RSS

Inside Job (documentary)

19 Apr

A few evenings ago, we watched the documentary Inside Job, directed by Charles Ferguson. It helped me understand how the recent financial crisis and recession developed.

After the Great Depression and the Second World War, the US and the western world enjoyed a forty year period of prosperity and growth with few and mild recessions. The policy makers who had lived through the Great Depression didn’t want anything like that to happen again and they took care to craft government policy in such a way as to make another Great Depression unlikely. As that generation of policy makers died out, their experience and wisdom died with them. Once no living policy maker could recall the pain and humiliation of living through the Great Depression, it got easier to change the rules.

In the 1980’s, to win more votes, the Clinton administration was obsessed with making home ownership available to a larger percentage of the electorate. Remember their slogan? “It’s the economy, stupid.” One of their maneuvers was to relax the laws governing the relationship between lenders and borrowers, allowing banks to loan money to borrowers with weak credit ratings and a high likelihood of defaulting on the debt (i.e., failing to keep up with their payments). The financial industry was lobbying for less regulation, the economy seemed to need stimulating, and this was the path that was chosen.

In earlier times, borrowing money implied a long term relationship between the borrower and lender. My banker would make me a loan and I would pay it back to the banker I borrowed it from over time. We knew each other, and the relationship lasted for years, as long as it took to pay off the debt.

Lending before deregulation

Deregulation and the resulting flood of easy money was very popular and not at all ideological. When George Bush entered the presidency, he reversed many of Clinton’s policies, but not deregulation of the financial services sector. Instead he extended those policies. The documentary shows George Bush making a speech in which he says, “Low income home buyers can have just as nice a house as anybody else.” One wonders how such a thing would be possible unless the meaning of “income” has changed. If your buying power is no longer related to your income, what does it mean to be “low” or “high” income?

With deregulation, it became easier for bankers to escape the risk of carrying the loan themselves. They could sell the loan (at a discount) to another bank or financial institution and receive back most of their money immediately. Lending bankers liked that idea.

Financial institutions that specialized in buying such loans figured out that in the deregulated world, they could package lots of such loans together and create Collateralized Mortgage Obligations (CMOs) and Collateralized Debt Obligations (CDOs), which they could then sell on to other institutions and investors at a profit. Such investment products are called derivatives because they are derived from an underlying equity or obligation. The theory was that combining high risk and low risk loans into a package would make it possible to design investments with known levels of risk and return, investments which could be counted on to behave as expected. In theory, this would make investment more predictable and stabilize the economy.

After deregulation

After deregulation

In practice, the arrangement failed to take into account the cupidity of human nature.

The first thing to notice in the picture above is that all the entities in the right column have divested themselves of any risk. All the risk is borne by the borrowers and the investors. The risk to the borrower is that he will be unable to keep up with his payments and his house will be foreclosed. The risk to the investor is that the borrower will be unable to keep up with his payments, will default on the loan, and she will not get her money back.

In either case, the salesmen, lawyers, and accountants on the right get a bonus. For them, the risk inherent in the original transaction is an externality. It’s something they won’t be held accountable for, so they have no incentive to make sure the deal will be successful. They can freely make irresponsible loans to borrowers with weak credit ratings, who might be expected to default, borrowers with whom a pre-1980’s banker would politely decline to do business. They just have to be sure to move the loan into the pipeline before the borrower has time to default. Such loans are called subprime for reasons that should be clear — they are less than first quality.

The securitization firms found themselves with too many subprime loans and not enough high quality loans to make balanced bundles, so they bundled lots of subprime loans together and presented them to the rating agencies (like Standard & Poor’s) as a standard, balanced bundle. S&P was willing to take the securitization firm’s word for what was in the bundle and many of these high risk derivatives wound up with ratings like AAA, indicating high quality and low risk. Bonds of the US government are rated AAA and are considered the safest investment available anywhere. Such ratings implied to the investor that these derivatives were of a similar quality to US government bonds. For S&P and the other rating agencies, the actual quality of the investment was an externality. There was no way to hold them legally accountable for the accuracy of their rating.

But these seeming safe investments were special! Because of the high interest rates charged to the original borrowers, the resulting investments promised an amazingly high rate of return for such a safe investment instrument. Investors liked that.

To put some icing on the cake, someone invented what’s called a credit default swap, or CDS. A CDS is a contract between an investor and an insurance company. In return for a quarterly premium from the investor, the insurance company promised to reimburse the investor if the insured investment loses its value. It’s basically an insurance policy, but with a difference.

In most other insurance domains, a property can only be insured once. Once a homeowner has purchased homeowner’s insurance, he can’t go to another insurance company and take out another policy. It’s against the rules. Another person can’t buy insurance on the homeowner’s house. It’s against the rules.

Deregulation removed those rules from the investment realm. An investor could use a CDS to insure her investment in a given investment. She could purchase several CDSs for the same investment — there was no rule barring the same property from being insured multiple times. Even crazier, someone else could buy insurance on her investment — there was no rule barring anyone from insuring anyone else’s investment.

So the securitization firms, knowing the actual quality of the derivatives they were selling, went to the insurance company and bought CDSs covering the bad investments they had just sold, essentially betting that the investment they had just sold would lose all its value in short order. In some cases they bought CDSs covering the same bad investment up to 30 times. When the investments failed, as the securitization firms anticipated, the securitization firms stood to make billions in insurance payments.

Remember AIG? They were the insurance company in this story. They sold CDSs to whomever had the money for quarterly premium payments. When the subprime-based derivatives collapsed, AIG was on the hook for an immense amount of money it didn’t have.The decision was made that AIG must be bailed out. It could not be allowed to fail.

The reason AIG could not be allowed to fail was because the funds they were liable for were owed to firms like Goldman-Sachs, who had engaged in the nefarious practices described above, and the decision makers responsible for determining whether to allow the house of card to collapse had been executives for those firms in previous job. The financial services sector had agents in the government, acting on their behalf. People like Henry Paulson and Ben Bernanke consistently advised and supported deregulation and the bailout of AIG and other large financial companies.

Those same people are still making policy about how the economy should work. How did they manage to get into positions of such power? Why would the government make such disastrous policy?

The financial service sector is very wealthy. They have lots of money to make contributions to political campaigns, and records show that the financial sector is one of the largest contributors to politicians of both major parties. They have money to fund academicians to do research and write papers and give advice to the government in support of deregulation. Such papers seldom report the conflict of interest inherent in the relationship between the professor and the financial services company funding his work.

And so it goes. There’s lots more in the movie. See it if you have the opportunity and can stand the aggravation.

Advertisements
 
Leave a comment

Posted by on 2011/04/19 in reviews

 

Tags: , , ,

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

 
%d bloggers like this: