The Financial Crisis: Predicting the Unpredictable

April 29, 2009
By Shivani Hajela, Cornell University, 2012

You just turned 21 and your friends take you on an all-expense paid vacation to Vegas. They release you to the card sharks with a blank check to gamble away whatever your heart may desire. You’re feeling lucky. So how much do you put on the table? A hundred? A thousand, maybe? How about billions?

Hey, if you lose all of it, maybe the government can just bail you out of debt with taxpayer money. After all, they did bail out AIG after they reported a loss of $61 billion – the largest quarterly loss in American corporate history (Taibbi 2009). Do the math – that means that AIG lost $27 million every hour of the last three months of last year, which breaks down to $465,000 a minute, which equates to the average American family’s annual income every six seconds, and about $7,750 every second (Taibbi 2009).

Okay, let’s go back to you now. I guess it is kind of important to know how much your friend has in his bank account right? After all, you can’t write a check for an amount of money that you don’t even have, can you? Even though AIG did that too! They played with about $500 billion that they did not have to begin with, in a completely unregulated derivatives market. AA And let’s not forget that they also spent over ten years methodically plotting to dodge the bullets coming their way via regulators from not only the U.S., but all over the world (Taibbi 2009).

Yes, the economic crisis that we are recovering from was orchestrated. When people talk about this crisis, they are in denial. The majority consensus i s that it is just an unfortunate tragedy that happened to fall upon us; that it is just a once in a generation kind of thing. People wonder who could have possibly predicted such an incident, but someone did see this coming! Her name is Brooksley E. Born (Schmitt 2009).
Ms. Born, the head of the Commodity Futures Trading Commission, in 1998, warned the leaders of the financial world, including, the head of the federal reserve, Alan Greenspan, that government regulation of Wall Street was necessary. Not only did he choose to ignore her, he worked hard to thwart her efforts to regulate this industry (Johnson 2009). That one action has brought the country to where we are today – recovering from the biggest financial debacle since the Great Depression.

Born was a big supporter of restricting the market for financial derivatives. This idea was met with a lot of controversy. Let’s first define what a derivative is – a financial tool whose value is based on other things, such as assets. Credit derivatives are based on loans, bonds, or other forms of credit. The use of credit-default swap derivatives was initially for major corporations to manage their risk across a series of investments; but it is exactly this that ultimately became a key factor in the downfall of the economy. Swap derivatives work like insurance: the insured pays a certain amount (“premium”) in exchange for protection from the insurer in case he/she defaults on a loan (Duffie 2009). The credit-default swap market, valued at about $45 trillion, allowed bank lenders to loan out more when giving out mortgages. Eventually, lenders began lending out more and more, and a problem arose because the swaps were not regulated. Lenders were taking more and more risks that they should not have been taking, and due to lack of regulation, there was no security that the borrowers had the funds to pay back what they were lent. So, when the housing market went downhill, the loans also took a dive, and banks were unable to adhere to the guidelines they had committed to in the derivatives contracts and thus got pulled down as well (Schmitt 2009).

Moral of the story: a little regulation could have gone a long way. Born made several attempts at warning Greenspan and other regulators of the impending crisis. Greenspan even invited her to lunch in his private dining room at the stately headquarters of the Fed in Washington, D.C., but when she got there, the conversation quickly turned controversial. Greenspan acknowledged that he and Born would always have differing opinions on the way that fraud in the economy should be handled – he with a more hands-off policy, and she with a policy of being more involved and monitoring the market. Greenspan made it clear to Born that he did not believe that there is any reason for there to be laws against fraud, while Born believes the exact opposite. Born says that when Greenspan said that to her, “that underscored [her to] how absolutist Alan was in his opposition to any regulation” (Schmitt 2009). Greenspan, along with other regulators, convinced Congress to take measures of passing legislation that made it illegal for Born’s agency to take any action. As a result, she decided to leave the government and return to her private law practice.

There are many theories as to why no one on Wall Street wanted to listen to Born’s warnings. Some people say that it is because she did not hold an important enough role – she was “a little person from one of [those] agencies trying to assertively expand her jurisdiction” (Schmitt 2009). Others found her difficult to work with and did not approve of her personal style – they saw her as counterproductive in the work place and characterized her as being abrasive. Some even dare to admit that they believe sexism may have played a role in this situation as well. Could Alan Greenspan handle the fact that someone in a skirt was telling him what to do? Of course Greenspan strongly refuted such allegations, but no one really knows for sure (Schmitt 2009). But ultimately, the reason does not even matter. The only thing that really matters is that this financial crisis was predicted and could have been prevented. Many people associate the financial crisis solely with money, yet while money is a key factor in the situation, there is something else that is of greater importance. And that is that the crisis was caused by a group of scheming insiders who were more concerned with their own personal profit than the taxpayers (a.k.a involuntary shareholders) who were unwittingly being taken advantage of.

References

Duffie, Darrell. 2009. Derivatives, the Basics. Stanford Magazine.
http://www.stanfordalumni.org/news/magazine/2009/marapr/features/duffie.html.

Greenwald, Glenn. 2009. Larry Summers, Tim Geithner and Wall Street’s ownership of government. Salon. http://www.salon.com/opinion/greenwald/2009/04/04/summers/index.html.

Johnson, Simon. 2009. The Quiet Coup. The Atlantic. http://www.theatlantic.com/doc/200905/imf-advice.

Schmitt, Rick. 2009. Prophet and Loss. Stanford Magazine.
http://www.stanfordalumni.org/news/magazine/2009/marapr/features/born.html.

Taibbi, Matt. 2009. The Big Takeover. Rolling Stone. http://www.rollingstone.com/politics/story/26793903/the_big_takeover.

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