy we met at the awards dinner in the beginning, Jim Finkel.
Adam Davidson: Jim Finkel runs this CDO shop, Dynamic Credit. It takes up three modified apartments on the upper East Side of Manhattan. The trading room is like a factory floor for CDOs, it’s where they make the things.
Adam Davidson: Maybe factory is the wrong term. But this is where he makes CDOs. But what is a CDO? He shows us on a computer screen.
Jim Finkel: Here’s our deal Monterey...
Adam Davidson: To start with, every CDO has its own name. Finkel loves his country house in the Berkshires, so he always names his CDOs after towns in western Mass. Like Monterey.
Jim Finkel: Monterey CDO limited. 189 assets...189 tranches of different MB pools
Alex Blumberg: Let’s translate some of that. A mortgage-backed security, you remember, is a pool of thousands of different mortgages. These are all put together and divided into different slices. Jim used the word tranche. Tranche is just French for slice - some of these slices are risky, some are not. OK, a CDO is a pool of those tranches. A pool of pools.
And Jim and most companies like his weren’t buying the top-rated tranches - the safest ones, the AAAs. They were buying the lower-rated stuff. The high-risk stuff. Jim’s company was buying tranches that came from Glen Pizzolorusso’s company. The guy who hung out at nightclubs with B-list celebrities. The guy who said he was selling mortgages to people who didn’t have a pot to piss in.
Adam Davidson: There's another term the industry uses, no joke, they call these lower-rated tranches toxic waste. They're so high-risk, they're toxic.
Alex Blumberg: So, a CDO is sort of a financial alchemy. Jim takes that toxic stuff, these low-rated, high-risk tranches, puts them all together. Re-tranches them, and presto: he has a CDO whose top tranche is rated AAA, rock-solid, good as money. If this seems too good to be true to you, you're in good company. Guys like billionaire investor Warren Buffet said the very logic was ridiculous. But back in 2005, 2006, the global pool of money couldn't get enough of these things. And the CDO industry was facing the same pressures everyone else was at every other step of this chain. To loosen their standards. To make CDOs out of lower and lower rated pools.
And then those "toxic" though triple A rated "tranches" of CDO's" were disseminated out into the markets of the international financial system in many forms and at many levels, instantaneously and electronically, implicating and involving pretty much everybody- wait a couple of years and voila: biggest financial crisis since The Great Depression.
Money ain't for nothing, as Dire Straits used to sing. If you have the time its very well done, very revealing and illuminating and well worth your time.
And so socialism comes to the U.S.A.
The bankers are the vanguard of the revolution.
This was the week the world changed. It started with the US authorities trying to rescue Lehman Brothers. It ended with the US taxpayer preparing to pick up the tab for the mistakes of Wall Street's elite. It started with the prime minister sipping cocktails with financiers in Canary Wharf.
It ended with the government slapping a ban on short-selling and Gordon Brown pledging to clean up the City. Britain's biggest lender was rescued and the Chinese government lined up to take a 49% stake in Morgan Stanley, one of the last US investment banks left after a week of carnage. Ben Bernanke, the chairman of the Federal Reserve and Hank Paulson, the Goldman Sachs tycoon who became US Treasury secretary, have done more for socialism in the past seven days than anybody since Marx and Engels.
Over and above the extraordinary individual events, there was the capitulation of the prevailing economic model. History will show that the great experiment with financial deregulation lasted from the first post-war oil shock in 1973 to the third oil shock in 2008.
Robert Kuttner in The American Prospect- The Seven Sins of Deregulation and the Three Necessary Reforms:
Sin Two: Allowing Unregulated Bond Rating Agencies to Decide What was Safe. Sub-prime is only the best known of a widespread fad known as "securitization." The idea is to turn loans into bonds. Bonds are given ratings by private companies that have official government recognition, such as Moody's and Standard and Poors, but no government regulation. These rating agencies have become thoroughly corrupted by conflicts of interest. If you want to package and sell bonds backed by risky loans, you go to a bond-rating agency and pay it a hefty fee. In return, the agency helps you manipulate the bond so that it qualifies for a triple-A rating, even if the underlying loans include many that are high-risk. Without the collusion of the bond-rating agencies, sub-prime lending never would have gotten off the ground, because it would not have found a mass market. Had regulators looked inside this black box, they would have shut it down. They might have needed new legislation, but they never asked for it. And public-minded regulators might have done a lot under existing law, since banks (which are regulated) were heavily implicated in the financing of sub-prime.
When I taught a journalism course at Princeton a couple of years ago, I was captivated by the bright, curious minds in my class. But when I asked students what they wanted to do, the overwhelming answer was: “Oh, I guess I’ll end up in i-banking.”
It was not that they loved investment banking, or thought their purring brains would be best deployed on Wall Street poring over a balance sheet, it was the money and the fact everyone else was doing it.
I called one of my former students, Bianca Bosker, who graduated this summer and has taken a job with The Monitor Group, a management consultancy firm (she’s also writing a book). I asked her about the mood among her peers.
“Well, I have several friends who took summer internships at Lehman that they expected to lead to full-time job, so this is a huge issue,” she said. “You can’t believe how intensely companies like Merrill would recruit at Ivy League schools. I mean, when I was a sophomore, if you could spell your name, you were guaranteed a job.”
But why do freshmen bursting to change the world morph into investment bankers?
“I guess the bottom line is the money. You could be going to grad school and paying for it, or earning six figures. And knowing nothing about money, you get to move hundreds of millions around! No wonder we’re in this mess: turns out the best and the brightest make the biggest and the worst.”
According to the Harvard Crimson, 39 percent of work-force-bound Harvard seniors this year are heading for consulting firms and financial sector companies (or were in June). That’s down from 47 percent — almost half the job-bound class — in 2007.
Institutions and products are graded by various credit-rating firms so as to supposedly give an objective view of the risks and of the possibilities of default. Can anyone say, while keeping a straight face, that the current system of having the institutions themselves pay for this service is a good idea? The moral hazard is so obvious you can almost taste it.
I spend a great deal of time speaking to people in banks about their mathematical models. I know which are using good models (a very few banks) and which are using bad models (most banks). I know of the dangers present, from a quantitative-finance and risk-management perspective. And for many years I have explained these dangers to anyone who would listen, and I will continue to do so. So it is incredible to think that ratings agencies, which must also have detailed knowledge of the nature and, more important, size of the toxic transactions, will happily give out their multiple A grades without any feeling of shame.
And then the word “theoretically” becomes very important. I have attended many conferences on quantitative finance, at which professors and practitioners describe their latest models for derivative instruments and the like. All the time I’m sitting in the audience thinking that these models are far too simplistic and based on countless unrealistic assumptions. I tell people that these instruments are dangerous, that no one understands the risks. But no one cares.
As long as people are compensated hugely for taking risks with other people’s money, and do not suffer equally on the downside, then those risks will inevitably become outrageous. Whether markets are efficient or not I don’t know for sure, but I do know that if there’s a way for someone to make money at another’s expense, he will. In spades. I want out.
Thus the current system of compensation at financial companies does not lead to anything good at all. If you give $10 million to random people on the street and tell them that they’ll get 20 percent of any profit they make, without any consequences if they lose it, then many of them will go into the nearest casino and bet it all on red. (The really clever ones will find a way to leverage it up first — after all, a $2 million bonus is nothing; you can’t seriously expect people to live in New York or London on less than eight figures, can you?)
If Wall Street gets away with this, it will represent an historic swindle of the American public--all sugar for the villains, lasting pain and damage for the victims. My advice to Washington politicians: Stop, take a deep breath and examine what you are being told to do by so-called "responsible opinion." If this deal succeeds, I predict it will become a transforming event in American politics--exposing the deep deformities in our democracy and launching a tidal wave of righteous anger and popular rebellion. As I have been saying for several months, this crisis has the potential to bring down one or both political parties, take your choice.
And as a bonus have some fun watching cheerleader Larry Kramer try to blame it all on the "guilty liberal consciences" of the U.S. Congress