The Subprime Security Market - an Investigative Report of Wall Street Culture and Accountability

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Despite these frightening figures, the Securities and Exchange Commission (SEC) conducted no major investigation on investment banks during the bubble3. In fact, they reduced their staff in the risk management department to one person![5] Furthermore, the SEC, under the pressure of lobbyists, lifted leverage limits for banks from 3:1 to 33:15. This meant that the slightest decrease in asset valuation of the bank could leave it insolvent.

The credit agencies too were compliant in this charade, with clear conflicts of interest at play. Their poor performance in rating these securities was instrumental in the damage felt with the economic collapse. Together, these three agencies were responsible for 98% of all outstanding ratings issued by SEC-recognized firms[6]. With over 46% of their revenues coming from financial institutions, they had no incentive to provide true data to investors6. Moody’s reported quadrupled earnings between 2000 and 20075. Their compensation was based on the positive reports and ratings they generated, regardless of their accuracy. The fee for rating a single mortgage pool alone was around $200,0006. At the height of the boom, there were thousands of CDOs being structured and sold, reaping tens if not hundreds of millions in fees. When asked at a deposition in front of Congress to explain their actions, senior executives argued that ratings were mere “opinions” and that “they should not be relied upon”5. This statement serves to highlight how accountability for irresponsible behavior is so blatantly inexistent that it is surprising the economy lasted this long without such a collapse.

The credit rating agencies showed once again serious lack of ethics when rating the investments. In fact, Lehman Brothers was rated A2 days before its collapse, Freddie Mac & Fannie Mae had triple A ratings days before being bailed out and Bear Stearns had an A2 rating as well right before it was forced to be acquired by J.P. Morgan[7].

AIG, the world’s largest insurance company started selling huge quantities of derivatives called Credit Default Swaps. These were essentially insurance plans for investors who had purchased CDOs from investment banks, in case they would default. However, because the speculators could also buy Credit Default Swaps, if the CDO would go bad, AIG would need to pay any other speculator who had bet against that CDO along with the initial investor. And because the Credit Default Swaps was a deregulated market, AIG did not have to put aside any funds in case of potential losses. This proved to be the cause of their ultimate downfall in 2008. While this was going on, AIG had many reasons to know the risky position it was holding by continuing to sell these contracts. In fact, Joseph St Denis, former auditor of AIG resigned in protest of their lack of vigilance and continued corrupt practices[8].

Goldman Sachs, one of the leading investment banks at the time took their corruption and greed to a whole other level. Recognizing that the very securities they were pushing to their clients were in fact highly risky investments, they started betting against them secretly by purchasing credit default swaps from companies like AIG. In this way, they assured themselves big profits when the imminent defaults would occur on the very securities they were selling. This means that while Goldman Sachs was providing huge incentives to its employees for pushing these securities to investors, they were simultaneously buying insurance against them, as they knew these CDOs were bad and risky. In 2006, Goldman Sachs purchased over $22 billion dollars of credit default swaps from AIG[9]. This figure was so large that even Goldman started worrying that should defaults actually occur, AIG would not be able to pay up on these Credit Default Swaps. They therefore went even further and spent another $150 million dollars to further insure themselves in case AIG collapsed[10]. In 2007, the company designed special CDOs that entitled bigger profits for the bank in proportion to the losses of its customers. That means, the bigger the losses of its clients, the greater the profits for Goldman[11].

Homeowners, oblivious to all this, were told that just because they did not have such high income did not mean they did not deserve “the American dream” of owning their own home. In many instances they were subsequently lured into purchasing something lenders knew they could not afford to repay. In fact, at times 99.33% of the value of the house was mortgaged[12]. This meant that should something go wrong, homeowners had no incentive to pay up since they had no real equity invested in the house to begin with. And yet, the credit agencies failed to see why these securities should not be rated triple A.

The Wall Street Culture:

In the documentary “Inside Job”, Kristin Davis describes the kind of clients she dealt with on a daily basis. She ran an elite prostitution service, servicing over a thousand customers; of which she says 40-50% were Wall Street clients. These were all spending corporate monies telling her to bill whatever she wanted and subsequently booking it to computer expenses, legal fees and other deductible expenses. This behavior is further backed by Jonathan Alpen, a therapist for many big Wall Street guys, who noticed similar patterns across these individuals throughout his sessions with them. In fact, he claims that many engaged in prostitution, drugs, and enormous risk taking, with blatant disregard on how their actions may affect society.

It is of no surprise then that CEOs such as Henry Paulson saw fit to pay themselves bonuses larger than what most of us make in a lifetime while selling total junk to its clients. Similarly, they saw no problem concealing from their clients the true risk of the investment they were selling, despite having full comprehensive knowledge of the extent of their riskiness.

At a deposition hearing after the crisis, Goldman executives were asked, “Did you believe you had a duty to act in the best interest of your clients?” the response was unshockingly, “We have a duty to show our clients the prices they ask for” 12. This implies that unless a client is shrewd enough to ask for specific information, the investment bank saw no reason to offer that information regardless of the fact that it was a crucial part of their role as investment bankers.

Similarly, the deposition continued to ask “does it bother you to sell securities that your own people believe to be crap” to which Lloyd Blankfein, the chairman and CEO of Goldman answered “as a hypothetical question, in the context of market making, that is not a conflict”1. The lack of accountability these executives displayed even after their