Financial Crisis Primer, Less Family Friendly (But Way Better)

God bless Matt Taibbi. He’s a great angry writer, and he’s nailed AIG and the financial crisis perfectly. I remember him from back during the 2008 election, when New York magazine thought it would be a great idea to post IM discussions between opposing argument sides. He talked with National Review’s Byron York (BY, below) about the then emerging financial crisis:

…M.T.: Oh, come on. Tell me you’re not ashamed to put this gigantic international financial Krakatoa at the feet of a bunch of poor black people who missed their mortgage payments. The CDS market, this market for credit default swaps that was created in 2000 by Phil Gramm’s Commodities Future Modernization Act, this is now a $62 trillion market, up from $900 billion in 2000. That’s like five times the size of the holdings in the NYSE. And it’s all speculation by Wall Street traders. It’s a classic bubble/Ponzi scheme. The effort of people like you to pin this whole thing on minorities, when in fact this whole thing has been caused by greedy traders dealing in unregulated markets, is despicable.

B.Y.: I was struck by the recent Senate testimony of James Lockhart, who is head of the Federal Housing Finance Agency, about the sheer recklessness of Fannie in recent years. Despite “repeated warnings about credit risk,” Lockhart testified, Fannie became more reckless in 2006 and 2007 than they had been in the scandal-ridden tenure of Franklin Raines (who departed in 2004). In 2005, Lockhart said, 14 percent of Fannie’s new business was in risky loans. In the first half of 2007, it was 33 percent. So something terribly wrong was going on there, and it became a significant part of the present problem.

M.T.: What a surprise that you mention Franklin Raines. Do you even know how a CDS works? Can you explain your conception of how these derivatives work? Because I get the feeling you don’t understand. Or do you actually think that it was a few tiny homeowner defaults that sank gigantic companies like AIG and Lehman and Bear Stearns? Explain to me how these default swaps work, I’m interested to hear.

Because what we’re talking about here is the difference between one homeowner defaulting and forty, four hundred, four thousand traders betting back and forth on the viability of his loan. Which do you think has a bigger effect on the economy?…

B.Y.: When you refer to “Phil Gramm’s Commodities Future Modernization Act,” are you referring to S.3283, co-sponsored by Gramm, along with Senators Tom Harkin and Tim Johnson?

M.T.: In point of fact I’m talking about the 262-page amendment Gramm tacked on to that bill that deregulated the trade of credit default swaps.

Tick tick tick. Hilarious sitting here while you frantically search the Internet to learn about the cause of the financial crisis — in the middle of a live chat interview.

B.Y.: Look, you can keep trying to make this a specifically partisan and specifically Gramm-McCain thing, but it simply isn’t. We’ve gone on for fifteen minutes longer than scheduled, and that’s enough. Thanks.

M.T.: Thanks. Note, folks, that the esteemed representative of the New Republic has no idea what the hell a credit default swap is. But he sure knows what a minority homeowner looks like.

B.Y.: It’s National Review.

Ha! I love the idea of York trying to read a wikipedia entry on a CDS, realizing his stock characters aren’t going to cut it with someone who knows what is going on. Taibbi knew back then what the problems were, and I imagined when he finally wrote a big piece on the CDS market and AIG, it was going to be big. He finally has, and it is fantastic. I’m just going to post a bunch of it:

…The latest bailout came as AIG admitted to having just posted the largest quarterly loss in American corporate history — some $61.7 billion. In the final three months of last year, the company lost more than $27 million every hour. That’s $465,000 a minute, a yearly income for a median American household every six seconds, roughly $7,750 a second. And all this happened at the end of eight straight years that America devoted to frantically chasing the shadow of a terrorist threat to no avail, eight years spent stopping every citizen at every airport to search every purse, bag, crotch and briefcase for juice boxes and explosive tubes of toothpaste. Yet in the end, our government had no mechanism for searching the balance sheets of companies that held life-or-death power over our society and was unable to spot holes in the national economy the size of Libya (whose entire GDP last year was smaller than AIG’s 2008 losses)…

The best way to understand the financial crisis is to understand the meltdown at AIG. AIG is what happens when short, bald managers of otherwise boring financial bureaucracies start seeing Brad Pitt in the mirror. This is a company that built a giant fortune across more than a century by betting on safety-conscious policyholders — people who wear seat belts and build houses on high ground — and then blew it all in a year or two by turning their entire balance sheet over to a guy who acted like making huge bets with other people’s money would make his dick bigger.

That guy — the Patient Zero of the global economic meltdown — was one Joseph Cassano, the head of a tiny, 400-person unit within the company called AIG Financial Products, or AIGFP. Cassano, a pudgy, balding Brooklyn College grad with beady eyes and way too much forehead, cut his teeth in the Eighties working for Mike Milken, the granddaddy of modern Wall Street debt alchemists. Milken, who pioneered the creative use of junk bonds, relied on messianic genius and a whole array of insider schemes to evade detection while wreaking financial disaster. Cassano, by contrast, was just a greedy little turd with a knack for selective accounting who ran his scam right out in the open, thanks to Washington’s deregulation of the Wall Street casino. “It’s all about the regulatory environment,” says a government source involved with the AIG bailout. “These guys look for holes in the system, for ways they can do trades without government interference. Whatever is unregulated, all the action is going to pile into that.”…

Cassano’s outrageous gamble wouldn’t have been possible had he not had the good fortune to take over AIGFP just as Sen. Phil Gramm — a grinning, laissez-faire ideologue from Texas — had finished engineering the most dramatic deregulation of the financial industry since Emperor Hien Tsung invented paper money in 806 A.D. For years, Washington had kept a watchful eye on the nation’s banks. Ever since the Great Depression, commercial banks — those that kept money on deposit for individuals and businesses — had not been allowed to double as investment banks, which raise money by issuing and selling securities. The Glass-Steagall Act, passed during the Depression, also prevented banks of any kind from getting into the insurance business…

The very next year, Gramm compounded the problem by writing a sweeping new law called the Commodity Futures Modernization Act that made it impossible to regulate credit swaps as either gambling or securities. Commercial banks — which, thanks to Gramm, were now competing directly with investment banks for customers — were driven to buy credit swaps to loosen capital in search of higher yields. “By ruling that credit-default swaps were not gaming and not a security, the way was cleared for the growth of the market,” said Eric Dinallo, head of the New York State Insurance Department.

The blanket exemption meant that Joe Cassano could now sell as many CDS contracts as he wanted, building up as huge a position as he wanted, without anyone in government saying a word. “You have to remember, investment banks aren’t in the business of making huge directional bets,” says the government source involved in the AIG bailout. When investment banks write CDS deals, they hedge them. But insurance companies don’t have to hedge. And that’s what AIG did. “They just bet massively long on the housing market,” says the source. “Billions and billions.”…

When one considers the comparatively extensive system of congressional checks and balances that goes into the spending of every dollar in the budget via the normal appropriations process, what’s happening in the Fed amounts to something truly revolutionary — a kind of shadow government with a budget many times the size of the normal federal outlay, administered dictatorially by one man, Fed chairman Ben Bernanke. “We spend hours and hours and hours arguing over $10 million amendments on the floor of the Senate, but there has been no discussion about who has been receiving this $3 trillion,” says Sen. Bernie Sanders. “It is beyond comprehension.”…

This cozy arrangement created yet another opportunity for big banks to devour market share at the expense of smaller regional lenders. While all the bigwigs at Citi and Goldman and Bank of America who had Paulson on speed-dial got bailed out right away — remember that TARP was originally passed because money had to be lent right now, that day, that minute, to stave off emergency — many small banks are still waiting for help. Five months into the TARP program, some not only haven’t received any funds, they haven’t even gotten a call back about their applications…

AIG might have been OK had it not been for a complete lack of internal controls. For six months before its meltdown, according to insiders, the company had been searching for a full-time chief financial officer and a chief risk-assessment officer, but never got around to hiring either. That meant that the 18th-largest company in the world had no one checking to make sure its balance sheet was safe and no one keeping track of how much cash and assets the firm had on hand. The situation was so bad that when outside consultants were called in a few weeks before the bailout, senior executives were unable to answer even the most basic questions about their company — like, for instance, how much exposure the firm had to the residential-mortgage market…

That roll of the eyes is a key part of the psychology of Paulsonism. The state is now being asked not just to call off its regulators or give tax breaks or funnel a few contracts to connected companies; it is intervening directly in the economy, for the sole purpose of preserving the influence of the megafirms. In essence, Paulson used the bailout to transform the government into a giant bureaucracy of entitled assholedom, one that would socialize “toxic” risks but keep both the profits and the management of the bailed-out firms in private hands. Moreover, this whole process would be done in secret, away from the prying eyes of NASCAR dads, broke-ass liberals who read translations of French novels, subprime mortgage holders and other such financial losers…

In essence, Paulson and his cronies turned the federal government into one gigantic, half-opaque holding company, one whose balance sheet includes the world’s most appallingly large and risky hedge fund, a controlling stake in a dying insurance giant, huge investments in a group of teetering megabanks, and shares here and there in various auto-finance companies, student loans, and other failing businesses. Like AIG, this new federal holding company is a firm that has no mechanism for auditing itself and is run by leaders who have very little grasp of the daily operations of its disparate subsidiary operations…

The most galling thing about this financial crisis is that so many Wall Street types think they actually deserve not only their huge bonuses and lavish lifestyles but the awesome political power their own mistakes have left them in possession of. When challenged, they talk about how hard they work, the 90-hour weeks, the stress, the failed marriages, the hemorrhoids and gallstones they all get before they hit 40.

“But wait a minute,” you say to them. “No one ever asked you to stay up all night eight days a week trying to get filthy rich shorting what’s left of the American auto industry or selling $600 billion in toxic, irredeemable mortgages to ex-strippers on work release and Taco Bell clerks. Actually, come to think of it, why are we even giving taxpayer money to you people? Why are we not throwing your ass in jail instead?”

But before you even finish saying that, they’re rolling their eyes, because You Don’t Get It. These people were never about anything except turning money into money, in order to get more money; valueswise they’re on par with crack addicts, or obsessive sexual deviants who burgle homes to steal panties. Yet these are the people in whose hands our entire political future now rests.

That last paragraph is perfect. Some time later this week I’ll write about why the financial sector is less productive than crack addicts, both with numbers and in theory, and why letting it essentially replace manufacturing as the engine of our growth was a disaster.

I loved this article. It also had the balls to name names and dates; there’s a narrative that some sort of mythical “Black Swam” has descended on us out of nowhere, or that America bought too many $3 cups of coffee and now everyone must suffer because of our sinful and gluttonous ways. But really, it was the result of concrete people doing concrete things to sneak past regulatory efforts, and the government regulators letting them on the belief that the market would regulate itself. Good for Taibbi calling bullshit.