What went wrong on Wall Street? It is the most critical question of our time, and we have got to get the answers right. When the “experts” start telling us how they’ll fix things, we need an independent understanding of the problem or we risk making even bigger mistakes. Unfortunately, the back story here isn’t so simple. It can’t be reduced to bullet points without the narrative. Nor can it be told without arousing some people’s ideological filters.
I unwittingly began learning about the problems before the question arose. The financial journalist in my family started sending me reading material so I wouldn’t be so clueless when we talked about her job. What seemed to me like interesting, but useless information suddenly became relevant when the sky started falling. I’m not an economist, but I want to share what I’ve learned so far.
As I see it, this story has lots of moving parts so I’ll start by introducing the players. It’s a cast that includes Congress, the commodities markets, banks, mortgage companies and the housing industry, investment firms, insurance companies, federal regulators, the super rich and a guy named Joe.
Let’s start with Joe. He represents all the folks who always wanted to buy a home, but couldn’t afford it. He was always on the outside looking in at the American dream because mortgage lenders had standards. Nothing personal Joe, but federal regulations required that lenders could only loan money to those who could actually pay it back. This even applied to Fannie Mae and Freddie Mac, the two largest mortgage companies that have a special federal mandate to grease the wheels of home ownership.
Banks traditionally competed for well-qualified mortgage loans as a way to invest our money. Some of the loans they kept and others they sold for profit. These were boring investments, but banking regulators required conservative investments to keep our money safe.
Next are the insurance companies. In addition to insuring our cars and homes, they insure companies against business losses. They too were under federal regulations to invest our premiums wisely so they would always have the funds to pay out any claims.
Investment firms like Lehman Brothers helped people and businesses to invest their extra cash in the economy, usually through the sale of stocks and bonds. That means buying and selling stock on exchanges where companies sell a stake in their business to raise the cash they need to run it. Investors buy stocks to share ownership in the company and, hopefully, in its profits.
A less well understood player here are the commodities exchanges, also known as the “futures” markets. If you’re thinking “pork bellies,” you are on the right track. It’s a place where people who actually produce certain goods like wheat or oil go to “hedge” or manage their risk to ensure their financial stake in the things they produce against the possibility that it might not sell or return a profit.
Consider the farmers, for example. They plow their money into the ground and hope for a harvest. But a huge crop surplus in the fall could cause prices to collapse, leaving them with no money to buy spring seed. Farmers need to “hedge” their investment in crops to ensure that future market prices will at least cover their costs. At the same time, the futures market helps set prices for the goods we buy today.
There are two types of commodities traders: “hedgers” who want to ensure their financial stake in a product, and “speculators” who agree to buy the product at some future date even if its value falls below what they agreed to pay. These purchase agreements are called “futures contracts.” Futures contracts are traded back and forth on federally regulated exchanges, much like stocks or bonds. These investments are often very profitable, but sometimes the losses can be disastrous. Even so, the commodities market has operated successfully for over 150 years, keeping prices in line with supply and demand. This is due in no small part to federal regulations and monitoring by the Commodity Futures Trading Commission (CFTC) to prevent any cheating.
For years, this more or less transparent arrangement of distinct financial institutions remained separated by a fire wall of federally imposed check and balances. This resulted in a relatively stable economy and general prosperity.
Prologue to Crisis
Enter the super rich, who need no introduction except to say they are wealthier and more numerous than ever before. They saw the opportunity to make lots more money if only the government would step aside. In fact, they realized that the money they could make would far exceed what it would cost to buy Congress and elect Presidents. Corporate lobbying soon became part of the cost of doing business, and part of the culture of Washington. One by one, federal restrictions began to fall and the parts in this story started to move.
Soon banks could offer insurance or buy stocks. Investment houses and insurance companies could take “positions” in the futures market or offer money market accounts. Mortgage companies could use home loans as collateral to create and sell bonds, so they bundled them together and sold them to investors as “mortgage-backed securities.” In short, the distinctions between our financial institutions faded as all the players moved into more profitable, but higher-risk investments.
Wall Street still wanted more. They didn’t like federal restrictions in the commodities market, so their Congress (no longer ours at this point) allowed them buy and sell various types of private futures-like contracts off exchanges and therefore outside of any federal control. It’s called the “over-the-counter” market, and purchase agreements here are called “swaps,” rather than “futures contracts.” Today, trillions of dollars worth of these swaps change hands every year with no federal oversight. Recent concerns have been raised that some institutional investors are working both inside and outside of the commodities markets to inflate prices and boost their profits. Oil and food prices are among the targets of current investigations, although little wrong-doing has been proven to date.