The Goliath In The Shadows

I want to talk about something that’s been bothering me for the past couple of days. If you don’t know, I’m planning on going into a career of Investment Banking. I always found finance to be very interesting, and I’ve been following it closely for nearly the past decade. But a couple days ago, I decided to review everything I’d followed, all in one day. And I discovered something. Something that wasn’t hidden per se, but something that I found profoundly disturbing, enough to make me question why this issue wasn’t more visible. Of course, what I had ‘discovered’ had to do entirely with the shadow banking system, and with a name like that, it’s no surprise it’s not well reported. Unfortunately, the only way I can explain this is by actually explaining it, meaning things could get a little technical. But I hope you find this as interesting as I did, and it gets you thinking about something I feel many people don’t really understand and tend to ignore.

Lets start our story from the beginning. Back in the 1930’s the United States went through the worst economic downturn in its history: The Great Depression. You all learned this in history class I’m sure, so I’ll skip to the important bits. As a result of the depression, Congress passed an act called the Glass-Steagall Act. Basically, this law prevented these corporations called investment banks from being associated with regular commercial banks, like the ones you and I bank at. Now you’re probably wondering what even is an investment bank. You’ve heard of them: Goldman Sachs, Morgan Stanley, Merrill Lynch. But you’ve personally never banked with them. That’s because unlike a traditional bank, investment banks don’t take people’s deposits, but instead manage the money of large corporations. Essentially any entity that has millions of dollars laying around becomes a client for an investment bank. The investment bank takes that money and invests it into securities, which is just a fancy way of saying they use other people’s money to buy a financial product (like stocks) on the gamble that they can sell it for a higher price. Of course it’s a bit more complicated than that, but it’s enough for our purposes.

Having investment banks merge with traditional banks creates a massive conflict of interest. When a regular bank gives out a loan, an investment bank can use their clients’ money to buy that loan from that bank. The regular bank gets instant cash and the investment bank gets to collect all the interest and future payments made by the person who got the loan. The total money the person will pay back is precalculated giving the loan an approximate value that the investment bank can sell it to someone else for, trying to make a profit. Packaging and selling this ‘product’ is the basic function of an investment bank. To the investment bank, these loans are just products that they can buy and sell, but in the real world these loans are held by real living breathing people. In any other industry, when you have a high demand, you just up your production to meet it. But investment banks can’t just produce more people that are willing to take out loans. So they pressure the regular banks to give out credit to people less than trustworthy all so they can have another loan to buy using another corporation’s money. This exact reason is why Glass-Steagall was passed, so investment banks couldn’t exploit the customers of regular banks, us.

Glass-Steagall led the way for the most prosperous economic age America had ever seen and it lasted for over a half century. Unfortunately, during this time, people forgot about the dangers of investment banks and how much influence they could have on how much credit (loans) regular banks provide. Loans being the life blood of America allowing people to start their American Dream. And most people didn’t know exactly what investment banks even were. So in 1999, President Clinton passed into law the Gramm-Leach-Bliley Act, which essentially repealed Glass-Steagall. Investment banks were now free to do business with regular banks. This coincided with the housing boom of the early 2000’s in which the values of American homes nearly doubled. People were buying lots of new homes and taking out mortgages on them from the regular banks. Without Glass-Steagall, investment banks were now free to package these loans to their clients and sell them for profit. Everything looked fantastic. The investment banks were making billions of dollars on these Mortgage Backed Securities (MBS) which were rated AAA and they wanted MORE.

There weren’t enough loans for the investment banks to buy from the regular banks, so the investment banks, now with their special relationship, pushed the traditional banks to give out loans to people with low credit scores. On top of that, the housing boom of the early 2000’s was caused by an influx of investors buying secondary homes as investment properties. These people tended to be richer and much more likely to pay off that mortgage in full so the rating agencies rated the MBS based off their mortgage as AAA. However, around 2006, these investors started to exit the housing market. Home prices were about to collapse dramatically. America didn’t realize that the housing market was being inflated by people buying investment properties instead of people actually buying houses to live in. As soon as they decided to stop making investments, the houses would lose all their value. The mortgages would instantly lose all their theoretical value and become worthless to the investment banks. The entire thing was just a bubble, but with essentially trillions of dollars on the line, everyone just closed their eyes to that fact.

The investment banks may have had their eyes closed, but they weren’t completely blind. They were the only ones who knew they were making the regular banks give out loans to untrustworthy people. So, they insured themselves from people defaulting on their loans by buying, what else, Insurance. One company in particular, AIG, sold trillions of dollars worth of insurance for these mortgages. If someone defaulted on their mortgage, AIG would pay out the investment bank for their loss. In the insurance business, it’s a very good idea to not sell more insurance than you have money to pay in case someone actually makes a claim. AIG seemed to be completely oblivious to this fact and oversold their insurance on mortgages. The MBS were rated AAA after all, there was no way America’s entire housing market could crash, right? That foolish assumption would end up costing us dearly.

In 2007, the first sign of this massive financial catastrophe emerged. The home investors had left the housing market and the bubble was bursting. One of the largest investment banks in the world, Bear Stearns was heavily invested in assets like MBS which meant it held hundreds of billions of dollars of MBS which were now potentially worthless. Their investors panicked and started to pull out of the company. Wall Street didn’t yet realize ALL of the banks had hundreds of billions of dollars worth of MBS and they were all in trouble. The Federal Reserve Bank of New York realized if Bear Stearns collapsed, investors would realize the reason behind it was the MBS and since all the other banks owned them too, investors would panic and all the banks in America would collapse. The government facilitated a deal in early 2008 in which JP Morgan Chase would buy up Bear Stearns preventing it from collapse and the scrutiny of Wall Street investors. The deal worked, but the MBS were still on the books of all the investment banks so it would only push the issue down the road.

Lehman Brothers was the fourth largest investment bank in America in 2008. By August, signs that it was struggling were becoming very apparent. The MBS it held were losing it billions of dollars each quarter and it’s stock price was a tenth of what it was in February. The bank was almost begging the US Treasury to give it a life line, but the government insisted it got itself into it’s mess and it needed to deal with it. Behind the doors, however, the Treasury was trying it’s hardest to prevent Lehman from collapsing and sending a shock through the market. It asked Bank of America to buy Lehman, but Bank of America was skeptical. The government was essentially forcing it to buy a multi billion dollar bank that was worthless. The third largest investment bank in America, Merrill  Lynch, knew they were next in line after Lehman since they too had the same toxic MBS assets on their books. They decided to court Bank of America to buy them instead of Lehman, and Bank of America, seeing the government was basically forcing it to buy a bank, chose to buy the larger and more profitable Merrill and the government agreed.

The Treasury and the Federal Reserve facilitated a deal with British bank Barclays to buy Lehman. Barclays only agreed to buy the profitable half of Lehman and refused to take its toxic MBS assets. If Lehman collapsed, the entire market would collapse, so Lehman’s competitors, Goldman Sachs, Morgan Stanley, and JP Morgan Chase agreed to purchase all of the toxic MBS assets so the Barclays deal would go through. At the last minute however, the British finance ministry which regulated Barclays refused to accept the deal, citing their unwillingness to import ‘this cancer’, and Lehman was completely out of options. The next Monday, the fourth largest investment bank in America, Lehman Brothers filed for bankruptcy. The tears in the financial system were finally starting to show.

At this same time, the insurance company AIG had a massive problem on its hands. All of the MBS they had insured were now toxic and worthless and AIG didn’t have the money to pay the banks they had foolishly insured. AIG was one of the largest insurance corporations in the world and insured more than just investment banks. If AIG went under, it would be disastrous for anyone that bought insurance from them, which was at that point was basically everyone. The Federal Government was forced to buy AIG for $180 Billion to prevent it’s collapse. To put that into perspective, the most expensive thing ever is the International Space Station which cost $150 Billion over multiple decades from multiple countries. The taxpayers were left to cover the full cost of AIG’s stupidity because it was too vital a company to allow to fail.

After AIG, it became apparent that there was no running from the MBS the banks held. They were entirely worthless and they would bring down every bank which held them, which was all of them. The US Federal Reserve and the Treasury worked with Congress to come up with a plan to buy all of the toxic MBS that the banks held. They came up with a staggering $700 Billion figure to cover the entire cost. Congress, at first reluctant, eventually agreed. At the time, the GDP of the US was about $14 Trillion. Meaning all the money every single person in the US made in the year 2008 totaled $14 Trillion. It then cost us a trillion dollars to cover the massive losses of the investment banks. Even then, it wouldn’t be enough. It would take too long for Congress to buy the MBS and the banks were about to collapse in weeks. Once the investment banks collapsed, their close friends the regular banks like Bank of America, JP Morgan Chase, and Citi Bank would collapse too.

You do business with these banks, but so does everyone from Boeing to McDonald’s. Every company in America has a finance division and regardless of how profitable their main business is, the losses they would accrue just from their finance divisions once the banks went out of business would cause every other corporation to go out of business. The entire American economy was about to collapse and catastrophe was only days away. The US Treasury was forced to do the unthinkable. It would have to buy the banks to keep them from collapsing. Nationalizing banks is one of the most unAmerican things imaginable but the FDIC threatened Wells Fargo, Morgan Stanley, Goldman Sachs, State Street, JP Morgan Chase, Citi Group, Bank of America, Merrill Lynch, and BNY Mellon to be bought by the the US Government temporarily to avert total economic collapse. It worked. The markets rose drastically and accepted the deal and investors didn’t pull out from the banks.

The hope was the banks would use their bailout money to free up credit, the life blood of America and promote growth of the economy. The banks had other plans. Still reeling from the massive losses they took from giving out credit to people they should not have, their own mistake, they became very tight with credit and horded all the money they were given. On top of this, the investment banks merged even further into traditional banks with Merrill Lynch becoming entirely part of Bank of America. All of this everyone knew. And I knew it and it seemed like a success story. At the end, a depression was avoided and 5 years later the economy recovered. But then I realized what it all meant.

With the largest banks now even larger, there’s nothing stopping them from doing this again. Sure there’s the threat of a global depression, but they knew the MBS was going to be a dead end but they played that game anyways, because it was earning them billions of dollars for the time being. They’re going to do the same thing again. As long as the music is playing, no one is thinking about when it stops. Except this time when the music stops, there’s no banks left to buy the investment banks. Who are we going to get that will buy Bank of America. There isn’t a bigger bank left. When it fails, they’ll all fail. And we can’t buy the banks anymore either. They’re worth trillions already and our debt is already more than our GDP. We just don’t have that kind of money anymore. Not after the last recession. The banks will do this again, and they have lobbied to undo all the legislation and regulation on the banking industry since the recession. So the next time this happens, there is no rescue. It will be full on depression. The supermarkets won’t have food, the gas stations won’t have gas, the airlines will be bankrupt and no one will be flying anywhere. And no one is talking about that. Probably because there is no solution. The only people that can do anything are congressmen, and their campaigns are financed by these same bankers. They won’t pass anything to stop the banks, because that would mean the banks would make less money, and the banks would be furious if anyone even suggests anything of the sort. If you read this whole thing, kudos, but unfortunately this is a pretty sad ending to it all. Which is why its been bothering me so much. There is a goliath problem getting only larger in the shadows and no one knows about it.

And that’s what’s in my head. Thanks for reading!