Dr. Susmit Kumar

The 2008 Wall Street crisis was started by the defaults of record numbers of sub-prime mortgages. Investment banks were securitizing the mortgages, including the sub-prime mortgages, and selling them all over the world, i.e. the mortgages were sold as securities all over the world to investors (for an example, they were bundling say 100 home mortgages and selling as securities to investors). In finance, a security is an instrument representing financial value. When the sub-prime mortgage market started to collapse in 2007, the investment banks that had sold these securities started to lose money. Although the mortgage based securities affected by the sub-prime crisis was said to be less than $2 trillion, the collapse of the US housing sector affected non-subprime mortgages too, leading to further losses in mortgage based securities. Bank officials were under pressure from their higher-ups to give mortgages and in turn, they as well as the top officials were getting huge bonuses at year end. At investment banks also, officials were putting pressure on workers to churn out securities that packaged mortgages and other forms of debt into bundles for resale to investors all over the world. The officials including the CEOs at these investment banks were making millions of dollars in bonuses due to the profit related to the sale of these securities. These officials were taking huge risks for their bonuses to show short-term gains for their financial institutions and many of those gains turned out to be huge losses later on.

During the 1990s and early 2000s, low interest rates and large foreign investments created a housing sector boom in the US. The percent of home ownership in US increased from a consistent 63 percent to 64 percent from the 1960s to early 1990s to a record 69 percent in 2005. During this housing boom period, banks were giving housing loans to people whose income was not sufficient enough to pay the monthly mortgage, but as home prices were rising every year at a record pace, people were making money by selling homes to each other. When home prices started to collapse, not only people having sub-prime mortgages but people with prime mortgages also found it difficult to pay their mortgages.

According to a Brookings Institution study, prime mortgages dropped to 64 percent of the total in 2004, 56 percent in 2005 and 52 percent in 2006.[1] According to Credit Suisse, 29 percent of new mortgages in 2005 allowed borrowers to pay interest only – not principal – or pay less than the interest due and add the cost to the principal. It was up from 1 percent in 2001. In 2006, half of new mortgages required no or minimal documentation of household income. According to the National Association of Realtors, the average down payment for the first-time home buyers was 10 percent, whereas in 2007, it was only 2 percent. Suppose you have $20,000 cash. In 2006, you could get a 5 percent down mortgage to buy a $400,000 home whereas a 10 percent mortgage will limit you to buy only a $200,000 home. [2]

According to John D. Parsons, a supervisor at a Washington Mutual mortgage processing center, almost all were granted mortgage loans irrespective of their real incomes. He said that it was normal to see baby sitters claiming salaries worthy of college presidents, and school teachers with incomes rivaling stockbrokers.’ Interviews with two dozen employees, mortgage brokers, real estate agents and appraisers revealed the relentless pressure to churn out loans.[3]

Credit Rating Agencies like Moody's and Standard & Poor's also played dubious roles by first assigning investment grade ratings to these sub-prime mortgage related securities. Both these agencies were getting substantial amount of money by grading these products. But later on when sub-prime mortgages started to collapse, they suddenly downgraded the mortgage-related securities to junk ratings. According to the Nobel Prize economist Joseph Stiglitz: ``I view the ratings agencies as one of the key culprits. They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.'' [4]

Despite having mortgage-related losses, top executives at Wall Street were getting huge bonuses. In 2007, Wall Street firms paid $33.2 billion in bonuses. Seven of Wall Street’s biggest firms (Merrill Lynch, Citigroup, Bear Stearns, Morgan Stanly, JPMorgan Chase, Lehman Brothers and Goldman Sachs) paid a combined total of $122 billion in total compensation and benefits, up 10 per cent since 2006, despite seeing their net revenue collectively fall 6 percent. On the other hand, in the same year mortgage-related losses reported by the seven firms totaled $55 billion and wiped out more than $200 billion in shareholder value which was nearly half the value of their holdings. Three of those firms suffered their biggest losses ever in the final months of 2007. Employee compensation at those firms was equal to 47 percent of net revenue in 2007, compared with 40 percent the year before.[5]

In 2006, Merrill Lynch had record earnings of $7.5 billion and the firm gave $5 billion to $6 billion in bonuses in that year. A 20-something analyst with a base salary of $130,000 received a bonus of $250,000, and a 30-something trader with a $180,000 salary got $5 million. Dow Kim, executive vice president, received a $35 million bonus whereas his salary was only $350,000. Since then, the company lost three times the money in mortgage related investments resulting the company, founded in 1914 to be sold to Bank of America in late 2008. In 2006, more than 50 people at Goldman Sachs were paid more than $20 million bonus. At Wall Street firms, bonuses are based on short-term profits which encourage people to take risk like gamblers in casino.[6]

When home prices started to collapse, not only did people having sub-prime mortgages find it difficult to make their mortgage payments, but also people with prime mortgages had difficulty. Bear Stearns, founded in 1923 and one of the largest global investment banks and securities trading and brokerage firms, collapsed in early 2008 because of the sub-prime mortgage crisis and was sold to JP Morgan Chase for as low as ten dollars per share, a price far below the 52-week high of $133.20 per share, traded before the crisis. The Federal takeover of Fannie Mae and Freddie Mac in September 2008 cost about $400 billion to the taxpayers. By the first half of 2008, the value of bad loans of Washington Mutual had reached $11.5 billion.[7] Due to its mortgage-related crisis and subsequent withdrawal of $16.4 billion in deposits, during a 10-day bank run in June 2008, Washington Mutual, a hundred year old bank, was seized by FDIC and finally sold to JP Morgan Chase for $1.9 billion in September 2008.

In September, 2008, after the failure of Lehman Brothers and the emergency rescue of AIG, Henry Paulson, the then US Treasury Secretary, warned of an economic calamity greater than the 1930s Great Depression when President Bush and Congressional Democratic leaders agreed to the $700 billion bailout. Government officials have acknowledged difficulties in tracking this $700 billion bailout fund because, apart from providing lending to customers and other banks, banks have leeway to use the money for other things such as buying other banks, paying dividends to investors or even bonuses to executives. Most of this money is being paid to the parties who won the bet on the derivatives. AIG, which had a record $62 billion loss in the last quarter of 2008, received about $170 billion as an emergency loan from the Fed until March 2009 and it paid $75 billion of this loan in the final months of 2008 to several domestic and foreign banks (like Goldman Sachs, Merrill Lynch, Morgan Stanley, Bank of America, Societe Generale and Deutsche Bank, Barclays), as well as to several U.S. municipalities. Most of this money was paid due to the collapse of mortgage-based securities.

Although banks, investment firms and a majority of hedge funds lost huge amounts of money due to the collapse of housing sector and the ensuing stock market collapse, some hedge funds made millions, even billions by betting on the collapse of the housing sector in 2008. For an example John Paulson, a New York hedge fund manager, made $3.7 billion in 2007 by betting on the collapse of mortgage market. George Soros and James Simons made $2.9 billion and $2.8 billion, respectively in 2007. At the beginning of 2007, Paulson’s hedge fund had $6 billion and by the end of December 2007, his fund assets were worth $28 billion. A few years ago, individual income reaching into billions of dollars was unfathomable. In 2002, the first year Alpha Magazine tracked hedge fund compensation; the top 25 managers earned $2.8 billion combined. Hedge funds are pools of private money, largely generated from wealthy individuals, pension funds and endowments, used for a wide range of investments. Usually 80 percent of any gains are given to such investors, while the fund manager takes 20 percent, plus an annual fee for their services.[8] Apart from this, these hedge fund managers claim their incomes as capital gains and pay only 15 percent federal taxes rather than the regular income tax rates, at least twice as high. On the other hand, several states are running out of money in this economic downturn and laying off school teachers and cutting back on essential services.

In short, banks gave home loans to people based on fictitious paper and bank officers as well as investment bankers made hundreds of millions of dollars in salaries and bonuses because of them. Later on common people lost money in shares, but hedge funds made a lot of money bringing down the shares of these banks. Finally it boils down to the fact that everything created a domino effect leading taxpayers to pay trillions of dollars for the bankers’ mis-deeds and exacerbating the economic recession of  the country as well as that of the entire world.

1 Tanneeru, Manav, “How a ‘perfect storm’ led to the economic crisis,” CNN.com, January 1, 2009.

2 Cauchon, Dennis, “Why home values may take decades to recover,” USA Today, December 12, 2008.

3 Goodman, Peter S. and Morgenson, Gretchen, “Saying Yes, WaMu Built Empire on Shaky Loans,” The New York Times, December 27, 2008.

4 Smith, Elliot Blair, “Bringing Down Wall Street as Ratings Let Loose Subprime Scourge,” Bloomberg.com, September 24, 2008.

5 Tse, Tomoeh Murakami and Merle, Renae, “The Bonuses Keep Coming,” Washington Post, January 29, 2008.

6 Story, Louise, “On Wall Street, Bonuses, Not Profits, Were Real,” The New York Times, December 18, 2008.

7 Goodman, Peter S. and Morgenson, Gretchen, “Saying Yes, WaMu Built Empire on Shaky Loans,” The New York Times, December 28, 2008.

8 Cho, David, “1 Man, 1 Year: $3.7 Billion Payout,” Washington Post, April 17, 2008.

Additional information