INTRODUCTION:
There are lots of books and articles explaining the financial collapse, first in the banking system and then the failure of so many other firms resulting in loss of jobs, savings and even hope for the future. For you and me who read this, the crisis is found in the terrible financial damage done to your household and mine and to small and big businesses resulting from the housing collapse and the credit market collapse. The authors point out that it was America’s bankers and businessmen, on one hand, and our government failing to regulate these credit markets which has put the American model of free market capitalism under a cloud.
The financial system collapsed. The government regulators failed to curb widespread abuses and corruption. America has lost its economic primacy in the world, just as you and I have lost much in terms of jobs, savings and hope. This economic crisis is global and it will go on longer than most of us think. America has to now focus inward because of unemployment and all our troubles. And much of the world blames American financial excesses of our bankers for the world crisis, and rightly so, as well as our government’s failure to regulate and rightly so. The good will towards President Obama mitigates some of this, but not very much.
What we are trying to do here is to help you understand how we got into this mess because it will help you personally get out of this mess, get your spiritual priorities right, free you from anxieties, and help you vote right so that we can put into our government leaders who can help us move forward in a just and honest way. This is a gigantic task.
1. So let us begin with the question: How did all this trouble get started? Lots of people have written much, but perhaps the most insightful way to look at it is to read a book by award winning Financial Times journalist, Gillian Tett, entitled Fool’s Gold. The basic narrative outline written here is following that text. Paraphrase is sometimes used. The ethical analysis and spiritual advice is mine. It is highly recommended that you buy the text itself. It is such worthwhile reading. It tells the story of how it all started at the beginning with bankers at J.P. Morgan who were looking for new “products” to peddle to make more money (the profit motive) and how they came up with exotic financial products known as credit derivatives. We will see how derivatives involved currency trading at the start and then grew to just about every aspect of the business known across the globe. We will describe some of it here. It is important we understand the great banks and financial institutions of the world were involved: Chase, Citigroup, Bank of America, UBS, Deutsche Bank, Barclay’s Bank of London, Merrill Lynch, Lehman Brothers and insurance giants such as AIG and Fannie Mae and Freddie Mac and many others.
2. Gillian Tett points out that this economic collapse was not triggered by a recession or war or other events. This is the way it usually happens. It was self-inflicted by the banking community, starting in America, and the failure of our government oversight bodies to regulate those bankers. The blame cannot be put on just a very few bad, greedy, ugly individuals, although there were some of those! The blame must be put on the entire investment system, as well as the watchdog regulatory structures of government and lack of oversight, plus plenty of greedy bankers who sat in their silos and abandoned the public and private virtues of prudence, moderation, balance and any real concern for the common good. A huge ethical failing. Instead, they relied on complex mathematical models which were based on what they now call a “ridiculously limited set of data” and which, they held, were an infallible guide.
3. Now this is an important point. Because these things were so arcane and hard to understand, these financial gurus did what, in anthropology, is called exercising the function of elites. Tett says: “Elites try to maintain their power, not simply by garnering wealth, but also by dominating the mainstream ideologies, in terms of both what is said and what is not discussed.” Bankers sat in their silos. They said: we’ll make lots of money. Everything is OK. Don’t think anything is bad. And those elites dominated everyone below them so as not to ask questions. Regulators sat in their silos placing blind faith in the creed of risk dispersion. There is no need for more regulation, they said, and need for even less regulation. And anyone who disagreed with them was laughed to scorn. Congress sat in their silos. The whole financial community was in its own great big silo separated from the rest of society. Many smaller investment firms and trust funds cannot be blamed for believing the “big fish” would not lead them this far astray.
So let us start at the beginning.
4. In the early 1980s, J. P. Morgan, along with several other famous banks jumped into the new fangled derivatives field which then exploded rapidly. Some ten years later, by 1994, the total notional value of derivatives contracts on J. P. Morgan’s books was estimated to be 1.7 trillion in derivatives. These activities were generating half of the bank’s trading revenue. If you make .02% on each contract it is a small amount but it adds up to huge sums with great volume.
It is important to note that most members of the banking and investment world had absolutely no idea how derivatives were producing some phenomenal sums, let alone what so called swaps groups (another kind of derivative) actually did. Those who worked in the area intended to revel in its era of mystery. These bankers referred to their experiments as “innovation”, meaning the invention of new ways of generating returns. Peter Hancock, the leader of the group at J.P. Morgan, often said to his subordinates: “You will have to make at least half your revenues each year from a product which did not exist before.”
5. A derivative is, on the most basic level, a bet on the future value of an asset. It is a contract whose value derives from some other asset such as a bond, a stock or quantity of gold. Those who buy and sell derivatives are each making a bet on the future value of that asset. The bet can be one of two kinds…either a high risk long shot bet on price swings to make huge profits…or a way to protect yourself against undesirable price swings. There is nothing intrinsically wrong with derivatives if used prudently and regulated wisely.
Here’s an example Tett uses. Let’s say that on a particular day the pound to dollar exchange rate is such that one British pound buys $1.50. So Joe is going to make a trip from England to the United States in six months and he wants to be sure that he can buy dollars at that rate just before the trip. So he might enter into an agreement to exchange 1,000 pounds at a bank in six months time at $1.50, no matter what the actual exchange rate is then. And he agrees the trade must happen no matter what the rate of exchange at the time. That is a future. There is nothing wrong with futures if used prudently and regulated wisely.
Or he may agree to pay a fee (let’s say $25) to have the option to make the exchange at the $1.50 rate which he would decide not to exercise if the rate actually became more favorable.
Although the complex derivatives of the 1990’s were new, simpler versions of derivatives trading go all the way back to clay tablets from Mesopotamia in 1750 B.C., with futures and options trading. In the 12th and 13th century, English monasteries that raised sheep entered into futures contracts with foreign merchants to sell wool up to 20 years in advance…in the 17th century, Holland’s tulip prices began to rise substantially. The merchants frantically bought and sold tulip futures leading to a bubble that ended in a spectacular crash.
In 1849, the Chicago Board of Trade began to allow buying and selling of futures and options on wheat and corn, cattle and hogs, etc. Farmers often lock in a specific price for grain “for September delivery.”
6. What ushered in a bold new era of derivatives innovation was the idea to bring derivatives not just to commodities, (corn, beans, wool, livestock) but to currency trading, to homes, etc. The value of foreign currencies, (which had been pegged to the dollar) after World War II, became free floating. That led to unpredictable swings in exchange rates. Inflation in the U.S. peaked at 13.2% in 1981 and it made investors try to find ways to protect themselves from high interest rates.
The prime rate in the U.S. rose to 20% in June 1981. So now you could buy derivatives which offered you the right to purchase currencies as specific exchange rates in the future.
Peter Hancock’s group in the 1980’s at J. P. Morgan specialized in another creative version of derivatives known as “swaps.” Let’s take a simple example of two home owners, owner A and owner B. They both have a $500,000 ten year mortgage. And owner A has a fixed rate of 8% and owner B has a floating rate. If owner A thinks that rates are going to go down and he doesn’t want to pay 8% which is fixed and owner B thinks they are going to go up so he would like to have a fixed rate of 8%, they could swap their payments for a while or for as long as they agreed to.
Then take the case of IBM in 1979. They had lots of Swiss franks and Deutschmarks (they sold bonds in those currencies). And IBM didn’t need so many of those and needed a lot of cash in dollars. The World Bank said it would issue World Bank bonds in dollars, own the bonds, give the dollars and IBM would pay the obligations to bond holders and IBM would swap Franks and Deutschmarks to World Bank without having to sell them.
Note, too, that after the financial crash of 1929, bringing the Great Depression to America and the world, there was a popular backlash against Wall Street and the Glass Steagall Act was passed by Congress and signed into law forcing banks to split off their commercial banking business from the capital markets operation (trading of debt and equity securities…derivatives). Stern government regulation!
The crucial point about derivatives is that they can, on one hand, help investors reduce risk or they can create a great deal more risk. Everything depended on how they were used and the motives and skills of those who traded in them. So J.P. Morgan’s New York headquarters in the 1980’s could not (because of the Glass Steagall regulations) play capital markets but its London office could because England was not subject to Glass Steagall and had a more hands off attitude towards regulation. The London traders had greater power and freedom and they could make a lot of money fast, take far greater risks and they could walk if anything terrible happened. Few of the higher ups at Morgan knew how the swaps team trades worked.
Morgan was one of the very few banks with a top AAA rating and that assured clients that the bank could stand by its trades. By the early 1990s, the swaps department accounted for almost half the bank’s trading revenues.
7. The head of the swaps groups once explained to a reporter from Fortune that his group was like “the spaceship Galileo heading for Planet Jupiter.” “It would be something in which you would get beyond binary risk and into a combination of risks such as interest rates and currencies.” Hancock gave an example of an oil company which was afraid of oil prices dropping and interest rates rising. To hedge, it would buy an oil price floor and an interest rate cap…but maybe the company would like something a little cheaper: “In that case, we could do a contract that would pay out only if oil prices are low and interest rates are high at the same time.”
8. By the early 90’s, U.S. government bank regulators knew that many of their rules had been drafted before the explosion of derivatives innovation. They, for example, determined levels of reserves banks must have if they were engaging in derivatives activities. But the problem was the regulators couldn’t get good estimates of the risks involved and so many kept saying everything is fine. So their rules for levels of bank reserves were way too low.
Now there was an industry body to represent the swaps world and it was called the International Swaps and Derivatives Association. And the first thing the ISDA did was conduct a survey of the market. And in 1987, ISDA guessed the total volume of derivative contracts was $865 billion. That shocked western government officials. So in 1987, the U.S. Commodities Futures Trading Commission wanted to regulate interest rates and currency swaps in the same way that it monitored commodities derivatives. The ISDA lobbied Congress and won. So government regulation did not happen as it should be. A sad day.
It was a crazy period because the ISDA now said that the rules should be written by the industry itself and upheld by voluntary mutual accord. Alan Greenspan, the Chairman of the Federal Reserve, liked voluntariness because he truly believed that if everyone followed their own self-interest everything would go fine. He’s a big follower of Ann Rynd whose books were popular in the 1950s, recommending what she called the “virtue of selfishness.” He believed: if everybody is selfish, everything will work out well. I know that sounds dumb, but Alan Greenspan believed it and so did lots of others because it fit their purposes…make a lot of money and the heck with everybody else. That is a horrible lack of virtue.
Remember a basic rule of anthropology: elites gain and maintain power not only by money, but also by making sure their view (Greenspan and Bernanke) dominated and prevailed. So if you were at a lower level in the industry, you were told to keep your mouth shut or you would be in trouble.
9. By now all the great banks and stock market firms not only of America, but the world were caught up in the derivatives movement: Chase Manhattan, Citigroup, UBS, Deutsche Bank, Wells Fargo, Bank of America, Bear Stearns etc.
And do not forget about the mortgage market which became huge. The assumption of the elite was that home prices would continue to rise as they had, more or less, ever since World War II. We talked earlier in this series about the democratization of credit. Groups like ACORN and other well intentioned groups who wanted to help the poor thought it would be a good idea if the poor could borrow money and own a house. The problem was that to borrow, the money lenders had to become a lot less fussy about demanding that borrowers prove they had the income to repay the loans. The money lenders gave loans they knew they should not give. That is morally wrong because the poor get hurt even worse. Tett mentions that they even were offering “teaser” loans with very low initial rates (below 2.5%) and these rose in stages to be quite high, often well above 10%. Well, many of these families were taking out teaser loans and they could barely make the 2.5%, but neither they nor the lenders worried about the risk because it was assumed that they would simply refinance the loans at the end of the teaser rate period.
10. And they all assumed that the incredible rise in home prices would continue, when, lo and behold, in 2006 in Las Vegas and Miami and San Francisco and then Southern California, home prices stalled. And this began to trigger a wave of subprime defaults (people could not make their mortgage payments) and some began abandoning their mortgages when their house was worth less than they owed on the mortgage. Some banks then, interestingly enough, turned to the derivatives market to reduce their risk. They purchased credit default swaps which promised to redeem any default losses on the mortgage bonds. Tett points out that in January 2006, folks launched an index for tracking these offerings and their values. It was sort of like the Dow Jones and was called ABX. “Why didn’t someone (either regulators or people in the business) blow the whistle?” And the answer comes from anthropology. The elites gain and maintain power not only by money, but by making sure that their view dominated and prevailed. Their view was: this will all work very well. So be quiet!
11. In early 2006, small groups began spotting something odd: some of the data in the mortgage database suggested the pace of defaults on risky mortgages was starting to rise. This seemed strange and did not fit what they thought were the normal economic rules. At the same time, banks and other lenders were passing out lots and lots of mortgages which were becoming riskier and riskier. These loans were repackaged into more and more CDOs (collateralized debt obligations) in order to make up for declining profit margins. And these were bundled and the products were sold creating huge masses of super senior risk – and guess what. They brought insurance against the super-senior risk from places like AIG. Remember that in 2004, the U.S. Security and Exchange Commission’s five members voted unanimously to lift the leverage ratio control, namely, the controls on the amount of assets a brokerage house could hold on its balance sheet relative to its core equity. The UBS folks in Europe developed mathematical models that said super-senior would never lose more than 2% of its value, even in the worst cases. Nonsense! This defied all prudence and common sense. But remember what elites do!
In 2006, home prices across America started to slide. In October, the famous home builder, Kara Homes, filed for bankruptcy.
12. In June 2007, a crisis hit a hedge fund connected to Bear Stearns…J. P. Morgan now threatened to call in its loans. Disaster was near. In mid-July, another tsunami appeared as Deutsche Industrie Bank (IKB), a medium size lender in Dusseldorf, Germany, started to go under. Would anybody help supply new sources of funds? Nobody did until the German government stepped in. As with Bear Stearns bailout, this was only a temporary reprieve.
On August 6, 2007, American Home Mortgage Investment Corporation filed for bankruptcy. Now the commercial paper market was starting to get jittery.
13. Then the Bank of England, the Bank of Japan, the Central Bank of Canada and the Swiss National Bank started to also get jittery. The Federal Reserve kept making statements that the problems were “contained.” Remember what elites do. They control what people believe. Investors were dumping anything that might contain default risk. They were heading for the safest assets around. Countrywide, America’s largest independent mortgage lender, on August 15, 2007, said its rate of foreclosure on subprime loans was roaring upward. Now real trouble came as many banks stopped lending money to any other banks or institutions that looked at all risky.
14. On August 31, 2007, then President George Bush stood in the Rose Garden with Treasury Secretary Henry Paulson. Adjustable mortgage rates were climbing and defaults were rising enormously. Democratization of credit failed so many! The then President Bush tried to calm the nation saying: “This market has seen tremendous innovation in recent years, as new lending products made credit available to more people. For the most part, this has been a positive development…this has led some homeowners to take out loans larger than they could afford based on overly optimistic assumptions about the future performance of the housing market. Others may have been confused by the terms of their loan or misled by irresponsible lenders.” The President only offered some simple band-aid solutions. Then in September, in England, the fifth largest British lender called Northern Rock announced it had gone to the Bank of England to seek emergency support. Then on October 11, just as Citicorp and J. P. Morgan were trying to create a Superfund, the famous Moody’s cut its ratings on $32 billion worth of mortgage backed bonds which were issued in 2006 and had carried a medium risk rating. They said they might downgrade $20 billion more of mortgage backed bonds that carried a AAA stamp.
15. The entire credit structure was built on the guess that AAA was ultra-safe and AA almost rock solid. Now this was all crumbling.
At the beginning of 2008, UBS, Merrill Lynch and Citibank all reported huge write-downs on credit assets, totally about $53 billion just for those three banks.
Then Bear Stearns found itself in horrible shape and J. P. Morgan Chase cut a deal to buy Bear Stearns for $2 a share with the Federal Reserve taking $30 billion of Bear Stearns’ assets. Remember that in October of 2007, Bear Stearns stock had been trading around $130 a share. Timothy Geithner, New York Federal Reserve Chairman, pulled this deal off at $2 a share! He is now Secretary of Treasury in the Obama administration! Yes, Geithner was part of that elite!
In February 2008, AIG finally admitted it did not have the reserves it would need to meet claims. It announced $43 billion of write-downs of super-senior assets, even more than at Citicorp and UBS. Lehmann Brothers then collapsed on Sunday, September 11, 2008 and at the prospect of AIG collapsing, the money market panicked…Tett notes calmly: “The three events produced the perfect market storm.” The markets went into a freefall.
The next logical step, if this crash continued, was there would be no money coming out of ATM machines. All commerce would be brought to a standstill. On the 16th, the Federal Reserve said it would give an $85 billion loan to AIG in exchange for almost 80% share of its company. Note the Federal Reserve had just refused that aid to Lehmann Brothers which was now gone. On Monday, the 15th, just before AIG deal, Bank of America was pushed to buy, by the feds, Merrill Lynch. Finally, on October 13, 2008, Treasury Secretary Paulson called nine American bank heads into the U.S. Treasury and they were each given a piece of paper the feds demanded they sell shares of their bank to the government and they were forcefully told to sign. Secretary of Treasury Paulson said: take it or leave it. Either you accept voluntary infusion of federal funds or you’re out on a limb by yourself. They accepted the funds and the rest is history.
16. Commercial paper was drying up. Credit was drying up. ATMs would have dried up had the Federal government not stepped in.
17. Summary and Conclusions:
A. Many people have wondered how these very bright people trading in derivatives and making subprime mortgages and taking huge risks with other people’s monies…their conscience did not bother them for what they did was ruin million of Americans’ dreams and deflate America’s greatness in the eyes of the world…Remember, these young people were trained in some of our finest universities. They were told not to worry about moral principles which were all relative anyway. They possess bright intellects and can understand complex business transactions. They have mastery of high level mathematical formulas.
A big part of the answer why their conscience didn’t bother them lies in that basic principle of anthropology we have repeated over and over again: “Elites try to maintain their power not simply garnering wealth, but also by dominating the mainstream ideologies, in terms of both what is said and what is not discussed.” It is what the behaviorists call environmental conditioning and that is easy to understand. Most of us live in a bubble and what is inside the bubble conditions us to think the way we think, believe and act unless we are countercultural. For example, if you are a teenager and live in the bubble of MTV, rock stars, rappers, drugs, sex and alcohol, you are going to believe that is “the normal way of life.” To a teenager, you have to live that way. The elites in the teenage world maintain that supremacy.
To not believe what the elite says means you need to be slightly countercultural. A person with strong religious convictions and relationship to God and His people could overcome that environment, but others cannot.
If you live in a silo of bright banking people and your purpose is to make as much money as possible and the elites around you and above you make sure their view dominates and prevails (There is nothing to worry about. Everything is OK.) Then you will not realize that what you are doing is a violation of prudence, moderation, responsibility, balance and common sense. A violation of virtue! What you will not realize is that you are becoming very greedy and selfish and are going to harm others. What you need to overcome this silo effect is a Power greater than the power of the elites. Most traders and bankers had their private doubts, but they were swayed by environmental conditioning by the spirit of their organization. Or it was simply too complex to understand and you could not be reasonably expected to figure it out!
If you questioned the rightness of the thinking of the elite, in your bank or government agency, you would probably be fired or at least not promoted. All of this should provide business schools with the realization that there has to be an enormous effort made in ethical training, in neutralizing environmental conditioning and understanding anthropology required of students if this is not to happen again. Without virtue all ventures collapse.
B. Many of the banking, business and government elites believed in what Ann Rynd, as we saw above, called “the virtue of selfishness.” They believed that if anyone acts on self-interest everything will work out well. Alan Greenspan believed it and so many others did because it fit their purposes…that ethical theory has to be abandoned (namely, that all persons should seek their own self-interest and all would go well). It has to be abandoned immediately. It is wrong and destructive of human flourishing. It is based on the denial of original sin.
C. The bankers and investors in this drama often describe themselves as feeling invincible, charting new territory, applying new financial services without a touch of humility. They were suffering from what the Greeks called hubris or pride/arrogance. There is an old adage: Pride always comes before the fall and that certainly is true here.
What is hubris? It is the belief that you personally can do no wrong and (if you do) that nobody will challenge you. Remember the story of Darius, the great Persian King in the 5th century B.C. who, when Athens decided to stand up and declare its independence from him, Darius made up his mind to punish them, gathering a great Naval Armada and crossing over to Peloponnesia only to suffer great damage to his fleet as a result of a terrible storm. Darius is said to have taken out a huge whip and whipping the sea said to the god of the sea, Poseidon: “You will not interfere with my will.” Because of his pride, in 490 B.C., his army suffered a huge disaster at the battle of Marathon at the hands of the Athenians who chose freedom over tyranny. The Greeks said Darius lost because of hubris. (sign of pride/arrogance) The reason the financial world went wacko is also because of hubris on the part of these people who thought they were invincible.
That hubris, once again, develops through environmental conditioning. You can be blinded into taking terrible risks with no thought of harm to others because you are reinforced to believe that you are the vanguard of the future. Or if you are at a lower organizational level, you are filled with fear if you don’t go along with the elites. In the 21st century, environments are created with such power they can blind you to moral values at stake. The propaganda machine of Joseph Goebbels was so powerful in Nazi Germany that even good Christian people were blinded into accepting and cooperating with the Holocaust. The Nazis suffered from great hubris.
If, in the 1980’s onward, you belonged to the banking fraternity which is close knit which feels itself superior and invincible and has success after success after success, pretty soon it is blinding to those who are part of it. You may otherwise be good persons, but here are surrounded by leaders and coworkers who feel themselves invincible, a new breed, and clearly making huge sums of money. This is heady stuff and you would have to be greatly countercultural to be morally sensitive and courageous enough to stand up to this pressure!
Postscript: As stated in the beginning of this paper, we are basically following the marvelous book by Gillian Tett, Fool’s Gold (New York: Free Press, 2009) for the financial tale. The ethical part is my own. Buy Fool’s Gold. You’ll like it.
