Tom Arena
Dystopia, Revolution, and Leadership
October 1st, 2012
The Consequences of Corruption in the Financial System
The year of 2008 saw an unprecedented change in the economic status of our
country. Beginning in late 2007, the first effects of the recession became evident,
setting the stage for the apex of the crisis. On September 15th of 2008, the
investment bank Lehman Brothers filed for bankruptcy, leading to the subsequent
collapse of the insurance agency American International Group. The ensuing results
were disastrous. The national debt doubled, nearly thirty million people were left
unemployed, and the effects resonated globally. The state of the American and
global economies at this point in time were the worst they had been since the Great
Depression. The economic downturn was caused by the dismantling of
governmental regulations that were put in place to stabilize the economy and
prevent the disastrous consequences of speculation from recurring in the future.
Deregulation of the economy has created a destructive and immoral financial
system that mimics the corrupt inner workings of a dystopia.
After the Great Depression, the American economy remained relatively
stable, enjoying a period of prosperity. The introduction of deregulation in the
1980’s marked the beginning of a new economic plight. It began with the decision of
many investment banks to transition toward becoming publically traded
corporations. The traditional investment bank consisted of a small group of wealthy
partners that pooled their money collectively in order to invest in stocks or bonds.
Their collective investing minimized any losses that each individual member might
incur (Knight). Before becoming publically traded, these banks invested only with
the money of the partners. In the 1980’s, the transition to becoming publicly traded
corporations gave the banks a massive increase in funds, and vastly bolstered their
investment power (Morrison and Wilhem 4). In 1981, Ronald Reagan chose the CEO
of the investment bank Merrill-Lynch, Donald Reagan, as the Secretary of the
Treasury. Reagan began to initiate the first steps of a thirty-year long period of
deregulation, setting the stage for a number of increasingly worse financial crises.
The growing power of the banks gave rise to a crisis that would function as a
deathblow to financial regulation. In 1998, Citicorp, a large commercial bank,
attempted a merge with Traveler’s, a large securities firm. At the time, the move was
illegal due to the Glass-Steagall Act of 1933, which prevented the merge of
commercial and investment banks (Gross). Though the move was illegal, the case
was delayed for a year, and on November 12th of 1999, the Gramm-Leach-Bliley Act
was passed, overturning the Glass-Steagall Act (Grant 374). This vastly increased
the power of the banks, allowing them to grow large enough that they became “too
big to fail.” The financial conglomerates had become large enough that bankruptcy
would mean disaster, allowing them to exploit the government-funded Troubled
Asset Relief Program, which provided bailout money to bankrupt companies (Grant
376). The strategic maneuverings of the banks provided them with a system of
uncontrollable expansion and a guaranteed safety net.
The consolidation of the banks enabled the creation of the tools that would
cause the downturn in our country’s economy. In the 1990’s, banks began a new era
of financial innovation. The banks created derivatives, complicated financial
instruments that derive their value from underlying assets such as stocks or bonds.
A derivative functions as a contract that specifies conditions under which a payment
should be made between two parties (Rubinstein 1). Derivatives were used
extensively for speculation, allowing banks to essentially gamble with their
investor’s money (Rubinstein 1). Growth of the derivatives market was explosive.
Statistics from the Bank for International Settlements indicate that the derivative
market exceeded 600 trillion dollars in 2008, and had grown by almost 800% in ten
years (Gyntelberg 1). In a move to protect their new system, lobbyists worked with
the Clinton Administration to pass the Commodity Futures Modernization Act, fully
preventing any regulation of derivatives (Scheer). This caused major complications
within the system, and would soon become one of the major factors in the creation
of the housing bubble and the decline in the economy.
Before derivatives, lenders gave out loans that were to be paid back in full
over time. This ensured that loans were given only to those with a low-risk of
defaulting. Derivatives allowed lenders to sell the loans to investment banks. The
investment banks would then combine numerous loans such as student loans, car
loans, and credit card debt into derivatives known as collateralized debt obligations,
or CDO’s. These CDO’s were then sold to investors by the investment banks. These
debt obligations are given grades by credit rating agencies. The agencies assign
rankings based on the perceived value of the debt obligations. Rating agencies held
no accountability for their ratings, and were thus able to rate a CDO regardless of its
actual value. Since profit was achieved by the volume of CDO’s sold, rating agencies
were incentivized to pump out massive amounts of highly rated securities. Robert
Kuttner, a prominent economist, states that one of the “core structural conflict[s] is
that the rating agencies are paid by the firms that issue the bonds” (Kuttner). James
Barth, another prominent economist, notes that “AAA-rated securities accounted for
29-45% of all rated fixed-income securities that were issued between January 1st,
2001 and September 30th, 2008” (Barth et al. 16). Of these supposedly strong
investments, “roughly one in six were downgraded within three years…and 56
percent of mortgage-backed securities issued from 2005 to 2007 were eventually
downgraded” (Barth et al. 17). The numbers clearly indicate the cooperative
behavior between banks and rating agencies to create a highly profitable system of
numerous well-rated securities.
This system stripped lenders of responsibility in who they chose to receive
loans, leading to an increase in predatory lending. An increase in loan volume and
security sales allowed for a greater increase in profit for the banks. From 2000 to
2003, the number of mortgage loans that were distributed each year rose
substantially, nearly quadrupling (Barth et al. 9). Riskier loans, known as subprime
loans, have a higher interest rate for the loan recipient in order to account for the
higher risk that the lender is supposedly taking. From 2001 to 2005, the percentage
of subprime loans in the country rose from 8% to 21% (Barth et al. 9). The sharp
rise in subprime loans illustrates the effective push toward predatory lending that
was caused by derivatives. The major increase in risky loans quickly became yet
another major factor in the decline of the economy.
The ease of obtaining a mortgage from the increased volume of these loans
fueled the formation of a housing bubble, causing home prices to rise substantially.
In 2007, home prices increased to nearly double their prior price (Barth et al. 8).
The money for these loans came from money borrowed by the investment banks.
The banks use a ratio known as leverage to track the ratio of their debt versus their
actual fiscal assets. Initially, laws were in place to keep this ratio balanced and to
keep the financial obligations of banks in check. On April 28th of 2004, financial
lobbyists worked with the Securities and Exchange Commission to relax laws
restricting leverage. Initially, leverage was maintained at a lower ratio near three to
one. By 2007, leverage rates skyrocketed, growing to ratio of 30:1 and higher. Such a
ratio, as Barth indicates, would leave only 40 billion dollars of supporting capital for
a loan worth 1.2 trillion dollars (Barth et al. 17). Insurance companies, particularly
AIG, only helped fuel the fire. They created a tool known as credit-default swaps,
which worked as an insurance policy for CDO’s. The insurance agency would be paid
a fee on the CDO they owned, and if the CDO went bad, the agency returned the
investor’s losses. In this convoluted system, investor’s could buy a credit-default
swap on a CDO that they didn’t own. This allowed investors to “buy the swaps as a
bet on bad news happening” (Zuckerman). Due to the deregulation of derivatives,
insurance agencies were not required to reserve any money to cover losses. This
allowed them to generate massive short-term revenue, fueling the implosion that
would eventually cause their demise.
Despite many warnings, the conglomerates of the financial sector continued
their destructive endeavors. Raghuram Rajan, a Chief Economist of the International
Monetary Fund, predicted the moral implications that would occur from such
massive sums of profit. In a paper he wrote concerning the repercussions of the
housing bubble, he claimed that banks “have greater incentive to take risk” and that
their actions would “create a greater probability of a catastrophic meltdown” (Rajan
4). Many banks realized the implications of their actions, and sought to take
advantage of the situation. In 2007, just before the housing bubble burst, the
investment bank Goldman Sachs sold over forty billion dollars in CDO’s backed by
subprime mortgages. They then utilized credit-default swaps purchased from AIG to
bet against housing prices, as well as the CDO’s they had just sold. This allowed them
to pass on any losses that they might endure to their investors (Gordon). Goldman
also realized the risk their actions were placing on AIG, and spent another 150
million dollars ensuring themselves against the collapse of AIG (Mollenkamp and
Ng). Though the banks realized the strain that their actions were taking on the
economy, they chose to proceed regardless of the consequences.
The corrupt behavior of the banks worsened over time. Goldman soon began
selling CDO’s that would become increasingly profitable as customers suffered more
losses. Three years later, in April of 2010, Goldman was brought before Congress
and the Securities and Exchange Commission for fraud concerning a security known
as Timberwolf (Story). During the trial, the Congress discussed emails between a
sales team, in which employees had been quoted as saying, “that Timberwolf was
one shitty deal.” Afterwards, Goldman continued to trade the security, and another
email between the sales team states that “the top priority is Timberwolf.” The CEO
of Goldman Sachs, Lloyd Blankfein, then stated during the trial that he had “heard
nothing today that makes me think anything went wrong” (Dayen). These situations
were a common occurrence amongst the investment banks, resulting in massive
profits for the financial conglomerates and fiscal devastation for the investors.
The absence of strong leadership and the immoral proceedings that occurred
within the financial sector demonstrates its similarities to dystopian society.
Deregulation of the financial sector allowed for the development of a system of
exploitation in which the conglomerates of the industry were free to manipulate the
economy at the expense of unknowing investors. Their actions represent the moral
corruption that plagued the financial industry, mimicking the exploitation and
decadence that characterizes dystopian societies.
Works Cited
Barth, James R., Tong Li, Wenling Lu, Triphon Phumiwasana, and Glenn Yago. "The
Rise and Fall of the U.S. Mortgage and Credit Markets." Milken Institute. John
Wiley & Sons, Jan. 2009. Web. 20 Sept. 2012.
<http://www.milkeninstitute.org/pdf/Riseandfallexcerpt.pdf>.
Berthelsen, Christian. "Keating Pleads Guilty to 4 Counts of Fraud." The New York
Times. The New York Times, 07 Apr. 1999. Web. 30 Sept. 2012.
<http://www.nytimes.com/1999/04/07/business/keating-pleads-guilty-to-4counts-of-fraud.html>.
Dayen, David. "That Timberwolf Was One Shitty Deal." Firedoglake. 27 Apr. 2010.
Web. 20 Sept. 2012. <http://news.firedoglake.com/2010/04/27/that-timberwolfwas-one-shitty-deal/>.
Gordon, Gregory. "How Goldman Secretly Bet on the U.S. Housing Crash." McClatchy.
McClatchy Newspapers, 1 Nov. 2009. Web. 21 Sept. 2012.
<http://www.mcclatchydc.com/2009/11/01/77791/how-goldman-secretly-bet-onthe.html>.
Grant, Joseph. "What the Financial Services Industry Puts Together Let No Person Put
Asunder." Albany Law Review 73.2 (2010): 371-420. Print.
Gross, Daniel. "The Rise of the Commercial Banks." Slate. Slate Magazine, 15 Sept.
2008. Web. 20 Sept. 2012.
<http://www.slate.com/articles/business/moneybox/2008/09/shattering_the_glasss
teagall.html>.
Gyntelberg, Jacob. "OTC Derivatives Market Activity in the First Half of 2008." Bank
for International Settlements. N.p., Nov. 2008. Web. 21 Sept. 2012.
<http://www.bis.org/publ/otc_hy0811.pdf>.
Knight, Laurence. "What Do Investment Banks Do?" BBC News. BBC, 09 July 2010.
Web. 20 Sept. 2012. <http://www.bbc.co.uk/news/business-11211776>.
Kuttner, Robert. "The Alarming Parallels Between 1929 and 2007." The American
Prospect. 2 Oct. 2007. Web. 20 Sept. 2012. <http://prospect.org/article/alarmingparallels-between-1929-and-2007>.
Morrison, Alan D., and William J. Wilhelm. "The Demise of Investment Banking
Partnerships: Theory and Evidence." University of Virginia, May 2004. Web. 21
Sept. 2012. <http://gates.comm.virginia.edu/wjw9a/Papers/ibdemise2.pdf>.
Ng, Serena, and Carrick Mollenkamp. "Goldman Fueled AIG Gambles." The Wall Street
Journal, 12 Dec. 2009. Web. 21 Sept. 2012.
<http://online.wsj.com/article/SB100014240527487042014045745904531769960
32.html>.
Rubinstein, Mark. Rubinstein on Derivatives: Futures, Options and Dynamic Strategies.
London: Risk, 1999. Print.
Scheer, Robert. "Robert Scheer on The Great American Stickup." Interview by Amy
Goodman. Democracy Now! Los Angeles, California, 7 Sept. 2010. Television.
Transcript.
Story, Louise. "Mortgage Deals Under Scrutiny as Goldman Faces Senators." New York
Times. 26 Apr. 2010. Web. 20 Sept. 2012.
<http://www.nytimes.com/2010/04/27/business/27goldman.html?_r=0>.
Zuckerman, Gregory. "Trader Made Billions on Subprime." The Wall Street Journal, 15
Jan. 2008. Web. 21 Sept. 2012.
<http://online.wsj.com/public/article/SB120036645057290423.html>.
I pledge that I have neither given nor received aid on this assignment.
-Thomas Arena
Word count: 1773