Advancing Oligarcy: a conversation with James Kwak
James Kwak is the author, with Simon Johnson, of 13 Bankers, an analysis of the 2008 financial crisis and is aftereffects, set within the larger context of the role of financial power throughout American history. The book arose out of an article Kwak and Johnson wrote in The Atlantic, which compared the character of the financial crisis in the U.S. to previous crises in so-called emerging market countries. In both types of crises, Kwak and Johnson contend, forms of oligarchy and dangerous concentrations of power played primary roles.
“The fact that our American oligarchy operates not by bribery or blackmail,” Kwak and Johnson write in 13 Bankers, “but by the soft power of access and ideology, makes it no less powerful. We may have the most advanced political system in the world, but we also have the most advanced oligarchy.”
13 Bankers’ title refers to two events: first, the March 27, 2009 meeting between representatives of 13 financial institutions and President Barack Obama. According to Kwak and Johnson, that meeting was the beginning of the Obama Administration’s continuation of the previous administration's “blank check”—as opposed to "takeover"—approach to managing the financial crisis:
In the blank check scenario, the government keeps the bank afloat in its current form: managers keep their jobs, shareholders keep some value, and creditors are kept whole, so taxpayers bear most of the losses. Shareholders own all the "upside," meaning that if the bank recovers and increases in value, they will reap the benefits. In the takeover scenario, by contrast, managers lose their jobs, shareholders are wiped out, and any remaining losses are shared between taxpayers and creditors. (In a crisis, creditors’ haircuts may have to be modest in order to protect those creditors from failing in turn.) Since the government now owns the bank, taxpayers can claim all the upside.According to Kwak and Johnson, when it came to decisions the financial crisis forced upon policymakers, “[Hank] Paulson, [Ben] Bernanke, [Timothy] Geithner, and [Larry] Summers chose the blank check option over and over again. They did the opposite of what the United States had pressed upon emerging market governments in the 1990s.”
A second event referenced by the book’s title was a 1997 call Summers made to Brooksley Born, then head of the Commodity Futures Trading Commission, who had been blocked in her attempts to strengthen regulation on derivatives trading:
She was worried that lack of oversight allowed the proliferation of fraud, and lack of transparency made it difficult to see what risks might be building in this metastasizing sector. She proposed to issue a “concept paper” that would raise the question of whether derivatives regulation should be strengthened. Even this step provoked furious opposition, not only from Wall Street but also from the economic heavyweights of the federal government—Greenspan, Treasury Secretary (and former Goldman Sachs chair) Robert Rubin, and Deputy Treasury Secretary Larry Summers. At one point, Summers placed a call to Born. As recalled by Michael Greenberger, one of Born’s lieutenant’s, Summers said, “I have thirteen bankers in my office, and they say if you go forward with this you will cause the worst financial crisis since World War II.”What was of particular benefit to Wall Street when its institutions faced collapse was not only that the government had chosen to negotiate with these institutions, and thus came to the table with "a weak hand [because the institutions they negotiated with were too big to fail]; it was that the government negotiators came to the table largely in agreement with the bankers' view of the world.”
In the end, Wall Street made out rather well—to the detriment of the general population:
As the Financial Times’ Martin Wolf wrote in September of 2009, “What is emerging is a slightly better capitalized financial sector, but one even more concentrated and benefitting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead.”
When the next crisis comes, either the government will ride to the rescue once again, costing taxpayers hundreds of billions of dollars, or popular revulsion at bailing out megabanks yet again will prevent the administration from saving the financial system—with potentially disastrous economic consequences.
The right solution is obvious: do not allow financial institutions to be too big to fail; break up the ones that are.In addition to 13 Bankers, Kwak and Johnson collaborate on The Baseline Scenario, a blog available here.
The Straddler met with James Kwak on September 18th in Hadley, Massachusetts. We began our conversation by exploring some cultural issues Kwak and Johnson touch upon in 13 Bankers, where they note that morality tales like Tom Wolfe's The Bonfire of the Vanities, Oliver Stone's Wall Street, and Michael Lewis' Liar's Poker seemed to have had, in many cases, an effect opposite their author's intentions. That is, for many people, they made the figure of the "swashbuckling banker" only more appealing.
But wasn't this, we wondered, just an industry-specific manifestation of something that has a storied place in American cultural life: namely, the adoration of the gangster?
Kwak, September 18, 2010
While I think few people would watch The Sopranos and say, “I want to be like Tony Soprano,” there is a very real admiration for the fact that he is essentially a successful businessman. That’s how he’s portrayed. And I think that certainly contributes to this admiration for people like Gordon Gecko and all these characters in novels and movies about Wall Street.
There are many people in the United States today who say, if you are successful and make a lot of money, as long as you didn’t break the law, that’s good. So things like immoral or abusive behavior—as long as it doesn’t break the law, people say more power to you. Now Gordon Gecko did break the law, but no one remembers that, all anyone remembers is “greed is good.”
It's interesting to consider in the context of the housing crisis. On the one hand, you had condemnation of the poor for buying houses that were too big, which has at least two roots in American thinking. One is this Puritan work ethic—you’re supposed to work for a living, not gamble on housing going up. Secondly, it has a class component, which is basically that the working class shouldn’t aspire beyond its station. "Who is this poor person with the gall to buy a nice house in a subdivision when he can’t afford it?" Both of those dictate that you should be critical of the poor person who buys a big house. But we have this other strain of thinking which says, (a) it’s a free market and you should maximize your profits, and (b) individual initiative is good, and you should go and do what is good for you. We don’t, however, apply those to the poor person who buys a big house; we apply those to traders on Wall Street. So, for some reason, we apply different elements of our national ideology to different sets of people.
As I say, you could see it in the housing crisis, where a lot of the right-wing think tanks blamed the individual and the government for the collapse. Now, even though there were people who were taking out mortgages that they couldn’t afford, or taking out lots of home equity in order to buy big, flat-screen TVs—everyone always says flat-screen TVs—I think that, this is just a guess, but for every person who was drawing down his home equity to buy a flat-screen TV, or an SUV, there were two people who were drawing it down to pay medical bills or college bills, basically trying to make ends meet. Middle class wages have been declining for ten years and stagnant for thirty years, and if you have a financial system that allows people making $15,000 a year to take out $400,000 mortgages, I don’t think that’s the fault of the guy making $15,000. I think it’s the fault of the financial system.
But, let’s say I’m a guy who makes $15,000 a year. I realize, wow, I can get a $400,000 mortgage and I can live in this house for a few years, and if housing prices go up, I can flip it and I can actually make a couple hundred thousand dollars. And let’s say I’m really clever, and I say, if housing prices go down, I’ll just walk away and I will have gotten to live in a really nice house for three years at no cost to myself. I mean, that’s the worst, most cynical spin you can put on it, right? But this is exactly what people on Wall Street do. The person who is criticizing the janitor for doing this is the same person who thinks that businesses should exploit every legal opportunity to make profits. So even if you attribute the worst possible state of mind to the guy making $15,000, he’s still just doing what any businessman should do under the circumstances. But our national ideology somehow doesn't allow us to think about it in those terms.
The key attribute of any successful ideology is that people don’t recognize it is an ideology. The best example of this in recent history, at least with regard to the ideology of technocracy, is the awe with which the Federal Reserve has been regarded—and frankly, is still regarded. This is actually a relatively modern phenomenon. The lionization of Alan Greenspan did not happen with Paul Volcker, even though we look back now and we think that Paul Volcker was a better Federal Reserve Chairman. Paul Volcker actually lost some important votes on the Board of Governors of the Federal Reserve. And the Board of Governors was a more democratic institution at the time. With Greenspan, there were two ideas at play. One was that Greenspan was omniscient. The second was that the Federal Reserve was the key to economic policy. The Federal Reserve could basically solve all of our problems by itself.
From the early 1990s to 2007, the Fed Chair was considered the second, if not the first, most important person in the country. The political arms of government—Congress and the Administration—largely abdicated responsibility for managing the economy to the Federal Reserve.
As we found out, the Federal Reserve in many ways did not know what it was doing. But we seem to have the same faith in Ben Bernanke as we did in Alan Greenspan, perhaps because we don’t know where else to turn. Faith in the political branches of government is considerably lower than in the Federal Reserve. That said, the Federal Reserve, even if it works properly, is essentially in charge of the most important tradeoff in economics as an area of policy, which is the tradeoff between inflation and unemployment. The tradeoff isn’t perfect, but essentially speaking, most people agree that if you try to have rapid economic growth, which will lower unemployment, you will eventually get high inflation, and therefore you should try to minimize inflation and inflation expectations. That’s a bipartisan position. For the past thirty years, going back to Volcker, the Federal Reserve has emphasized inflation considerably more heavily than economic growth.
So this is the most fundamental question affecting the economy as a whole and the welfare of ordinary people—and it’s just been turned over from Congress to the Federal Reserve. On the one hand, it’s because of this ideology of technocracy—we want technocrats running our economy. But on the other hand, it’s basically worked out to the benefit of the rich as opposed to the poor. Because who doesn’t want inflation? People who don’t want inflation are people who have a lot of assets, who don’t want them inflated away. If you don’t have any assets, inflation doesn’t matter that much to you. So this kind of nonpartisan ideology has had very real consequences on inequality.
Yes, most economists would agree that if unemployment is too low, inflation will accelerate. But the lesson we’ve learned is that inflation should be two percent a year. Two percent is completely arbitrary, but that is essentially what the Federal Reserve and all major central banks focus on. Everyone agrees that fifty percent inflation is bad, but why it has to be two percent as opposed to three percent or four percent is completely arbitrary, and low by historical standards. It’s an interesting phenomenon how a reasonably sound economic doctrine has led to a completely arbitrary inflation target of two percent—which, again, ends up benefitting people who have a lot of assets.
And this isn't really debated. I mean, I think the commercialization of the media and dependency on ratings is certainly a major factor in the sort of debates we get. And the need for the news to be entertainment has certainly dumbed it down to the point where even some of the better news programs often come off more like theater than as a serious distillation of issues. But when it comes to issues of economics and finance there is something else at play: once the Democratic and Republican parties started agreeing with each other on all the issues, then, without the traditional left-right, Democratic-Republican axis to use, the media basically decided, well, if they agree then they must be right. Because the typical thing to do is to bring in a Democrat and a Republican to talk about how they disagree on an issue. When it came to Wall Street, when they started to agree on all these issues, I think two things happened. One is that the media, and frankly, Washington, didn’t know how to think about what an opposing view could be in the absence of a Democratic-Republican dichotomy. And then secondly, because these issues are somewhat technical, people feel intimidated. There has been this trend in the past thirty years which you might call “intimidation by math.”
Take a simple issue of public policy: given that a company makes a lot of profits, should it share those profits with its workers in the form of higher wages? People would debate questions like this in the 1970s. Today, the Economics 101 position on this is “no, they shouldn’t.” And that has not only become the dominant ideology, but it has become an ideology that poses as mathematical truth. So the pretension is that if you don’t agree with that, it’s not that you have different premises or different political inclinations, it’s that you don’t understand math and you’re just wrong.
Take, another example, the Efficient Market Hypothesis. Most people today would agree that you can’t predict the future price of a stock just by looking at its past price. This is the weak to moderate form of the Efficient Market Hypothesis. The strong version of the Efficient Market Hypothesis, however, says that the price is always right in that it reflects all information, not just all publicly available information. The strong version of the Efficient Market Hypothesis is philosophy, because it doesn’t address the question of what the price being right means. Some people do like to talk about the fundamental value of a stock, but it’s very difficult to come up with a definition of what the actual value of a stock is, because all you know is that it’s going to change in the future in response to various things, so it’s impossible to say what it should be. So, in its weaker forms, the Efficient Market Hypothesis is not particularly partisan, or ideological, and it led to some very positive and democratizing developments, most notably the rise of index funds. Index funds work because of the Efficient Market Hypothesis, which basically says you shouldn’t waste your time trying to pick stocks. And index funds are probably one of the best things that have happened for ordinary investors in the last forty years.
But in its stronger form, the Efficient Market Hypothesis does have a partisan application. And I don’t think it was ever even allegedly proven. That part was really just a hypothesis, and right from the beginning people contested it. But this was also a time, the 1970s, when the right-wing think tanks were really getting going and one of the things on their agenda was financial deregulation, and the strong form of the Efficient Market Hypothesis helps them, because if prices are always right, then there’s no reason for government to interfere in markets. If markets yield the prices that things are supposed to have, then everything always works out for the best.
So the Efficient Market Hypothesis is an example of a theory that, when dumbed down into sound bite form, is superficially convincing if, say, you’re on the PBS Newshour debating some representative from the AFL-CIO. If you say, “well, actually, modern finance has proved that markets operate efficiently,” it’s hard for people to refute, and it’s an example of intimidation by math and intimidation by economics.
Just to give you a completely different example of something that I think is analogous—a complex economic topic being boiled down for political purposes—look at the minimum wage. First semester economics teaches that if you raise the minimum wage, unemployment goes up. Without a minimum wage, the market will clear at the level it should clear at; if you raise the minimum wage, then the market won’t clear and fewer people will have jobs. You learn that in the first month of economics.
Now, people have done actual empirical studies of this, and it’s just not true. So one study, I can’t remember who did it, looked at one fast food chain's franchises on the New Jersey and Pennsylvania sides of the border after New Jersey raised its minimum wage. There was no impact on the number of jobs. The only change was that people in New Jersey were now being paid more than in Pennsylvania. And the field of economics actually has lots of explanations for that—but the simple argument, that if you raise the minimum wage unemployment will go up, is easy to understand and makes sense on first glance. So if you are not an economist and an economist tells you that, you are going to be intimidated into believing it.
On these complicated policy issues, any statement you make is going to abstract away from the details of the policy in certain ways. On many of these issues, the first-semester free market answer is just simpler than the more complicated answers that better reflect the world. It’s hard to condense them into sound bites.
But too, look at an issue that’s gotten a fair amount of attention this year, hydraulic fracturing. This is injecting water and chemicals underground to break up rock and free up natural gas deposits. The two sound bites on each side of that argument are, on the one hand, we need natural gas because it’s clean—I mean, that’s not true—but it’s clean, it’s domestic, we don’t have to fight wars in Afghanistan to get it, it’s good for our energy security, and it’s good for economic growth. The other sound bite is that we’re just poisoning our water supply. You’d think that would be an equally effective sound bite. And perhaps it is when you reach the popular media. But it’s certainly not as effective in Congress. The process of translating the political will into issues that people actually vote on has become increasingly mediated by organizations, particularly lobbying groups and so-called grassroots movements (which occasionally are—and usually are not—grassroots movements).
On the issue of inequality, most Americans today think that our economic system is unfair, and the number of people who say that it is unfair is actually higher than it was in the 1970s and 1980s. And yet, over that period, we have seen a vast reduction in the usage of government to address inequality. One reason for that is simply that, if you believe that political pressure is mediated by organizations, the unions have gotten weaker and the right-wing groups have gotten stronger. I think another way to look at it though is informed by behavioral economics and what we know about people’s preferences. At any moment, people hold any number of contradictory positions. So, on the one hand, they think that the system should be made more equal; on the other hand, they don’t trust government to be able to do anything right, and they also think that we need lower taxes because they think that it’s their money.
So I think that political combat is largely an issue of how to get people to think about a particular issue—raising taxes on the rich, for example. Why has the right been so much more effective than the left on these issues over time? There are various theories on that. One is the theory of political organizing. One is ideological: so even on the specific question of “is the economic system unfair,” even if over time that is trending in the same direction, even then I would bet—I don’t have proof of this—but I would bet the importance of that question relative to other questions has gone down. Probably the best example of this is the issue of the national debt and our supposed fiscal crisis. If you asked people, “should the government have a balanced budget?” I would guess the answer to that has been the same for thirty years. Most people say yes. So the real question to ask is, why has that question become so important in the last year? And before you get to answering that, you should note that one of the central arts of political combat is figuring out how to make a given question central as opposed to another question.
There’s also a role for ideology, and what I mean by that is, one way to look at, say, Jacob Hacker and Paul Pierson’s claim that Senators are more likely to vote with rich constituents than poor constituents is to say, well, they’re getting more money from those people. And that is factually true, they are getting more money from those people. But another way to look at it is that they are just predisposed to agree with those people. Washington, perhaps more than the rest of the country, has been steeped in this Economics 101 ideology, because that’s what comes from the lobbying firms and right-wing think tanks. They are predisposed to think that we should lower taxes because it is good for economic growth independently of whether their rich constituents want it.
And Wall Street's argument that it has this mysterious power, that you have to trust it that it's using it for good, and that if you take it away, the world will end, is obviously obnoxious—but it’s a hugely successful debating point. Congressmen are afraid of it. They’re afraid that they don’t understand what’s going on, and they’re hearing these lobbyists say that if you push too hard on the banking industry, the world will end. And they’re hearing consumer advocates say, the financial sector is really bad, because it’s hurting poor people. And frankly, one of them is riskier than the other, even if you give them equal weight.
The class warfare argument is also highly effective. Most people think that society is too unequal. Yet at the same time, we have an instinctive dislike for class warfare. If you’re engaged in class warfare against the rich, that must mean you’re poor, and people don’t want to think they’re poor. We like to think we’re not a class society; everyone likes to think they’re middle class; even large proportions of the rich identify themselves as middle class. And we have this belief in social mobility, though in fact we’re less mobile than most European societies. And as a result, we think you should become rich; you shouldn’t attack the rich.
So we have these two self-defeating thoughts. One is that society is unequal, and one is that we should not engage in the most obvious consequence of that behavior, which is to take stuff from rich people and redistribute it to poor people—the obvious, first order solution to that problem.
And this reflects a fundamental contradiction in the way we think about Wall Street. Most of us still admire them. Most Americans are upset with Wall Street, and angry, and don’t really understand it, and think they’re getting screwed. But at the same time, these are the winners, in a sense. And we feel it’s un-American to trash the winners.
And to some extent I would say that the people on Wall Street themselves may have fallen victim to our cultural image of them and an ideology of the permanent upside. I do think that a lot of people on Wall Street probably fell victim to the belief that prices could only go up, because people tend to fall victim to beliefs that seem like they’re going to make them a lot of money. Stock traders fall victim to the belief that they are really good at stock trading, instead of just lucky, because it’s more convenient to believe that than the opposite. So, I think it’s quite possible that a majority of people on Wall Street, creating and trading these complex securities really did believe that they would do just fine because the prices would go up.
But there are a couple of interesting questions. One is that a number of hedge funds did not believe this. Remember, at this time there are the five classic investment banks: Goldman, Morgan Stanley, Merrill Lynch, Bear Stearns, Lehman Brothers, and then the three big commercial banks who were engaged in this stuff: Citigroup, JPMorgan, and Bank of America. So about eight U.S. Banks doing this. And if you have a small number of companies engaged in a certain behavior, you’re more likely to get herd behavior than you are if you have, let’s say, two thousand companies. If your seven competitors are doing the same thing, it is intellectually easier for you to do the same thing, and it is safer for you to do the same thing—it would be harder to defend not doing that thing. Whereas, when you have a universe of hedge funds, you’re going to have more contrarian behavior. And that’s exactly what we saw. We saw hedge funds taking bets that these things would collapse; we did not see investment banks taking bets that the whole thing would collapse. I mean, Goldman, to some extent, hedged itself better than some of the other banks. And this is, like, the fifth or sixth argument against having these huge banks: you’re more likely to get herd behavior than with smaller institutions.
The reason the administration, in my opinion, was against breaking up the big banks really reflects the thinking that it would have just been too hard to do. Either politically—certainly, politically—or technically. That reflects a failure of imagination, because breaking up a bank like Bank of America would actually be very easy. I mean, Bank of America was created as a product of a whole bunch of regional mergers. There’s no particular reason why a bank has to have branches in every state in the country. Bank of America would be trivially easily to break up. Goldman presents a more complicated question because you can argue that there are some efficiencies of scale in investment banking, particularly in trading, and that to be an effective trading operation these days you have to have offices in London, New York, Singapore, Tokyo, and so on. That said, we’re still talking about banks with a few hundred billion dollars in assets [after breaking them up], and there’s no reason they couldn’t handle all of those markets.
I think that the administration thought that politically it would be too difficult, and I also think they thought that the benefits would be too low because they could achieve the same goals with different means. No one serious, certainly not in the administration, was arguing that too big to fail was not a problem.
Now, the main approach to too big to fail in the Dodd-Frank Bill [the financial reform bill that President Obama signed on July 21] is increased regulatory authority, which takes a couple of forms. One is a mandate and some additional tools to monitor and take action in the event of systemic risk. So, for example, regulators were told to set higher capital requirements for all banks; they were told, without giving details, to set even higher capital requirements for the supposedly systemically important financial institutions. The philosophy there is, we’re just going to police them more carefully.
Secondly, there was a thing called resolution authority, which in the bill is called “Orderly Liquidation Authority.” That’s the idea that in an actual crisis, the government will be able to take over and liquidate financial institutions. So the idea is that, with Lehman Brothers on the verge of collapse, the government would have been able to take it over and liquidate it. The problem with Lehman Brothers collapsing was that Lehman had to go through bankruptcy, and in bankruptcy all the creditors apply to the court to get their money back, which means money is tied up for a long time. For financial institutions, that’s a big problem, because financial institutions are generally highly leveraged, so if a small amount of their money is tied up, they might themselves fail.
So that’s the Dodd-Frank response, which I think is insufficient for a couple of reasons. The first is that I don’t think that resolution authority would actually be used if it were needed. Resolution authority kicks in if a bank is judged to be failing. That’s a decision made by regulators—it’s ultimately a political decision. The idea that something like JPMorgan Chase would be judged to be failing by the government is pretty farfetched. It certainly wouldn’t happen in a Republican administration; it certainly would not happen in this Democratic administration. There are also international complications. So, if we were the only country in the world, then maybe this would work, but all the institutions that matter are multinationals with subsidiaries all over the world. Therefore, if one of them is failing, it immediately becomes subject to bankruptcy regimes in many different countries. Typically, each country tries to seize the local assets as quickly as possible to pay off the local creditors. So it’s unclear if technically this would work.
More broadly, to the whole issue of increased police power—a lot of our book is about regulatory capture, which we say is generally innocent; that is, not corrupt like the capture of the Materials Management Service. The bill really does nothing about this. So we have this problem which many people have pointed out, which is that regulators have the incentive to let the industry do what it wants. The response is a bill that gives more power to regulators, without addressing any of the regulatory capture concerns. Now, I’m not sure that the regulatory capture concerns can be addressed, which is why I was on the side of people saying that we should have stricter rules in the bill itself, as opposed to leaving them all up to regulators. And this is not a perfect solution, because people in Congress don’t know that much about the financial sector, and Congress is a politicized organization. But still, what we have learned in the last twenty years is that regulatory discretion is bad and we should have less of it—instead, we have a bill that has more of it.
Now, if you’re willing to posit a perfect regulator, then the powers in the bill might solve the too big to fail problem, but I think it’s a fantasy to posit the perfect regulator. You have to deal with the ones we have, and the ones we have are the same ones we had for the last ten years.
On the consumer protection front, on the other hand, the bill is quite good. Elizabeth Warren herself said she was satisfied with the bill. Some of the supporters had some reservations, but eventually everyone said they thought it was good, and certainly as good as we could have gotten. So I think that’s a major step forward. I think it’s going to help consumers for a number of reasons. We had a system that was getting more and more complicated and it was getting harder and harder for consumers to make the right choices, and we had a regulatory structure in which nobody cared about consumers—because the primary job of any bank regulator is to make sure that the banks he regulates do not fail. And this is a very simplistic way of putting it, but one way of helping your bank not fail is letting it rip off its customers. So now you have an agency that has the authority and mandate to protect consumers.
But it’s not going to solve all of our problems once and for all because, again, I don’t have a solution to the problem of regulatory capture. The first few years will be fine, because this is going to be stocked with consumer advocates who are going to want to do the right thing. But what happens when the next Bush becomes president and we appoint someone who doesn’t believe in regulation? In my opinion, that’s an insoluble problem.
You’re always going to need regulators; they’re always going to write rules. But when regulators write rules they are generally constrained by the text of the statute and the intention of Congress. Part of the problem with Dodd-Frank is that in some of these provisions the intention of Congress is actually quite unclear. For example, when it comes to credit rating agencies, the Dodd-Frank Act says that the SEC must conduct, I think, six different studies, one of which is a study of whether or not there are conflicts of interest within rating agencies. And then they’re supposed to write appropriate regulations given the studies. So that’s an example where you give a lot of discretion.
Here's another question to consider in the context of the continued existence of too big to fail. Why, within these big banks, did people not see the risks of what they were doing? I think there are two interpretations. One is that they did see the risks and just ignored them, because it was in their interests to ignore them. So, for example, Magnetar was a hedge fund that in 2007 thought that the subprime mortgage market would collapse, and they wanted to bet against it. The typical way to short housing at this time was to buy credit default swaps on collateralized debt obligations (CDOs), because CDOs concentrated risk—they were a lot more risky than your typical mortgage-backed security. But it seems that Magnetar, based on the investigation done by ProPublica, wanted even more toxic CDOs, because the CDOs that were on the market weren’t toxic enough. They wanted CDOs that would collapse even faster. So they went to some banks, including JPMorgan, to create even more toxic CDOs that they could short. This is similar to what John Paulson did with Goldman, and the thing that led to the SEC-Goldman lawsuit.
In one transaction that ProPublica talks about, JPMorgan did this deal, they got $20 million in fees, they created a CDO whose total value was about a billion dollars, and for whatever reason, instead of selling it to other investors, they held onto it. The next year, when the crisis hit, they booked a loss of about $880 million and Magnetar made about $1 billion.
So there are two possibilities here. One is that the people at JPMorgan really thought that the CDO wouldn’t collapse, even though these are people who should have known more about this market than anybody else. The other possibility is that they knew there was a fair chance it would collapse, but the $20 million in fees—half of that went into the bonus pool, most of it went into their bonuses, and they knew that if the collapsed, as long as it didn’t collapse this year, the losses would be borne by other people, which is exactly what happened. So it’s hard to say, were they clever and exploiting their own bank, or were they so caught up in how much money they were making that they were blind to the fact that it was going to collapse?
You know, there is a famous saying of Balzac that behind every great fortune there is a great crime—we certainly do not believe that in this country. The people on Wall Street are a kind of aristocracy, and I think a lot of Americans have deeply mixed feelings about whether they really want to overthrow their aristocracy.