How Wall Street Became a Mess

By BRIAN LYNCH, Special to Taking Back Politics

What went wrong on Wall Street? It is the most critical question of our time, and we have got to get the answers right. When the “experts” start telling us how they’ll fix things, we need an independent understanding of the problem or we risk making even bigger mistakes. Unfortunately, the back story here isn’t so simple. It can’t be reduced to bullet points without the narrative. Nor can it be told without arousing some people’s ideological filters.

I unwittingly began learning about the problems before the question arose. The financial journalist in my family started sending me reading material so I wouldn’t be so clueless when we talked about her job. What seemed to me like interesting, but useless information, suddenly became relevant when the sky started falling. I’m not an economist, but I want to share what I’ve learned so far.

The Players

As I see it, this story has lots of moving parts so I’ll start by introducing the players. It’s a cast that includes Congress, the commodities markets, banks, mortgage companies and the housing industry, investment firms, insurance companies, federal regulators, the super rich and a guy named Joe.

Let’s start with Joe. He represents all the folks who always wanted to buy a home, but couldn’t afford it. He was always on the outside looking in at the American dream because mortgage lenders had standards. Nothing personal Joe, but federal regulations required that lenders could only loan money to those who could actually pay it back. This even applied to Fannie Mae and Freddie Mac, the two largest mortgage companies that have a special federal mandate to grease the wheels of home ownership.

Banks traditionally competed for well-qualified mortgage loans as a way to invest our money. Some of the loans they kept and others they sold for profit. These were boring investments, but banking regulators required conservative investments to keep our money safe.

Next are the insurance companies. In addition to insuring our cars and homes, they insure companies against business losses. They too were under federal regulations to invest our premiums wisely so they would always have the funds to pay out any claims.

Investment firms like Lehman Brothers helped people and businesses to invest their extra cash in the economy, usually through the sale of stocks and bonds. That means buying and selling stock on exchanges where companies sell a stake in their business to raise the cash they need to run it. Investors buy stocks to share ownership in the company and, hopefully, in its profits.

A less well understood player here are the commodities exchanges, also known as the “futures” markets. If you’re thinking “pork bellies,” you are on the right track. It’s a place where people who actually produce certain goods like wheat or oil go to “hedge” or manage their risk to ensure their financial stake in the things they produce against the possibility that it might not sell or return a profit.

Consider the farmers, for example. They plow their money into the ground and hope for a harvest. But a huge crop surplus in the fall could cause prices to collapse, leaving them with no money to buy spring seed. Farmers need to “hedge” their investment in crops to ensure that future market prices will at least cover their costs. At the same time, the futures market helps set prices for the goods we buy today.

There are two types of commodities traders: “hedgers” who want to ensure their financial stake in a product, and “speculators” who agree to buy the product at some future date even if its value falls below what they agreed to pay. These purchase agreements are called “futures contracts.” Futures contracts are traded back and forth on federally regulated exchanges, much like stocks or bonds.

These investments are often very profitable, but sometimes the losses can be disastrous. Even so, the commodities market has operated successfully for over 150 years, keeping prices in line with supply and demand. This is due in no small part to federal regulations and monitoring by the Commodity Futures Trading Commission (CFTC) to prevent any cheating.

For years, this more or less transparent arrangement of distinct financial institutions remained separated by a fire wall of federally imposed checks and balances. This resulted in a relatively stable economy and general prosperity.

Prologue to Crisis

Enter the super rich, who need no introduction except to say they are wealthier and more numerous than ever before. They saw the opportunity to make lots more money if only the government would step aside. In fact, they realized that the money they could make would far exceed what it would cost to buy Congress and elect presidents. Corporate lobbying soon became part of the cost of doing business, and part of the culture of Washington. One by one, federal restrictions began to fall and the parts in this story started to move.

Soon banks could offer insurance or buy stocks. Investment houses and insurance companies could take “positions” in the futures market or offer money market accounts. Mortgage companies could use home loans as collateral to create and sell bonds, so they bundled them together and sold them to investors as “mortgage-backed securities.” In short, the distinctions between our financial institutions faded as all the players moved into more profitable, but higher-risk investments.

Wall Street still wanted more. They didn’t like federal restrictions in the commodities market, so their Congress (no longer ours at this point) allowed them to buy and sell various types of private futures-like contracts off exchanges and therefore outside of any federal control. It’s called the “over-the-counter” market, and purchase agreements here are called “swaps,” rather than “futures contracts.” Today, trillions of dollars worth of these swaps change hands every year with no federal oversight. Recent concerns have been raised that some institutional investors are working both inside and outside of the commodities markets to inflate prices and boost their profits. Oil and food prices are among the targets of current investigations, although little wrongdoing has been proven to date. Stay tuned!

As our federal rules fell, it created an explosion of creative new ways to make money, and the wealthy of the world got a whole lot wealthier.

Hmmmm … how to invest all this wealth? That became the billionaire’s problem worldwide. And here is where it all begins to unravel.

Events in Motion

The world’s wealthiest investors began looking around for good places to put all their money and decided the U.S. housing market was a sound bet. Buying mortgages directly is too messy, however, so they started gobbling up those mortgage-backed securities. The demand for these investments became enormous. Soon, the source of these securities, qualified home buyers, became scarce. There weren’t enough mortgages to satisfy the demand.

Market pressures on Wall Street lead them to put pressure on Washington to ease credit qualification for home mortgages. The loosening of credit accelerated home buying, especially by Joe and his friends who never qualified for mortgages before.

Housing demand soon pushed home prices through the roof, creating the “housing bubble.” Still, the insatiable appetite for mortgage-backed securities continued driving lenders and realtors to evermore creative ways to market houses and squeeze people into supersized mortgages while home prices sky rocketed.

Soon, Joe was able to buy a house without putting money down or buying mortgage insurance. To shoehorn buyers into supersized homes, adjustable rate subprime mortgages were created so buyers could initially pay less than the full mortgage rate. At certain intervals their payments would increase until they reflect the full interest rate plus back payments for the initially lower rates. Can’t make those payments in the future? No problem! Home buyers were assured that their home values would soar allowing them to sell their house at a profit before the higher payments came due.

Bad-faith mortgages began creeping into the system, increasing in number until it became a flood.
Everyone involved turned a blind eye because everyone seemed to be making money.

Back on Wall Street, these bad-faith loans continued to underwrite mortgage-backed securities, turning them into junk bonds. But credit-rating agencies did not raise any alarm bells, and their failure to do so helped perpetuate the sale of these securities all over the world. All the major banks purchased them. To keep up the appearance of being conservative investors, banks hedged these investments on the over-the-counter swaps market. They bought what are called “credit-default swaps,” which would pay back some of the value of these investments in case the bonds went bad.

Some investment firms and insurance companies were eager to deal in these credit-default swaps as they seemed like easy money. Bonds almost never go bust, right? One insurance giant, American International Group, Inc. (AIG), sold over $45 billion worth of these credit-default swaps.

For some global perspective on the crisis, it is estimated that there are about $65 trillion worth of credit-default swaps on the over-the-counter market today. Contrast that with our national Gross Domestic Product, which is only $14 trillion ― or against the Wall Street bailout, which is a meager $700 billion by comparison.

The whole house of cards began to collapse when Joe’s friends, along with millions of middle-income home buyers duped into subprime mortgages, discovered they couldn’t make their payments because the interest rates jumped while their home values fell. That meant refinancing was no longer an option for them. Banks and mortgage companies started foreclosing on homes at record rates. This created a glut of houses on the market that collapsed the already inflated home prices. The U.S. housing bubble burst with a bang heard around the world.

The impact was immediate. Fannie Mae and Freddie Mac lost hundreds of billions of dollars almost overnight. The government was forced to buy them out to prevent massive housing foreclosures.

Banks and investment firms started to collapse from the sudden loss of capital. Mortgage-backed securities defaulted. AIG and others were on the hook for billions in credit-default swaps. The Treasury acted again and bought AIG to prevent an immediate cascade of bank failures. Even so, Washington Mutual, Lehman Brothers and other huge banks imploded. The stock market went on the skids. Foreign investors and foreign banks lost billions of dollars in equity as well. Our hapless president and our blind-eyed Congress thrashed about for ways to prevent economic Armageddon.

They passed the $700 billion “rescue” package after loading it up with pork to satisfy its detractors.
It’s too soon to tell if the rescue plan will help. It may be too little too late. As I write, the worldwide economy continues its free fall with no bottom yet in sight. It’s not too soon to begin to look for answers.

Where to Look Next

This is a very simplistic description of the events leading up to this crisis. The facts here are subject to change as new information emerges. There are many more players to look at, more details to uncover and lots of blame to be assigned. The culprits who tilted the system to feather their nests must be brought to justice. Yet the broader outlines of what went wrong are slowly becoming clear and should serve as a guide to search for answers.

The main point for now is that we have to understand what went wrong so we aren’t taken for a ride by those offering to fix things. There are certain areas where we should be looking for the root causes. A critical examination of Congressional lobbying and campaign-finance practices is certainly needed. This crisis is a repudiation of the market fundamentalism that has guided politicians and businesses for over 20 years. The notion that free markets always self-correct is dead wrong. So we need a healthy debate on the role and importance of government in the regulating of commerce. We should reconsider the ethical standards to which we hold public corporation accountable. We have to develop a better understanding of modern markets and the regulatory agencies such as the Securities and Exchange Commission and the CFTC, which are supposed to protect us from abuses and economic meltdowns.

Perhaps above all, we need to take a good look at ourselves as citizens. Are we paying enough attention to what was going on in our country? Are we actively participating in civic affairs? Do we keeping ourselves well-informed and demand full disclosure from government, corporations and the media?

When we saw mortgage brokers and bankers running amok, we should have sounded alarm bells and held our representatives more accountable. So many of us knew things weren’t right, but we did nothing. As citizens, we must never neglect our responsibilities to each other to stay vigilant, informed and mobilized when necessary to promote the welfare of our communities and our nation.

Nightmare on Wall Street

By EUGENE MULERO, Correspondent

Last week, Sen. Barbara Boxer, D-Calif., said her office was getting tons of calls from her constituents, begging her not to bailout Wall Street’s titans.

“… in general, we got to make sure we don’t walk away from this thing, and we don’t handout a blank check to (the) CEOs and CFOs who got us into this mess. People are telling me, ‘Barbara, use your authority to make sure this isn’t a disastrous boondoggle’,” Boxer told me outside the Senate chamber.

This also was the concern from the conservatives. Sen. Jeff Session, R-Ala., said to me, before he met with the Treasury Secretary: “Let’s read the documents they are proposing. Congress can’t rubber-stamp a proposal. Our inherent duty is of protecting the Treasury. I think Congress needs a reasonable time to review this before we rubber-stamp a matter of this huge nature. And by the tens of thousands, constituents actually contacted their members of Congress, objecting to Secretary Paulson’s proposal.”

In House Speaker Nancy Pelosi’s now-famous speech on Monday, she reminded her colleagues that the White House had fooled them before—and rash actions, especially when a potential Great Depression 2.0 hung in the balance—was not the best way to proceed this time around.

So-called conservative mainstream media pundits who support Paulson’s proposal, criticized Pelosi. However, they forget Americans are still wondering why the Bush administration still hasn’t captured Osama bin Laden, allowed the NSA to eavesdrop on citizens and are pissed off about $3-plus for a gallon of gas (if there’s even gas available in some places around the country). And, most of them don’t cry because a CEO went from earning $1.1 billion annually, to a measly $500 million.

Oh, not to mention, three out of every four Americans do not support President Bush.
After all that, is it any mystery why voters called their lawmakers to oppose approving the largest golden parachute ever – $700 billion – for some of the richest men in the world, who caused this financial meltdown in the first place?

Economist Joseph Stiglitz of Columbia University said it best. Last Sunday on 60 Minutes he told Scott Pelley that Paulson’s “proposal is to take on to American taxpayers the millions of bad mortgages – toxic mortgages – that no one on Wall Street wants to take. When they announced that plan the champagne bottle corks were popping on Wall Street. You know, they finally found the sucker to take on these assets; no one in the private sector would touch these private mortgages.”

Pelley asked, “Who’s the sucker?”

“The American taxpayer,” Stiglitz responded.

Eugene Mulero may be reached at Eugene.Mulero@gmail.com.