As mentioned in the previous Wall Street post, Part 2 will focus on the various bubbles that occurred throughout the late 1990s and early 2000s.

At the end of the 1990s, the investment banks fueled a massive bubble of internet stocks.  A bubble, as referenced in “Part 1”, is an overvaluation of security prices that continues to increase until prices go into free-fall from a massive sellout, effectively bursting the bubble.  This financial phenomenon typically occurs in a particular sector of the economy, in this case internet, or “dot-com” companies.  When the internet bubble burst in 2001, the market crashed and investors lost nearly $5 trillion.  Federal regulators, including the SEC and the Federal Reserve, just sat on the sidelines and watched.

Interestingly enough, it was Eliot Spitzer of all people (not exactly a saint himself) who stepped in and discovered that the investment banks had sold internet securities to clients while betting they would fail at the same time (conflict?).  Even more troubling, however, was the fact that rating agencies like Moody’s and Fitch, had rated these internet stocks well, providing no indication to investors of the risky nature of their investments.  The defense from all of these parties was based on an appeal to popularity – all of the Wall Street banks and rating agencies acted this way, therefore it should be acceptable.  With the absence of federal regulation, many of the banks from Goldman Sachs to Citigroup and UBS all settled for hundreds of millions of dollars and promised to behave in the future.

They must have forgotten their promise.  Technological advances were not only made by internet companies in the 1990s, but by investment banks as well.  Innovative new products called derivatives were originally thought to make markets safer by spreading out risk over multiple underlying assets, which could include stocks, bonds, commodities, and more.  Derivatives enabled financial firms to gamble on essentially anything from the bankruptcy of a company to the rise and fall of commodity or oil prices.  The versatility and profit potential this provided banks only exacerbated their lobbying efforts to continue the deregulation of the financial industry.  Alan Greenspan, Larry Summers, and the rest of the Clinton administration at the time viewed the regulation of derivatives as unnecessary because there were often sophisticated parties on each side of a derivatives transaction.  That’s like stripping away professional responsibility rules for lawyers who represent sophisticated clients (who often have their own team of lawyers) solely because each party is sophisticated…  It would be a recipe for disaster.

The Clinton administration was not the only responsible chef for this disaster recipe.  The Senate Banking Committee in a Republican-controlled Congress passed legislation protecting the derivative market and exempting them from any financial regulation.  This legislation was called the Commodity Futures Modernization Act, and was passed in December of 2000.  Derivatives were given a green light to innovate even further.

Changes to the mortgage lending process only added fuel to an already burning fire.  In the old system of lending, a home buyer would take out a mortgage from a lender.  Normally, there were only two parties in the transaction.  The lender was naturally cautious because the mortgage often took the buyer a long time to repay, and if the buyer defaulted, the lender would be left holding the bag.  In the new system, however, lenders would sell the mortgages to investment banks who in turn combined these mortgages with a multitude of other loans (car, student, etc.) to create other financial products known as collateralized debt obligations or CDOs.  The CDOs were sold to investors.  Rating agencies were paid by the investment banks to evaluate the same CDOs they were selling.  Coincidentally (of course), most of these CDOs received AAA ratings (the highest rating possible).  How nobody thought there was a conflict of interest here is absolutely baffling.

Not only did lenders no longer have any risk when selling a mortgage to a home buyer, but the investment banks who were buying and packaging these mortgages were also paying off third-party companies to “assess” their products!  Lenders were encouraged to engage in predatory lending by offering subprime mortgages because they carried higher interest rates and a greater profit potential.  Rating agencies did not know any better because these risky subprime mortgages that were bought and sold by investment banks were often packaged with less volatile debt masquerading their risk.  Meanwhile, the rating agencies were incentivized to keep giving CDOs high ratings because they were being paid by the same institutions that were selling them, the investment banks.  Rating agencies would not incur ANY liability for evaluating CDOs incorrectly, so the risk was negligible if not nonexistent.

Courtesy of http://nafma.blogspot.com/
Courtesy of http://nafma.blogspot.com/

Risk was spread so far throughout the financial system that each of the players, from lenders to investment banks, acted almost without restraint.  It created the potential for massive private gains at the expense of cataclysmic social losses. With a greater incentive to approve mortgages so they could be sold to investment banks, lenders like Countrywide tried to churn out as many mortgages (at the highest interest rates) to buyers as they could, regardless of the buyers’ eligibility.  Welcome, everyone, to the real estate bubble.

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