A Fighting Chance

Chair of the Commodity Futures Trading Commission Brooksley Born pushed for greater regulation of derivatives and other products, “warning that unregulated financial contracts such as credit default swaps could pose grave dangers to the economy. Her efforts brought fierce opposition from Wall Street and from Administration officials who believed deregulation was essential to the extraordinary economic growth that was then in full bloom.” See Henry Liu, “Financial Reform Warrior Brooksley Born Warns of More Crises to Come,” Roosevelt Institute, November 2009. See also Manuel Roig-Franzia, “Credit Crisis Cassandra,” Washington Post, May 26, 2009.

a catastrophic meltdown: A new type of insurance product played a large role in exacerbating the financial crisis—the credit default swap. Credit default swaps were designed to protect investors from defaults or declines in the value of mortgage-backed securities. In exchange for periodic payments from the buyer, the insurer would pay the buyer the face value of the debt in the event of default or other specified “credit event.” “The Financial Crisis Inquiry Commission Report,” 50. Unlike other insurance products, credit default swaps were not subject to federal regulation because they were treated as over-the-counter derivatives. As the Financial Crisis Inquiry Commission Report noted, credit default swaps contributed significantly to the financial crisis by “fuel[ing] the mortgage securitization pipeline,” as they helped to create an illusion of safety. “The Financial Crisis Inquiry Commission Report,” xxiv. AIG sold more than $79 billion worth of credit default swaps in the run-up to the crisis. The combination of credit defaults swaps and CDOs—discussed above—created a dangerous environment in which there were multiple opposing bets on the same securities spread across different sectors of the financial system.

financial system might crumble to nothing: Bear Stearns, an investment bank and securities trading and brokerage firm, collapsed in early 2008 as a result of excessive exposure to subprime mortgages. The Federal Reserve Bank of New York negotiated a sale of Bear Stearns to JPMorgan on March 16, 2008, which was supported by a $30 billion loan from the government to JPMorgan to salvage the company. Federal Reserve chairman Ben Bernanke defended the bailout as necessary to protect asset values and to prevent a “chaotic unwinding” of investments across the United States. See Yalman Onaran, “Fed Aided Bear Stearns as Firm Faced Chapter 11, Bernanke Says,” Bloomberg, April 2, 2008.

Lehman Brothers, a leading investment bank and global financial services firm, filed for bankruptcy protection on September 15, 2008, after suffering major stock losses and devaluation of its assets by credit-rating agencies. The failure of Lehman was the largest failure of an investment bank in decades, and it sent a shock wave through the markets. Sheila Bair notes: “First, the bankruptcy defied market expectations. Bear Stearns had been bailed out, and most market players assumed that the government would step in with Lehman as well.… Markets hate uncertainty, and the Lehman failure confused them.” She continues, “Because of that flexible accounting treatment for complex securities, Lehman looked as if it was much stronger than it really was. The lack of transparency about Lehman’s true financial condition immediately created suspicion about other financial institutions that also held opaque, complex mortgage investments on their books. As a consequence, the institutions with the biggest exposures, such as Merrill and Citigroup, started having problems accessing credit even from other financial institutions.…” Sheila Bair, Bull by the Horns, 107. Merrill Lynch, a large brokerage firm, was on the verge of collapse due in large part to its involvement in the mortgage-based collateralized debt obligations market. On September 14, 2008, Bank of America acquired Merrill Lynch, with Bank of America citing pressure from the US government to follow through with the transaction.

struggled to get car loans: “In the aftermath of the panic, when credit was severely tightened, if not frozen, for financial institutions, companies found that cheap and easy credit was gone for them, too. It was tougher to borrow to meet payrolls and to expand inventories; businesses that had neither credit nor customers trimmed costs and laid off employees. Still today, credit availability is tighter than it was before the crisis.” See “The Financial Crisis Inquiry Commission Report,” 389. Also, from p. 214: “Securitization of auto loans, credit cards, small business loans, and equipment leases all nearly ceased in the third and fourth quarters of 2008.”

See also Nick Carey, “Credit Seen Drying Up for U.S. Small Business,” USA Today, July 25, 2008. Bill Vlasic and Nick Bunkley, “With Credit Drying Up, Car Buyers Bring Cash,” New York Times, October 7, 2008.