B00BLPJNWE EBOK (19 page)

Matt Taibbi (
Griftopia
, 2010) and Gretchen Morgenson and Joshua Rosner (
RECKLES$ Endangermen
t, 2011) document the financial crisis associated with subprime derivatives and credit default swaps as the result of stupidity, greed, and criminality on the part of both government policymakers and financial executives.

The US government set the crisis in motion with the repeal in 1999 of the Glass-Steagall Act, which had kept commercial and investment banking separated since 1933.

Deregulation of the derivatives market followed. Soon fraud was running rampant, and debt was leveraged to irresponsible heights. The incompetent fools responsible for these “financial reforms” were portrayed in the media as heroes of Caesarian stature.

Mortgage securitization was the vehicle that spread Wall Street’s fraudulent “securities” around the world. Securitization allows lenders to issue mortgages for fees and to sell the mortgages to third parties, who combine them with mortgages from other lenders. The collection of mortgages is then sold to investors. Securitization removed the risk of payment failure from lenders, who thus became less concerned with the credit-worthiness of borrowers.

In order to reassure investors about credit-worthiness and to appeal to risk-tolerant hedge funds, the next development was to take a pool of mortgages of varying credit-worthiness and to organize them into three tranches. The mortgages were separated into AAA, B grade, and high-risk. The triple A tranche could be sold to pension funds and institutional investors. Hedge funds would take the high-risk tranche for the high-interest rate that they offered, intending to get rid of the mortgages before they had time to go bad. The middle tranche was the one hard to sell. The interest rate on the B grade tranche was not high enough to appeal to hedge funds, and pension funds were restricted to investment grade.

So what did the banksters do? They lumped together all the B grade tranches and repeated the process all over. The best of the lot were turned into—you guessed it—AAA, then came the B grade, and then the worst of the lot became the third tranche. And then the process was repeated again.

This was bad enough, but even worse was happening. Many of the AAA and B grade mortgages had that rating only because of fraudulent credit scores that lenders created for borrowers and because Wall Street rating agencies assigned investment grade ratings to lower grade mortgages. The rating agencies are not independent of Wall Street. The rating agencies are paid a fee by the issuers of financial paper for the ratings. Everyone was focused on short-term profits, from the lenders who churned out mortgages for fees, to rating agencies that churned out ratings for fees, to hedge funds that had no intention of holding the high-risk tranches beyond the short-run. This is how “toxic waste” was spread throughout the financial system.

Then it became possible to "insure" the AAA mortgages (many of which were not AAA). Once this happened, financial institutions that were required to maintain reserves against deposits or to capitalize obligations, such as insurance policies, could now substitute higher-paying mortgage derivatives for U.S. Treasury notes and still meet their reserve requirements for a ready cash reserve. Treasury notes are so liquid that they are considered the equivalent of cash, and insured AAA securitized mortgages acquired similar status.

The insurance company, AIG, became the big provider of "insurance" in an operation run by Joe Cassano. Taibbi’s account is masterful. Cassano's "insurance" product is called a credit default swap (CDS). It was not insurance, because AIG did not set aside capital to pay any claims. And claims there would be. Not only were the AAA mortgages that were being insured littered with subprime derivatives and other toxic waste, but also investment banks and hedge funds could purchase swaps against debt instruments that they did not even own. As Taibbi puts it, people were gambling in a casino in which gamblers did not have to cover their bets or own the financial instruments that they were insuring by purchasing credit default swaps.

While Cassano was collecting fees for bets that he could not cover, Win Neuger on the other side of AIG was lending the insurance giant's long-term portfolio of sound investments to short-sellers for a fee.

Short-selling works like this: A short-seller has a hunch or inside information that a company's stock price is going to fall in value. He borrows the stock from AIG or some other company by putting up collateral equal to its market price on the day the stock is borrowed plus a small fee. Then he sells the stock, pockets the money and waits for the stock to fall. If his hunch or inside information is correct, and the stock falls in value, he buys the stock and returns it to AIG, pocketing the difference in the two prices.

Normally, people who lend stock to short-sellers are content with the fee and with the interest on the collateral (cash) invested in safe instruments like Treasury bills. The lender of the stock cannot take any risk with the cash collateral, because the cash must be returned to the short-seller when he returns the borrowed stock.

However, once questionable financial instruments got AAA ratings from Wall Street rating agencies plus insurance from AIG, these dubious financial instruments could displace US Treasuries as a place for Neuger to hold the short-sellers' collateral. You can see the untenable position into which Cassano and Neuger put AIG.

Enter Goldman Sachs as a buyer of swaps from Cassano and a borrower of stocks from Neuger. Once the real estate bubble popped that the crazed Federal Reserve had caused, all the fraud that had been hidden by rising real estate prices appeared in its naked glory. AIG could not cover Cassano's swaps, and it could not return to short-sellers their collateral that Neuger had invested in subprime derivatives.

This was the origin of the 2008 Troubled Asset Relief Program (TARP) bailout. Goldman Sachs (whose former executives, as Taibbi relates, controlled the U.S. Treasury, financial regulatory agencies, and the Federal Reserve) perceived a bailout as an opportunity to have U.S. taxpayers pay off AIG’s losing bets with Goldman Sachs and also fund with free capital supplied by the bailout more money-making opportunities for "banks too big to
fail."

As Taibbi shows, Goldman Sachs had yet more ruin to bring to America and the world. Goldman Sachs managed to get the position limits repealed that regulation imposed on speculators. Position limits served to prevent speculation from taking over commodity markets (for example, grains, metals, and oil). Position limits on speculators limited the number of options or future contracts speculators could accumulate. The repeal of the limits allowed Goldman Sachs to create a new product, index speculation, which brought hundreds of billions of dollars of speculative money into commodities markets, allowing speculators to dominate commodity markets and to manipulate commodity markets as they do equity, debt, and currency markets.

There is much evidence of fraud and criminality on the part of financial firms and of conflicts of interest on the part of government policymakers, but no one has been held accountable and no meaningful corrective regulation has been enacted. The financial system remains a casino.

One hallmark of a failed state is that the crooks are inside the government, using government to protect and to advance their private interests. Another hallmark is rising income inequality as the insiders manipulate economic policy for their enrichment at the expense of everyone else.

As noted above, income inequality in the US is now extreme. The 2008 Organization for Economic Co-operation and Development (OECD) report, “
Income Distribution and Poverty in OECD Countries,
” concludes that the US is the country with the highest inequality and poverty rate across the OECD and that since 2000 nowhere has there been such a stark rise in income inequality as in the US. The OECD finds that in the US the distribution of wealth is even more unequal than the distribution of income.

On October 21, 2009,
Business Week
highlighted a
new report
from the United Nations Development Program that concluded that the US ranked third among states with the worst income inequality. As number one and number two, Hong Kong and Singapore, are both essentially city states, not countries, the US actually has the shame of being the country with the most inequality in the distribution of income.

The stark increase in US income inequality in the 21st century coincides with the offshoring of US jobs, which enriched executives with “performance bonuses” while impoverishing the middle class, and with the rapid rise of unregulated over-the-counter (OTC) derivatives and extraordinary debt leverage, which enriched Wall Street and the financial sector at the expense of everyone else.

Many critics of the worsening income and wealth distribution place the blame on President George W. Bush’s tax cuts, which were extended by Congress and President Obama. As the richest 1% receive much of their income in the form of capital gains, the reduction in the capital gains tax rate to 15% helped to worsen the inequality. However, the emphasis on taxation ignores the impact that two decades of jobs offshoring has had on the distribution of income and wealth. Taxing the rich cannot redress the loss of income for most Americans caused by moving US jobs offshore and by the conversion of that income into executive pay and shareholder’s capital gains.

The OECD report shows that the rate of increase in US income inequality declined during the Reagan years despite the tax rate reductions. During the mid-1990s the Gini coefficient (the measure of income inequality) actually fell. Beginning in 2000 with the New Economy (essentially financial fraud and offshoring of US jobs)
,
the Gini coefficient shot up sharply
.

While income and wealth accumulates at the top, millions of Americans have lost their homes and half of their retirement savings, while being loaded up with government debt to bail out the banksters who created the crisis.

Frontline’s TV broadcast, “The Warning,” documents how Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert Rubin, Deputy Treasury Secretary Larry Summers, and Securities and Exchange Commission Chairman Arthur Levitt blocked Brooksley Born, head of the Commodity Futures Trading Commission (CFTC), from performing her statutory duties and regulating over-the-counter (OTC) derivatives.
http://www.pbs.org/wgbh/pages/frontline/warning/view/

After the worst crisis in US financial history struck, just as Brooksley Born predicted, a disgraced Federal Reserve Chairman, Alan Greenspan, was summoned out of retirement to explain to Congress his unequivocal assurances that no regulation of derivatives was necessary. Greenspan had even told Congress that regulation of derivatives would be harmful. A pathetic Greenspan had to admit that the free market ideology on which he had relied turned out to have a flaw.

Greenspan may have bet America’s economy on his free market ideology, but does anyone believe that Rubin and Summers were doing anything other than protecting the enormous fraud-based profits that derivatives were bringing Wall Street? As Brooksley Born stressed, OTC derivatives are a “dark market.” There is no transparency. Regulators have no information on them and neither do purchasers.

Even after Long Term Capital Management failed in 1998 and had to be bailed out, Greenspan, Rubin, and Summers stuck to their guns. Greenspan, Rubin and Summers, and a gullible Securities and Exchange Commission Chairman, Arthur Levitt, who now regrets that he was the banksters’ dupe, succeeded in manipulating Congress into blocking the CFTC from doing its mandated job. Brooksley Born, prevented by the public’s elected representatives from protecting the public, resigned. Wall Street money simply shoved facts and honest regulators aside, resulting in the financial crisis that hit in 2008 and continues to plague the economy today.

The financial insiders running the Treasury, White House, and Federal Reserve shifted to taxpayers the cost of the catastrophe that they had created. When the crisis hit, Henry Paulson, appointed by President George W. Bush to be Rubin’s replacement as the Goldman Sachs representative running the US Treasury, hyped fear to obtain from “the people’s representatives” in Congress with no questions asked hundreds of billions of taxpayers’ dollars (TARP money) to bail out Goldman Sachs and the other malefactors of unregulated derivatives.

When Goldman Sachs announced that it was paying massive six and seven figure bonuses to every employee, public outrage erupted. In defense of banksters, saved with the public’s money, paying themselves bonuses in excess of most people’s life-time earnings, Lord Griffiths, the British Vice Chairman of Goldman Sachs International, said that the public must learn to “tolerate the inequality as a way to achieve greater prosperity for all.”

In other words, “Let them eat cake.”

According to the UN report cited above, Great Britain has the 7th most unequal income distribution in the world. After the Goldman Sachs bonuses, the British will move up in distinction, perhaps rivaling Israel for the fourth spot in the hierarchy.

Despite the absurdity of unregulated derivatives, the high level of public anger, and Greenspan’s confession to Congress that his theory has a flaw, still nothing has been done to regulate derivatives. One of Rubin’s Assistant Treasury Secretaries, Gary Gensler, replaced Brooksley Born as head of the CFTC. Larry Summers was appointed head of President Obama’s National Economic Council. Former Federal Reserve official Timothy Geithner, a Paulson protege, was appointed Treasury Secretary. A Goldman Sachs vice president, Adam Storch, was appointed the chief operating officer of the Securities and Exchange Commission. The Banksters remain in charge.