The Great American Stickup

Yes, there is a "they": the captains of finance, their lobbyists, and allies among leading politicians of both parties, who together destroyed an American regulatory system that had been functioning splendidly for most of the six decades since it was enacted in the 1930s.

"They" will emerge largely unscathed—indeed, likely wealthier—from exploiting the newfound bargains in foreclosed properties and bankrupt businesses that this turmoil provides to those with access to ready cash. And even as they make taxpayers foot the bill for their grievous greed and errors, they are eager to cover their tracks and unwilling to accept responsibility for the damage done.

The big cop-out in much of what has been written about the banking meltdown has been the argument by those most complicit that there was "enough blame to go around" and that no institution or individual should be singled out for accountability. "How could we have known?" is the refrain of those who continue to pose as all-knowing experts. "Everybody made mistakes," they say.

Nonsense. This was a giant hustle that served the richest of the rich and left the rest of us holding the bag, a life-altering game of musical chairs in which the American public was the one forced out. Worst of all, legislators from both political parties we elect and pay to protect our interests from the pirates who assaulted us instead changed our laws to enable them.

The most pathetic of excuses is the one provided by Robert Rubin, who fathered "Rubinomics," the economic policy of President Clinton's two-term administration: The economy ran into a "perfect storm," a combination of unforeseen but disastrously interrelated events. This rationalization is all too readily accepted by the mass media, which is not surprising, given that it neatly absolves the majority of business reporters and editors who had missed the story for years until it was too late.

The facts are otherwise. It is not conspiratorial but rather accurate to suggest that blame can be assigned to those who consciously developed and implemented a policy of radical financial deregulation that led to a global recession. As President Clinton's Treasury secretary, Rubin, the former cochair of Goldman Sachs, led the fight to free the financial markets from regulation and then went on to a $15-million-a-year job with Citigroup, the company that had most energetically lobbied for that deregulation. He should remember the line from the old cartoon strip Pogo: "We have met the enemy and he is us."

For it was this Wall Street and Democratic Party darling, along with his clique of economist super-friends—Alan Greenspan, Lawrence Summers, and a few others—who inflated a giant real estate bubble by purposely not regulating the derivatives market, resulting in oceans of money that was poured into bad loans sold as safe investments. In the process, they not only caused an avalanche of pain and misery when the bubble inevitably burst but also shredded the good reputation of the American banking system nurtured since the Great Depression.

This book aims to describe how and why this was done, as well as who tried to stop it and why they failed, because if we accept a broad dispersal of blame or a sense of inevitability—or simply ignore the details, since they can be so confusing—we lose the opportunity to rearrange our institutions to prevent such disasters from happening again.

That this is true was only reinforced by the tentative response of the Obama administration in its first year. Even after a crash that economists agree is the biggest since the granddaddy of 1929, the president's proposed reform legislation stops far short of reintroducing the kind of regulation of the markets that prevented such disasters in the intervening eighty years. We still see a persistent fear, stoked by the same folks who led us into this abyss, that regulation and scrutiny will kill the golden goose of Wall Street profits and, by extension, U.S. prosperity.

If we as a people learn anything from this crash, however, it should be that there are no adults watching the store, only a tiny elite of self-interested multimillionaires and billionaires making decisions for the rest of us. As long as we cede that power to them, we can expect to continue getting bilked.

Three key myths consistently propagated about the financial markets proved devastating in this event. The first is that buyers and sellers are all logical and well-informed about what they are doing, so the markets will always be "corrected" to provide accurate price values. The second is that whatever happens in these "free markets," the general public will not be hurt—only irresponsible gamblers will lose their shirts. The third is that whenever the government gets involved, it will only screw things up; even if regulators only ask questions, it will poison the pond and spook the fish, to everybody's detriment.

As we will see in the following chapters, all of these assumptions were proven false; the brave new world order of super-rational high-tech derivative marketing based on Nobel Prize-winning mathematical models turned out to be a prescription for financial madness. A win-win system too good to be true turned out to be a cruel hoax in which most suffered terribly—and not just that majority of the world's population that suffers from the whims of the market, but even some who designed and sold the new financial gimmicks. Left to their own devices, freed of rational regulatory restraint by an army of lobbyists and the politicians who serve them, one after another of the very top financial conglomerates imploded from the weight of their uncontrolled greed. Or would have imploded, as in the examples of Citigroup and AIG, if the government had not used taxpayer dollars to bail out those "too big to fail" conglomerates.

Along the way, these companies—including the privatized quasi-governmental Fannie Mae and Freddie Mac monstrosities—were exposed as poorly run juggernauts, with top executives having embarrassingly little grasp of the chicanery and risk taking that was bolstering their bottom lines. Worst of all, damage from this economic chain reaction didn't, of course, stop at the bank accounts of Saudi investors or American CEOS but led to soaring unemployment and federal debt, the acceleration of the home foreclosure epidemic, massive unemployment, and the wholesale destruction of pension plans and state education budgets.

Since the collapse happened on the watch of President George W. Bush at the end of two full terms in office, many in the Democratic Party were only too eager to blame his administration. Yet while Bush did nothing to remedy the problem, and his response was to simply reward the culprits, the roots of this disaster go back much further, to the free-market propaganda of the Reagan years and, most damagingly, to the bipartisan deregulation of the banking industry undertaken with the full support of "liberal" President Clinton. Yes, Clinton. And if this debacle needs a name, it should most properly be called "the Clinton bubble," as difficult as it may be to accept for those of us who voted for him.

Clinton, being a smart person and an astute politician, did not use old ideological arguments to do away with New Deal restrictions on the banking system, which had been in place ever since the Great Depression threatened the survival of capitalism. His were the words of technocrats, arguing that modern technology, globalization, and the increased sophistication of traders meant the old concerns and restrictions were outdated. By "modernizing" the economy, so the promise went, we would free powerful creative energies and create new wealth for a broad spectrum of Americans—not to mention boosting the Democratic Party enormously, both politically and financially.

And it worked: Traditional banks freed by the dissolution of New Deal regulations became much more aggressive in investing deposits, snapping up financial services companies in a binge of acquisitions. These giant conglomerates then bet long on a broad and limitless expansion of the economy, making credit easy and driving up the stock and real estate markets to unseen heights. Increasingly complicated yet wildly profitable securities—especially so-called over-the-counter derivatives (OTC), which, as their name suggests, are financial instruments derived from other assets or products—proved irresistible to global investors, even though few really understood what they were buying. Those transactions in suspect derivatives were negotiated in markets that had been freed from the obligations of government regulation and would grow in the year 2009 to more than $600 trillion.

America's middle class, excited to be trading stocks on the Internet and leveraging their homes to remodel their kitchens, approved heartily, giving Clinton seemingly irrepressible popularity even in the face of personal scandal. "It's the economy, stupid," was his famous campaign mantra, although statistics would later show that the vast majority of new wealth was going to the top 10 percent of the population. Even if real wages were basically stagnant, people felt richer, because they had what seemed to be limitless credit to enjoy the best of what the consumer culture had to offer.

Meanwhile, the Democrats had reversed a decades-long decline in fundraising might, surpassing the Republicans as Wall Street, whose denizens tended to be socially liberal, suddenly poured money into the party's coffers. This trend continues today: President Obama's second-biggest contributor was the investment bank Goldman Sachs, which played a key role in the economic collapse even as, with the government's help, it survived and went on to new heights of profit.

The good times, however, were based on a foundation of sand. At the boom's heart was a casino in which everyone was seemingly betting one way—even as they were buying insurance on their bets, which allowed them to believe they were playing it safe. This virtual market was a huge expansion in derivatives futures trading, transforming a market based on predicting the prices of well-understood commodities into the realm of financial hocus-pocus. Unlike the traditional staple products—pork bellies, wheat, and other such commodities—of the major futures exchange, these new products were more varied, less transparent, and almost completely unregulated. The new derivatives were sold over the counter—instead of on a public exchange—meaning that a buyer and a seller simply made deals directly. But what was really different about these OTC derivatives that caused the meltdown was what the investors were buying: future payments and/or interest on debts.

Here's how it worked: Initial lenders—banks, savings and loans, credit companies—would give out money to consumers or businesses to purchase equipment, inventory, credit cards, cars, and boats, but mostly mortgages on houses and commercial real estate. Investment banks would then buy these "debt obligations" in "bundles" worth hundreds of millions of dollars. Using complex mathematical formulas, they would then sort the contents of a bundle by the predicted risks.

Those risks involved either default on loan obligations or the prepayment of loans by consumers to avoid interest obligations. In either case, the flow of interest income—the basis of the bundled derivatives—would be compromised. To avoid such losses, the bundles of derivatives would be sliced and diced into "tranches" (French for slices), in which investors, especially huge institutional buyers, could more easily invest. Oh, and they would pay an ostensibly neutral rating agency to validate that the risk level was as advertised.

As if this wasn't enough of a complicated novelty, another angle was linked to this market: swaps. This was a form of insurance, or so it appeared to those who paid for it, that would protect investors if things went so sour that folks stopped paying back their debts. AIG, for example, once a traditional and regulated insurance provider, suddenly started making wild profits backing up bad debts on those credit derivatives. As opposed to their traditional insurance, however, these "swaps" were not regulated. And when the collapse occurred, it happened that AIG had not put aside sufficient funds to back these obligations. Your taxpayer dollars, $180 billion worth, were used instead.

Beginning in the early '90s, this innovative system for buying and selling debt grew from a boutique, almost experimental, Wall Street business model to something so large that, when it collapsed a little more than a decade later, it would cause a global recession. Along the way, as we will see, only a few people possessed enough knowledge and integrity to point out that the growth and profits it was generating were, in fact, too good to be true.

Until it all fell apart in such grand fashion, turning some of the most prestigious companies in the history of capitalism into bankrupt beggars, all the key players in the derivatives markets were happy as pigs in excrement. At the bottom, a plethora of aggressive lenders was only too happy to sign up folks for mortgages and other loans they could not afford because those loans could be bundled and sold in the market as collateralized debt obligations (CDOs). The investment banks were thrilled to have those new CDOs to sell, their clients liked the absurdly high returns being paid—even if they really had no clear idea what they were buying—and the "swap" sellers figured they were taking no risk at all, since the economy seemed to have entered a phase in which it had only one direction: up.

Of course, this was ridiculous on the face of it. Could it really be so easy? What was the catch? Never mind that, you spoiler! Not only were those making the millions and billions off the OTC derivatives market ecstatic, so were the politicians, bought off by Wall Street, who were sitting in the driver's seat while the bubble was inflating. With credit so easy, consumers went on a binge, buying everything in sight, which in turn was a boon to the bricks-and-mortar economy. Blown upward by all this "irrational exuberance," as then Federal Reserve Bank chair Alan Greenspan noted in one of his more honest moments, the stock market soared, creating the era of e-trade and a middle class that eagerly awaited each quarterly 401(k) report.

Later, in the rubble, consumer borrowers would be scapegoated for the crash. This is the same logic as blaming passengers of a discount airline for their deaths if it turned out the plane had been flown by a monkey. Shouldn't they have known they should pay more? In reality, the gushing profits of the collateralized debt markets meant the original lenders had no motive to actually vet the recipients—they wouldn't be trying to collect the debt themselves anyway. Instead, they would do almost anything to entreat consumers to borrow far beyond their means, reassuring them in a booming economy they'd be suckers not to buy, buy, buy.

That this madness was allowed to develop without significant government supervision or critical media interest, despite the inherent instability and predictable future damage of a system of growth predicated on its own inevitability, is a tribute to the almost limitless power of Wall Street lobbyists and the corruption of political leaders who did their bidding while sacrificing the public's interest.

While much has been made of the baffling complexity of the new market structures at the heart of the banking meltdown, there were informed and prescient observers who in real time saw through these gimmicks. The potential for damage was thus known inside the halls of power to those who cared to know, if only because of heroes like gutsy regulator Brooksley Born, chair of the Commodity Futures Trading Commission from 1996 to 1999. When they attempted to sound the alarm, however, they were ignored, or worse. Simply put, the rewards in both financial remuneration and advanced careers were such that those in a position to profit went along with great enthusiasm. Those who objected, like Born, were summarily crushed.

What follows in this book is the story of those who acted in the public interest and attempted to prevent this unfolding disaster and the response of a far more powerful coterie of ideologically driven and yet avaricious government and business leaders. By and large, those leaders have not been held accountable for their actions and, indeed, most often went on to reap even greater rewards as born-again reformers called upon to set right that which they had wrecked. Far too many have been granted far-reaching powers in President Barack Obama's administration as foxes told to fix the damage they themselves have done to the henhouse.

Of the leaders responsible, five names come prominently to mind: Alan Greenspan, the longtime head of the Federal Reserve; Robert Rubin, who served as Treasury secretary in the Clinton administration; Lawrence Summers, who succeeded him in that capacity; and the two top Republicans in Congress back in the 1990s dealing with finance, Phil Gramm and James Leach.

Arrayed most prominently against them, far, far down the DC power ladder, were two female regulators, Born and Sheila Bair (an appointee of Bush I and II and retained as FDIC chair by Obama). They never had a chance, though; they were facing a juggernaut: The combined power of the Wall Street lobbyists allied with popular President Clinton, who staked his legacy on reassuring the titans of finance a Democrat could serve their interests better than any Republican.

Clinton's role was decisive in turning Ronald Reagan's obsession with an unfettered free market into law. Reagan, that fading actor recast so effectively as great propagandist for the unregulated market—"get government off our backs" was his signature rallying cry—was far more successful at deregulating smokestack industries than the financial markets. It would take a new breed of "triangulating" technocrat Democrats to really dismantle the carefully built net designed, after the last Great Depression, to restrain Wall Street from its pattern of periodic self-immolations.

Even some of the brightest liberals, such as Nobel Prize- winning economist Paul Krugman, have failed to realize how their party, long claiming to represent the middle and working classes, did so much to let the smart money guys run us all into the ground. "The prime villains behind the mess we're in were Reagan and his circle of advisers," Krugman wrote in a June 2009 column, perhaps out of wishful thinking. Reagan's 1982 signing of the Garn-St. Germain Depository Institutions Act easing mortgage interest requirements pales in comparison to the damage wrought fifteen years later by the collateralized debt bubble, which couldn't have existed but for a series of key deregulatory laws pushed through during the Clinton years with the president's support.

This process was neither an accident nor an oversight; at the center of Clinton's strategy for political success was the much commented-on "triangulation" that sought to avoid the traditional liberal-conservative divide on issues by finding a win-win solution that appropriated the most politically appealing elements of competing approaches. Nowhere during the eight years of the Clinton presidency was that triangulation strategy applied with greater energy than toward economic policy.

But while the strategy appeared to work wonderfully and the administration was praised widely for having presided over what Clinton often referred to as the longest sustained period of prosperity in American history, it no longer can be logically viewed that way after the banking meltdown. Instead of sustained prosperity, the U.S. economy had created an enormous bubble, based on rampant borrowing and speculation, that inevitably burst, as all bubbles do. And whereas Clinton would brag that his management of the economy had embraced the needs of Wall Street as well as the vast majority, including those at the lower end of the economic scale, it ended up performing well only for those already at the top.

Analyzing U.S. tax data and other supporting statistics, UC Berkeley economist Emmanuel Saez and his colleague Thomas Piketty concluded that the boom of the Clinton years and afterward primarily benefitted the wealthiest Americans. During Clinton's tenure—from 1993 to 2000—the income of the top 1 percent shot up at the astounding rate of 10.1 percent per year, while the income of the other 99 percent of Americans increased only 2.4 percent annually. In 2002-2006, the next surge of the boom that Clinton's policies unleashed, the numbers were even more unbalanced: The average annual income for the bottom 99 percent increased by only 1 percent per annum, while the top 1 percent saw a gain of 11 percent each year.

Further, just as the good times of the Bush years saw almost $3 out of every $4 in increased income go to the wealthiest 1 percent, the GOP cut taxes for the richest brackets. An understanding of why the nation's media and political elites failed to question the Clinton claim of prosperity may be found in the fact that almost all of them were in the elite that benefitted, having had pretax family income higher than the $104,700 that qualified for the top 10 percent category in 2006, and some made more than the $382,600 to be included in the top 1 percent.

Presumably, had the boom continued, some would have argued that the rapid enrichment of the top 1 percent would have been justified by the increases in the real worth of the bottom 99 percent. But the boom didn't continue, and with the crash came unfathomable loss across the board. By June 2009, the Federal Reserve reported that the net worth of U.S. households had dropped for seven straight quarters, with families losing 22 percent of the wealth that they had obtained by the spring of 2007. Most of that loss occurred in the declining value of homes and stocks in retirement programs.

And nobody was predicting that all that paper wealth was going to come back in a hurry—or perhaps ever at all. "I don't think the worst is over," Lawrence Summers, who was Clinton's Treasury secretary and who would reemerge as the top economic adviser in the Obama White House, told the Financial Times on July 10, 2009. "It's very likely that more jobs will be lost. It would not be surprising if GDP has not yet reached its low. What does appear to be true is that the sense of panic in the markets and freefall in the economy has subsided, and one does not have the sense of a situation as out of control as a few months ago."

Some experts were less sanguine. Former Clinton administration Labor secretary Robert Reich believes there is no going back to the way things were. "In a recession this deep, recovery doesn't depend on investors," wrote Reich on his blog on July 9, 2009. "It depends on consumers who, after all, are 70% of the US economy. And this time consumers got really whacked." Reich continues:

What Reich was suggesting was that there would be neither a sharp ("V") nor a more gradual ("U") return to the high rolling times before the balloon burst. Instead, we have entered a very different economy in which high-paying jobs and the appearance of lower-middle-class prosperity might not return ("X").

Into this mess stepped Barack Obama, after his historic election as America's first African American president. Early in the campaign, Obama had shown a sophisticated grasp of the causes of the crash, and one in line with the central thesis of this book. Speaking at Manhattan's Cooper Union on March 27, 2008, the Democratic Primary candidate provided what still stands as one of the best analyses of the extent and causes of the economic crisis: