Charles Dharapak/AP Images

President-elect Barack Obama and Lawrence Summers, Obama’s choice as director of the National Economic Council, Chicago, November 24, 2008

Some prominent figures in the financial markets insist that unchecked opportunism by financiers was not a root cause of the current credit crisis. Robert Rubin, the former Treasury secretary who has just resigned as a high-level adviser and director at Citigroup, told The Wall Street Journal in November that the near collapse of Citigroup, which was bailed out by the federal government, was caused by the “buckling” financial system, and not any mistakes made at his company. “No one anticipated this,” said Rubin, who once ran the investment firm Goldman Sachs. Others such as Harvey Golub, former chairman of American Express, maintain that the fault lies principally with the federal government, which since the 1990s and even earlier has been actively promoting mortgages for low-income Americans. This, he argues, led to the unsustainable frenzy of sub-prime mortgages in the 2000s.

Charles Morris’s informed and unusual book, The Trillion Dollar Meltdown, provides a decisive rebuttal to all such excuse-making and blame of “government.” Morris makes it clear that it was an unquenchable thirst for easy profits that led commercial and investment banks in the US and around the world—as well as hedge funds, insurance companies, private equity firms, and other financial institutions—to take unjustifiable risks for their own gain, and in so doing jeopardize the future of the nation’s credit system and now the economy itself. In fact, government-sponsored entities, Fannie Mae and Freddie Mac, did have a part in the crisis, but not because they were principally trying to help the poor buy homes. Rather, they were also trying to maximize their profits and justify large salaries and bonuses for their executives. They had been made into publicly traded companies in 1989.

It would be wrong to conclude, however, that the new investment vehicles and intricate strategies for “securitization” that developed in the last thirty years had no value. Beginning in the late 1970s, the practice of packaging mortgages together and marketing them as so-called “collateralized debt obligations” was initially designed with the sensible aim of spreading the risk of making loans, particularly residential mortgages, by selling them to many kinds of investors throughout the US and eventually around the world. If many parties share the risk, this lowers the cost of borrowing and enables more people to buy homes and businesses to invest more in research, plants, and equipment.

But over the last two decades, this innovative system was exploited to stunning excess. Charles Morris is one of the observers who, contrary to Rubin’s claim that no one foresaw the current crisis, anticipated that the increasing gathering of mortgages into highly attractive investment devices had made the financial system dangerously vulnerable. A former banker himself, and author of several excellent books on finance over the past thirty years, Morris has described the intricacies of the American investment world as clearly as anyone. At the time of his latest book’s publication at the start of 2008, it seemed far-fetched for him to say that the cost of the financial meltdown throughout the world was a trillion dollars. In fact, Morris may have underestimated the amount of financial damage. Estimates of losses by financial institutions now range between $1 trillion and $2 trillion.

Morris starts his account of the unwinding of the markets with the collapse of the housing market, as does Mark Zandi, a respected Wall Street economist, whose book Financial Shock is intelligent, useful, and a more recent if less detailed book on the crisis. But the crisis cannot be understood without looking back a couple of decades to the development and rapid spread of the investment technique on Wall Street of packaging loans, principally mortgages made by banks and savings and loan associations, into an investment vehicle in which pension funds, money managers, foreign governments, hedge funds, and others could invest. Securitizing residential mortgages in this way was especially appealing, in view of the size of the US mortgage market, which runs into the trillions of dollars.

There was a strong precedent. The Federal National Mortgage Association, or Fannie Mae, established in 1938, had been packaging federally insured mortgages since the 1970s and selling them to investors. It was joined by the Federal Home Loan Mortgage Corporation, Freddie Mac, started in 1970. The two government-sponsored organizations bought up many of the mortgages on the books of commercial banks and savings and loans, allowing them to write more such mortgages, thus making home ownership more widely available to Americans. Owning a home in America is an integral part of the nation’s promise. Even in the revolutionary years a far higher proportion of colonialists owned property than in the Old World. And today no transaction is more favored by income tax advantages, including the deductibility of mortgage interest, than the purchase of a home. Home ownership is the principal source of the typical American’s wealth.


But in the late 1970s, investment banks—Salomon Brothers in particular—discovered a profitable new source of business in these mortgage-backed securities and began packaging them in a way that made them more like conventional bonds, except that they paid higher interest. The most important breakthrough, says Morris, came in 1983, when an innovative banker at First Boston, Larry Fink, divided packages of mortgages into several different tiers of risk with appropriately graduated interest rates. These tiers are now called “tranches,” the French word for “portion” or “slice.” Fink’s innovation attracted many more clients, including pension funds and major money market institutions, to invest in mortgage-backed securities, and eventually the private market accounted for substantially more such securities than did the government.

The first tier—or some 60 percent of all the investors in a mortgage-backed security—was to be paid interest and principal fully from the monthly cash flows of the mortgage holders and was therefore best protected. But these investors received the lowest interest rate. The more subordinate tiers were paid off after this senior tier received its payments, and thus earned higher interest because of the higher risk of nonpayment. The lowest tiers were the riskiest, the so-called toxic waste, which would get money last, and therefore lose money first if there were unanticipated defaults. But these investors were paid two to three percentage points more in interest to take the risk. This toxic waste was typically bought by hedge funds, the aggressive investment vehicles that took higher risks to earn higher returns for their investors, and often borrowed liberally to increase their returns on capital even further.

For the banks and mortgage brokers who wrote the mortgage loans, the financial advantage was significant. They could now sell the mortgages they wrote almost immediately to packagers, often investment banks, earning a quick and very handsome fee—one half to 1 percent of the value of the mortgage—in the process. By selling the mortgage loans, the banks did not have to maintain capital requirements for those loans, requirements that were imposed internationally by the Bank for International Settlements in the 1990s. The banks and mortgage brokers were then free to make still more loans with the cash they got back from selling the packaged mortgages and quickly to earn another round of fees.

Homeowners also benefited significantly from the securitization. In response to the demand for mortgages by pension funds, investment managers, banks, hedge funds, and others across the globe, mortgages were easily granted; banks and mortgage brokers lowered the interest rates on mortgages charged to home buyers in order to attract more customers. It was principally the investor appetite for the mortgage-based securities and the easy profits made by the banks and mortgage brokers that led to the mortgage-writing frenzy in the 2000s, not encouragement by the federal government to lend to low-income home buyers.

Securitization of mortgages was not all. In the 1990s, commercial and investment bankers expanded the market for new forms of insurance, called credit default swaps, which would supposedly guarantee holders of mortgage-backed securities against losses incurred by defaults. These were complex transactions involving derivatives—investment vehicles such as options or futures contracts based on traditional stocks, bonds, and averages or indices of stocks or bonds. Such insurance protection encouraged investors, including hedge funds and commercial and investment banks, to be still more bold in packaging and investing in mortgage-backed securities. Now that many of these mortgages have in fact defaulted, whether most of the insurance claims on them will be met is still an open question. AIG, the giant insurance company that was rescued by the federal government in September, for example, backed many of these insurance products and may not be able to meet its obligations.

By the late 1990s, America’s credit system had changed radically. Enormous numbers of loans were held, not on the balance sheets of commercial banks or thrift institutions, which are regulated by the federal government, but in a rapidly growing “shadow” banking system of hedge funds and other unregulated investors in New York, London, and around the world. This shadow banking system in effect made the loans, but unlike commercial banks, which have reserve and capital requirements legally imposed upon them for activities on their balance sheets, and are also subject to Federal Reserve scrutiny, its capacity to borrow was by and large unrestricted. By the 1990s, securitizers, often investment banks and even commercial banks, were packaging not only residential mortgages but also equipment loans, commercial mortgages, credit card debt, and even student loans—known in general as collateralized debt obligations (CDOs)—and the shadow banking system was buying them. Morris writes that 80 percent of all lending by 2006 occurred in unregulated sectors of the economy, compared to only 25 percent in the mid-1980s.


The mortgages traveled such a long distance from institution to investor that no one was in personal touch with the actual mortgage holder any longer. Now, the likelihood of defaults was assessed not by someone who tracked a specific mortgage holder but by complex, computer-generated statistical models of the entire portfolio of mortgages. Like all such models, no matter how mathematically intricate, they required an estimate about the future based on the past—an estimate that was inherently incapable of adequately taking into account the consequences of a historically rare and therefore seemingly unlikely crash in housing prices.

In addition, the ratings agencies used these statistical models to award ratings to the mortgage-backed obligations sold to investors. The ratings agencies were paid by the commercial and investment banks, who sold the packages of mortgages according to their rating, and who invariably benefited more the higher the rating. The agencies now have much to answer for.

The recession of 2000 and the World Trade Center attacks of September 11 led the Federal Reserve under Alan Greenspan to cut its target interest rate, the federal funds rate, from 6.5 percent at the end of 2000 to 1 percent in 2003, the lowest since the 1960s. For major institutions borrowing was now almost free, but there was no commensurate increase in the federal scrutiny of the loans being made, a power the Federal Reserve had but that Greenspan foreswore. And investment banks, hedge funds, and even commercial banks through off-balance-sheet subsidiaries known as structured investment vehicles borrowed aggressively to invest in the mortgage-backed securities—sometimes their borrowings amounted to thirty or forty times capital. The structured investment vehicles, typically domiciled in the Cayman Islands, enabled the banks to avoid higher capital requirements placed on balance sheet loans and closer scrutiny by the Federal Reserve and other federal watchdogs.

Henry Paulson
Henry Paulson; drawing by John Springs

Because the short-term interest rates most affected by the reduced federal funds rate were so low, investors, including commercial banks, borrowed money in the form of short-term commercial paper, and invested it in the longer-term mortgages, adopting exactly the highly dangerous strategy that led to savings and loan bankruptcies in the late 1980s. Commercial paper consists of loans businesses make to one another with their temporarily excess cash. If rates suddenly went up on the commercial paper, profit margins on the long-term investment, whose rates stayed the same, would disappear, and they did. Not to have taken account of this result was a crucial and unambiguous example of irresponsibility by executives at banks like Citigroup.

The new financial structure might have worked out nevertheless had the loans been as safe as widely believed. It turned out that they were not. The investors had failed to scrutinize them. By 2006, Zandi points out, more than $1.1 trillion of the $3 trillion in mortgages written were either subprime—mortgages to individuals with questionable ability to pay—or so-called Alt-A loans—made to people without verifying their income.

Most remarkable, perhaps, the frenzied subprime lending occurred after the housing market had already climbed to unthinkable heights. On average, the prices of homes had been rising since the early 1980s, but between 2000 and 2005, they leaped by 50 per-cent despite low inflation. Yale economist Robert Shiller estimated that it was the largest housing boom in American history. Of course, the easy mortgage availability and low rates fueled the rising market.

Some mortgage brokers claim that the subprime mortgage holders were simply irresponsible, buying houses they couldn’t afford. In fact, bankers and mortgage brokers promoted enticing loans, the most important of which was the adjustable rate mortgage, or ARM, in order to lower mortgage payments temporarily to levels that might seem well within the means of lower-income buyers. The initial interest rate on an ARM was about 3 percent, or even lower, but it would be automatically reset higher in two years. Surveys showed that many mortgage holders did not understand the terms. Remarkably, Alan Greenspan publicly suggested that if borrowers failed to take advantage of the ARMs, they could lose “tens of thousands of dollars” on their mortgage payments.

But Zandi makes clear that the mortgage writers believed house prices would continue to rise, enabling the owners to refinance their mortgages at a value higher than the original mortgage and at more advantageous terms. A rapidly growing proportion of the subprime loans in this period were also made to speculative investors who bought several houses at a time and “flipped” them to profit from the rapidly rising prices.

The housing market at last began to falter in the spring of 2006. At first, home prices moved downward and then the rate of defaults by homeowners began to escalate. The following year, the rates on many ARMs were reset upward, adding an average of $350 to monthly payments, and doubling defaults to an annual rate of 1.6 million by the end of 2007. That year, as housing prices fell and defaults rose, the ratings agencies started downgrading some of the mortgage-backed holdings on the books of investment banks, hedge funds, and the subsidiaries of commercial banks. Their values began to fall in the market. In addition, other packages of debt obligations based on consumer debt or equipment purchases were looking less reliable.

As the mortgage-backed obligations began to look less sound, the commercial paper buyers demanded higher rates, squeezing profits, and forcing the investors to sell more of these obligations, pushing their values down further. Eventually, many of the commercial paper lenders refused to lend their short-term money to the investors at all.

What made matters worse is that when the values of these securities fall, the banks and other investors are obliged to write down the investment on their books —a widely practiced accounting rule, established by the Financial Accounting Standards Board and encouraged by regulators, known as mark-to-market. This produced losses that reduced capital and the ability to make new loans. Meantime, lenders to these investors also typically require that investors put up more money as the value of the investment falls—in order to meet what is known as the margin requirement. This, too, resulted in more selling.

When two hedge funds at Bear Stearns, with substantial investments in mortgage-backed securities, had to unload investments to meet their margin requirements in 2007, it generated such enormous losses that the old-line brokerage firm, in order to avoid outright bankruptcy, had to sell itself at fire sale prices to J.P. Morgan in early 2008, in a deal engineered by the Federal Reserve. The Bear Stearns losses in 2007 were the first concrete signs of looming catastrophe. Others were soon to come. Losses were being announced publicly at America’s leading investment and commercial banks as well as foreign banks like the Royal Bank of Scotland and Switzerland’s UBS.1

An excellent series this fall in The New York Times, called “The Reckoning,” has provided fascinating insights into the reckless decision-making in some financial firms in the years just preceding the crisis. One of the reporters for the series, Gretchen Morgenson, describes how Merrill Lynch made twelve major acquisitions of mortgage and real estate companies between 2005 and early 2007 in order to take advantage of the boom, packaging the mortgages into mortgage-backed obligations themselves and selling them off or investing in them.

Merrill earned record profits in 2006 and set another record in the first quarter of 2007. But a common view outside the firm, Morgenson found, was that the Merrill executives did not understand the risks they were taking—or were perhaps deliberately looking the other way. Investors on all sides of these transactions were making a fortune. By the summer of 2007, with defaults rising and the value of the mortgage-backed obligations falling, the magic powder quickly turned to dust, and that October, Merrill reported a $2.3 billion loss. Stanley O’Neal, the chief executive, was forced to leave, as were other executives. But O’Neal took with him a $160 million severance package. Under O’Neal’s successor, John Thain, former head of the New York Stock Exchange, Merrill sold itself to Bank of America in September 2008, during the same week in which the prestigious firm Lehman Brothers collapsed and AIG was bailed out by the federal government.

The Times series tells similar stories about the management of Citigroup, which tripled its issues of CDOs between 2003 and 2005, under the leadership of Charles Prince and, reportedly, the encouragement of Rubin. As late as the fall of 2007, reporters Eric Dash and Julie Creswell found, Prince was assured by the bond executives that the company would not suffer serious losses. Little attention was paid to risk taking. Less than a year later, total losses at Citigroup exceeded $65 billion and the bank was forced to seek federal help to stay in business. But Charles Prince, like Stanley O’Neal, walked away rich from Citigroup when he was replaced in 2007.

The Federal Reserve, which since 2006 has been led by Ben Bernanke, a former Princeton professor, only started cutting interest rates in the fall of 2007. In fairness to Bernanke, he was bold in light of the widespread opposition to such a cut. Many economists were worried at the time that rate cuts would reinforce an improbable resurgence of inflation.

One problem was that the Fed did not have adequate information about these markets because derivatives were not traded openly and the latest CDOs, including mortgage-backed obligations, were mostly on the books of the shadow banking system. It was a serious lapse of judgment, not to mention responsibility, on the part of the Federal Reserve under Greenspan and the Securities and Exchange Commission under Christopher Cox to fail to seek more comprehensive information far earlier about the surge of lending.

After the Federal Reserve stepped in to avoid a Bear Stearns bankruptcy in the spring of 2008, Treasury Secretary Henry Paulson continued to reassure the public that the mortgage crisis was contained. But only after Lehman was allowed to go bankrupt in mid- September, followed by the collapse of AIG and other financial institutions, did he at last demand the controversial $700 billion bailout fund from Con-gress and eventually proceed to supply capital to banks with part of it.

But even with the new capital, the banks were not lending appreciably more; nor, without specific stipulations guaranteeing their loans, should anyone have expected them to do so. The values of even more solid mortgage-backed obligations based on prime mortgages were falling and eating up the new capital.

Bernanke then cut the funds rate sharply again, lowering it in all to 1 percent from more than 5 percent in mid-2007, but with falling housing prices, credit largely unavailable, and declining consumer confidence, a serious recession was not to be averted. The Fed has taken other bold actions by buying or guaranteeing assets held by institutions. But as of this writing, defaults on mortgages are still running high, and all kinds of consumer and business loans are now under similar threat.

At the end of 2007, the administration and Congress pieced together a first stimulus plan composed of government spending and business tax breaks. It was not enough. The rebate checks eventually doled out to most American consumers were swallowed by the rapidly rising price of gasoline in the spring and summer of 2008. Congress talked about a second stimulus plan but it failed to act, partly because the administration offered no support. In 2008 job losses reached 2.6 million, and by December President-elect Obama was discussing an “economic recovery” package of more than three quarters of a trillion dollars, unthinkable only three months earlier.

The Obama team has not yet announced its thinking about how to reregulate the financial community once the economy is righted again. The team of economists headed by Lawrence Summers, the former Treasury secretary (1999–2001), were, after all, themselves supporters of financial deregulation in the 1990s when most of them were members of the Clinton administration. As the Times’s series notes, Rubin, who preceded Summers as Treasury secretary (1995–1999), Summers, then his deputy, and Greenspan opposed regulating derivatives. In 1999, Rubin and Summers supported the repeal of the Glass-Steagall Act, the New Deal restriction separating investment and commercial banking.

In fact, with the blessings of the Clinton administration and Greenspan, commercial banks were already engaging in many of the more aggressive activities of investment banks; and investment banks, along with hedge funds, private equity firms, and other institutions, as we have seen, were making the loans once the province of commercial banks through purchases and packaging of mortgage-backed obligations. The Bush administration took deregulation further, essentially eliminating, for example, limits placed on borrowing by major investment banks.

One principle should dominate future regulation—the shadow banking system should be brought under the same regulatory oversight as commercial banking. In sum, these firms must maintain minimum capital requirements against the loans they make and mortgage-backed obligations and other CDOs they buy, just as commercial banks do. The structured investment vehicles commercial banks use to avoid such capital and other requirements should be disallowed. A federal agency, most desirably the Federal Reserve, should have the authority and obligation to examine the books of investment banks, hedge funds, and other participants in the shadow banking system to determine the quality of their investments and to set the standards by which capital is deemed adequate. Derivatives should be required to be listed on an exchange, where information about them and their prices is openly visible to market participants and federal authorities.

Rules are not enough, however. Greenspan had been given the authority to examine the quality of mortgage lending by Congress in the 1990s, but simply did not use it, pleading free-market principles. The SEC under Bush appointee Cox could have examined the books of investment banks, but again mostly did not bother. Congress will have to talk louder and exercise stronger authority.

Any regulation should also take account of the incentives for managers to take company risk for personal benefit. The ability to take immediate profits from fees on risky loans infected the financial industry and eventually the entire economy, and made possible disproportionately large annual bonuses. These incentives were among the main causes of the irresponsibility on Wall Street. The best way to prevent that from occurring is to base the bonuses and compensation of financial executives on the long-term profitability of the investment firms for which they work.

But the first order of business is to right the economy, and so far there has been only modest success at preventing matters from getting worse, for all the seeming activity by the Fed and Treasury. The number of lost jobs is rising sharply, consumption and manufacturing output are falling at record rates, house prices keep sliding, and large firms, like Linens ‘n Things, have closed their doors. The major auto companies have only just won a reprieve with a loan from the federal government. What makes this recession more precarious than the steep 1982 recession is that a further fall in incomes will bring another round of intense credit contraction, as more home owners default, including prime borrowers. Now, many corporate borrowers are also one or two steps away from defaulting.

The broad outline of a rescue plan should be clear. It requires a two-pronged approach. First, the credit system must be unfrozen and loans must flow again, including mortgages. Second, demand for goods and services must be restored to slow the downward spiral of the economy, which is now well underway.

Restoring the health of the credit system, while some slight progress has been made, is not being managed well. The Treasury has given about half of the $700 billion bailout money approved by Congress to the banks as capital injections. But as noted, the banks largely have not used these funds to revive the credit markets. In fact, Paulson’s original idea to buy some of the banks’ assets that could not be sold or even priced, which was strongly criticized, was clumsy and expensive but was based on a sensible principle. If the banks are given capital, and it just falls down a hole because the banks’ assets keep losing value, little good is done. The value of the assets have to be stabilized.

The recent bailout of Citigroup, which guarantees 90 percent of a portion of the bank’s investments for a fee to be paid by the bank, was more practical if too generous to Citibank. A better proposal, offered by the Barnard College economist Perry Mehrling, is to have the federal government either insure or even buy the better assets of the banks, which have fallen irrationally in value along with the so-called toxic assets. At a reasonable cost, the federal government could then stop some of the bleeding and the capital could be put to work to make new loans, including writing new mortgages, and perhaps slow the fall in house prices.2

But if defaults continue at their current pace, the value of mortgage-debt obligations will remain under constant downward pressure, as will bank capital. The Bush Treasury has done little about this, leaving the task to modest measures taken by Fannie Mae and the Federal Deposit Insurance Corporation and purchases of assets by the Fed. There is no easy or cheap way to guarantee the bad loans, but ways must be found to slow the default rate. It is of some concern that as of this writing we have not heard more from the Obama transition team specifically on this issue.

Another necessary component for reviving the credit system involves the self-destructive accounting rules and loan covenants that are making the crisis worse than it need be. The losses required to be taken under mark-to-market accounting, and the consequent reduction in capital, reinforce the fall in asset values. Similarly, current ratings requirements force the financial institution to sell investments to raise capital. Federal authorities should imaginatively reassess these arrangements to adjust them, even if only temporarily, to minimize the crisis. International capital requirements should also quickly be relaxed.

The second major part of a rescue plan involves the so-called real economy. If fearful Americans start saving as much of their income as they did even in the early 1990s—a savings rate of 5 or 6 percent compared to nearly zero in 2007—the economy will lose $750 billion to $1 trillion in buying power. The stunning losses of stock market and housing wealth—which in the last year total well more than $10 trillion—could cause consumers to spend several hundred billion dollars less than was expected. Such a loss in demand will drive employment and profits way down. Moreover, with the federal funds rate already so low, the Federal Reserve’s ability to stimulate the economy by lowering interest rates is now limited.3 Thus, additional federal government spending of as much as $750 billion a year is by no means an exaggeration of what may be needed.

Here Obama has moved intelligently if cautiously in projecting a large spending package, probably amounting to as much as $800 billion over two years. He will invest part of the money in infrastructure and in clean energy, with emphasis on measures to protect against global warming. Such longer-term investment will create domestic jobs and is likely, if managed well, to stimulate higher productivity. The package will also include expanded unemployment benefits, aid to the states, and perhaps, to win political support, substantial tax cuts. Again, however, the hole in the economy may be still larger than Obama anticipates, and he may have to address the possibility of a further stimulus in six months or so.

This is, as many economists now concur, the worst economic crisis since the Great Depression. Financial market participants created a financial bubble of tragic proportions in pursuit of personal gain. But the deeper cause was a determination among people with political and economic power to minimize the use of government to oversee the financial markets and to guard against natural excess. If solutions are to be found, the nation requires robust and pragmatic use of government, free of laissez-faire cant and undue influence from the vested interests that have irresponsibly controlled the economy for too long.

—January 14, 2009

This Issue

February 12, 2009