Credit Crisis was a Heist

Fluke? Credit crisis was a heist

Thanks to a complicit Congress, the reins were systematically loosened on the looters of the financial industry. And they're still at it, looking for new plunder.

By Jim Jubak 3/20/09 Jubak's Journal, CNBC.com

It was no accident.

The folks in power in Washington and on Wall Street want to pretend that the current global financial crisis -- you know, the one that reduced household net worth in the United States by $11.2 trillion in 2008, according to the Federal Reserve -- was an accident caused by some unfortunate confluence of greed and asleep-at-the-switch regulators.

What we're now living through, though, is the result of a conscious, planned looting of the world economy. Its roots stretch back decades. And it wouldn't have been possible without the contrivances of the bought-and-paid-for folks who sit in Congress.

Of course, just because the plan blew up on the looters, taking off a financial finger here and a portfolio hand there, you shouldn't have any illusion that they've retired. In fact, in the "solutions" now being proposed -- by Congress -- to fix the global and U.S. financial systems, you can see the looters at work as hard as ever.

Blaming the regulators

The smoke screen -- the official explanation of the global crash -- was on full display at a March 5 hearing led by Sens. Chris Dodd, D-Conn., and Richard Shelby, R-Ala., respectively the chairman and ranking minority member of the Senate Banking Committee, into the $170 billion morass that is American International Group (AIG, news, msgs). Served up on the grill were Eric Dinallo, the supervisor of insurance for New York state, and Scott Polakoff, the acting director of the federal Office of Thrift Supervision.

"Are you trying to evade your responsibility?" Shelby thundered at Dinallo, who was responsible for regulating AIG's insurance business, headquartered in New York.

Neither Dinallo nor Polakoff had a convincing explanation for why their agencies hadn't done more to stop the meltdown at AIG, which has so far cost taxpayers $170 billion. At times, they certainly seemed like they were trying to weasel out of responsibility, exactly as Shelby suggested.

Dinallo, for example, pointed out his agency regulated only AIG's insurance business and not the London financial-products unit, which had written the derivative contracts that took down the company. Shelby countered by asking why Dinallo's office hadn't done more to stop the risky lending of securities by the company's regulated insurance units, which account for $35 billion of the $170 billion bailout.

Polakoff wound up eating crow and more crow. "AIG was successful in many regards for many years, but it had issues and challenges," he said in his prepared statement for the committee. After that exercise in the numbingly obvious, it was hard to muster up much sympathy for Polakoff when Sen. Jack Reed, D-R.I., got him to participate in his own evisceration. "The perception that this London operation was some rogue group that was unsupervised, that you had no access to it and that your regulator authority didn't reach there is not accurate," Reed said. "Correct," Polakoff answered. "That would be a false statement."

Riddle me this

By trotting out these sacrificial victims in this show trial, our representatives in Washington hope you won't ask the hard questions, the questions that show that they bear far more responsibility for this crisis and for the destruction of trillions of dollars in global assets than any state insurance commissioner or Washington bureaucrat. What questions? How about these:

Question: How is it that the Office of Thrift Supervision, a unit of the Treasury Department that regulates the savings and loan industry, wound up as the primary federal regulator for insurance giant AIG?

Answer: The company was essentially able to shop for the regulator of its choice. AIG's acquisition of a small savings and loan in 1999 gave oversight responsibility to the Office of Thrift Supervision, a 1,000-employee agency with offices in Washington, Atlanta, Dallas, San Francisco and Jersey City, N.J.

The agency hasn't exactly been a regulatory bulldog in recent years. The Treasury's inspector general blasted the agency for its role in propping up IndyMac Bank in the days before the savings and loan collapsed last July. The agency's auditors allowed the company to backdate cash infusions to make it seem like IndyMac had enough capital. The S&L's eventual collapse cost the Federal Deposit Insurance Corp. $9 billion.

For the past four years, the agency had staff regularly on site at the AIG financial-products branch office in Connecticut, The New York Times' Gretchen Morgenson reported in September. Either these examiners, used to the world of savings and loans, didn't understand the complex derivatives transactions they were seeing, or, as in the IndyMac case, they decided to go along. In either case, the agency didn't step in to halt the practice.

Question: Why weren't state insurance regulators more aggressive in regulating AIG?

Answer: Because the federal government had forced them to back off. An aggressive interpretation of the definition of insurance could have let state insurance agencies regulate the derivatives contracts that AIG's financial-products group was writing out of London. These were, in fact, insurance policies that guaranteed the companies taking them out (banks, other insurance companies, investment banks and the like) against losses on securities in their portfolios.

But Congress had made it very clear in the Commodity Futures Modernization Act -- supported by then-Federal Reserve Chairman Alan Greenspan, steered through Congress by then-Sen. Phil Gramm, R-Texas, and signed into law by President Bill Clinton in December 2000 -- that most over-the-counter derivatives contracts were outside the regulatory purview of all federal agencies, even the Commodity Futures Trading Commission.

With the new law on the books, the market for credit default swaps exploded from $632 billion outstanding in the first half of 2001, according to the International Swaps and Derivatives Association, to $62 trillion in the second half of 2007.

Question: Wasn't anybody worried about the risk to the financial system posed by a market that dwarfed the assets of the sellers of this insurance?

Answer: Worry about leverage? You've got to be kidding.

In 2004, the Securities and Exchange Commission, after hard lobbying by Wall Street, reversed its 1975 rule limiting investment banks to leverage of 15-to-1. The new limit could be as high as 40-to-1 if the investment banks' own computer models said it was safe.

Question: Why wasn't Wall Street more nervous about the rising tide of leverage and the risk it posed?

Answer: Ah, come on. You know why: The new business model was incredibly profitable. In 1999, AIG's financial-products group had revenue of $737 million, Morgenson reported in the Times. That had climbed to $3.26 billion by 2005. And almost all of that was profit: Operating income was 83% of revenue in 2005. The biggest expense, by far, was compensation. Salaries and bonuses ranged, depending on how good a year the unit had, from 33% to 46%.

Question: Why didn't Washington step to at least temper the risk?

Answer: Money. Just look at the who's who of senators receiving campaign contributions from AIG. According to Federal Election Commission data at the Center for Responsive Politics, Sen. Max Baucus, D-Mont., has received more money from AIG -- $91,000 -- than from any other contributing company. Baucus chairs the Senate Finance Committee. Dodd, the head of the Senate Banking Committee, has received $280,000 from AIG. (In the 2003-08 election cycles, AIG was only the fourth-largest contributor to Dodd; Citigroup (C, news, msgs) ranked No. 1.) And Dodd now admits he's the one who wrote the loophole that allowed AIG to award $165 million in bonuses to its financial-products group. (In his defense, Dodd says he inserted the language at the request of the Obama administration.)

AIG doesn't show up among the top 10 contributors to Shelby, but the ranking Republican on the Banking Committee does count Citigroup (at No. 1) and JPMorgan Chase (JPM, news, msgs) (at No. 3) among his top donors. Twenty-eight current members of Congress own stock in AIG. Sen. John Kerry, D-Mass., is the biggest investor, with stock valued at $2 million (it was valued at $2 million at the time he filed his lastest financial reports, anyway).

Congress has delivered a lot of other goodies in the past decade or so that have contributed to this crisis -- and made the cleanup more expensive and painful. For example, the Office of the Comptroller of the Currency and the Office of Thrift Supervision both moved to block states from enforcing their consumer-protection laws against any nationally chartered bank.

Among the measures states were prohibited from enforcing were rules against predatory lending. Not that the federal government stepped in for the states: The Federal Reserve took all of three formal actions against subprime lenders from 2002 to 2007, and the Office of the Comptroller, with authority over 1,800 banks, took only three enforcement actions from 2004 to 2006, according to Multinational Monitor.

But you get the idea by this point.

The next round of looting

What should worry you now -- if you can spare a neuron or two from worrying about the economy, your job, your retirement savings, your mortgage and the meltdown of the global financial system -- is that the looters aren't in retreat. If anything, they're getting more brazen. For example, in the early days of the AIG crisis, Goldman Sachs Group (GS, news, msgs) denied it had any "material" exposure to AIG's troubles. It wasn't until months after then-Treasury Secretary Henry Paulson, a former CEO of Goldman Sachs, organized a bailout of AIG that taxpayers found out the biggest recipient of taxpayer money, pocketing $12.9 billion of the $170 billion bailout, was -- ta-da! -- Goldman Sachs.

The next round of looting is likely to come in the name of reform. Already, Shelby has called for federal regulation of the insurance industry. For years, the industry itself has been arguing for this, seeking to replace all those pesky state agencies and their differing rules with one federal standard. That's great if the federal standards are tougher than the toughest state standards and the federal regulators are tougher than the best state regulators.

On recent evidence, I'm not counting on that. Are you?

I'm just as skeptical about calls to give the Federal Reserve more power, turning it into a superregulator for the financial system. More power to the same Fed that could find only three examples of predatory lending, that fought against regulating derivatives and that did nothing as risk piled up at the nation's banks?

I think reform -- stem-to-stern reform -- is an absolute necessity. But I think almost all the existing regulatory bodies have been captured by the industries they are called upon to regulate. Tear them all down, I say, and begin from scratch. Within 20 years, we'll be facing the same problem of regulators captured by their regulated industries, but, as Huey Long said about his plan to redistribute the country's wealth, what a time we'll have had.