At summer’s end, the U.S. economy looks to be sizzling. Unemployment is low. Growth is higher than expected. Consumer confidence is soaring and Wall Street just set a record bull run.
“We are crushing it,” Trump’s economic advisor Larry Kudlow recently boasted.
The euphoria feels a bit like… just before the crash of 2007-8. Does that worry you? It should.
Hold onto your 401(k)s, because the Wall Street casino that nearly tanked the global economy ten years ago is up and running amok again.
But what about the much-touted safeguards in place today? It’s true that in 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act was passed to ensure that taxpayers would never again be on the hook to bailout big financial institutions.
Alas, according to Michael Greenberger, a law professor at the University of Maryland and one the key voices to raise alarms a decade ago, you can’t trust that promise. In new research for the Institute for New Economic Thinking, he warns that bankers are wriggling right out of Dodd-Frank’s rules.
If something goes wrong it could be even worse than last time. So we need to clearly see the game that’s being played.
A Boom That Went Bust
First, let’s recap what happened last time to knock millions out of their jobs and homes and send peoples’ savings down the tube.
The late nineties real estate boom made people think, wow! Housing prices are going to keep going up. Let’s get a mortgage! Banks got excited and created investment vehicles to sell loans bundled together as Collateralized Debt Obligations (CDOs), which promised higher returns to investors. Credit ratings agencies gave the CDOs high ratings and investors snapped them up.
CDOs became so hot that banks wanted to make more of them, so they started giving mortgage loans to just about anybody, even if they were broke. More than a few became famous as “Ninja” loans — no income, no job (see Thomas Herndon’s recent discussion of that fraud-fueled nightmare).
Banks said no problem: housing prices will keep rising, so people can just refinance their homes to pay off the loans. They sold these dodgy bundled mortgages to investors, and the credit ratings agencies cheered them, too, because banks paid them.
A few people said, wait; maybe the value of these CDOs will collapse if people default on the underlying mortgages. They wanted to insure the CDOs in case that happened—even though they had made none of the underlying loans! Banks and other financial institutions at first thought these people were stupid, but they were happy to sell them insurance for a hefty fee, using a financial product called a “naked” credit default swap.
The naked credit default swap is a problem. Picking out sets of mortgages that you have no financial relationship to and betting that they won’t be paid off is like seeing a sick neighbor who you think is going to die and taking out insurance on their life. For centuries insurance law said no, you can’t insure risk that is not your own.
If you take out insurance on mortgages you don’t own, you sure as heck don’t want the debtor getting out of debt, through bankruptcy for example, do you? No way: then you don’t get your insurance pay out. Incentives get very shady.
But the banks and big financial institutions, including insurance companies like AIG, sold the naked credit default swaps anyway, saying they weren’t really insurance. Which was nonsense.
By federal statute, transactions on all this stuff were unregulated and undisclosed, so nobody had a clue how much they were worth and who had them. Investors kept on betting trillions that people would fail to pay off their mortgages even though they didn’t own them. Some of these actual home mortgages were bet on as many as nine times!
Then everything spun out of control. Too many houses got built that people couldn’t afford and prices started coming down. Folks started to default, so CDO values collapsed, too, and banks like Goldman Sachs bought “insurance” on the very products they sold to investors. That’s kind of like selling cars and betting they will blow up as you drive home.
Greenberger points out that if we had just had regular defaults on mortgages, without all the crazy side bets, we would have had economic problems, sure, but nothing like a Great Recession.
Instead, banks ended up with heaps of bad loans they couldn’t sell. Everybody who had taken out “insurance” on CDOs demanded their money, but nobody could pay.
The rest is history. Lehman Brothers imploded. The Federal Reserve bailed out AIG so that it could pay off at full value the naked credit default swaps of big banks. Taxpayers shelled out trillions—first a $7 billion bailout package, then trillions more in the form of a special Federal Reserve magic called quantitative easing, to keep the banks afloat. The guys who ran the firms that made this disaster got gold-plated bonuses and retirement packages.