10 Years Of 2008 Financial Crisis: How US Created The Great Recession

Once upon a time, a group of friends decided to race cars. Borrowing money from their parents, relatives, distant aunts, and anyone who could lend them, each one in the group bought a car for themselves. Their allowances sponsored a small share of the vehicle. Each one in the group had the best sports car in business with elaborate customisations. They were all set for the race.

However, how does one get to race on a regulated city road? Therefore, the group got all traffic signboards removed from the way. All cameras were disabled. Sensors for curves, speed bumps and potholes, and other warning signs were discarded. No cop was allowed to be on the road during the race. Now, they got their expensive sports cars to race. To be a part of this fun activity, people from the city were invited to watch and bet on the outcome.

When asked about the potholes and speed bumps on the road, the group collectively assumed that the expensive cars would withstand the conditions. As the race began, it started raining, worsening the drivers’ vision and also the road. The cars only accelerated.

After a brief haul, the first car fell apart after hitting a pothole. Soon, another followed, and in a matter of a few minutes, all the cars were damaged to be driven. The friends stood and watched as their expensive cards turned to trash in the rain and potholes.

Disappointed, the people who had come to watch the race blamed the authorities for not having put enough traffic signboards, and for not regulating the competition for rules. Robbed without a refund on their tickets and bets, the people returned empty-handed.

The story of the financial crisis of 2008 is similar to the above story. Elaborate in its intricacies, however, the recession of 2008 saw how a group of bankers crashed the global economy in their race to earn millions of dollars as bonuses.

For most spectators across the globe, the 2008 crisis was about millions of Americans defaulting on their home loans. The banks, which had gleefully churned out these loans since the early 2000s, were seen as the temples of financial innovation and intelligence. In the September of 2008, a decade ago, it all changed.

Even as many observers of the 2008 crisis attribute the causality to a few million bad loans, the foundations of the recession go back many years before the first loan was even made.

Leverage, Leverage, And More Leverage

Leverage, which is the use of borrowed money to expand the business operations of these investment banks, doubled between 2000 and 2007. Top three investment banks on the Wall Street, Lehman Brothers, Merrill Lynch and Bear Stearns were leveraged at 30 to one by at the end of 2007. Thus, a mere 3 per cent of their assets were paid for by these banks, similar to that group which added only a tiny share of their allowances to buy expensive cars for racing.

There is nothing wrong with leverage, for companies across the world have profited using borrowed money to expand a firm’s operations. In the case of Wall Street, however, borrowed money was used to dish out cheap loans and create a hoard of other financial instruments that created an interconnected network of these investment banks.

With a 30 to one leverage ratio, a mere 3 per cent decline in the value of the assets was needed for the bank to collapse thus wiping out all shareholder value, and that is what just happened. Bank of America bought Merrill Lynch. Bear Stearns was sold to JPMorgan Chase with assistance from the United States (US) Treasury. Lehman Brothers, without a buyer or the luck of Bear Stearns, went bankrupt.

The Transformation Of The Banking Industry

If an investment banker from the late 1960s of the US were hired to work on the Wall Street in the 2000s, he/she would have been clueless. Until 1971, investment banks were registered as partnerships. If three partners were to register an investment bank on the New York Stock Exchange in the late 1960s, the bank’s entire capital had to come from those three partners alone.

Starting in the 1980s, this began to change. Driven by immediate compensations on short-term profits, bankers, chief executive officers, analysts, and everyone involved on the trading floor used firm’s borrowed money to take high risks. Since there was no personal money at stake, the people working were reckless in their dealings. The recklessness was motivated by the hefty pay packages that came along.

At the end of 2007, the top five bankers at Goldman Sachs, on an average, took home $61 million. Many junior traders, across Wall Street, were pocketing more than $1 million annually through a fee on short-term transactions and trading of other sophisticated financial instruments. Before the crisis hit, the average salary on the Wall Street was more than $375,000. However, this figure does not include the lavish parties, the luxury tours, private mansions, and other entertainment options that included strippers, all amounting to millions of dollars of borrowed money.

When America’s Banks Woke Up: The Decade Of 1972-82

The foundations of Wall Street’s crisis of 2008 were laid in the decade from 1972 to 1982. In 1973, the first oil shock hit the US. In 1974, president Richard Nixon became the only president to resign from office. A failed end to the Vietnam War and the second oil shock of 1979 which resulted in inflation across the country facilitated the end of US’ global dominance after the end of the Second World War. To add to the woes of the US, the Soviet Union invaded Afghanistan in December 1979.

When president Ronald Reagan took over in 1981, he was faced with low growth, the oil shocks of 1973 and 1979, and most importantly, manufacturing competition from Japan along with a persisting Cold War in Asia. The Reagan leadership proposed eliminating government regulations in the financial sector, as they thought it would ensure the much-needed economic growth.

The 1980s US banking industry was built on the lessons learned from the Great Depression of 1929. The Glass-Steagall Banking Act of 1933 separated the commercial banks (savings, deposits, loans for homes and cars) from the investment banks, resulting in the dismantling of the big banks. For instance, JP Morgan in 1935 had to create Morgan Stanley to continue its investment banking operations.

Along with the Glass-Steagall Act, a set of other legislations reigned over the banking industry in the 1980s. Commercial banks were so tightly regulated that most of them used to shut down by 3 in the afternoon, for the lack of work. Merrill Lynch, a brokerage firm, used to sell bonds. The likes of Goldman Sachs, Lehman Brothers and Bear Sterns offered financial consultation including the management of bonds. Against over 34,000 in 2011, Goldman Sachs had only 2,000 employees in 1980, and for all investment banks, the capital came from the partners and not gullible Americans.

Another low-key branch of the banking sector was the Saving and Loans (S&Ls) banks. Based locally, they used to accept customer deposits and sell fixed-rate long-term residential mortgages. This sector became the first lab rat for Reagan’s deregulation experiment.

After the 1970s, S&Ls’ operations were hindered by interest-rate volatility and inflation. Tired of the low returns on their deposits, consumers started withdrawing their money from S&Ls and moved them to other market funds. Had the government shut down the S&L banking sector, the loss would have been a few billion dollars back then. However, pressed by the S&L lobby, the administration loosened the regulatory chains on this sector.

Soon, the S&Ls went out of control. Charles Keating, one of the biggest S&L players and fraudster in the history of the US, took over an S&L in 1984. Using the money to ward off investigating agencies, Keating made great financial profits for himself. The infamous ‘Keating Five’ was a group of five US senators which also included John McCain (who passed away last week). Each senator was helped with $300,000 by Keating for their campaign. Keating also hired Alan Greenspan (who would go on to become the chairman of the Federal Reserve in 1986 till 2007) for a mere $40,000 for lobbying for him before Reagan.

Starting from 1986 until 1995, S&Ls across America crashed, costing the US government more than $130 billion in hundreds of bailouts. Keating along with many other fraudsters went to prison, and the US taxpayers had the first teaser of what crony deregulation in the financial industry could lead to. However, Greenspan continued his job as the chairman of the Federal Reserve. Deregulations continued.

Junk Bonds, A Decade Of Greed, And The Crash Of 1987

The 1980s also saw the rise of the bond market. Contrary to the 1970s, when only highly-rated companies could issue bonds, the 1980s saw underrated and unknown companies issuing bonds, which later came to be known as the junk bonds.

These junk bonds offered a higher rate of interest than conventional bonds, helping low-level companies raise money. Many investment banks used these junk bonds to take over companies to dismantle, restructure, and then take them public. This systematic buyout lasted across the 1980s, coming to an end after the crash of 1987. However, this phase changed investment banking forever as banks focussed more on raising capital, short-term goals, hefty bonuses, and no customer ethics.

This transformation in investment banking coupled with the technology revolution resulted in more financial innovation. By 1987, Wall Street was selling insurance on stocks in the form of stock-index futures. For instance, traders could insure themselves against a fall in the stock price by selling a stock-index future. Thus, if the stock price were going up, stock-future selling would be minimum. However, mere speculation on the stock market could drive the fast sale of stock-index futures.

By 1987, however, a $100 billion worth of stocks had been insured through stock-index futures.

Then came the October crash of 1987. While the stock market was in New York, the stock-index futures market was in Chicago. The computer links between the two cities were so slow that the stock market fall that started on 14 October 1987, wasn’t felt until 19 October. Before Greenspan stabilised the market with a fresh flow of money, the stock market fell by 23 per cent. This was another instance of a financial instrument almost causing the market to crash, the second teaser to the crisis of 2008.

The creation of more sophisticated financial instruments, however, continued.

The Party In The 1990s And The Last Nail In The Coffin

Banking on the internet stocks, the banks on the Wall Streets partied hard in the 1990s. Tech innovation, better internet infrastructure and personal computers integrated the many aspects of banking more closely than ever before. The administration of president Bill Clinton further deregulated the financial sector.

Four significant developments on the Wall Street were witnessed in the 1990s. One, lobbying for further deregulation by Federal Reserve and the Congress. Interestingly, Hank Paulson, the US Treasury Secretary during the 2008 crisis, was the one pressing for deregulation during the Clinton years. Two, consolidation and integration of commercial and investment banking. The Glass-Steagall Act of 1933 was removed in 1999 with Citigroup becoming the first bank on Wall Street to integrate investment banking with its commercial operations.

The third was the increased integration of the banking system via financial instruments. Loans made for buying homes, cards, credit cards were purchased by investment banks to be repackaged as ‘structured’ investments to be sold to gullible Americans. Four, the compensation, for the ones who issued a loan, to the ones who traded on the floor, the senior management, and for the CEOs of these banks increased multifold. By the end of the 1990s, Wall Street was all about making money for the bankers with little concern for those whose money was being invested in the first place.

Consolidation Of The ‘Too Big To Fail’ Banks

The banking industry of the 2000s was way different from what it was in the 1960s. In these 40 years, the 10 largest investments banks in the US increased their market capitalisation from $1 billion to $179 billion with a five times increase in employee count.

Many takeovers and acquisitions followed the fall of the Glass-Steagall Act further consolidating the players on the Wall Street. Merrill Lynch, Goldman Sachs, Morgan Stanley, Bear Stearns and Lehman Brothers were the top five investment banks in 2000 along with JP Morgan Chase, Citigroup and the Bank of America. European banks too joined the party with the likes of Deutsche Bank and Credit Suisse. Insurance companies like the American International Group also joined in. Rating agencies, namely Moody’s, Standard & Poor’s and Fitch dominated their industry.

Thus the entire financial industry in the early 2000s was concentrated in a few names. The profits of each were linked to the other, and therefore, the bankers flouted every law they hadn’t yet deregulated to run a charade on the Wall Street in the name of financial innovation and economic growth.

Then followed a period of reckless credit expansion for home loans, making millions of middle-class Americans a part of this charade, a car race with no winners.

And then came the Great Recession of 2008.

This article is first of a multi-part series on the Great US recession, which marks 10 years this September.