Money, Power and Wall Street, Part One (full documentary) | FRONTLINE

to employment, etc. It was no longer just an idea in a room in Florida, it was the creation of an entire market. Now risk can be easily negotiated. It fueled a global credit boom. Soon other banks became excited about the

money

to be made by issuing credit derivatives. Paul LeBlanc was a derivatives salesman at Morgan Stanley who remembers the pressure to close more deals. Transaction volume was skyrocketing. I mean, I used to know all the statistics because they used to talk about it in every meeting, how this is a growing market and you have to get customers involved.

They can make

money

. We can earn money. It was a hugely important sector to focus on: derivatives. And most importantly, it was a private market, unregulated and out of sight. —the Dow Jones is up about two and three-quarters of— Look, unlike an exchange-traded market where all the banks can see all the positions, there is no public market for these derivatives. You can't look at the newspaper and get a price for them. These are all private, off-exchange markets. And no one else in the market knows what's going on. And because this market was opaque, the spreads (the difference between what banks could charge for derivatives and what it cost to provide them) could be huge.

How much did these things generate for the bankers who sold them? Spreads on derivatives are several times larger than those on comparable cash securities, as a general rule. And that is why banks market them. Cash securities are those that are— Stocks, bonds— Well, paint a picture of that and the amount of money people made. The best reference I could give is that if you look at, let's say, the margin that a bank could earn doing an IPO for FaceBook, maybe they will earn 1 percent to take out that IPO, a very interesting IPO. . If you were making the same size trade in a derivative security, you could earn 10 times the fee.

And the core business they created was immensely profitable. But there is a problem with all this. Most people in finance assume that risk can be eliminated, but all you can do is move it from one

part

y to another. There was growing concern in Washington. We are moving towards greater risk. We must do something to address the regulation of hedge funds and especially derivatives in this country, $33 trillion, a substantial amount held by the 25 largest banks in this country, and a substantial amount traded on proprietary accounts of those banks. That kind of risk hanging over this country's financial institutions will one day, with a thud, wake everyone up.

Proposals circulated to control banks and regulate derivatives. What are you trying to protect? We are trying to protect the money of the American public, which is at risk in these markets. Commodity Futures Trading Commission head Brooksley Born led the charge. Certainly, we are the regulator that has been given the authority to supervise the major derivatives markets— Brooksley Born was absolutely right because what he said is that if there is no transparency and regulation of derivatives, the risk goes To increase. are accumulating and will lead to a financial crisis that will lead to massive taxpayer bailouts. Banks lobbied intensely for derivatives not to be regulated.

The banks didn't want anyone to know how much risk they were taking on. They didn't want to have to quantify it on their balance sheet. They wanted to be able to push it away and hide it. And that's why they pushed so hard to make sure that swaps and derivatives were treated differently from other types of financial products. Others wanted them to be regulated as safe. One of the most regulated products in the country are insurance products, for all the obvious reasons. If you're going to... if you're going to take out insurance, you have to have enough money to pay for that insurance.

But if you write a credit default swap, you don't have to have the same amount of money on hand. Or anything else, including, most importantly, non-disclosure. So you're saying it's a kind of hidden insurance arrangement that avoids regulation. It is an insurance product designed not to be regulated as an insurance product and designed to avoid any regulation. And one thing we do know is that when a product of any kind is designed with minimal regulation, capital and activity moves into that area and it expands dramatically. Regulation of derivative transactions negotiated privately by professionals is unnecessary. Federal Reserve Chairman Alan Greenspan sided with the banks.

Alan Greenspan came from a very libertarian tradition. Keep your hands away from everything. The markets will take care of themselves. And if there is a problem, we will clean it up afterwards. And now, that was really the way the Federal Reserve operated under his leadership for almost 20 years. On Capitol Hill, supporters of banking deregulation made urgent and forceful pleas. The future of the United States' dominance as the world's financial center is at stake. Before them was legislation to lift restrictions on how banks could do business. If we don't pass this bill, we could see London, Frankfurt or Shanghai become the financial capital of the world.

This bill will make the United States more competitive in the global marketplace, and that's important. And legislation to prevent the supervision of credit derivatives. —high-paying jobs not just on Wall Street in New York City, but they affect every business in America and benefit every consumer in America. And we do it by repealing Glass-Steagall. It is the most important example of our efforts here in Washington to maximize the possibilities of the global economy of the new information age. In the end, banks would grow and derivatives would remain in the shadows. The derivatives market was left in the dark, with almost no transparency and no regulation.

And what you see is this explosion in the growth of derivatives in the United States and around the world. The banks had won. Credit default swaps would now be introduced into new markets. The next application of this same technology was to consumer credit risk portfolios, and in

part

icular. credit risk related to mortgages. And the higher the risk, the better. What everyone is trying to create is something that is highly rated and high performing. That's the holy grail, that's the goal, to combine assets in some way to get AAA and great performance. And so Wall Street discovered the rewards of financing the American dream.

Just as they had bundled corporate loans, bankers now bundled mortgages. You would buy these large pools of mortgages, and these credit default swaps would allow you to bundle all of this together, bring it in-house, to prepare it to go through the sausage machine and create these securities. Bankers spread their investment dollars across the country, but especially in states experiencing historic levels of population growth, places like Florida, Nevada, California and here in Georgia. Well, Atlanta was one of the hottest markets in the country, the Atlanta region. Roy Barnes is the former governor of Georgia. Georgia was the fourth-fastest-growing state at the beginning of the last century, and the fastest-growing state east of the Mississippi.

So it was a hot market to begin with. Elected in 1998, Barnes is famous for taking on Wall Street over subprime lending, a market the Street had traditionally shunned. And in the '80s, there was no place for subprime mortgages. Nobody wanted it. Banks wouldn't buy it because there was a greater risk. What really changed the appetite for subprime mortgages was that they could be securitized. And you could sell it on Wall Street. They do it in tranches and then package them together so they can package them together for higher overall performance. Nearly half of all new single-family home construction is in the South, now more than 50,000 a month.

And of course, Moody's says AAA. So it was just a feeding frenzy. I mean, it was just an absolute frenzy for subprime mortgages. With a strong economy, home buyers are willing and able to spend twice as much as they did just two decades ago. And you could drive by a bank and they would throw a loan document in your car as you passed. It was very loose. He became very lazy. But what the big Wall Street banks didn't see or wouldn't see was what was happening across the United States: a wave of credit abuses. The Wild West experience in home mortgages was already underway.

Hessiemay Hector, 41 years old and mother of three, accepted a second mortgage at 27.5 percent. We were creating mortgages that we had never seen before. And they were being created faster and faster. The interest rate on these loans reached 42 percent. We saw borrowers make loans that were greater than the value of their home. Homebuyers were getting loans with no income. When you have a high interest rate, then you have high points. Then we have prepayment penalties, when we have balloon payments, when we have adjustable rate mortgages, and when we add those bad practices to a high interest rate, it becomes predatory.

Housing advocates across the country took on predatory lenders. But one of the fiercest fights took place here in Georgia, for what was called the Georgia Fair Lending Act. It's in the House right now, a bill from the governor to crack down on... Mortgage lenders and banks fought back. None of these people have any idea what's going on! Nobody understands the business here and they didn't let us talk! You would have thought I had recommended that we repeal the Salvation plan. Why were they so opposed to it? Money. Money.  This bill will cripple the mortgage business! It's going to cripple real estate sales!

It's going to completely devastate the real estate market in Georgia, I guarantee it! There were threats that Georgia residents would no longer be able to get mortgages because investors would not buy mortgages in Georgia. And if that were true, no bank would create a mortgage in Georgia. Georgia now has the strictest predatory lending law in the country— Despite the efforts of the mortgage lobby, the bill passed. Fearing similar bills in other states, the lobby helped overthrow Barnes and rescind the law. Immediately after Governor Barnes' defeat in November, one of the top legislative priorities for the new governor and the new legislature was gutting the Georgia Fair Lending Act.

I think it was about two weeks into the new legislative session and it was destroyed. There is no respite in the real estate boom, which is good for the economy. Homes sold last month at a record pace, the main reason being low mortgage rates... Big banks continued to package and sell more mortgage portfolios. And more and more of these CDOs contained high-risk subprime debt. To keep the rating agencies on board, more credit default swaps were sold. Let's say I have a set of mortgages. I have a thousand California mortgages and I want to bundle them together.

But I decide, "Well, some of these mortgages may be subprime and I want to buy some credit default insurance." And by doing that, you improve the profile- In theory, yes. —from your CDO- That's right. —so you can sell it better. And I can also get a grade. I could go to Moody's and say, "Look, I've written off 2 percent of the risk in this portfolio. Shouldn't I get a better rating than if I sold the whole thing as it was?" So you take a lot of garbage- That's right. —many mortgages that are- Awful shit. —people are not going to pay— right.

OK. But you insure it and the credit agency says, "Hey, that's a good idea." Yes. Yes. New home sales increased 13 percent from the previous year, while existing home sales increased 4.5 percent, setting a new record— The JP Team Morgan was also dabbling in mortgage debt, but they weren't sure it made sense. We negotiate mortgages. We had some mortgages on our books. We certainly understood the mortgage-backed securities market. But we had a hard time getting comfortable with that risk. The big problem for us was data. We had years and years of historical data on how companies performed during economic cycles.

But we didn't have much data on how retail mortgages performed during different economic cycles. We knew how much money people said they made. We saw that UBS and Merrill Lynch had securitized product earnings growing faster than ours. And we asked ourselves the question: "What are we doing wrong? What are we missing? Aren't weHave we figured out how to avoid some of this risk?" And honestly, we couldn't figure it out. What we never imagined was that those other companies weren't doing anything at all. They were just taking the risk and accepting it. Sales of new single-family homes skyrocketed— The first wave of JP Morgan bankers who had developed these original ideas in the 1990s, when they saw what was starting to happen; essentially, other banks were taking these ideas and applying them in ways they had never done before. expected: some of them started to get very worried.

We were about to say that a transaction was made. We had a global phone call and we were discussing the risk we were about to take, and we had discussed it over and over again. finally, someone on that phone call said, "I'm nervous." Twice as many home buyers get adjustable mortgages— —huge increase in new home sales— We had almost stopped thinking and stopped reevaluating. the risk as we went. And suddenly, we found ourselves with a product that was very different from where we started. And at every little change along the way, we'd all said, "Oh, okay.

Okay. Okay," until suddenly, we all manipulated bank results by taking risk out one door, but putting it back into the banking system through another door. The risk was not leaving the banking system and everyone was connected to these risk chains. And if any part of that chain breaks because they can't fulfill the contract, the entire system implodes. The idea hatched by a group of young JP Morgan bankers at a weekend retreat many years ago was supposed to reduce the risk. Their original idea had been taken and turned into a Frankenstein's monster, which they never imagined would become so big and get out of control to that point.

It was a very scary moment. We were in totally new territory. And the idea that Lehman Brothers could declare bankruptcy and AIG could take the same risk was unprecedented. And the implications—think about the implications of that for the health of not just the American economy but the world—were... I mean, it wasn't... it really wasn't conceivable to do that. I couldn't understand it. I know others couldn't. We never saw it coming. We never saw it coming. And I was disappointed, enormously disappointed. I mean, I was part of a market that believed it was doing the right thing.

And maybe I was idealistic, maybe I was young, maybe I... I didn't

full

y understand where we were going, but there was a whole system at work from the mortgage borrower to the investor. . There's a whole system of people who maybe were turning a blind eye, maybe, you know, just... I don't know. It's... it's frustrating to watch, certainly. It shouldn't have happened. Most of our past financial crises are due to some macroeconomic event: an oil disruption, a war. This was caused by a few institutions, around 20, that, in my opinion, lost all credibility in relation to their risk management.

And the sad thing is that it should never have happened. Management should have stopped it before it got big. And people suffer for something that should never have happened. Today, the consequences are mainly felt in places that had experienced the most growth, like Georgia. Ground zero of the subprime mortgage crisis: local neighborhoods, city

street

s. Cities across the United States are experiencing an increase in vacant and abandoned properties. And that's where the neighbors feel it. As neighbors, we are not so concerned about the complexities of the subprime mortgage market and derivatives. We will almost never understand these things.

What we feel on the

street

is that the house next door is empty, abandoned, partially burned. And we wonder how long it will be there, how long we will pay the price for that abandonment. A neighborhood cannot survive for long when it has a growing inventory of vacant and abandoned properties. Sometimes, no one even knows who owns the properties. It's hard to know who owns it because investors have split it up in so many ways that it could be someone in Ireland who owns it. There are these securitized pools, where investors own parts of them. Investors are literally all over the world, so it's no man's land.

It's an empty property, mostly trashed, and it's just here and we can't do anything with it. And the reality is that this is repeated in this neighborhood hundreds of times.  That house has a loan that is lost somewhere in a huge financial vehicle created by some young turks on Wall Street. It gets lost in that billion-dollar package because there's no one assigned to take care of it. And by the way, there are entire subdivisions like this that just get lost in this big swamp. And that's why it affects Main Street because Wall Street was too greedy.

Wall Street's greed wiped out Main Street.