This paper will now discuss the history that led up to the 2008-2009 credit crises. October 29th 1929 was the day the United States stock market crashed and became known as Black Tuesday. Stocks became popular during economic expansion. As up and coming businesses were growing they needed funds to assist with development and were a widely popular way for investors to gain wealth. But on October 29th that would all change when stocks plummeted, and when investors tried to sell the stock no one was buying. It was not only private citizens that realized their losses but the banks that had invested the savings of their customers in stocks and could not pay the customers back. After the Great Depression subsided the financial industry was tightly regulated. Of the new regulations put into place the most important were: banks are prohibited from gambling with customer’s savings and investment bankers need to be more risk averse. The effect of the new changes would result in economic growth for the next 40 years in the United States.
In the 1980’s banks went public giving them huge amounts of stockholder money. They used it as a reason to get into risky investments and slowly started becoming more irresponsible with other people’s money. The deregulation of savings and loans in 1980 gave them many of the capabilities of banks, without the same regulations as banks. When the real estate market crashed savings and loans went with it. (http://en.wikipedia.org/wiki/Savings_and_loan_crisis) In The nineties banks consolidated into a few huge firms. Banks became so large that their failure could mean catastrophic consequences for the entire financial sector. “One such merger was already carried out well before the passage of the legislation, the $72 billion deal which brought together Citibank, the biggest New York bank, and Travelers Group Inc., the huge insurance and financial services conglomerate, which owns Salomon Smith Barney, a major brokerage. That merger was negotiated despite the fact that the merged company, Citigroup, was in violation of the Glass-Steagall Act, because billionaire Travelers boss Sanford Weill and Citibank CEO John Reed were confident of bipartisan support for repeal of the 60-year-old law.”(http://www.wsws.org/articles/1999/nov1999/bank-n01.shtml retreived 10-24) It turned out that their confidence was merited on November 12, 1999 the Gramm Leach Bliley Act was passed. The act made acquisitions of other companies and consolidations into large firms legal.
Also a problem in the mid to late nineties was the rise of internet companies. “The IPOs of internet companies emerged with ferocity and frequency, sweeping the nation up in euphoria. Investors were blindly grabbing every new issue without even looking at a business plan to find out, for example, how long the company would take before making a profit, if ever.” (http://www.investopedia.com/features/crashes/crashes8.asp#axzz1bj4GhqBG) By the time the bubble was about to burst Eliot Spitzer found that banks were promoting internet companies they knew would fail. They had an “everybody is doing it” attitude. It didn’t make it right but they used it as justification to make millions at other people’s expense. In 2002 ten investment banks settled a law suit and promised to change their ways. They didn’t.
Deregulation continued allowing room for severely unethical activities. These included JP Morgan bribing government officials, Riggs bank laundering money for a Chilean dictator, Credit Suisse laundering money for Iran in violation of US sanctions, Fannie Mae and Freddie Mac participating in accounting fraud, and UBS helping people evade taxes. In addition Citibank, JP Morgan, and Merrill Lynch all helped Enron conceal fraud. (1)
Also emerging in the late nineties were derivatives. These investment vehicles made markets incredibly unstable and were the gateway to CDOs. The CFTC issued a proposal to regulate derivatives, but banks were making too much money to accept the regulation. In 2000 The Commodity Futures Modernization Act banned regulation on derivatives. (1)
In the past mortgages were issued with caution and when mortgages were paid lenders made a profit and had a direct accountability to the risk associated with issuing a bad mortgage. With derivatives lenders sold mortgages to investment banks who would package the mortgages with other collateralized debt; now when the mortgages are paid the profit goes to the investors. Adding a layer of complexity to the situation were rating agencies who had high incentive to rate CDOs at AAA even if the debt in the investment vehicle they were rating was subpar. Lenders no longer had consequences for non- repaid loans and they started making riskier loans to less qualified people only caring for the commission and fees made by issuing these loans. Investment banks were also paid on quantity not quality so they also had no repercussions if the loans failed. Rating companies were not held responsible if there ratings were wrong. No one was held accountable for this predatory lending. Housing prices soared to 200% what they were just a few years earlier. The SEC did nothing.
Henry Paulson took things a step further lobbying for a relaxation on leverage limits and he got what he wanted. Many banks became so highly leveraged that even a small change in profits would yield disastrous consequences. In addition the industry started to become aware that most of the loans that had been issued were not going to be repaid. AIG began selling credit default swaps insuring that if a CDO went south AIG would cover the losses. An employee of AIG named St. Denis tried to warn executives that this was a dangerous but he was ignored. Things started on a downward spiral and Goldman Sachs started betting against CDOs insuring through AIG and getting paid when they failed. There was no disclosure to investors and history was repeating itself.
The warnings about what these practices were doing started in 2004. Nobody paid attention because the deregulation and the lack of regulation in the financial sector was making everyone so much money and they were blinded by greed. It took a major crisis which started in March of 2008 to shake the financial industry to its core and decide to change.