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Monday, September 16, 2013

10 things we learned from the '08 crash - or have we?



10 things we learned from the '08 crash

Among the hard lessons: Bankers and regulators can make awful mistakes. Consumers must stay on their toes. Home prices can fall. What looks safe often isn't. And greed is a powerful drug. 

Stockbroker watching falling stock chart (© H-Gall/E+/Getty Images)

Shattered economic illusions

If the financial crash that came to a head five years ago this month has a bottom line, it's this: It shattered the illusions about how we live our financial lives.

Retirement plans exploded in our faces. Millions lost jobs, many permanently. Millions more lost homes. We learned new vocabularies to explain the forces that combined to push the economy into possibly the worst recession since World War II. People we thought were honest turned out to be sloppy, venal or both.

Events moved so devastatingly fast that it was nearly impossible to take it all in. Consider: The government takeovers of the mortgage giants Fannie Mae (FNMA) and Freddie Mac (FMCC) on Sept. 7, 2008, were followed a week later by the collapse of Lehman Brothers on Sept. 15. At the end of that week came the rescue of American International Group (AIG). Bank bailouts followed in early October.

It was a frightening time, exceeded in recent times only by the economic scare that followed the Sept. 11, 2001, terror attacks. The 2008 crash generated anger, an anger that still hasn't faded away. That anger makes us wary about ideas both new and old and has kept many away from Wall Street despite the huge rally that began in 2009. The fallout has also made our politics feel downright nasty.

Click ahead for a look at 10 important things we learned from that crash and would be wise not to forget.
Man playing blackjack in casino (© Adam Gault/OJO Images/Getty Images)


No. 1: Bankers are gamblers -- and often stupid ones at that

Bankers are supposed to take risks. That's the point of banking, or at least the part of it that involves lending to support new ideas and new ventures. But they too easily take risks they shouldn't. Consider Stanley O'Neal, the former CEO of Merrill Lynch. In the quest to make as much money as Goldman Sachs Group (GS), O'Neal pushed Merrill heavily into subprime mortgages even as the housing market was showing clear signs of distress. In July 2007, he discovered that Merrill owned $48 billion on collateralized debt obligations -- securities built around subprime mortgages -- that the nearly 100-year-old investment house couldn't hedge or sell. Selling Merrill became a question of when, not if. Bank of America (BAC) bought it a year later in a deal to save it from outright bankruptcy.

Photo illustration of world map outline on list of share prices (© Adam Gault/Digital Vision/Getty Images)

No. 2: The global financial system is too complex

Markets around the world are so intertwined that a problem in one country can cause havoc everywhere else. When Lehman Brothers, a storied financial firm, filed for bankruptcy, hedge funds suddenly were unable to take back securities they'd parked with Lehman's brokerage operation in London. The losses that followed were in the billions.

The Lehman collapse also set off a huge run on the Reserve Fund, one of the nation's largest, because it routinely bought short-term debt issued by the investment house. The run quickly spread to other money-market funds; $123 billion was pulled out of U.S. funds in a week. The U.S. government was forced to guarantee money-market funds for the next year, stopping the run.

Good ideas can also create unforeseen consequences. The Clinton administration and, later, the Bush administration pushed to expand homeownership -- and succeeded. By 2006, some 69% of U.S. families owned their homes. But a large portion of those new owners couldn't handle the costs of homeownership. The rate has since fallen back to 65%, the lowest level since 1995, but close to the overall rate since 1965.

And while we've seen some financial reforms, the big banks are still too big, and the system basically remains unchanged.

Businessman holding laptop on balcony (© Martin Barraud/OJO Images/Getty Images)

No. 3: Entire markets can be manipulated too easily

Not only is the global system unbelievably complex, it's also so interconnected it can easily be gamed -- even by a guy trading in his parents' basement with the help of a Twitter account, let alone a huge brokerage house.

In January, someone posting on Twitter announced that chipmaker Audience (ADNC) was being investigated by the Justice Department for possible fraud. The stock fell 23% in the ensuing few minutes as computer trading systems power by supposedly smart algorithms picked up the report and issued sell orders. The problem? The Twitter post was false.

The incident shows how easy it is to manipulate a market. If day traders can do it, imagine what big firms can do.

In July, a New Jersey oil trader was fined millions of dollars after using a series of high-speed buy-and-sell orders to push oil and natural gas prices lower. He would buy, pulling the price higher, then quickly sell.

Oil prices are set mostly by trading in futures markets and cash markets, with Platt's, the price-reporting agency, having an outsized influence. The biggest traders are big oil companies, big trading companies and big banks.


No. 4: Regulators work for the regulated -- and so do rating agencies


In 2007, when huge mortgage lender Countrywide Financial and its CEO, Angelo Mozilo, found themselves struggling with the Comptroller of the Currency over multiple issues, especially how mortgage appraisers were selected, Countrywide solved the problem neatly.

It switched its regulation to the Office of Thrift Supervision, allowable because Countrywide owned a savings and loan. The OTS promised more flexible regulation. Countrywide later got into so much subprime-loan trouble that it sold out to Bank of America (BAC).

Then there are the rating agencies, which are supposed to evaluate securities offerings objectively to help investors judge them. Yet the securities backed by subprime mortgages that lay at the heart of the financial crisis were routinely given high ratings by Moody's and Standard & Poor's. Critics say that's because the securities issuers were paying for the ratings. (And it appears that hasn't changed.)

Confused man looking at laptop (© Sturti/E+/Getty Images)

No. 5: The crash forced us all to expand our vocabularies

In addition to stocks, bonds, mortgages and the like, Americans have had to learn a whole new set of terms, starting with subprime mortgages. These are mortgages made to customers with little or no credit histories.

There are also mortgage-backed securities. These are basically bonds backed by a pool of mortgages. The borrower makes his monthly principal-and-interest payment, and the cash is forwarded on to bond investors. During the housing bubble, bonds backed by low-quality subprime mortgages were often sold as high-quality securities.

Then there are collateralized debt obligations. These are securities backed by, for example, mortgages in which payments are made in a precise order. The securities are sliced into what are called "tranches," which range from high quality to low quality. The highest-quality tranche gets principal and interest first. If the cash flows aren't sufficient, the lower-quality tranches don't get paid.

And, of course, ther are synthetic CDOs. These are bets on how a CDO will perform, not a CDO backed by mortgages.

And what about credit default swaps? These are effectively private insurance policies. Company A pays a premium to Giant Insurer X insure that its business won't fall apart. If it does, Giant Insurer X must pay off. Company A might also buy a swap betting that competitor Company B won't make a timely payment on its outstanding bonds; this would be like you taking out insurance on a neighbor because you think that neighbor will crash his car. In the financial crisis, credit default swaps sold by American International Group (AIG) required $182.3 billion in federal assistance to fix.

And what exactly is a derivative? Almost anything that involves some sort of bet on the price of an underlying asset could become a derivative. A futures contract on Treasury bonds is a derivative -- a hedge by the owner of the bonds that the price will be at a specific level on a specific date. Oil futures are technically derivatives. And then there are options -- options on stocks, options on futures, options on market indexes.

Five years ago, all these wonky terms probably seemed far away from home. In the meltdown, we learned they impact our homes.

Foreclosure sign in front of house (© Fotog/Getty Images)

No. 6: The terrible reality about home prices: They can fall

Most Americans buy houses because they like the neighborhood. Owning property makes them feel good about themselves. And, of course, the potential profit later on isn't so bad, either.

Yet every 10 to 15 years or so, Americans learn an awful truth about homeownership. The price of a home -- the price of your home -- can fall. When the housing bubble was building a decade ago, banks also ignored this reality; the perceived safety of U.S. housing led to a lot of risky lending.

The bursting of the housing bubble after 2006 caused home prices in nearly all U.S. markets to fall. In some markets, such as Phoenix and Las Vegas, the declines were as much as 50%. Too many were houses built, there weren't enough buyers to buy them, and, worse, many buyers couldn't afford what they'd bought.

Places like Detroit, where the economy falls apart and everyone leaves town, present another problem.

Housing markets usually recover. But millions of "underwater" homeowners today still can't sell because the value of their home is less than they owe on the mortgage.

Video still of Elmo & his family in PBS' 'Families Stand Together: Feeling Secure in Tough Times' (Courtesy of WVIZPBS via YouTube, http://aka.ms/MuppetsRecession)

No. 7: Investors are 'muppets,' and consumers are suckers

This view was exposed in a broker's e-mail that termed investors "muppets" who could easily be taken for a ride.

We learned during the crisis that brokers and adviser can lie to clients and even push them into investments they knew were risky – or even designed to collapse – without facing any punishment. The financial crisis exposed brokers who hawked investments to customers without telling them what they were buying, let alone if the investments were appropriate.

That's akin to a car salesman insisting that the cute roadster on the lot is the greatest vehicle ever, even when he knows the body is rusted out.

The bottom line for investors and consumers alike: If you don't understand what you're being pitched, walk away. Quickly. You have to look out for your own interests.

Protesters rally to reject cuts to Medicare and Medicaid on Dec. 18, 2012, in Washington. (© Bill Clark/CQ Roll Call/Getty Images)

No. 8: Austerity isn't prosperity

Yes, the Greeks are profligate spenders. But they have also endured a recession that's now six years old. The social safety net is collapsing and people are leaving the country. That's because the terms of loans designed by the European Union, the European Central Bank and the International Monetary Fund to keep governments in Greece afloat have cut social spending, infrastructure investment and the like to the bone. Greeks have also absorbed huge pay cuts.

And austerity has only made their economy worse.

Greece isn't alone, either. The same prescriptions have been applied to Spain, Portugal, Italy, Cyprus and Ireland.

It's also being applied to a lesser degree in the United States, as sequestration legislation has forced mandatory cost-cutting on the federal government. And so far, austerity measures haven't freed up capital and creativity in Greece or Spain. Instead, it has added to the misery. The Europeans are finally starting to think about how to get investment flowing again.

Worried stockbrokers looking at financial monitor displays (© Joshua Hodge Photography/E+/Getty Images)

No. 9: There are no safe investments or guaranteed returns 

All investments carry risk. That is the essence of capitalism: You take a risk for the potential to make a profit on an investment. But the 2008 crash and its aftermath have shown that even what looks like a safe investment can fall in value in a heartbeat.

Take Apple (AAPL), which was, for a while, supposedly the greatest stock ever. In 2011 and into '12, analysts fell all over each other raising price targets on the stock. Some thought $1,000; others guessed $1,200 or more. The shares hit $705 in September 2012 -- and fell 45% in the ensuing nine months to $385.10.

Shocking. Just shocking.

The smart investor who studied the stock would have known its history of extreme volatility. The shares previously peaked in December 2007 at $202.96, then fell 61% in 11 months.

The lesson: Guaranteed returns may not stay guaranteed for long.

Want another example? Bernard Madoff conned investors with promises that he could deliver the returns they wanted. And he manipulated his books to ensure the performance. The crash dried up the inflow of money to his firm, and the Ponzi scheme fell apart in late 2008. He's in jail.

Man holding briefcase full of $100 bills (© Caroline Purser/Photographer's Choice/Getty Images)

No. 10: The banker who kills the bank keeps most of his money

Bernie Madoff is an exception, though. None of the chief executives of the banks that fell apart in 2008 have faced serious punishment or any criminal charges. While some had to give some money back, they're still very rich men.
In this collapse, investors and consumers suffered the most, along with some low-ranking bankers who lost jobs.

The developments leading up to the 2008 financial crisis and the crash itself are filled with examples of bad decisions -- or worse -- by the bankers in charge. Some saw their institutions fail. Some lost their jobs. But all left the mess with many millions.

Stanley O'Neal was forced out at Merrill Lynch in the fall of 2007, mostly because he saw that the investment house was about to fail and tried to sell it without telling his board first. His severance package included Merrill stock and options worth $161.5 million, on top of the $91.4 million in total compensation he earned in 2006. Merrill was sold a year later.

Kerry Killinger, CEO of Washington Mutual, left in before his ouster in 2008 with a $25.1 million payoff. The package included a $15.3 million severance payment, a $6.8 million lump-sum pension benefit and a prorated share of his $1 million annual salary. WaMu was seized by regulators 18 days later in the largest U.S. bank failure ever.

From 2003 -- when investigators said WaMu had begun a disastrous push into high-risk, subprime-mortgage lending -- to his 2008 exit, Killinger received a total of $103.2 million in cash, stock and options.

Killinger has kept most of his money and lives in one of Seattle's most affluent neighborhoods. In March 2011, Killinger and two other WaMu executives were sued by the Federal Deposit Insurance Corp. for more than $900 million. The trio settled for $64 million in December, but they only paid $400,000 each. The rest was covered by insurance.

Countrywide's Mozilo amassed $470 million in salary, bonuses, options and restricted stock from 2001 to 2006, the peak of the housing bubble. He sold hundreds of millions of dollars of shares before Countrywide was sold to Bank of America (BAC). The deal was such a disaster that B of A has spent $40 billion in legal and other costs trying to get the mess resolved.

Mozilo did agree to pay $67.5 million to settle securities and fraud charges. Of that, $20 million was paid by Countrywide as part of an indemnification agreement. He remains a very rich man.

Is this fair? Perhaps not. Will something be done about it? Well, the statute of limitations on cases involving alleged violations of securities laws in the meltdown expires soon. So probably not.

Are criminals are getting off scot-free? In some cases, perhaps. But while many were guilty of not understanding the risks they asked their institutions to take -- or ignoring them -- that isn't a crime. In fact, in a deregulated banking world, nothing done in the housing mess may in fact be illegal.

Case in point: Lehman Brothers. The SEC spent years investigating the causes of the Lehman collapse in 2008. The agency's army of lawyers couldn't come up with charges backed by evidence they thought was strong enough to win judgments. So they never brought a case against former CEO Richard Fuld -- or anyone else.

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