The Subprime Security Market – an Investigative Report of Wall Street Culture and Accountability
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Toledano Esther 260584337April 12, 2016The Subprime Security Market: An Investigative Report of Wall Street culture and AccountabilityExecutive Summary:The financial crisis of 2008 caused tens of trillions of dollars to tax payers, rendered thirty million people unemployed in the USA alone and doubled the national debt while causing a global recession that we are barely managing to recover from. When looking at how we got there and what were the main causes of it, it is easy to point to the average American and blame them for overconsumption and taking on loans they could not afford. The question we should really be asking ourselves however is, how and why did the banks allow this to happen. While the housing bubble is only a part of the cause, the dynamics of the mortgage industry are a crucial indicator in how the financial sector operated at the time and how it managed to corrupt both the political system and innocent taxpayers while ensuring it continued to reap unprecedented levels of profits. With over 300 lobbyist employed by the financial sector, (that is 5, for every Congress member) and over 500 billion dollars spent on political contributions and lobbying, it is of no surprise that Washington has adopted all sorts of measures to clear the way for banks and investment companies to operate as they see fit. What’s more, with little to no accountability despite repeated fraud committed by investment powerhouses, these crimes continue to repeat themselves at the expense of the lower income taxpayer whose monies are often tied to these investments in the form of retirement savings. By studying how derivatives, securitization of mortgages into Collateralized Debt Obligations (CDOs) and Credit Default Swaps operate, we are left, without the shadow of a doubt, with the knowledge that CEO’s and senior executives of the 5 powerful investment banks, as well as higher up’s in Washington, knew at the time that the crisis was imminent and definite and yet they continued to sell securities to their clients, while simultaneously betting against them should they default. This report suggests that shareholder accountability alone cannot govern the rules of corporate actions. If corporations are regarded as legal entities, equivalent to a person, they should be held accountable as such as well and be tried in court for fraudulent behavior. A mere fine cannot do justice to rectify the wrong it has caused. The Regulatory Setting:         Following President Reagan’s lead into economic deregulation, the Clinton administration continued lifting control in the financial sector in order to stimulate further business activity. In 1999, the Glass-Steagall Act was overturned, which up until now did not allow investment and commercial banking to merge, clearing the way for future mergers that eventually led to a crisis in 2001 that cost 5 trillion dollars in investment losses[1]. At the time, analysts were promoting Internet companies they knew would fail as they had referred to them in internal memos as “pieces of junk” or “worthless heap of crap”1. And yet, when confronted with this, analysts responded in defense “everyone is doing it… no one should have relied on these analysts’ opinions anyway” 1. While most investment banks had to face fines and penalties for fraudulent reporting and misleading clients, not one ever had to admit any wrongdoing[2]. In fact, when testifying in front of Congress, one senior member stated, “It’s a very complex system, it is normal that mistakes happen”1. Not only is there no accountability, but there is also clearly no guilt or shame, as the million dollars losses are summed up as a mere “mistake” and a victim of the nature of the job.
When G.W. Bush came into office, the financial sector was exploding, with a small group of dominating players. There were the five bulge-bracket investment banks: Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch and Bear Sterns; two financial conglomerates; Citigroup and J.P. Morgan; three insurance companies; AIG, MBIA and AMBAC; and three major rating agencies; Moody’s, Standard and Poor’s and Fitch. Linking them all together was the “securitization” food chain, which proved to be the basis for earning huge rewards.Securitization is a financial innovation, which enabled the growth of many financial products because it lowered their cost and reduced their risk, in theory at least. Traditionally, when a homebuyer wanted to borrow money to purchase a home, the lender (i.e. the bank) would carefully analyze the borrower’s ability to repay the loan as the risk rested on the bank. However, with the introduction of derivatives, the banks would sell the mortgages to investment banks, who would in turn combine thousands of these mortgages and other loans into Collateralized Debt Obligations (CDOs). These CDOs were then sold to individual investors all over the world. This led the original lenders to issue loans to whoever wanted one, since the risk of repayment was no longer on them. In order to attract investors to purchase these CDOs, investment banks paid rating agencies to evaluate them and give them a rating. If the rating did not satisfy them, the rating agency would be at risk for losing the business to one of their competitors. This ultimately removed the neutrality of rating agencies in providing unbiased information. However, as the explosion of the CDO market led to huge volumes of ratings business, their neutrality was no longer credible. Bank lenders continued to push homeowners to borrow money despite the lack of funds to repay, knowing this would put them in the subprime category, which yielded higher interest rates for the lender. It was a win-win situation for everyone, except of course, the ignorant borrower. This practice, which we now call predatory lending, caused the number of mortgage loans per year to quadruple in the early 2000’s[3]. Despite the fact that most were subprime loans (meaning, the riskiest possible), when combined to create CDOs, the rating agencies gave them a triple A, signifying them as among the safest investments possible. Retirement funds and other low risk investors found themselves investing heavily in these kinds of securities, later causing entire populations to lose their retirement savings. The Housing Bubble and its Key Players:From the years 2001-2007, commonly known as the Housing Bubble, excess leverage led to large increases in home prices as nearly anyone could purchase a home. In fact, the subprime lending increased from $30 billion dollars per year to over $600 billion dollars3. Countrywide Financial Group, the largest subprime lender at the time issued $97 billion dollars in loans and made 11 billion dollars in profits as a result[4]. Many new acronyms began to emerge, including perhaps the most famous one, “NINJA” – a borrower with no income and no job.