How Bankers Made Billions From The 2008 Financial Crisis - And How They Could Do It Again

Some people know how to profit from the misery of others.
Then-Republican presidential candidate Donald Trump gives the thumbs up while standing with John Paulson at a luncheon for the Economic Club of New York in New York, Thursday, Sept. 15, 2016. (AP Photo/Seth Wenig)

Then-Republican presidential candidate Donald Trump gives the thumbs up while standing with John Paulson at a luncheon for the Economic Club of New York in New York, Thursday, Sept. 15, 2016. (AP Photo/Seth Wenig)

In 1929, the media dubbed them ‘market crash millionaires.’

In 2008, crafty money managers made billions. The media ignored this disturbing phenomenon by making them heroes of Wall Street.

The most successful of them all, John Paulson, made $20 billion on the 2008 Crisis while millions lost their homes and is honored with his name on a building on Harvard’s campus.

There is one financial instrument that these wily money managers primarily use. It has been so obfuscated that the voting public does not know how they profit on a market meltdown — and it has escaped any meaningful regulation.

The wealthy investors’ method for making a mass of money when the average citizens lose their life savings is called the Credit Default Swap (CDS). It is still alive and well, and once again a threat to the stability of our financial system.

A CDS is one type of derivative. A simple explanation of derivatives in general here

The term CDS is just one of many used in finance to convince the outsider it’s all high finance and above their ability to understand. It is, however, a simple concept when traced back to its original form: mortgage default insurance.

Let’s say you buy a mortgage from a private lender at a discount as an investment. There is a risk that the mortgagor will not pay. You can manage that risk by taking out an insurance policy that will pay if the mortgagor does not. Insurance companies that specialize in this type of insurance take the premium and create a reserve fund to meet all potential claims (as the law requires).

There is another relevant point of insurance law. Insurance companies can only issue policies to people who have a financial interest in the loss (called an insurable interest). Otherwise, a Mafia Don could take out a life insurance policy on a guy he was going to have whacked — this is exactly what banks are allowed to do, as we shall soon see.

A Geek Interlude: The term “swap” refers to swapping the risk. When you take out mortgage default insurance, you transfer, or swap, the risk of losing money with the insurance company. When a party to a CDS does not have an interest in the underlying security, it is called a naked swap.

The Twist: From Insurance To Pure Betting

An Accurate Representation of What Bankers Do to Earn Their Outsized Bonuses

An Accurate Representation of What Bankers Do to Earn Their Outsized Bonuses

In the naked CDS, the owner does not have any interest in the mortgages, that is, will not suffer a loss if the mortgages default. And best of all, for the banks and insurance companies that issue these CDSs, a law was passed (discussed below) specifically to say they are not subject to the insurance law restrictions just mentioned. The premiums do not go into a reserve fund to meet losses, but slip directly into income to glide quickly into banker bonuses.

Hard to believe, but yes, no reserves to pay claims, and issued to people who have no interest in the mortgage loss. Thus the arrangement is more like shorting than insurance. As we shall soon see, this allows hedge funds or banks to sell CDOs to unsuspecting clients and at the same time bet that very same CDO will fail by taking out a naked CDS.

A Geek Interlude: Shorting a stock is betting that the price will go down. Assume the price of one share of Acme Inc is $100 today. A speculator bets that in one week it will go down to $50. Another says I’ll take that bet as I believe it will stay at $100. If it goes down, the first spectator makes 50 bucks. This the essential nature of a short. The actual mechanism is a bit more complicated and can be reviewed here.

Two critical questions raise their head: Who did the banks owe all that money to in 2008 and why?

They owed most of the whopping billions to hedge funds and each other on CDSs. This is how that came about.

Money managers of the hedge funds realized there was a coming meltdown of the mortgage market, but the mainstream bankers seemed oblivious to it. Micael Lewis told the story of a few of the many victorious hedge fund managers in his The Big Short.

Now, that obliviousness is curious because we now know that the bankers were fully aware that they were passing off subprimes as if they were AAA prime mortgages. Eventually, all of the major banks, some 18 in total, pleaded guilty to this fraud. The Department of Justice helped to minimize the seriousness by giving the banks non-prosecution agreements in exchange for fines. The mainstream media helped by blacking out coverage of the admissions of guilt. Just try to search this issue of banks admitting large-scale fraud in the 2008 crisis. Here is one of the few articles that I could find. Notice that it’s not on the front page, but in a specialty section with a much more restricted readership.

Basically, the banks pulled off the largest fraud in history — probably of the better part of $700 billion dollars — that was kept from the public. And when told, the public shake their shoulders in disbelief. That could not have happened.

BTW: It is worth noting here that the media largely reported the 2008 meltdown as the subprime mortgage crisis — and failed to point out that these subprime mortgages were passed off to government agencies like Fannie Mae and to large investors such as pension funds as AAA safe. No pension fund believed they were buying CDOs comprised of subprime mortgages — but they were.

Saving the CDS from Scrutiny

A Geek Interlude: The derivative market was called a dark or shadow market because it was completely unregulated. So also private mortgage lenders and hedge funds were called shadow banks for the same reason. Thus, we had shadow banks operating in shadow markets–and our regulated banks dealing with shadow banks in the multi-trillion dollar shadow derivative market.

Didn’t someone say, ‘Hey guys, we might have a problem here with all this darkness and all.’ Yes, someone did. For her perceptiveness and courageous attempt to shine a spotlight into the dark corners of these shadow markets, she was silenced and driven to the obscurity of a few, brief public television appearances. This is the story of how the powers of the day, whom Time Magazine anointed with the reverential title, ‘The Committee to Save the World,” squelched her and kept the derivative markets dark and fertile soil for the coming market meltdown.

The then hopeful Committee to Save the World consisted of two of the most influential economists of the day: Alan Greenspan, then head of the Fed; and Larry Summers, assistant Treasury Secretary, and former Harvard president. Treasury Secretary Robert Rubin, an ex-Goldman Sachs CEO, made the third member. a powerhouse of economic advisors.

The Woman Who Threatened Wall Street

The Woman Who Threatened Wall Street

Our story ’s protagonist is one Brooksley Born, head of an obscure regulatory agency called by the mind-dulling name of The Commodities Futures Trading Commission (CFTC).

The battleground was set. For the forces favoring light, we had Born. On the forces favoring darkness, we had the above-noted committee members: Greenspan, a brilliant economist by training and Summers, equally brainy in that field. Then comes Rubin whose values were shaped by Goldman Sachs.

Here’s the difference between our groups. Born has only a law degree — although she graduated top of her class at Stanford Law — it does not count among economists who consider their field superior to all others in matters of banking as it affects the economy,

But Born had something neither Greenspan nor Summers had, actual experience with the derivative market. She had been a derivatives lawyer for some 20 years. She had been in the trenches, not in the wombs of academia or government civil service. At this juncture, I like to point out that economists are invited into bank boardrooms to give overpaid talks catered by 5-star restaurants. Lawyers get invited into the back rooms — therefore the vast difference in perspective.

Now, the derivative market is so large that it defies comprehension by those of us who are used to dealing in hundreds and thousands of dollars. Analysts estimate that derivative trading by 2008 was $596 trillion, give or take. That’s almost 10 times the size of the world economy. It was for this highway with no speed limits, dividing lines or, best of all for banker bonuses, no traffic cops that Born argued there should be police.

This is not a Hollywood script, but a real story regarding Wall Street. So you already know who won and who lost. But read on; there are still a few twists that will invoke more than a few WTF moments.

The Famous Maxim: The Markets Can Regulate Themselves

Born remembers this chat with the great deregulator, Greenspan.

“Well, Brooksley, I guess you and I will never agree about fraud,” Born remembers Greenspan saying.

“What is there not to agree on?” Born says she replied.

“Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,” she recalls. Greenspan, Born says, believed the market would take care of itself.

Greenspan says he does not remember this conversation.

Born circulated a concept release to the bank industry and Congress about her concerns about this gigantic market that no one, probably not even the banks, knew much about.

We know of the Committee’s response through Michael Greenberger, a former top official at the CFTC who worked closely with Born and who also saw the danger in the derivative market. Greenberger said:

“I walk into Brooksley’s office one day; the blood has drained from her face. She’s hanging up the telephone; she says to me, ‘That was [former Assistant Treasury Secretary] Larry Summers. He says, “You’re going to cause the worst financial crisis since the end of World War II. [He says he has] 13 bankers in his office who informed him of this. Stop, right away. No more.”’

The Committee acted immediately to get Congress to shut her up and shut her down. I can do no better than repeat Born’s description of what Congress did:

“And as a result of that report, a statute was passed in 2000 called the Commodity Futures Modernization Act [CFMA] that took away all jurisdiction over over-the-counter derivatives from the CFTC. It also took away any potential jurisdiction on the part of the SEC, and in fact, forbids state regulators from interfering with the over-the-counter derivatives markets. In other words, it exempted it from all government oversight, all oversight on behalf of the public interest. And that’s been the situation since 2000.”

Actually, it did more and worse. That statute also declared that the CDS was not insurance and therefore not subject to the requirements of insurance law.

We all know that Wall Street controls Washington, but this example gives us a glimpse of one of the ways it does so. Greenspan and colleagues were members of President Clinton’s powerful Working Group on Financial Markets. Another member, then-SEC Chairman Arthur Levitt gives us this insight in an article in the Business Insider:

“ “I didn’t know Brooksley Born,” Levitt said. “I was told [by Greenspan, Summers, and Ruben] that she was irascible, difficult, stubborn, unreasonable.” They convinced him Born’s attempt to regulate the risky derivatives market could lead to financial turmoil, a conclusion he now believes was “clearly a mistake.”

Frontline has a penetrating documentary on the Born warning that could have prevented the 2008 crisis: The Warning.

The Infamous Abacus 2007 AC1 Credit Default Swap

With this background on insurance law and the protective Commodity Futures Modernization Act, let’s have another look at the famous Abacus CDO promoted by Goldman Sachs. For the earlier and more complete explanation see the section A Real CDO Deal in the article here.

John Paulson had brought the deal to Goldman and received a $20,000 commission for putting the naked CDO together. Paulson said that, as is standard practice with naked CDOs, an independent mortgage manager had selected the mortgages for quality. Paulson also certified that he had reviewed the quality of the mortgages. While Goldman was recommending this CDO to investors, it knew that Paulson had bet that this CDO would fail by taking out a CDS against it.

In effect, Paulson had not only taken of insurance on his neighbor’s house but had scattered gasoline over the entire main floor, then patiently waited.

It was later discovered that the mortgage manager had not acted independently, but acquiesced to Paulson’s pressure and included subprime mortgages.

This was too blatant. The Department of Justice had to do something. It charged the lowest level employee involved, a Frenchman in the London office, Fabrice Tourre. He was given a fine that basically took away his bonus for that year, but he kept all his million-dollar salary.

Paulson was untouched, is revered as one of the wizards of Wall Street. He made $20 billion on the 2008 Crisis — and has his name on a building on Harvard’s campus.

Deja Vu 2008

Michael Greenberger, A Voice Crying in the Wilderness Again (Inside Job – 2010)

Michael Greenberger, A Voice Crying in the Wilderness Again (Inside Job – 2010)

Three months ago, Michael Greenberger, who now teaches law at theUniversity of Maryland, released a working paper warning that there was a gigantic loophole caused by an interpretation of a guidance paper issued by the CRTC regarding regulation of the CDSs.

The regulators knew that it would be easy for US banks to avoid Dodd-Frank regulations by doing their CDS deals through their foreign subsidiaries. Since 1992, the standard CDS contract included a term by which the US parent guaranteed any swap issued by its foreign subsidiary. However, in 2013 the swap dealers trade association found what it said is a loophole in an obscure footnote, 563, of a 2013 CRTC guidance on implementing Dodd-Frank. The new standard form CDS contract no longer has a guarantee by the US parent over foreign subsidiary issued swaps.

Greenberger reports that studies show most US swap business is now run through foreign subsidiaries and thus probably doesn’t comply with Dodd-Frank.

When this loophole came to light in October 2016, the CRTC proposed a patch to close it. However, it was not finalized prior to Trump’s inauguration. Greenberger fears that it will never be implemented. The CDS market is now as unregulated as it was pre-2008.

How The Bankers Got Their Power

The CDS is only the instrument. On the other side of the bet, you need banks that can pay up (with taxpayer bailouts if necessary); and bankers who will keep their bonuses earned on the sale of these toxic instruments. Then, notwithstanding a total banking system collapse, the bankers will be motivated to do the deals again. Most importantly bankers can’t go to jail as they did in 1929 and after the S&L crisis in the 1980s (Nearly 1,000 bankers went to jail in that debacle).

How did the bankers achieve all those objectives of escaping jail and keeping their sky-high pay? It took careful planning and effective propaganda that even (especially) well-intentioned Democrats would believe. Their foundation big lie is the well-accepted maxim: The best people to regulate Wall Street are the people from Wall Street.

Once that saying became well entrenched as a truism, the stage was set.

Bankers knew that the actual power over banking was not with the politicians. Politicians come and go. Almost none of them have a good understanding of banking — nor do they think its important to learn about it. They depend on advisors. These advisors mainly come from the Treasury Department. So they set about to get control of that department.

Sometimes politicians listen to leading economists. So bankers also got control of them.

The Attorney General decides whether to prosecute bankers commonly and seek jail sentences. So bankers got control of that department. Any doubt of their success, look at how many bankers went to jail in 2008 compared to 1980.

The former heads of the Fed get lucrative positions with a Wall Street investment firm on retirement. So they must be nice to their future mates on the Street.

When they retire, Politicians are increasingly getting positions on board of directors and becoming lobbyists for corporate America. What happened to The sponsors of Dodd-Frank? Barney Frank now sits on the board of directors at a New York bank (The Signature Bank) with a vested interest in fiscal deregulation, and Chris Dodd became a lobbyist for the Motion Picture Association.

Whistleblowers are a great threat so bankers made certain whistleblowers on illegal activity get punished via jail like Bradley Birkenfeld and whistleblower legislation is ineffectively implemented.

That is the state of America today — and no politician has a workable plan to wrest control back from the Wall Street.

If Wall Street’s methods are understood, the solutions to counter them are surprisingly simple. But implementing them would take an awakened voting public with the determination to fight the united power of the Street.

I will look at how bankers did all of the above in my coming article: How Wall Street Got Control of Washington: And What We Can Do About It

For more on the banking system follow Jan at and on Twitter @JanWeirLaw

Opinion // Dodd-Frank / Donald Trump / Economy / Financial Crisis / Money