To the Teacher
The first student reading below outlines (and inevitably oversimplifies) the events that led to the near collapse of the U.S. financial system. The reading answers a few major questions about the behavior of mortgage brokers, credit agencies, and leading investment banks. The second reading details some of the deceptive, possibly fraudulent, actions of brokers and banks and the failure of government financial experts to prevent a financial crisis. The third reading describes the environment in which House and Senate committees have worked to produce financial reform bills, which are now being reconciled in a conference committee. The reading includes several perspectives on what reforms are needed and what is likely to pass.
Student Reading 1:
Why a financial crisis?
September 15, 2008: The investment bank Lehman Brothers filed for bankruptcy. Losses on Wall Street were severe. The Dow Jones closed down by over 500 points. Two weeks later it fell even further, resulting in a loss of $1.2 trillion in market value. The biggest financial crisis in US history since the Great Depression of the 1930s had begun.
An exact measure of the losses on Main Street is impossible to tally. But millions of jobs are gone, millions of homes lost; billions in savings evaporated. Almost two years later, countless Americans (and others around the globe) are still trying to put their lives back together.
This financial crisis will be the subject of study and analysis for many years. But there is broad agreement now that:
- At its root was a spectacular housing boom fed by reckless and at times corrupt financial speculation by Wall Street investment banks—Goldman Sachs, JPMorgan Chase, Citigroup, Morgan Stanley, Lehman Brothers.
- Some firms, caught up in a frenzy of profit-making, borrowed more than 40 times their capital to invest primarily in mortgages during a boom turned bubble and bust. Loans for subprime mortgages had been available for some years. These loans enabled people to buy houses for payments sharply lower than the prime rate—but the low monthly payments typically ballooned after two years. The loans were often made to people who did not have to produce evidence that they could repay them and whose poor credit records may not have even been checked.
- As more and more subprime mortgages were sold, they drove up house prices at the fastest pace in US history.
- Investment banks packaged hundreds of such mortgages—as well as risky hedges or bets on such mortgages—as "mortgage-backed securities" and sold them to investors worldwide, making billions.
- When the housing bubble collapsed, banks were left with hundreds of billions of dollars' worth of mortgage-backed securities whose value was now much less than their paper value as well as debts that they could not pay.
- Treasury Secretary Paulson formulated a $700 billion+ bailout plan known as TARP (Troubled Asset Relief Program) to keep those banks, which were "too big to fail," in business, convincing Congress that if they collapsed, the US and the world financial system would go with it.
Today most of the institutions that received bailout funds have repaid with interest what they were loaned and are once again making huge profits. Many people are angry about that, because 15 million Americans are still out of work, and millions more lost their homes or are in danger of foreclosure. The vast majority of these people bear no responsibility for the crisis.
Q & A
Why would mortgage brokers offer loans to people who would probably not be able to repay them?
Because they were making lots of money at it. So, for a time, was everyone else. The brokers would sell subprime mortgages to banks, which would make money by packaging them into "mortgage-backed securities" and other derivatives (securities whose price was "derived" from an underlying asset—for example, hundreds of houses in the case of mortgage-backed securities). They would then resell them to investors, who would make money too—until the music stopped. In this game of musical chairs, the last one holding failed mortgages lost.
How could mortgage brokers get people to sign up for subprime mortgages?
Sometimes by such practices as emphasizing the low beginning rate of repayment, skimming over the ballooning payments after two years. Even, perhaps, by telling clients that if they had trouble meeting payments, they could borrow on the increased value of their house to get a home equity loan. Or they could sell the house for more than they paid for it and go elsewhere. The housing boom guaranteed that house prices would continue to go in one direction only: up. But by 2005 average prices were no longer going up, and by 2006 they were going down.
Why would investors buy mortgage-backed securities?
Because almost everyone thought that they were safe. Such leading ratings agencies as Moody's and Standard & Poor's, which were paid by Wall Street financial houses for their work (an obvious conflict of interest, but unknown to most investors), rated most of the securities AAA, the highest they could get.
And why was everyone convinced that house prices would keep going up even when house prices began to fall in 2007?
Because the experts told them so. Not everyone believed the experts. Economist and author Dean Baker and others heard the time bomb ticking and warned of a coming disaster. Baker later wrote, "The nation's top economic leaders acted as if they were ignorant of third-grade arithmetic." (False Profits, by Dean Baker. Baker is the co-director of the Center for Economic and Policy Research.)
Seeing the arithmetic on the chalkboard, some leading Wall Street banks only stepped up their selling of packaged house loans to people they often knew might not be able to repay them. What's more, through such Wall Street creations as "credit default swaps" and "collateralized debt obligations," the banks spun straw into gold, , like Rumpelstiltskin, turning triple-B bonds into triple-A bonds, and ultimately making billions in the process.
Two critical overviews of the crisis
The financial crisis "was less a function of subprime mortgages than of a subprime financial system. Thanks to everything from warped compensation structures (the very high salaries and bonuses of top executives) to corrupt ratings agencies, the global financial system rotted from the inside out. The financial crisis merely ripped the sleek and shiny skin off what had become, over the years, a gangrenous mess."
—Nouriel Roubini, professor of economics at NYU, and Stephen Mihm, a history professor, in their book Crisis Economics: A Crash Course in the Future of Finance)
"When the financial crisis first engulfed the world, opinion leaders rushed to explain it as a freak of nature, like a 'perfect storm' or a tsunami that comes every 100 years. Subsequent revelations destroyed that nonsense. Like famines, financial crises are man-made. This one was made in America—invented on Wall Street and enabled by Washington complicity, Democrats and Republicans alike."
—William Greider, The Nation, 5/10/10)
For discussion
1. What questions do students have about the reading? How might they be answered?
2. The housing boom that became a bubble appears to be the main underlying cause of the financial crisis that began in September 2008. Why?
3. Why were mortgage brokers so free and easy with loans for houses to people who might very well not repay them?
4. What made people take on mortgages that they might not be able to repay?
5. What are mortgage-backed securities? How did they fuel the housing boom?
6. Roubini and Mihm see corruption behind the housing boom. Why?
7. Why do you think Greider views Wall Street, Democrats and Republicans as enablers of the crisis?
8. Why did the government bail out the big financial institutions? If you disagree with the bailout, how would you answer government leaders like Paulson, who said the financial system would have collapsed without TARP?
Student Reading 2:
Deception & leadership failure=boom, bubble & bust
Just as there is broad agreement about why the financial crisis happened, so there is agreement about deceptive, possibly fraudulent, Wall Street practices and the failure of government leaders to prevent it.
Examples of Wall Street practices that were questionable, or worse:
- Mortgage brokers around the country used deceptive practices to lend money for houses to people who were unlikely to be able to repay the loans.
- New York officials are investigating Morgan Stanley, Citigroup, Merrill Lynch, and five other banks to find out whether they misled rating agencies like Moody's and Standard & Poor's to pump up the grades of certain securities. Those same rating agencies provided bankers with the information they needed to get higher grades than were deserved for securities they wanted to sell.
- A bank examiner reported in a 2,200-page document how Lehman Brothers, whose collapse two years ago announced the beginning of the financial crisis, used "materially misleading" accounting trickery to disguise the bad investments that led to its failure.
- In a post-bankruptcy lawsuit, Lehman Brothers sued JPMorgan Chase for more than $5 billion, accusing it of taking advantage of its dire state, siphoning billions of its assets and speeding up its collapse.
- The Securities and Exchange Commission charged Goldman Sachs with fraud for selling securities designed to fail that gave Goldman the opportunity to bet against them and make billions.
- The securities sold by Goldman, the Bank of America, Wells Fargo and other big banks often had baffling, abstract names like "credit default swaps" (CDSs) and "collateralized debt obligations" (CDOs). These derivatives were so complex that even CEOs of major banks could not explain them.
- Goldman executives were convinced by late 2006 that the mortgage market was headed down but one of its units continued to sell mortgage-backed securities to investors at the same time that other traders in the same unit made investments essentially betting that the securities would decline (New York Times, 5/19/10)
During the housing boom (roughly, 2001-2006), none of top government financial leaders recognized, at least publicly, that the boom had become a bubble that would collapse. None acted to prevent the financial crisis that struck in September 2008. Federal Reserve Chairman Ben Bernanke, who was recently reappointed to his position by President Obama, declared in a major speech in 2007 that the mounting number of people failing to make their mortgage payments would not spread, that the financial system was basically sound.
Bernanke's predecessor, Alan Greenspan, had said the same thing earlier. In October 2008, after the crisis began, Greenspan testified before the House Committee on Oversight and Government Reform, chaired by Rep. Henry Waxman:
WAXMAN: You have said, "My judgment is that free, competitive markets are by far the unrivaled way to organize economies. We've tried regulation. None meaningfully worked." You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others. And now our whole economy is paying its price. Do you feel that your ideology pushed you to make decisions that you wish you had not made?
GREENSPAN: What I'm saying to you is, yes, I found a flaw...
WAXMAN: In other words, you found that your view of the world, your ideology, was not right, it was not working?
GREENSPAN: ...Precisely.
Other leaders who were wrong: President George W. Bush's Treasury Secretary Henry Paulson, who gained that position after heading Goldman Sachs; President Bill Clinton's Treasury Secretary Larry Summers, who is now Obama's chief economic advisor; and the chairman of the New York Fed, Timothy Geithner, who is now Obama's Treasury Secretary.
Jeff Madrick writes in the New York Review of Books that at the time Bernanke declared that there was no housing crisis, "house prices had already been falling for a year, major mortgage brokers were going broke, and two Bear Stearns hedge funds, which invested aggressively in mortgage-backed securities, were near collapse. Well before Bernanke's inexplicable statement, prominent Wall Street Traders and analysts were warning their bosses about the broad dangers of the system." (Jeff Madrick, "Can They Stop the Great Recession," New York Review, 4/8/10)
For discussion
1. What questions do students have about the reading? How might they be answered?
2. What evidence is there that deception and perhaps outright fraud brought on the crisis?
3. What is Alan Greenspan's explanation for his failure to foresee the crisis? How would you explain why so many "experts" failed to see it coming?
Student Reading 3:
How can a future financial crisis be prevented?
For months following the crisis that began with the Lehman Brothers collapse almost two years ago, Rep. Barney Frank, chairman of the House Financial Services Committee, and Senator Christopher Dodds, chairman of the Senate Banking Committee, led studies and meetings to produce reform bills aimed at preventing future financial disasters.
But such legislators do not work in a vacuum. Using First Amendment rights of "freedom of speech" and "to petition the government for a redress of grievances," lobbyists for corporations, unions, and other businesses and groups work daily to influence lawmakers with words backed by money.
On May 21, 2010, the Center for Public Integrity reported: "850 businesses, trade groups and other corporate interests have hired more than 3,000 lobbyists to shape the [financial reform] bill — roughly five lobbyists for each member of Congress...Lobbying disclosure data...show that all the big players in American business lobbying were active as regulatory reform proposals worked their way through Congress.
"The US Chamber of Commerce deployed 85 lobbyists, including 49 hired from outside lobbying firms. The Securities Industry and Financial Markets Association employed 54 lobbyists, including 37 from outside firms. The American Bankers Association deployed 53 lobbyists; the Business Roundtable, 42; and the Mortgage Bankers Association, 29... In the financial services industry, some 175 companies and groups...— hired lobbyists to try to weaken or eliminate reform proposals aimed at banks and the capital markets." (www.publicintegrity.org)
Members of the Senate Committee on Banking, which has worked since the crisis hit to produce a reform bill to prevent another financial crisis, have received in two recent election cycles more than $39 million from Wall Street and banks. Members of the House Financial Services have received $21 million. (Bill Moyers Journal, www.pbs.org, 10/26/09)
The House and Senate bills are now being reconciled in a conference committee, with a single bill and a vote on it expected before the July 4 congressional break.
Public Citizen, a non-profit organization that declares its purpose is to serve "as the people's voice in the nation's capital," calls for reforms in "five critical areas":
1. "a strong, independent consumer protection agency," like that in the House bill, but not like the one in the Senate bill, which folds the agency into the Federal Reserve, "one of the agencies most hostile to consumer interests during the run-up to the crash."
2. the break-up of "too big to fail" institutions "that the government, fearing a total collapse, feels compelled to bail out if they are in danger of failing." Such a bailout creates what is called "a moral hazard"—the danger that an institution is more likely to take aggressive and risky action if it expects to be rescued by the government because it is "too big to fail."
3. a clamp-down on "out-of-control pay" on Wall Street, which has now resumed, to the tune of "$145 billion in bonuses and compensation for its 2009 performance." This is why Public Citizen is pushing for a "windfall tax levied on the bonuses paid in 2009 and likely in 2010."
4. an end to "the casino economy," meaning an outright ban of certain derivatives, which Wall Street has used to "take advantage of investors."
5. prevention of "global deregulation," which "would subordinate new regulatory efforts to the World Trade Organization's regulatory rules." (Public Citizen, May/June 2010)
Opposing view of reform bill provisions
President Obama declared: "Here's what this plan would do. First, it would enact the strongest consumer financial protections ever. It would put consumers back in the driver's seat by forcing big banks and credit card companies to provide clear, understandable information so that Americans can make financial decisions that work best for them. Next, these reforms would bring new transparency to financial dealings. Part of what led to this crisis was firms like AIG and others making huge and risky bets - using things like derivatives - without accountability...We would also close loopholes to stop the kind of recklessness and irresponsibility we've seen. It's these loopholes that allowed executives to take risks that not only endangered their companies, but also our entire economy. And we're going to put in place new rules so that big banks and financial institutions will pay for the bad decisions they make - not taxpayers. Simply put, this means no more taxpayer bailouts. Never again will taxpayers be on the hook because a financial company is deemed "too big to fail." (4/17/10)
Joseph Stiglitz, a Nobel Prize-winning economist testifying before Congress last year said: "I think it would be far better to break up these too-big-to-fail institutions and strongly restrict the activities in which they can be engaged than to try to control them." (New York Times, 5/24/10)
Paul Krugman, also a Nobel Prize-winner in economics, wrote: "...while the problem of 'too-big-to-fail' has gotten most of the attention..., the core problem with our financial system isn't the size of the largest institutions. It is, instead, the fact that the current system doesn't limit risky behavior by...institutions like Lehman Brothers...because they...face minimal oversight." (New York Times, 4/5/10)
No one thinks that any reforms will guarantee the end of financial crises. But as former Federal Reserve chairman Paul Volcker wrote: "The point is to keep the inevitable excesses and points of strain manageable, to reduce their scale and frequency..." ("The Time We Have Is Growing Short," New York Review, 6/24/10)
Joe Nocera, a financial and economics columnist, wrote of the bills being reconciled by Congress: "Nobody is talking about breaking up banks the way they did in the 1930s...Nobody is even talking about a wholesale revamping of a regulatory system that so clearly failed in this crisis." Nocera sees "good news" in the fact that a proposed Consumer Protection Agency "hasn't been completely gutted...[but] perhaps the most troubling fact of all is that the bill will do very little to reduce systemic risk." (Dubious Way To Prevent Fiscal Crisis," New York Times, 1/5/10)
For discussion
1. What questions do students have about the reading? How might they be answered?
2. What is the role of lobbyists and campaign finance contributions during the fashioning of a bill in Congress? What legitimates the behavior of lobbyists and contributors? What problems are there with that behavior?
3. What major differences of opinion are there about what a final bill should include?
4. What conclusions do you reach about what major provisions should be in a final financial reform bill? Why? If you need to get more information, how might you find it?
5. What, if anything, do you know about President Roosevelt's New Deal financial reforms? If you need information, how might you find it?
This lesson was written for TeachableMoment.Org, a project of Morningside Center for Teaching Social Responsibility. We welcome your comments. Please email them to: lmcclure@morningsidecenter.org.