Introduction

The introduction sets the stage for a four-hour investigation into the financial crisis. It highlights how Wall Street got bailed out while Main Street didn't and asks how we got here.

The Financial Crisis

• Tens of thousands of workers make their way to Wall Street every day, working for banks, brokerages, hedge funds, insurance companies, and mortgage lenders.

• The banking industry is almost double the size of America's manufacturing sector and led America and the world into its worst economic crisis since the Great Depression.

• Occupy Wall Street demonstrations spread across scores of cities in America and around the world calling for radical changes in the banking system.

Occupy Wall Street

This section covers how Occupy Wall Street wanted bankers held responsible for their role in causing the financial crisis.

Bankers Held Responsible

• Occupy Wall Street demonstrations spread across scores of cities in America and around the world calling for radical changes in the banking system.

• Most Americans think that Wall Street got bailed out while Main Street didn't. High unemployment rates, lost jobs, devalued houses, and college graduates moving back home are some of the issues faced by Americans.

• There was massive illegality going on during this time. If someone with subpoena power was intent on prosecuting that, they would be quite successful in criminal prosecutions.

Banking System Changes

This section covers how bankers responded to calls for change from Occupy Wall Street.

Calls For Change

• Bankers responded by saying that moving on and getting back to business is what needs to happen.

• Financial services companies that are safe and sound and able to lend and finance their customers are necessary for a strong economy.

• Hammering the banks will lead to another recession.

Hearings

This section covers how there have been dozens of hearings since the meltdown of 2008, but few satisfying answers have been given.

Lack of Answers

• Many questions have been asked, but few satisfying answers have been given.

• It's difficult to understand what caused the crisis and how we got where we are, even for professionals.

• The managers of these large financial institutions in some ways have been given an impossible task. They won't be able to comprehend what it is their institutions are doing.

Origins of America's Financial Crisis

This section covers how one weekend at a resort in Boca Raton, Florida is a good place to start when looking at the origins of America's financial crisis.

Origins of Crisis

• It's hard to pinpoint the origins of America's financial crisis, but one weekend at this resort in Boca Raton, Florida is a good place to start.

The Birth of Credit Derivatives

This section discusses how credit derivatives were created and how they allowed banks to reduce risk and free up capital.

Parties, Pools, and Risk Reduction

• Young bankers at JP Morgan got drunk and threw parties.

• They were also working on reducing risk in banking.

• Credit default swaps (CDS), a type of derivative that insures a loan against default, were developed as a way to pass risk between financial institutions.

• CDS allowed banks to trade their loan risks and free up capital.

The Exxon Deal

• Blythe Masters engineered the first big CDS deal with Exxon.

• Exxon took out a multi-billion dollar letter of credit with JP Morgan after the Exxon Valdez oil spill.

• A letter of credit creates credit risk for the bank, which requires setting aside certain reserves of capital for the loan.

• JP Morgan found a taker in London, the European Bank for Reconstruction and Development (EBRD), to assume credit risk associated with the Exxon deal.

• EBRD received compensation from JP Morgan for taking on or assuming credit risk.

Skirting Capital Requirements

• Credit derivatives made it possible for banks to skirt capital requirements by reducing the amount of capital they had to hold relative to loans made.

• Banks could create more credit and make more loans as a result.

Building a Credit Derivatives Trading Book

This section discusses how Terri Duhon was brought in by JP Morgan to build a trading book around credit derivatives.

Bundles of Debt

• Terri Duhon was brought in to build a credit derivatives trading book.

• She wrote swaps on bundles of debt, putting together a portfolio of credit risk.

• Her first trade was a CDS on 306 corporate names on JP Morgan's books.

• The list of 306 entities were highly rated and had low credit risk.

Slicing Up the Portfolio

• JP Morgan facilitated the trading by slicing up the portfolio into different risk levels or tranches.

• Investors could choose how much risk they were willing to take.

• Different investors wanted different levels of risk, with some wanting to earn big returns on risky investments.

Conclusion

This section concludes the video by summarizing how credit derivatives allowed banks to reduce risk and free up capital, leading to more loans being made.

Credit Derivatives Revolution

• Credit derivatives revolutionized banking by allowing banks to reduce risk and free up capital.

• Banks could create more credit and make more loans as a result.

The Birth of Synthetic CDOs

In this section, we learn about the creation of synthetic collateralized debt obligations (CDOs) and how they allowed investors to invest in entities they previously did not have access to. We also see how the credit default swap market grew naturally once the seed was planted.

Creation of Synthetic CDOs

• Derivatives were sold as bets on any and all portfolios, whether the bank owned them or not.

• These products came to be known as synthetic collateralized debt obligations, synthetic CDOs.

• Investors were able to invest in some entities that they had not had access to before by buying a credit default swap.

• By investing in a credit default swap because it was a name that they hadn't previously had access to.

Growth of Credit Default Swap Market

• There was positive reinforcement of the market which led it to grow very naturally.

• With the creation of the credit default swap market, banks made banking history.

• Credit became a more readily available asset which helped drive growth, helped companies deploy capital and employment.

Private Markets for Derivatives

In this section, we learn about private markets for derivatives and how risk could now be easily traded. We also see how spreads between what banks could charge for derivatives and what it cost to provide them could be huge due to lack of transparency.

Private Markets for Derivatives

• Unlike an exchange-traded market where all banks can see all positions, there's no public market for these derivatives.

• These are all private off-exchange markets and nobody else in the market knows what's going on.

• The banks lobbied hard for no derivative regulation because they didn't want anyone to know how much risk they were taking on.

Spreads

• Due to lack of transparency, spreads between what banks could charge for derivatives and what it cost to provide them could be huge.

• The basic business that they created was immensely profitable.

Concerns in Washington

In this section, we learn about growing concerns in Washington regarding the regulation of hedge funds and derivatives. We also see proposals circulated to rein in the banks and regulate derivatives.

Growing Concerns

• There was growing concern in Washington that we are moving towards greater risk.

• Brooksley Born led the charge for proposals to regulate derivatives.

Proposals

• Proposals circulated to rein in the banks and regulate derivatives.

• Brooksley Born was absolutely right because if you don't have transparency and regulation of derivatives, the risk is going to build up and lead to a financial crisis that's going to cause massive taxpayer bailouts.

The Giant Pool of Money

This transcript discusses the deregulation of the financial industry and how it led to the creation of credit default swaps, which were used to bundle subprime mortgages into securities that were sold to investors. The transcript also covers the wave of lending abuses that occurred during this time, as well as efforts by housing advocates to take on predatory lenders.

Deregulation and Derivatives

• Products designed with minimal regulation attract capital and activity.

• Alan Greenspan's libertarian views influenced Federal Reserve policy for almost 20 years.

• Legislation was passed to lift restrictions on how banks could do business and prevent oversight of credit derivatives.

• The derivatives market expanded dramatically with no transparency or regulation.

Subprime Mortgages

• Credit default swaps enabled bundling of subprime mortgages into securities with high ratings and yields.

• Banks bundled mortgages in states seeing historic levels of population growth, such as Florida, Nevada, California, and Georgia.

• Georgia Governor Roy Barnes took on Wall Street over subprime lending.

Lending Abuses

• Borrowers were given loans greater than the value of their home with no income verification.

• Predatory practices such as high interest rates, pre-payment penalties, balloon payments, adjustable-rate mortgages were layered on top of a high interest rate.

Conclusion

The deregulation of the financial industry led to an explosion in the growth of derivatives in the United States and throughout the world. Credit default swaps enabled bundling subprime mortgages into securities with high ratings and yields. Lending abuses occurred, with borrowers given loans greater than the value of their home with no income verification. Efforts by housing advocates to take on predatory lenders were made, but banks continued to bundle mortgages and sell them as securities.

The Housing Market in Georgia

This section discusses the impact of predatory lending practices on the housing market in Georgia and how it led to the creation of a new law. It also highlights how the mortgage lobby helped to unseat Barnes, and rescind the law.

Predatory Lending Practices

• Threats were made that residents in Georgia wouldn't be able to get mortgages anymore because investors would not buy them.

• Georgia now has the toughest predatory lending law in the nation.

Mortgage Lobby's Response

• Despite efforts by the mortgage lobby, the bill passed.

• Fearing similar bills in other states, the lobby helped to unseat Barnes and rescind the law.

• Two weeks into a new legislative session, they gutted the Georgia Fair Lending Act.

Credit Default Swaps

This section explains credit default swaps and how they were used to keep rating agencies on board while selling high-risk subprime debt.

Credit Default Swaps Explained

• Credit default swaps were sold to improve CDO profiles.

• By insuring high-risk subprime debt, credit agencies gave better ratings for CDO portfolios.

JP Morgan's Troubles with Mortgage Debt

This section discusses JP Morgan's struggles with getting comfortable with mortgage debt due to lack of historical data about retail mortgages' performance during different business cycles.

Struggles with Mortgage Debt

• JP Morgan had trouble getting comfortable with mortgage debt due to lack of historical data.

• They saw UBS and Merrill Lynch's earnings growing faster than theirs, and they couldn't figure out how to lay off some of the risk.

The Unforeseen Risks

This section highlights how other banks were taking risks that JP Morgan never expected, leading to the creation of vastly different products from where they started.

Unforeseen Risks

• Other banks were taking risks that JP Morgan never expected.

• They found themselves with a product that was vastly different from where they started due to every little tweak along the way.

Subprime CDO Sales

This section discusses how other banks aggressively sold subprime CDOs to customers all over the world, including state-run banks in Germany known as Landesbanks.

Aggressive Subprime CDO Sales

• Other banks aggressively sold subprime CDOs to customers all over the world.

• State-run banks in Germany known as Landesbanks were among the biggest customers.

The Rise of the Mortgage Market

This section discusses the rise of the mortgage market and subprime lending, which was a part of it. It also highlights how credit default swaps were doubling every year.

Bullish on Mortgage Market

• We were bullish on the mortgage market in general, and subprime, which was an element of it.

• Americans are buying real estate in record numbers.

• By the end of 2005, the total outstanding value of credit default swaps around the world was measured in trillions of dollars and was doubling every year.

Understanding Credit Derivatives

This section discusses whether top management at JP Morgan understood credit derivatives and if regulators understood them.

Understanding Credit Derivatives

• Did top management at JP Morgan understand credit derivatives? Yes, they did. Absolutely, they did.

• Did they at other banks? No, not all other banks. Certainly not.

• I don't think the regulators understood.

Lack of Understanding

This section highlights that some big banks simply didn't know what they had in terms of risk.

Lack of Understanding

• I don't think the credit ratings agencies, the bankers or the regulators fully understood all kinds of credit instruments that we're talking about.

• In other words, some big banks simply didn't know what they had in terms of risk.

• Certainly, they didn't— they didn't know some forms of risk that they had.

Packaging CDOs

This section discusses how banks packaged more and more CDOs without any limit and how synthetic CDOs allowed investors to bet many times over on someone else's portfolio debt.

Packaging CDOs

• Banks packaged more and more CDOs. Theoretically, there was no limit. An investor didn't need to own any actual mortgages.

• So-called synthetic CDOs allowed investors to bet many times over on someone else's portfolio of debt.

• In synthetic CDOs, all you had to do was make a side bet based on what would happen to this group of mortgages and have that be the basis of the CDO.

Betting on Mortgages

This section discusses how betting on mortgages is similar to betting on sports or gambling.

Betting on Mortgages

• It allowed participants— either buying or selling, so on either side of the market — to take their positions without being constrained by the size of the underlying market.

• In other words, some big banks simply didn't know what they had in terms of risk.

• So how is that different than betting on the outcome of the Super Bowl? Or a horse race or a craps table. There's no different at all.

Housing Boom

This section highlights how everyone believed that housing prices would continue to rise and how profits soared.

Housing Boom

• We're pretty confident that the housing market's not going down at all. It's just going to go up.

• Within a decade, you have the most phenomenal machine anybody's ever seen.

• Profits soared 93 percent.

Toxic Waste

This section discusses how some bankers were concerned about toxic waste but others were greedy and wanted more profits.

Concerned About Toxic Waste

• And when they came to me, I would say, "This is toxic waste. We're building a bubble. We're not going to like the outcome."

• But we saw risk all over the place.

• The— I mean, there— I— look, very simply, there are certainly some— some investors, some banks, some borrowers who are a bit greedier than they should be.

Flawed Logic

This section highlights how most banks believed that housing prices would never go down and how flawed this logic was.

Flawed Logic

• Most banks believed housing prices would never go down, let alone crash.

• To imagine losses of that severity required very significant assumptions about the path of the economy which were just not in people's mind.

• So it required things like assuming that house prices in the United States fell by 25 percent. People weren't thinking that way. And as long as house prices never fell, then these risks would never come home to roost. And that ultimately was obviously very flawed logic.

The Housing Market Turns into Time Bombs

This section discusses how the housing market turned mortgages into time bombs and how banks tried to repackage what they were stuck with as quickly as possible.

Banks Repackaging Mortgages

• The smart money knew the game had ended by 2007, 2008.

• Goldman Sachs created a series of CDOs containing toxic subprime and then sold them to customers.

• Goldman Sachs bet against their own clients using credit default swaps.

• In a settlement with the SEC, Goldman admitted that some of their marketing materials did not disclose important information.

Subprime Mortgage Companies Go Bust

This section discusses how subprime mortgage companies went bust and how some investors still bought even when there was a downturn in the markets.

Investors Still Buying

• Thirty-four subprime mortgage companies have gone bus—

• One customer was that German Landesbank, IKB.

• Discussions happened about telling investors to stop buying this temporary glitch in an overall bull market.

Wall Street's Reassurance Proves Wrong

This section discusses how it became clear that the housing bubble burst was a much bigger problem than anyone anticipated.

Misconception of Risk in Housing Prices

• By the beginning of 2008, it was becoming clear that this was a much, much bigger problem than anybody anticipated.

• There was a broad misperception of risk in housing prices.

• It was quite clear to me that a number of really quite large financial institutions had not had the kind of management information systems which allowed them even to know what all their risks were.

Credit Default Swaps

This section discusses how credit default swaps would come down to whether they pay off as they were designed to do.

Banks Susceptible to Runs

• The sort of origination of these subprime loans, the creation of the CDOs— that business is gone.

• It would all come down to those credit default swaps. Would they pay off as they were designed to do?

• We need to stabilize this industry. It can spread throughout the economy.

A Financial Nuclear Holocaust

This section discusses how AIG was on the hook for $440 billion worth of credit default swaps and how it could be a very dangerous situation.

Run on an Insurance Company

• September 18th of 2008, when there was talk about problems in funds.

• AIG securing an $85 billion bailout.

• AIG could not conceivably have paid off.

The Financial Shell Game

This section discusses how the banks turned the market into their own private game, manipulating banking results by moving risk out through one door and bringing it back in through another.

Banks' Private Game

• The banks turned the market into their own private game.

• They manipulated banking results by moving risk out through one door and bringing it back in through another.

Chains of Risk

• Everybody in the world was connected to these chains of risk.

• If any part of that chain breaks down because they can't honor the contract, the entire system implodes.

Frankenstein Monster

• The idea dreamed up by a group of young JP Morgan bankers at a weekend retreat many years ago was supposed to reduce risk.

• Their original idea had been taken and turned into a Frankenstein monster which they never dreamt would become so big and spin out of control to that degree.

Unprecedented Implications

This section discusses how unprecedented it was for Lehman Brothers to file for bankruptcy and AIG to be at risk of the same fate.

Unprecedented Implications

• Lehman Brothers filing for bankruptcy and AIG being at risk of the same fate was absolutely unprecedented.

• Thinking through the implications not just for the U.S. economy but also for the world were almost inconceivable.

Scary Time

• It was a very scary time.

• We were in totally new territory.

No One Saw It Coming

• We never saw it coming.

• Most of our financial crisis in the past is due to some macroeconomic event— an oil disruption, war. This was caused by a few institutions, about 20, who lost all credibility relative to managing their risk.

The System

This section discusses how there was a whole system going on from the borrower of the mortgage all the way through to the investor and how people are suffering for something that should never have happened.

Idealistic Market

• The speaker believed he was part of a market that was doing the right thing.

• Maybe he was idealistic or young and didn't fully appreciate where they were going.

Blind Eye

• There's a whole system of people who maybe were turning a blind eye.

• As neighbors, we're concerned not so much with the complexities of the subprime mortgage market and derivatives.

Frustration

• It's frustrating to see certainly.

• People are suffering for something that should never have happened.

Fallout

This section discusses how today, fallout is felt mostly in places that had seen the highest growth like Georgia and ground zero of the subprime crisis - local neighborhoods and city streets.

Fallout in Places with High Growth

• Today, the fallout is felt mostly in places that had seen the highest growth, like Georgia.

• Ground zero of the subprime crisis— local neighborhoods, city streets.

Vacant and Abandoned Properties

• Cities throughout the United States are seeing a rise in vacant and abandoned properties.

• A neighborhood cannot survive long when it has a growing inventory of vacant, abandoned properties.

No One Knows Who Owns It

• Sometimes no one even knows who owns the properties.

• It's hard to know who owns it because it's been sliced and diced so many ways by investors that it could be somebody in Ireland who owns it.

Conclusion

This section concludes with how a vacant property just sits there and we can't do anything with it.

Vacant Property

• It's a vacant property, mostly vandalized, and it just sits here and we can't do anything with it.

• That house has a loan that is somewhere lost in a huge financial vehicle put together by some young Turks on Wall Street.