The 2008 financial crash was the worst since the great crash of 1929 and caused the worst economy since the Great Depression. It has cost the United States more than $20 trillion in lost GDP and tens of millions of Americans are still recovering from lost homes, jobs, savings, stagnant wages and crushing student loan debts. In addition to diverting trillions of dollars to bailouts for the financial industry, the crash caused massive deficits and debt, which have resulted in the ongoing underfunding of all of America’s priorities from education and health care to science and job creation.
The causes of the crash and the economic crisis it created will be debated for decades, if not longer. They were indeed multifaceted and complex. But make no mistake: the primary culprits were Wall Street’s too-big-to-fail financial institutions that engaged in an almost unprecedented binge of risk-taking, irresponsible lending and, at times, massive illegal conduct.
Some of this behavior was legal. Some of it illegal. Some of it was criminal. Some of it was just unethical, irresponsible or stupid. Much of it was a mix of all of that. Some of it contributed directly to the financial crisis, some of it indirectly. But Wall Street’s reckless, high-risk behavior was all too representative of the unregulated, freewheeling, anything-goes, money-soaked, bonus-driven culture that existed throughout too much of the financial industry before 2008.
Wall Street and its allies have been trying to shift the blame for the financial crisis to someone or something — anything — since the crash. They blamed regulators at the U.S. Securities and Exchange Commission and the Fed. They blamed indebted homeowners, the very victims of their scams, frauds and predatory activities. They even blamed Jimmy Carter and a 40-year old law designed to expand credit to underserved communities.
But the facts show that for years prior to the crisis, the biggest financial firms gorged themselves on short-term debt and left themselves critically undercapitalized and without sufficient liquidity; originated poorly underwritten mortgages that they knew would never be repaid; and packaged those mortgages into deceptively valued securities, derivatives and structured products that they sold to unsuspecting investors around the world, often fraudulently. The big banks and bankers did these things because they were focused on maximizing short-term profits to pocket huge annual bonuses — at the expense of their clients, customers and counterparties, as well as the long-term viability of their firms, the financial system and the U.S. economy.
Many, if not most of them, knew exactly what they were doing. In 2007, Citigroup’s then-CEO Chuck Prince famously said, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
In other words, “we know this risk-taking binge isn’t sustainable and will end in disaster. But, in the meantime, as long as others are doing it, we’re going to keep doing it too and keep making as much money as fast as we can.” Thus, legal or illegal, Wall Street’s biggest firms irresponsibly maximized their short-term wealth based on incredibly dangerous leveraged risk-taking, courting disaster that ultimately fell on America’s families, workers, taxpayers and communities.
First, the legal activities. The years before the crash saw a dramatic increase in irresponsible and unethical behavior by Wall Street. For example, Wall Street firms grew enormously in size while ramping up their leverage to dangerously high levels. They also originated or supplied the funding for others to originate as many subprime mortgages as they could, while their derivatives and structured products divisions simultaneously created an insatiable demand for those mortgages.
This was enabled by the massive bipartisan deregulation during the 1990s and 2000s. Following the crash of 1929, the U.S. passed laws and regulations to create layers of protection between Wall Street’s high-risk activities and Main Street’s homes, jobs and savings. Those reforms imposed the heaviest regulation on the financial sector in the history of the world. Wall Street and its allies claimed that those laws and regulations would be the end of capitalism, destroy the banking sector, prevent lending, kill economic growth and cause the loss of jobs across the country.
Yet, Wall Street’s hysterical claims of doom on Main Street if they were required to reduce their most dangerous, socially unproductive risk-taking all proved wrong. With the innumerable new laws and rules focusing finance on the real economy, America enjoyed an unprecedented booming economy in the following decades, which created the largest middle-class history, and even the financial industry thrived. That’s what prevented another catastrophic financial crash for more than 70 years.
Until deregulation. One of the more important laws passed after the great crash and whose repeal was a key factor leading to the 2008 crisis was the Glass-Steagall Act. It prohibited the same bank from engaging in both relatively low-risk traditional commercial banking (using FDIC-insured and Fed-backed deposits to make mortgage and business loans) and higher-risk trading, insurance and investment banking operations. Because Glass-Steagall required those activities to be conducted in entirely different financial firms, it prevented Wall Street’s highest-risk activities from endangering the bank that engaged in socially beneficial lending to the real economy. (It also prevented low-cost, sticky and federally insured deposits from funding and thereby unfairly and anti-competitively subsidizing the high-risk trading operations of the banks.)
Glass-Steagall was effectively repealed with the passage of the Gramm-Leach-Bliley Act in 1999, which unleashed an acquisition spree that supersized banks by allowing the combination of traditional bank lending with trading, securities and insurance activities. When the merger frenzy peaked, what had been almost 40 financial institutions resulted in just four sprawling financial conglomerates. Three of those spanned the globe with trillions of dollars in assets and derivatives, hundreds of thousands of employees, operating through thousands of subsidiaries in 50 or so countries.
The result was gigantic, sprawling, interconnected, global financial institutions that threatened the financial system and the entire economy if they ever failed. These so-called “collateral” consequences are what makes these giants “too big to fail” and, in violation of the most basic rules of capitalism, virtually guarantees they would be bailed out rather than failing in bankruptcy like every other firm in the U.S.
Two other deregulatory changes made these firms more fragile and unstable. First, the Commodity Futures Modernization Act was passed in 2000, which effectively prohibited the regulation of the swaps derivatives markets. As a result, legal hurdles to unbridled derivatives speculation that dated back decades allowed the derivatives markets to balloon to more than $700 trillion, only a small fraction of which was related to the real economy. Not only were these derivatives bets dangerous to the individual firms, but they acted as a conveyor belt distributing unseen risks throughout the global financial system (as proved by AIG, Lehman Brothers and so many others). That’s why Warren Buffett called them “weapons of mass financial destruction.”
Second, while the banks were supersizing themselves, combining lending and trading, and engaging in the highest-risk derivatives trading, they were also leveraging themselves to extremely dangerous levels with very short-term, often overnight, debt. This was accelerated in 2004 after the SEC dramatically loosened its regulations governing leverage ratios for Wall Street’s banks. As a result, the typical ratio for a big bank shot up to 33-to-1, leaving a razor-thin layer of capital between the bank and bankruptcy: a mere 3 percent decline in asset values would essentially wipe out the firm. This excessive short-term borrowing and extraordinarily high levels of leverage resulted in very fragile too-big-to-fail firms.
This mindless deregulation was compounded by compensation schemes that incentivized the highest-risk short-term behavior imaginable from the executive suites to the streets. For example, because leverage boosted the firm’s return on equity (ROE) and executive compensation was based in significant part on ROE, leveraging a firm to near-fatal levels was incredibly lucrative for Wall Street’s financiers. Also, the no-risk “originate to distribute” fee-based business model fueled the crash with hundreds of billions of dollars in fraudulent subprime mortgages that were packaged into trillions of dollars of worthless derivatives like credit default swaps (CDS) and structured products like collateralized debt obligations (CDOs) by Wall Street’s biggest banks. From mortgage brokers to Wall Street CEOs, irresistible compensation schemes that rewarded short-term profits with big bonuses supersized the subprime bubble, showering unimaginable riches on a few thousand financiers at the expense of all Americans.
This reckless, irresponsible and unethical — albeit mostly legal — conduct due to deregulation, nonenforcement and upside-down incentives all contributed to causing the crash, but they are only part of the story. Massive illegal and, at times, criminal conduct also caused the crash.
Remember that trillions of dollars of securities and derivatives had to be written down in value, often to zero. This wasn’t a case of one or two or three mortgages or derivatives being overvalued by 10 percent or 20 percent. Entire categories had to be written off, often entirely. Just one example: When housing prices fell, one credit rating agency downgraded 83 percent of the $869 billion in mortgage securities it had rated AAA in just one year (2006). These across-the-board downgrades and the trillions of dollars in losses they reflected were not the result of an occasional or intermittent mistake or negligence. Instead, they reveal that the crash was the result of pervasive industrywide practices of fraudulently mispricing and misselling mortgages and the securities and derivatives based on them.
As one of the most insightful and prolific experts on Wall Street’s too-big-to-fail firms, George Washington University law professor Art Wilmarth observed, “You had systemic fraud at the origination stage, then you had systematic fraud at the securitization stage, then you had systemic fraud at the foreclosure stage. At what point do we consider these institutions to have become effectively criminal enterprises?” There is ample evidence of illegal if not criminal conduct, highlighted, for example, by PBS’s Frontline show “The Untouchables,” the 60 Minutes expose “Prosecuting Wall Street,” Bob Ivry’s book “The Seven Deadly Sins of Wall Street,” and Matt Tiabbi’s “The $9 Billion Witness.”
But that’s not all. Goldman Sachs’ infamous “Abacus” CDO that it constructed for John Paulson epitomized it’s illegal conduct; Citigroup’s CDO mayhem machine cut out the middle men like Paulson and shorted its constructed CDOs itself, as blatantly illustrated in its 2013 settlement with the SEC; the Lehman Brothers’ examiner’s bankruptcy report detailed widespread illegal conduct; the Senate Permanent Subcommittee on Investigations’ various reports on wrongdoing at every stage of the subprime bubble; the Financial Crisis Inquiry Commission’s 550-page report on its investigation of the crash; the 361-page decision by the federal judge in the Southern District of New York in the cases against Nomura Holdings and the Royal Bank of Scotland; and the innumerable multibillion dollar settlements by virtually all the biggest banks for their role in inflating the fraudulent subprime bubble.
There can be no genuine doubt that pervasive fraud in the sale of residential mortgage-backed securities — and the related derivatives and structure products the biggest banks created, packaged and sold — were significant contributors in causing the crash.
There certainly are other fact-based contributors to the crash, like the role of the Fed and low interest rates, an ideology of “markets know best,” and the conversion of investment bank partnerships into public companies, among others. However, other claimed causes are baseless and rejected by almost everyone. For example, the worn-out and discredited idea that federal housing policy caused the crisis. This argument focuses primarily on the Community Reinvestment Act as the chief culprit, but that is contradicted by the facts. First, the CRA only applies to banks and the vast majority of subprime mortgages were not even issued by banks. Second, if the CRA had caused the crisis, a number of events should have transpired: home sales and prices in urban communities would have inflated the U.S. housing market; CRA-mandated loans would have defaulted at rates higher than other mortgage loans; foreclosures in these same communities would have outpaced rates in the suburbs; and, the loan portfolios of banks in the Troubled Asset Relief Program should have been full of bad CRA loans. None of this happened because the CRA was not a contributor to the crash.
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, while imperfect like all laws, addressed what actually did cause the crash: unreasonable risk-taking, low capital and high leverage, short-term runnable debt, liquidity and interconnectedness, unregulated derivatives, the shadow banking system, resolution mechanisms, consumer protection, lending standards, compensation schemes, externalized costs and much more. As a result, the law and rules enacted to implement it not only addressed systemic risk and financial crashes, but also refocused and rebalanced finance away from socially unproductive trading and gambling to juice the bonus pool toward lending to the real economy to support jobs, communities and economic growth.
The evidence is overwhelming that financial reform is working, that finance is more stable, that the risk of a crash or economic catastrophe in the U.S. is greatly reduced, that banks are highly profitable and significantly increasing their lending, and that the economy is steadily growing. Yet, the Trump administration and Republicans in Congress have nonetheless wholeheartedly embraced Wall Street’s agenda and the siren songs of deregulation and unenforcement of the law. So far, their deregulation has focused particularly on shadow banking, consumer protection and derivatives rules, but they are really just beginning. It’s as if they want to return to regulatory system of 2005, pretending that the 2008 crash never happened.
It’s as if someone suggested that the U.S. should take down half or more of the protections put up around New Orleans after Hurricane Katrina in 2005 because 10 years have passed and there hasn’t been another disastrous hurricane. No responsible person would even suggest that. Yet, the equivalent of that in financial reform regarding the Dodd-Frank law and rules is the prevailing ideology in the Trump White House, the administration more broadly, and too much of Washington.
These are stunning acts of willful blindness that are sowing the seeds of the next crash. With our fiscal, monetary, social and political capacities to respond to another crash exhausted, the next crash will almost certainly be much worse than the last one. That this is happening when financial institutions are consistently reporting increasing — if not historically high — revenue, profits, lending and bonuses makes the coming tragedy all the more indefensible.
[This op-ed was originally published atLaw360.com and can be found here.]
