The Simple, Clear Depth of Deception that Created the Crash

by Tom Cantlon

The Problems Were Well Known Before

The financial crash of 2008 might as well be called the lies of 2008 because that is the core of it. That was well documented before the crash. Yes, before the crash. It was clearly foreseeable. It was only about the bursting of a real estate bubble to a small extent. Most of the damage was caused by the collapse of financial lies. Think of the bubble as merely the blasting cap, while it was the built-up financial lies that were the real dynamite. The lies were carried out by virtually all of the major financial players, and by regulators, and by the politicians over them.

What led to the crash has since been documented by numerous sources but one of the most interesting is the book Infections Greed, by Frank Partnoy, because it was published in 2004, well before the crash. It's a well researched book with full references and documentation. It details how the major banks gradually developed the scams and lies that led to the crash, and how once they got going they ramped them up to as high of a pitch as they could.

The book was given to me shortly after the crash by John Danforth (not the senator) who until shortly before the crash had been senior vice president and director of research at the Federal Reserve Bank of Minneapolis, and a former associate economist of the Federal Open Market Committee. He stands by his recommendation of the book to this day.

The major investment banks had been changing their nature since the 1980s, and in 1999 the repeal of the Glass-Steagall Act, which regulated investment banking, magnified these changes. That background is its own story but it led to the banks no longer just being helpers to their investors, and making a profit from that. Instead they began investing for themselves, and looking for ways to do that aggressively, and before long, also deceptively. Extremely deceptively.

The most important change this brought was the shift from being wary of risky mortgages, to creating as many as they possibly could and pushing the entire market to do the same. This stage of the story is exceptionally well explained in the book "The Big Short", by Michael Lewis, who worked for Salmon Brothers as a bond trader and is most famous for his book "Moneyball".

How did the major investment banks come to that point? They started by selling bundles of various investments and finding they could profit off them, and wanting to sell more. For instance there were investments that were essentially bets on whether one country's currency would go up or down relative to another. They would bundle a set of these investment/bets and sell it to someone else as a package, covered in a lot of deception about what the real odds were of it paying off. Good profit, great business, just not enough of it. Where to find more material for investments? A good source was mortgages. Bundle a set and sell them as a package. More good business, but they sold all they had and wanted to sell more. How to get more?

They set out by pushing their own mortgage departments to push looser mortgages, accepting lower credit scores and other riskier criteria. Anything to generate more mortgages so they could sell them. What did they care if they were risky? They weren't going to hang onto them, because there was no regulation to do so at the time.

They wanted still more mortgages so they pushed for looser and looser criteria, and they pushed other independent mortgage companies to create the same, and the banks would buy them. The message got through that it didn't matter if they were risky mortgages, just crank out more of them and the banks would buy them and resell them.

Pushing the mortgage market this way was analogous to a cola company selling all that the market wanted, wanting to sell still more, and so salting the water to force people to be thirstier and create a false market for the product. The banks pushing fast and loose mortgages were a key part in the very hot real estate market, and the overdrive of people buying homes, and of refinances for the home value plus extra cash. It was a big part of why the market got so hot.

All of this was easily known before the crash. Partnoy was able to document how the banks had developed deeply deceptive practices on a massive scale well before it happened.

The Open Secret Everyone Knew

It was an open secret that the mortgage market was full of lies, which means it could easily have been foreseen and prevented, had regulators wanted to.

The major investment banks pushed the mortgage market to create a huge number of bad mortgages so they could bundle them and sell them at a profit. But how could they make profit off bad mortgages? Didn't the buyers catch on that the bundles had a lot of bad in them? That problem was overcome by a combination of some people lying, and a lot of other people willing to go along with the charade in hopes of getting their own piece of the scam.

All of the major banks were in on the selling of mortgage bundles that had bad mortgages. The bundles were often labeled as having some that were not top quality, but this went far beyond that. After the crash there were many regulatory actions and investor suits against banks for selling bundles that, upon examination, had many with missing documentation, critical signatures missing, evidence of the mortgage holder's income missing, or mortgages to people who clearly had no ability to pay. In other words, mortgages that were certain to be losers.

In addition to banks initiating these bundles there were other bank-sized financial players in the game. General Electric, the massive manufacturer of everything from toasters to jet engines, had their financial wing grow so large that it earned more profit than all the rest of the company combined. It had become predominantly an investment company. These big players weren't regulated because they weren't banks, but the market in the buying and selling of mortgages was so hot that everyone was in on it.

This being the nature of the mortgage market at the time, with all the major banks playing the game, and such huge, sophisticated third-party players deeply involved, it would be incredulous to believe they didn't know the game was full of lies. That mortgage bundles selling like hot cakes were sprinkled heavily with real stinkers. Hell, it was advertised everywhere. Mortgages available with no money down and interest only payments? How could anyone not know the market was full of junk? And their was at least one chief regulator, Brooksley Born, chair of the Commodities Future Trading Commission, who warned about the danger well in advance. And there were at least a couple of major investors who saw the trouble coming, shouted loudly about it, and eventually bet against it so that they made a bundle as a result of the crash. They are documented in the book previously referenced, "The Big Short".

Anyone heavily involved in that market, and any regulator with an ounce of competence, would have to have known. The players didn't care because as long as they kept selling they would stay on the winning end of the game. The regulators either didn't care, or were incompetent, take your pick.

But how? How did these bundles keep selling and reselling for a profit each time? How did the players manage to make this profit? Well, we haven't even gotten to the major lies in the game.

The Simple Tricks That Created Fake Value

The major investment banks, and many other big investment players, were buying and selling and reselling mortgage bundles for profit. But what warranted those bundles seeming to be valuable enough to sell at a profit? Lies.

There were many games played with Credit Default Swaps and Collatoralized Debt Obligations and many other fancy arrangements that allowed a seller to offer a financial package while claiming it had little or no risk, all of which is exceptionally well explained for the layman in the book, "The Big Short", but there's no need to dig in that deep. Two of the biggest lies were plain and out in the open.

The first one was the credit ratings. Any financial package up for sale can be rated by one of the credit ratings houses. There are only a few major companies who do this, with Moody's, Standard and Poor's, and Fitch having about 95% of the market. The thing is they get their fee from the bank or company that's asking them to rate a package. Naturally the big banks make up the bulk of the income for these ratings houses, so they want to treat the banks well and give them good ratings on their investment packages.

The result was that bundles of mortgages with a heavy mix of bad mortgages still got good or even top ratings. It's like going out into the fields and picking the rottenest tomatoes, putting them in a closed box, having the most authoritative tomato-certifier label them as "the very best", and taking the box to market, to be sold closed but with a "very best" certificate on it. Talk about a way to make a profit.

The thing is, the lie didn't stop there. Often the bundles were teased apart, remixed and rebundled, ready to be sold as a new bundle. Well, a new bundle needs a new rating. So the lie was repeated, or made worse if the new bundle actually had a heavier mix of bad mortgages. Profit on a platter.

The second easy lie was insurance. Financial insurance. This was sold primarily by AIG (American International Group). If you owned a financial package you wanted to sell, for a small fee AIG would give you a certificate saying that whoever owns that package, if it turns out to be a loss, AIG will pay the difference. You can't lose. The worst that can happen is you'll break even. A no-lose investment? Everyone wanted them, and would pay well for them.

There was just one problem. With other kinds of insurance, say home insurance, regulators won't let the company sell more than they can cover. The insurer has to have the resources to deal with a large number of claims at a time, as when a hurricane strikes. Financial insurance was not regulated that way. If anything, financial insurance needs that regulation more. A hurricane is not going to hit the entire country or the entire world at once, but we know that the national and global economy goes up and down. The next time it goes down, even moderately, everyone whose investment comes out short will all going to go to a company like AIG at once demanding, "Pay up!" Investors from all over the country and all over the world, all at once. It's as predictable as could be. AIG didn't have a fraction of a fraction of a fraction of enough capital to deal with that. The insurance was a lie.

Spiraling Up to a Fragile House of Cards

Here's how all of those lies leveraged up to mountains of on-paper, fake wealth, and a fragile, house-of-cards situation ripe for collapse.

First, the fake wealth. When real investments are sold, their value has some relation to the real item they're based on. A company's stock has a relation to what the company is worth. A bundle of good mortgages is valued relative to what those mortgages will bring in the long run.

When fake wealth is generated it is value based on a lie. It's taking a Volkswagen and putting a plastic Ferrari-like shell on it and selling it at a Ferrari price. It's fake value. When a bank pushes mortgage lenders to create lousy mortgages but then sells them as a bundle of good mortgages, that's fake value.

But it goes further. There's a circular, spiraling up, effect to it. The bank offers bad mortgages as good. That's the start of a bundle's fake value. Then they get a good rating from the rating house, who know that they're giving it an unrealistically high rating, and the value goes up, again on a lie. The next owner might tease the mortgages apart, along with those from other bundles, repackage them, get new ratings, describe them with some new lies, and the fake value goes up again. The next owner might pay AIG a little insurance premium and get a certificate that it's a no-lose package, and the fake value goes up again. All of these big investors are buying and selling, often to one another. In some cases banks bought back their own bundles and reshuffled them again and sold them at another profit, again documented in "The Big Short".

Every time these investments change hands, back and forth, round and round, the fake value goes up. On paper the players are worth a lot. You can show on paper that you own this bundle of mortgages that previously sold for $X. Now you own it. On paper it's part of your net worth. No wonder the buying and selling was so hot.

There are ways to turn that on-paper, fake wealth into cash. You can sell part of your investments and not reinvest that part, just keep it and spend it. You can use your ownership of these supposedly valuable assets as collateral to do real things, like invest in a company and live large off the proceeds.

Part of the game were the Collatorlized Debt Obligations (CDOs) and Credit Default Swaps (CDSs) and similar arrangements. These arrangements can be used in legitimate ways, but as applied to the fake-wealth, hot mortgage market they were primarily used to pretend you could get into an investment with no risk. In a way they were like insurance in that as long as things went well then all was okay, but if your investment went down then you would still be okay because someone else would owe you money. Except when everyone was making these arrangements too, then once the whole market started to go down, everyone owed everyone else.

Remember that huge players like GE were involved in this market and they were not regulated. The market was riddled with investors making these interdependent deals with one another. When the market starts to go down then investor number one turns to investor two to collect. And they need to collect because they're leveraged far beyond what was reasonable, and needed to collect to stay solvent. But investor two is in the same boat and is trying to collect from investor three, who in turn needs to collect on a deal they made with investor one. It's all interdependent. It's all a house of cards that could only stand as long as the market kept going up. The moment it started down, the whole thing was certain to collapse.

A Few Obvious Steps Could Have Avoided It.

The common refrain after the crash was that no one could have seen it coming, and it couldn't have been prevented. These are the last two lies covered here. It is very simple to see how it was clear the crash was coming, and with three common-sense changes, could simply have been avoided.

As noted earlier, any large bank or investment company deeply involved in the mortgage market, and any regulator who wasn't blind or incompetent, had to have known the market was full of bad mortgages. All the major banks were doing it. Anyone who dug into the documents of a bundle could find it, as many did after the crash. It was advertised everywhere that ridiculous mortgages were being given out.

Anyone involved in the industry could hardly have not known that was the case, and that's the first simple way it could have been avoided. If regulators, getting a whiff of the industry starting to lie about what was in mortgage bundles, had reviewed a good sampling of them and cracked down on lies early, that run-away train would never have left the station.

The conflict of interest of the ratings houses, getting paid by the banks and firms that want good ratings, was known for decades before the crash and was never addressed. That's the second way it could have been avoided. By the way, neither Dodd-Frank nor any other change has corrected this since. This problem is still the same.

The third item is the financial insurance. If any regulator had bothered to calculate what would happen to AIG in even a moderate market downturn they would have seen they couldn't begin to cover it and should have been prevented from selling more than they had the resources for.

Those three common-sense items, stop the lies when they started, solve the ratings houses conflict of interest, stop insurance from being sold if it can't be covered, would have prevented the fake-wealth mortgage-market from winding up, which means the real estate market wouldn't have risen to such a false crest, and when it did turn down it would have been a normal downturn, not a catastrophic crash.

You don't need a crystal ball to tell you when your car is about to slide into a tree so you can stop flooring it and put on your seat belt. You always drive cautiously, with your seat belt on. Then, either the crash is minor, or you never get into one at all.

That it was unforeseeable and unavoidable is a lie. The entire process was lies. The massive build up of it, the fragile, certain-to-fail nature of it, and the feigned ignorance after, was all a matter of lies. Lies by all the major players in the financial world, and by regulators, and by elected officials over them. It was all a massive, idiotic, predictable, fraudulent, horrifically painful for most people, pack of lies, from beginning to end.

That, is the history of the crash.

Tom Cantlon has the interesting challenge of being a left-leaning writer for the paper in a small, right-leaning Western town, in a right-leaning state. He can be reached at comments at TomCantlon dot com.