A Fighting Chance (52 page)

scientific research for the next twenty years:
I recognize that TARP was a loan that was designed to be repaid, but a loan from the government—particularly on terms that no private lender would take on—is fundamentally about investment. Thus the examples in the text include other investments that the United States could have made, such as education, infrastructure, and scientific research, that also would have paid out over time, albeit over a longer time horizon, with a more productive and inventive workforce, more efficiency in power, transportation, and other production necessities, and a boost to business innovations that come through support of scientific and medical research.

previously been closed off to them:
The regulatory changes in the 1980s (see note,
“
the cap on interest rates…
”
) enabled banks to engage in increasingly risky, nontraditional practices. In the 1980s and 1990s, regulators reinterpreted—and Congress ultimately repealed—the Glass-Steagall Act, which had separated commercial and investment banking activities. These changes, in combination with other changes that encouraged greater consolidation of financial institutions, enabled banks to enter new and dangerous terrains. As basic banking—checking, savings, mortgages, loans—were folded into increasingly complex financial institutions, regulators were called on to oversee a wider variety of intricate investment and hedging activities. Everything became more complicated, from the balance sheets to the credit ratings. A few banks ballooned in size, posing more risks for the economy and more challenges for the regulators.

See Matthew Sherman, “A Short History of Financial Deregulation in the United States,” Center for Economic and Policy Research, July 2009.

During this time, the financial industry developed a number of new products, including a variety of derivatives (instruments used to hedge against risk without involving an actual transfer of underlying assets) and securitized assets (instruments used to pool assets and repackage them into securities). As discussed in the text, the risky proliferation of securitized mortgage loans contributed significantly to the 2008 financial crisis.

By selling the mortgages to investors, the banks had more money to lend. That turned out to have good and bad elements: more people now had access to mortgages and could buy homes, but with more mortgage money available, the housing bubble also began to inflate and prices began to rise. See “The Financial Crisis Inquiry Report.” The 2008 crisis had many contributing factors and no one solution can address all of them, but I partnered with Senators John McCain, Maria Cantwell, and Angus King several months after arriving to the Senate in proposing a twenty-first-century Glass-Steagall Act to dial back the risk and shrink the largest institutions. The big banks remain adamantly opposed, but we’ve had some strong support from Americans for Financial Reform, the Progressive Change Campaign Committee, and many other groups who are fighting for a safer banking system.

out to make a quick buck:
Banks became heavily involved in developing and peddling mortgage-backed securities in the 1990s and 2000s. As Fannie Mae and Freddie Mac focused on securitizing prime mortgage loans, banks, thrifts, and investment banks focused on securitizing riskier mortgage loans, such as subprime loans, “Alt-A” loans, and non-conforming loans. Since interest rates were low, many investors were looking for safe investments that would pay higher premiums. Home mortgages seemed like the perfect answer, with low default rates and higher returns. Over time, originators began to peddle more and more high-risk mortgages to satisfy the greater and greater demand for the securities. And the mortgage bundlers developed more and more refined techniques for disguising the risk, even fueling further demand for the securities. Thus originators peddled more and more high-risk mortgages to satisfy greater and greater investor demand for the securities. This was all done with the imprimatur of the credit rating agencies that repeatedly signed off on the safety of the underlying packages of mortgages. Between 2003 and 2007, financial institutions created more than $4 trillion in mortgage-backed securities. See “The Financial Crisis Inquiry Report.” As the Financial Crisis Inquiry Commission noted, this “originate-to-distribute model undermined responsibility and accountability for the long-term viability of mortgages and mortgage-related securities and contributed to the poor quality of mortgage loans” (125).

got more and more complicated:
“In the first decade of the 21st century, a previously obscure financial product called the collateralized debt obligation, or CDO, transformed the mortgage market by creating a new source of demand for the lower-rated tranches of mortgage-backed securities. Despite their relatively high returns, tranches rated other than triple-A could be hard to sell.… Wall Street came up with a solution: in the words of one banker, they ‘created the investor.’ That is, they built new securities that would buy the tranches that had become harder to sell. Bankers would take those low investment-grade tranches, largely rated BBB or A, from many mortgage-backed securities and repackage them into the new securities—CDOs. Approximately 80% of these CDO tranches would be rated triple-A despite the fact that they generally comprised the lower-rated tranches of mortgage-backed securities.” “Between 2003 and 2007, as house prices rose 27% nationally and $4 trillion in mortgage-backed securities were created, Wall Street issued nearly $700 billion in CDOs that included mortgage-backed securities as collateral.” See “The Financial Crisis Inquiry Commission Report,” 127–50.

mortgage bundles AAA ratings:
See “The Financial Crisis Inquiry Commission Report” on AAA ratings of bundled mortgages.

For one example, see: “In May 2007, Standard & Poor’s confirmed its initial AAA ratings on $772 million of a collateralized debt obligation known as Octonion I. Within 10 months, the Citigroup Inc. (C) deal defaulted, costing investors and the bank almost all their money.… Octonion I underscores how inflated grades during the credit boom contributed to more than $2.1 trillion in losses at the world’s financial institutions after home-loan defaults soared and residential prices plummeted.” Jody Shenn, “Default in 10 Months After AAA Spurred Justice on Credit Ratings,”
Bloomberg
, February 5, 2013. For more examples, see Kevin G. Hall, “How Moody’s Sold Its Ratings—and Sold Out Investors,”
McClatchy
, October 18, 2009. See also David Evans, “Banks Sell ‘Toxic Waste’ CDOs to Calpers, Texas Teachers Fund,”
Bloomberg News
, June 1, 2007.

Chair of the Commodity Futures Trading Commission Brooksley Born pushed for greater regulation of derivatives and other products, “warning that unregulated financial contracts such as credit default swaps could pose grave dangers to the economy. Her efforts brought fierce opposition from Wall Street and from Administration officials who believed deregulation was essential to the extraordinary economic growth that was then in full bloom.” See Henry Liu, “Financial Reform Warrior Brooksley Born Warns of More Crises to Come,” Roosevelt Institute, November 2009. See also Manuel Roig-Franzia, “Credit Crisis Cassandra,”
Washington Post
, May 26, 2009.

a catastrophic meltdown:
A new type of insurance product played a large role in exacerbating the financial crisis—the credit default swap. Credit default swaps were designed to protect investors from defaults or declines in the value of mortgage-backed securities. In exchange for periodic payments from the buyer, the insurer would pay the buyer the face value of the debt in the event of default or other specified “credit event.” “The Financial Crisis Inquiry Commission Report,” 50. Unlike other insurance products, credit default swaps were not subject to federal regulation because they were treated as over-the-counter derivatives. As the Financial Crisis Inquiry Commission Report noted, credit default swaps contributed significantly to the financial crisis by “fuel[ing] the mortgage securitization pipeline,” as they helped to create an illusion of safety. “The Financial Crisis Inquiry Commission Report,” xxiv. AIG sold more than $79 billion worth of credit default swaps in the run-up to the crisis. The combination of credit defaults swaps and CDOs—discussed above—created a dangerous environment in which there were multiple opposing bets on the same securities spread across different sectors of the financial system.

financial system might crumble to nothing:
Bear Stearns, an investment bank and securities trading and brokerage firm, collapsed in early 2008 as a result of excessive exposure to subprime mortgages. The Federal Reserve Bank of New York negotiated a sale of Bear Stearns to JPMorgan on March 16, 2008, which was supported by a $30 billion loan from the government to JPMorgan to salvage the company. Federal Reserve chairman Ben Bernanke defended the bailout as necessary to protect asset values and to prevent a “chaotic unwinding” of investments across the United States. See Yalman Onaran, “Fed Aided Bear Stearns as Firm Faced Chapter 11, Bernanke Says,”
Bloomberg
, April 2, 2008.

Lehman Brothers, a leading investment bank and global financial services firm, filed for bankruptcy protection on September 15, 2008, after suffering major stock losses and devaluation of its assets by credit-rating agencies. The failure of Lehman was the largest failure of an investment bank in decades, and it sent a shock wave through the markets. Sheila Bair notes: “First, the bankruptcy defied market expectations. Bear Stearns had been bailed out, and most market players assumed that the government would step in with Lehman as well.… Markets hate uncertainty, and the Lehman failure confused them.” She continues, “Because of that flexible accounting treatment for complex securities, Lehman looked as if it was much stronger than it really was. The lack of transparency about Lehman’s true financial condition immediately created suspicion about other financial institutions that also held opaque, complex mortgage investments on their books. As a consequence, the institutions with the biggest exposures, such as Merrill and Citigroup, started having problems accessing credit even from other financial institutions.…” Sheila Bair,
Bull by the Horns
, 107. Merrill Lynch, a large brokerage firm, was on the verge of collapse due in large part to its involvement in the mortgage-based collateralized debt obligations market. On September 14, 2008, Bank of America acquired Merrill Lynch, with Bank of America citing pressure from the US government to follow through with the transaction.

struggled to get car loans:
“In the aftermath of the panic, when credit was severely tightened, if not frozen, for financial institutions, companies found that cheap and easy credit was gone for them, too. It was tougher to borrow to meet payrolls and to expand inventories; businesses that had neither credit nor customers trimmed costs and laid off employees. Still today, credit availability is tighter than it was before the crisis.” See “The Financial Crisis Inquiry Commission Report,” 389. Also, from p. 214: “Securitization of auto loans, credit cards, small business loans, and equipment leases all nearly ceased in the third and fourth quarters of 2008.”

See also Nick Carey, “Credit Seen Drying Up for U.S. Small Business,”
USA Today
, July 25, 2008. Bill Vlasic and Nick Bunkley, “With Credit Drying Up, Car Buyers Bring Cash,”
New York Times
, October 7, 2008.

For COP’s critique of Treasury reaction to inadequate credit for small businesses, see note,
“
actual policies were anemic
.”

financial system had stalled:
On Thursday, September 19, 2008, Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke began their push for broad bailout authority by meeting with members of Congress. See David Herszenhorn, “Congressional Leaders Stunned by Warnings,”
New York Times
, September 20, 2008. See Edmund L. Andrews, “Bush Officials Urge Swift Action on Rescue Powers,”
New York Times
, September 19, 2008. They sent a three-page written request to Congress. See “Treasury’s Bailout Proposal: The Legislative Proposal Was Sent by the White House Overnight to Lawmakers,”
CNNMoney
, September 20, 2008. Henry M. Paulson and Ben S. Bernanke appeared before the Senate Banking Committee on Tuesday, September 23, and the House Financial Services Committee on September 24. See “Prepared Text of Paulson’s Statement,”
New York Times,
September 23, 2008. Henry Paulson would later write in his book: “Going into the hearing, I knew I had to choose my words carefully. We faced a real dilemma: To get Congress to act we needed to make dire predictions about what would happen to the economy if they didn’t give us the authorities we wanted. But doing so could backfire. Frightened consumers might stop spending and start saving, which was the last thing we needed right then. Investors could lose the final shred of the confidence that was keeping the markets from crashing.” Henry M. Paulson,
On the Brink: Inside the Race to Stop the Collapse of the Global Financial System
(2010), 281–83.

auto companies reported that they were on the verge of bankruptcy:
See December 2008 COP report, “Questions About the $700 Billion Emergency Economic Stabilization Fund,”
http://cybercemetery.unt.edu/archive/cop/20110402034700/http://cop.senate.gov/documents/cop-121008-report.pdf
. For more on the auto companies, see Chris Isidore, “Big Three Face Bankruptcy Fears,”
CNNMoney
, August 6, 2008.