Risk over Reward

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Causes of the US economic &

financial crisis in 2008
by Alpha and Vega, an Investor and a Trader
September 19th, 2010

In this issue:
1) A difficult question
2) Long-term structural economic problems
3) Short term catalysts for the financial crash
4) Bluto’s revenge in the movie “Animal House”

In this letter we answer the question: “What caused the US economic and financial crisis in
2008?” We look at long-term structural causes and short-term catalysts. This is a longer piece
than most, and we try to present many arguments, data points, and references for further
reading.

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1
1) A difficult question

What caused the US economic and financial crisis in 2008?

Whatever it was, it was enough to cause former Fed Chairman Alan Greenspan, a free-market
disciple of Ayn Rand, to sit in front of a Congressional panel and admit, while squirming in front
of lights and TV cameras: “This crisis has turned out to be much broader than anything I could
have imagined. It has morphed from one gripped by liquidity restraints to one in which fears of
insolvency are now paramount. . . I don‟t know how significant or permanent [the flaw in my
ideology] is. But I‟ve been very distressed by that fact.”1 Greenspan was one of the few
intellectually honest people in admitting his own ignorance and error.

Greenspan Admits Mistakes in 2008

No one has given a cogent, comprehensive answer that is brief and non-technical.
Economists have responded like ducks by sticking their head in the water and blaming one
another, with debates between “saltwater” and “freshwater” economists. 2 Historians point to
disparate episodes and facts like the Great Depression and Asian Crisis of 1998 (while
ignoring the US depression of 1870-1890 and the Japanese balance sheet recession of 1990-
2008).3 Financial experts point to short-term catalysts and trends, like MBS or CDO issuance
and the failure of ABCP or money markets (acronyms are one tool Wall Street uses to screw

1
Edmund Andrews. ―Greenspan Concedes Error on Regulation.‖ NY Times, October 23, 2008,
http://www.nytimes.com/2008/10/24/business/economy/24panel.html.
2
Paul Krugman. ―How Did Economists Get It So Wrong?‖ NY Times, September 2, 2009,
http://www.nytimes.com/2009/09/06/magazine/06Economic-t.html?pagewanted=all.
3
Christina D. Romer. ―Lessons from the Great Depression for Economic Recovery in 2009.‖
Council of Economic Advisers, Speech to the Brookings Institution, Washington, D.C., March 9, 2009
http://www.brookings.edu/~/media/files/events/2009/0309_lessons/0309_lessons_romer.pdf
Adam S. Posen. ―THE REALITIES AND RELEVANCE OF JAPAN‘S GREAT RECESSION
NEITHER RAN NOR RASHOMON.‖STICERD Public Lecture, London School of Economics
24 May 2010, http://www.bankofengland.co.uk/publications/speeches/2010/speech434.pdf.
2
people); but these experts ignore the big picture.4 This letter will attempt an explanation for
what caused the 2008 crisis in the US while acknowledging its global context. I shall also link
the insight that numerous thinkers and writers have brought to the issue and try to frame a
robust answer. For further reading beyond the books and articles in this letter’s references,
the St. Louis Fed has a nice repository of academic articles about the US financial crisis (and a
first-rate glossary).5

Two types of problems created the crisis. First were deeper, long-term structural problems,
such as:
a) Too much total debt accumulation per person and per unit of GDP from1980-2007
b) Looming structural deficits from Medicare and Social Security (off-balance sheet debt) make the
US even more insolvent
c) Consistent trade deficits powered by the US’s reserve currency status, an undervalued Chinese
yuan, and the resulting decline of the US export and manufacturing bases:
d) A financial industry acting as a giant tax on the US: Too much deregulation of financial markets,
leading to spurious innovation that enriches the financial sector at the expense of consumers
(corporate and retail)
e) A massively inefficient tax code, with too many complex rules and hidden “tax expenditure”
subsidies to wasteful interest groups
f) Resources wasted on two wars (2002-2008) and US military protection for the rest of the world

Most politicians, economists, and the news media personalities have tried to conceal the
structural economic problems of the US rather than honestly deal with them. Within the
structural environment of economic degradation, there came second a group of short-term
catalysts. When these combined, they were toxic and led to a period of financial fragility from
2007 on and a tipping point in September 2008:
a) Low interest rates and weak mortgage regulation: this enables speculation leading to the
mortgage boom and real estate bubble
b) Bad bank balance sheets due to excessive risk-taking and agency costs: Weakening regulation
of large banks causes re-consolidation and dangerous investment bank debt levels
c) Black-box derivatives: The development of a complicated and unstable, even destabilizing,
derivatives market
d) The trader mentality in the US: The short-term price appreciation and momentum mentality of
professional investors versus long-term yield oriented mentality (average holding period for
stocks has fallen from 8-10 years (pre-1960 average) to 4 years (pre-1980 average) to about six
months in 2007. Very few investors left (some VCs and corporate investors).
e) Extreme financial fragility through 2007 into 2008:
 Early signs: Bear Stearns hedge funds blowing up and the implosion of the shadow
banking system (an old fashioned bank run)
 Inflection Point: From Bear Stearns going bankrupt in March 2008 to the failure of insolvent
Fannie/Freddie in early September 2008 – largest financial institutions in the US (maybe
the world) based not on their actual balance sheet, but their guarantee liability for
mortgages (above $5 trillion combined)
 Phase Shift: Failure of insolvent Lehman Brothers and illiquid AIG causes phase shift in
markets in late September 2008

4
Markus K. Brunnermeier. ―Deciphering the Liquidity and Credit Crunch 2007-08.‖ NBER Working Paper No. 14612,
December 2008. http://www.princeton.edu/~markus/research/papers/liquidity_credit_crunch_NBER.pdf
5
Federal Reserve Bank of St. Louis, ―The Financial Crisis.‖ http://timeline.stlouisfed.org/index.cfm?p=articles&ct_id=7

3
2) Long-term structural economic problems

a) Too much total debt accumulation per person and per unit of GDP of
GDP from 1980-2007.
 Too much debt. At its core, this is the problem plaguing the US and much of Western Europe. This
applies to all parts of society: households, corporations, and the government. The entire Western
world went on a debt binge, in good times and bad from 1980 on, as McKinsey documented in an
excellent report in January 2010 titled “Debt and Deleveraging.”6 The best way to measure total
debt is to compare the level of debt with the gross domestic product (GDP) of a country, that is, the
total amount of goods and services a country produces in a year. Basically one can only borrow as
much as one’s “income” can support. So if your income goes up faster than your debts (while both
grow), you’re fine; if you’re debt goes up faster than your income, you’re screwed. By this measure,
most countries went from a debt-to-GDP ratio of 100% to 150% in 1990 to above 300% in 2010.
The actual dollar amounts went up even more. As debts increased and reached a maximal/tipping
point (where no one could borrow any longer), households, companies, and governments put aside
other activities and focused on reducing debt (either by paying it down or defaulting). This naturally
leads to a situation called “debt deflation” by Irving Fisher, an American economist in the 1930s.
o Debt Deflation: As people, companies, and countries focus on paying off debt, there is a
higher demand for cash and less for goods and services, credit, or financial assets. As
interest rates fall and the demand for money is high while the demand for everything
else is low, inflation falls and a country may start to experience deflation (a wide-spread
falling of prices). Deflation, however, increases the “real” value of debt ($100 goes from
buying 50 loaves of bread to 60 loaves of bread). As deflation sets in, debts actually rise
even as people pay down debt (the nominal value of debt may fall, but the real value
rises). This creates a vicious and nasty cycle, causing further deflation and the crashing
of prices of goods and financial assets. This essentially happened in the US from 1930-
1933, as Fisher showed.7 As of August 2010, the US still faces debt deflation. It is the
most important economic fact today, and no economic policymaker has confronted it
head on.
o Overgrown Financial Sector and Too Much Private Debt: In the US, all sectors had
increased debts, but the financial sector had a much faster and greater increase in debt,
as the red chart below shows. The financial sector then created credit, circumventing
the central banks, and leading to artificial GDP growth through more debt. Professor
Steve Keen has a great explanation in his post “What Bernanke doesn’t understand
about inflation.” (August 29, 2010).

6
Charles Roxburgh et al. ―Debt and deleveraging: The global credit bubble and its economic consequences.‖ MGI Special
Report, Jan. 2010,
http://www.mckinsey.com/mgi/reports/freepass_pdfs/debt_and_deleveraging/debt_and_deleveraging_full_report.pdf
7
Irving Fisher. ―The Debt-Deflation Theory of Great Depressions.‖ Econometrica, 1933.
http://fraser.stlouisfed.org/docs/meltzer/fisdeb33.pdf
4
 “Let them eat credit”: When the destitute French peasants turned against the monarchy in 1789,
one reason they were so pissed was the attitude of the royals, such as one princess who saw
starving peasants and said: “Qu‟ils mangent de la brioche.” (Yes, that’s “Let them eat brioche”, a
French pastry, not cake!). Unfortunately, for the average American, their lifestyle is peasant-like
compared to our elite royalty like CEOs, politicians, and hedge fund managers. For example, the
hedge fund manager John Paulson netted over $3 billion in 2008, about 75,000 times the average
household income (one man earned what 75 thousand households could hope to earn). Stagnant
income growth for the median American household from 1978 on, and certainly from 2002 on, led to
borrowing to sustain a lifestyle. By 2008, the richest 1% of Americans had 24% of the national
5
 income (compared to 18% during the Robber Baron days in the early 20th century). Basically, during
the last 30 years the rich got richer but everyone else got poorer (in real, inflation-adjusted dollars).
But what the rich did to fool the poor was to let them borrow money to buy stuff they couldn’t afford.
This worked until the poor literally couldn’t borrow anymore, as their most generous lenders, like
mortgage firms such as Countrywide, went bust. As the core issue behind income stagnation was
lack of education for the bottom quartile of half of American society, politicians didn’t push education
reform and skills growth. Rather, they pushed more unsustainable lending to households.8

 The destruction of the US’s financial good standing and its balance sheet: The US has,
through Congress and the Presidents from 1980 on, taken on ever larger amounts of government
debt in good times and bad times (unlike economic theory which suggests taking on debt in
recessions and paying it off in expansions). What this means is that the US is slowly moving toward
default (which still seems a decade or more off, as the IMF estimates in a politely termed paper
called “Fiscal Space”).9 As a note, governments don’t go bankrupt; they just default on debt and
keep going on. Ronald Reagan destroyed the balance sheet to fight the cold war and cut taxes.
George H.W. Bush (senior) and Bill Clinton repaired it by cutting spending and raising taxes. But
then George W. Bush (junior) inherited from Clinton government fiscal surpluses (when tax revenues
were greater than spending, causing the government to have extra cash) and did two dumb things.
First he cut taxes too much, and second he started two very wasteful wars. (Arguably a third game
changer was the Medicare Prescription Drug Act). There was a major policy shift from government
frugality to wastefulness under Reagan and Bush junior, as the chart below shows. Basically two
Presidents convinced Congress to undo the frugality that 5 previous Presidents built up. Two
monographs from the Peterson Institute cover the topic well: Cline’s “The United States as a Debtor
Nation” and Bergsten’s “The Long-Term International Economic Position of the United States.”

8
Raghuram G. Rajan. ―Let Them Eat Credit. How inequality is at the root of the Great Recession.‖ The New Republic.
August 27, 2010. Timothy Noah. ―The United States of Inequality.‖ Slate, Sept. 8, 2010,
http://www.slate.com/toolbar.aspx?action=print&id=2266025.
9
Jonathan D. Ostry, Atish R. Ghosh, Jun I. Kim, and Mahvash S. Qureshi, ―Fiscal Space,‖ IMF Research,
September 1, 2010, http://www.imf.org/external/pubs/ft/spn/2010/spn1011.pdf.
6
 When the debt to GDP ratio goes somewhere above 200%, eventually a country will default (no one
knows the exact point – it depends on bondholder “confidence”, which Japan had in 2010 but
Greece didn’t). The US is close, as the BIS projects below (best case is the US hits 200%, base
case is 300%) by 2040.10

The scariest thing is that the austerity (ole’ fashioned belt tightenin’) needed to stabilize public debt
levels has never happened in the US. Ever. As the table below shows, the US needs surpluses of

10
Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli, ―The future of public debt: prospects and implications,‖ BIS
Working Papers No. 300, March 2010.
7
 8% for 5 years, 4.3% for 10 years, or 2.4% for 20 years. This has never happened in the last 100
years of US history (when reliable statistics were kept). Hence many smart analysts believe the only
way the US can get out of the debt is outright default (unlikely) or soft default (high inflation). Only
our profligate fellow English-speakers of the UK and Ireland are in a worse situation.

 Not enough saving: The final point of “too much debt” is the corollary of “not enough saving.”
When large populations of people save, it allows investment, which is more productive than
consumption. Higher investment should lead to greater productivity and hence higher wealth
creation or GDP growth. But the US government, through tax policies that encouraged consumption
(low sales taxes) but discouraged investment and saving (high capital gains taxes, along with
dividend and interest taxes) basically did the opposite of responsible governance. Basically the US
government, through the arcane area of tax policy, sold the American people snake oil and told them
it was growth tonic. Like the Great Depression, it took a real crisis in 2008 for the savings rate to
come back up again (leading to debt deflation). Many economists still hail a failed policy model of
“consumption” and “aggregate demand”, as opposed to a more sensible model of “investment”,
“savings,” and “productivity growth.” An asset bubble created the illusion of “wealth”, which the Fed
endorsed in its research and actions, while most Americans were poorer than they were willing to
admit (or adequately save for).11

11
Milt Marquis. ―What's Behind the Low U.S. Personal Saving Rate?‖ FRBSF Economic Letter, 2002-09, March 29, 2002,
http://www.frbsf.org/publications/economics/letter/2002/el2002-09.html.

8
b) Looming structural deficits from Medicare and Social Security (off-
balance sheet debt) make the US even more insolvent
 The US is more insolvent than the official dismal numbers above show: The problem with the
numbers above is that they are too conservative. They don’t count “unofficial liabilities”, that is,
things not counted on the balance sheet. It makes one think of an Abraham Lincoln fable, when the
bearded President asked: “How many legs does a dog have if you count the tail as a leg?” “Four –
because if you count the tail that still doesn’t make it a tail.” Well as one brave economist wrote in
2010: “Based on the CBO‟s data, I calculate a fiscal gap of $202 trillion, which is more than 15
times the official debt. This gargantuan discrepancy between our “official” debt and our actual net
indebtedness isn‟t surprising. It reflects what economists call the labeling problem. Congress has
been very careful over the years to label most of its liabilities “unofficial” to keep them off the books
and far in the future.”12 By IMF estimates, to close the “fiscal gap” on the revenue side, the US
would have to permanently double all taxes (personal, corporate, payroll, FICA, etc.).13

 Medicare and Social Security, along with unfunded pensions at the state level, are killing the
US: Whether one likes or dislikes these socialist programs of government pensions and benefits,
one has to admit that they are insolvent. A string of false promises. While most government
spending may stabilize, Social Security hurts the US balance sheet and Medicare wrecks it. As
Congress’s budget office acknowledge in its recent “The Long-Term Budget Outlook”, health care
kills America.14 Conservatives want to keep high spending (attacking Social Security or Medicare is
an elective death wish) but enact tax cuts. Liberals want to keep high spending and hope
productivity gains or Jesus will save them (without the necessary tax increases necessitated by

12
Laurence Kotlikoff, ―U.S. Is Bankrupt and We Don't Even Know It: Laurence Kotlikoff,‖
Bloomberg, Aug 10, 2010, http://www.bloomberg.com/news/2010-08-11/u-s-is-bankrupt-and-we-don-t-even-know-
commentary-by-laurence-kotlikoff.html
13
Ibid.
14
Congressional Budget Office, ―The Long-Term Budget Outlook‖ June 2010,
http://www.cbo.gov/ftpdocs/115xx/doc11579/06-30-LTBO.pdf.
9
 their generous benefit programs). State public pensions are so underfunded that those liabilities
will cause many states to go bust within 10-20 years, by one estimate.15

15
Joshua D. Rauh. ―Are State Public Pensions Sustainable? Why the Federal Government Should Worry About State Pension
Liabilities‖May 15, 2010. Available at SSRN: http://ssrn.com/abstract=1596679. Robert Novy-Marx, Joshua D. Rauh.
―Public Pension Promises: How Big are They and What are They Worth?‖July 19, 2010. Available at SSRN:
http://ssrn.com/abstract=1352608. Jonathan R. Laing. ―The $2 Trillion Hole,‖ Barrons, March 15, 2010,
http://online.barrons.com/article/SB126843815871861303.html#articleTabs_panel_article%3D1.
10
c) Structural trade deficits powered by the US’s reserve currency status, an
undervalued Chinese yuan, and the resulting decline of the US export and
manufacturing bases:
 The US as a country lived above its means, and foreigners, especially Chinese and Middle
Eastern countries, funded the credit card spree: The US has massive trade deficits where it
imports more from a handful of regions than what it sells; mostly cheap goods from China, oil from
the Middle East, and goods from Japan. Over time, the US has had to sell assets to live above its
means, as Warren Buffett so clearly explains in his essay, “Squanderville versus Thriftville,”16
regarding the consequences of US trade deficits:
 “Our trade deficit has greatly worsened, to the point that our country's "net worth," so to speak,
is now being transferred abroad at an alarming rate. A perpetuation of this transfer will lead to
major trouble. To understand why, take a wildly fanciful trip with me to two isolated, side-by-side
islands of equal size, Squanderville and Thriftville. Land is the only capital asset on these
islands, and their communities are primitive, needing only food and producing only food.
Working eight hours a day, in fact, each inhabitant can produce enough food to sustain himself
or herself. And for a long time that's how things go along. On each island everybody works the
prescribed eight hours a day, which means that each society is self-sufficient. Eventually,
though, the industrious citizens of Thriftville decide to do some serious saving and investing,

16
Warren Buffett. ―Squanderville versus Thriftville,‖ Fortune. October 2003.
11
and they start to work 16 hours a day. In this mode they continue to live off the food they
produce in eight hours of work but begin exporting an equal amount to their one and only
trading outlet, Squanderville. The citizens of Squanderville are ecstatic about this turn of
events, since they can now live their lives free from toil but eat as well as ever. Oh, yes, there's
a quid pro quo -- but to the Squanders, it seems harmless: All that the Thrifts want in exchange
for their food is Squanderbonds (which are denominated, naturally, in Squanderbucks). Over
time Thriftville accumulates an enormous amount of these bonds, which at their core represent
claim checks on the future output of Squanderville. A few pundits in Squanderville smell trouble
coming. They foresee that for the Squanders both to eat and to pay off -- or simply service -- the
debt they're piling up will eventually require them to work more than eight hours a day. But the
residents of Squanderville are in no mood to listen to such doomsaying. Meanwhile, the citizens
of Thriftville begin to get nervous. Just how good, they ask, are the IOUs of a shiftless island?
So the Thrifts change strategy: Though they continue to hold some bonds, they sell most of
them to Squanderville residents for Squanderbucks and use the proceeds to buy Squanderville
land. And eventually the Thrifts own all of Squanderville. At that point, the Squanders are
forced to deal with an ugly equation: They must now not only return to working eight hours a day
in order to eat -- they have nothing left to trade -- but must also work additional hours to service
their debt and pay Thriftville rent on the land so imprudently sold. In effect, Squanderville has
been colonized by purchase rather than conquest. It can be argued, of course, that the present
value of the future production that Squanderville must forever ship to Thriftville only equates to
the production Thriftville initially gave up and that therefore both have received a fair deal. But
since one generation of Squanders gets the free ride and future generations pay in perpetuity
for it, there are -- in economist talk -- some pretty dramatic "intergenerational inequities."”

12
 Global imbalances cause bad turbulence: “Global imbalances” are the structural factors that
cause long-term surpluses and deficits (of both trade and capital) which eventually must reverse.
The countries above the zero line in the graph above from the IMF’s Global Financial Stability
Report17 are lending and exporting, those below are borrowing and importing. Again, it’s mostly the
US, along with OCADC (“other current account deficit countries” like the PIIGS such as Portugal,
Italy, Ireland, Greece, and Spain) who buy costly yet cheap goods from China (CHN+EMA), oil from
the Middle East (OIL), and goods from Japan (DEU+JPN). As the imbalances get bigger, the
surplus countries (“Thriftville”) who loan the US (“Squanderville”) all the money to buy goods on
credit get scared and trigger-happy as Americans get close to the point of default. This causes
edgy behavior and the movement of capital in strange ways (esp. fast moving capital, which
disrupts financial markets). One another point is that these foreign holders want ultra-safe assets,
so they buy US Treasuries and agency-backed mortgage bonds. This lowers interest rates across
the board in the US, and encourages two bubbles, one in real estate (which has been partially
pricked) and the other in government bonds (which gets bigger and more dangerous as of August
2010). Prof. Richard Cooper has a nice discussion of the deeper issues, titled “Understanding
Global Imbalances.”18

 Battle of two currencies - The US Dollar (USD) versus the Chinese Yuan (CNY): For most
outsiders this is a strange technical debate. Yet it has important implications. Paul Krugman gave
the simplest explanation:
 “China has become a major financial and trade power. But it doesn‟t act like other big
economies. Instead, it follows a mercantilist policy, keeping its trade surplus artificially high. And
in today‟s depressed world, that policy is, to put it bluntly, predatory. Here‟s how it works: Unlike
the dollar, the euro or the yen, whose values fluctuate freely, China‟s currency is pegged by
official policy at about 6.8 yuan to the dollar. At this exchange rate, Chinese manufacturing has
a large cost advantage over its rivals, leading to huge trade surpluses. Under normal
circumstances, the inflow of dollars from those surpluses would push up the value of China‟s
currency, unless it was offset by private investors heading the other way. And private investors
are trying to get into China, not out of it. But China‟s government restricts capital inflows, even
as it buys up dollars and parks them abroad, adding to a $2 trillion-plus hoard of foreign
exchange reserves. This policy is good for China‟s export-oriented state-industrial complex, not
so good for Chinese consumers. But what about the rest of us?. . . [the] trade surplus drains
much-needed demand away from a depressed world economy. My back-of-the-envelope

17
International Monetary Fund. ―Global Financial Stability Report: Meeting New Challenges to Stability and Building a
Safer System,‖ April 2010, http://www.imf.org/external/pubs/ft/gfsr/2010/01/index.htm.
18
Richard Cooper. ―Understanding Global Imbalances.‖ Federal Reserve Bank of Boston.
http://www.bos.frb.org/economic/conf/conf51/conf51f.pdf
13
 calculations suggest that for the next couple of years Chinese mercantilism may end up
reducing U.S. employment by around 1.4 million jobs.”19
Basically China is using an undervalued currency to preserve local jobs there and keep its
exporters and manufacturers strong; this does the exact opposite by hurting US job growth and the
manufacturing and export base in the US, which cannot compete. One of the few intelligent
analysts of the mercantilist (predatory) trade situation is a former American professor and Wall
Street expert who now teaches in China: Michael Pettis, blogging about “China Financial Markets.”

 The decline of American exports and the US manufacturing base: Conventional economists
could care less about manufacturing; in their mind, service jobs are “just as good.” This is
nonsense. Long-term productivity gains come from manufacturing, which gives a society large
increases in productivity. Services don’t and can’t do this. While high-end services like engineering
and health care can lead to scalable innovation (manufactured goods like search engines,
smartphones, MRI scanners, and biotech treatments), manufacturing itself is key. It gives scale in
such a way that services cannot (giving haircuts or treating psychiatric patients is just as time-
consuming and resource intensive today as it was 100 years ago). Just as the US loses this
capability, the core of its real economy, China takes over. Or as former Intel CEO Andy Grove
opined:
 “Today, manufacturing employment in the U.S. computer industry is about 166,000 -- lower than
it was before the first personal computer, the MITS Altair 2800, was assembled in 1975.
Meanwhile, a very effective computer-manufacturing industry has emerged in Asia, employing
about 1.5 million workers -- factory employees, engineers and managers. The largest of these
companies is Hon Hai Precision Industry Co., also known as Foxconn. The company has grown
at an astounding rate, first in Taiwan and later in China. Its revenue last year was $62 billion,
larger than Apple Inc., Microsoft Corp., Dell Inc. or Intel. Foxconn employs more than 800,000
people, more than the combined worldwide head count of Apple, Dell, Microsoft, Hewlett-
Packard Co., Intel and Sony Corp.”20

19
Paul Krugman, ―Chinese New Year,‖ NY Times, December 31, 2009,
http://www.nytimes.com/2010/01/01/opinion/01krugman.html.
20
Andy Grove. ―How to Make an American Job Before It's Too Late: Andy Grove‖, Bloomberg, Jul 1, 2010,
http://www.bloomberg.com/news/2010-07-01/how-to-make-an-american-job-before-it-s-too-late-andy-grove.html.
14
d) A financial industry acting as a giant tax on the US:
 Too much deregulation of financial markets, leading to spurious innovation that enriched the
financial sector at the expense of consumers (corporate and retail): The US financial industry
got too big for its britches. It started sucking up a large portion of the US GDP pie while giving little
in return. Banks essentially found a back door way to tax the entire country and then live on the
high hog. The interaction between the financial industry and the economy are complex. As
Thomas Philippon of NYU’s business school opines: “Economic growth in the 1960s was
outstanding, but seemed to require little financial intermediation. Finance grew quickly in the 1980s
while the economy stagnated, and the pattern changed again in the 1990s. So it is certainly not
true that a large financial sector is required for sustained economic growth (see the 1960s).”21 The
financial industry took 1.5% of US GDP in the 19th century, went to a 1920s bubble high of about
6%, and then dropped till the end of World War II. It stabilized at around 4% for two decades, and
then starting in the 1980s (right when the national debt binge began!), it rose to about 8% in 2006,
twice the previous norm. However besides debt and high fees, the financial industry gave the US
nothing – it was just a big transaction tax (economists call people who get something for nothing
“rent seekers”, and often point to lawyers, bankers, and politicians as examples). While the costs of
offering a basic depository account or stock brokerage service has dropped, Wall Street has fought
to keep fees high (bank fees for overdrafts and investment bank fee levels for IPOs haven’t
changed in decades, though they are much cheaper to provide – greater profits for bankers).

 Innovation to avoid regulation: As one of the savviest financial analysts, Martin Wolf of the FT
stated in June 2009: [A]n enormous part of what banks did in the early part of this decade – the off-
balance-sheet vehicles, the derivatives and the 'shadow banking system' itself – was to find a way
round regulation.”22 More later on spurious innovations like derivatives.

 The finance industry hasn’t innovated for decades: Wall Street’s lobbyists like to point to
derivative innovations as benefiting the US. That’s hooey. The innovations have benefitted Wall

21
Thomas Philippon, ―The future of the financial industry,‖ Stern on Finance Blog, October 16, 2008,
http://sternfinance.blogspot.com/2008/10/future-of-financial-industry-thomas.html.
22
"FT Martin Wolf - Reform of Regulation and Incentives". Financial Times. June 23, 2009.
http://www.ft.com/cms/s/0/095722f6-6028-11de-a09b-00144feabdc0.html.
15
 Street as a very effective tax on the US, but they haven’t actually benefited the real US economy
(they’ve hurt it through financial houses of cards crashing down). As Paul Volcker stated (only half-
jokingly) in 2009, the last real financial innovation in the US was the ATM. This was first used in
Tokyo in 1966 and spread through the US by Citibank in the 1970s. Previously the credit card was
another innovation. More recent, genuine innovations include PayPal (secure online payments),
Amazon’s “Buy it Now” (fast, “one-click” online payments), and Square (smart phone payments to
credit cards); all are from Silicon Valley and not Wall Street.

 The US’s top talent is going to Wall Street instead of manufacturing and other fields: The
worst thing is that Wall Street is picking off America’s top talent, graduates of its best schools and
programs, to join this rent-seeking machine, instead of going to jobs and industries which actually
produce things. Even worse is that math, science, and engineering PhDs flocked there for the quick
buck (building credit and trading models they didn’t understand which helped cause the crash).23
Paul Volcker, a former Fed Chairman, relates his disappointment in a speech:
 “One of the saddest days of my life was when my grandson – and he‟s a particularly brilliant
grandson – went to college. He was good at mathematics. And after he had been at college for
a year or two I asked him what he wanted to do when he grew up. He said, „I want to be a
financial engineer.‟ My heart sank. Why was he going to waste his life on this profession? A
year or so ago, my daughter had seen something in the paper, some disparaging remarks I had
made about financial engineering. She sent it to my grandson, who normally didn‟t communicate
with me very much. He sent me an email, „Grandpa, don‟t blame it on us! We were just following
the orders we were getting from our bosses‟ The only thing I could do was send him back an
email, „I will not accept the Nuremberg excuse.‟”24

e) A massively inefficient tax code, with too complex rules and hidden “tax
expenditure” subsidies
 The US tax code is horribly inefficient, and so creates a second level of taxes that no one
benefits from: According to one GAO study in 2005, the US tax code has an annual individual and
corporate compliance cost of $107 billion. So if the US government collects $2.5 trillion every year, it
forces the American populace to lose a hundred billion on figuring out how to comply, and hiring tax
accountants and lawyers. The economic efficiency costs could be higher, but are harder to
measure.25

 Tax giveaways to subsidize interest groups, that is, distortionary credits and deductions
called “tax expenditures”, deprive the US government of revenues and shift the burden of
taxation on unfavored groups: As Marty Feldstein of Harvard points out, tax expenditures fell from
9% of US GDP in the 1980s to 6% today. The biggest ones, like corporate interest deductions, the
mortgage interest deduction, and the deduction for local property taxes, all contributed to the
financial crisis by favoring debt structures and not outright equity ownership.26
23
Ezra Klein. ―Why do Harvard kids head to Wall Street? An interview with an ex-Wall Street recruit.‖ Wa. Post Blog,
April 23, 2010, http://voices.washingtonpost.com/ezra-klein/2010/04/why_do_harvard_kids_head_to_wa.html.
24
Kelly McParland. ―Paul Volcker: The banking world needs more Canadas.‖ National Post, Feb. 17, 2009,
http://network.nationalpost.com/np/blogs/fullcomment/archive/2009/02/17/paul-volcker-the-banking-world-needs-more-
canadas.aspx.
25
Government Accountability Office, ―Summary of Estimates of the Costs of the Federal Tax System‖, August 2005,
http://www.gao.gov/new.items/d05878.pdf.
26
Marty Feldstein, ―The 'Tax Expenditure' Solution for Our National Debt,‖ WSJ, July 20, 2010,
http://online.wsj.com/article/SB10001424052748704518904575365450087744876.html.
16
f) Resources wasted on two wars (2002-2008) and US military protection for
the rest of the world
 The Iraq and Afghanistan wars from 2002-2010 were an economic sinkhole: As of May 2010,
the book value costs of both wars was $620 billion for Iraq and $190 billion for Afghanistan.
However, the CBO estimates that by 2017 the total cost of the Iraq war (including veteran health
care costs and other indirect costs) will be $2.4 trillion. At that level, Afghanistan’s costs could be
estimated at above $700 billion, for a total cost of both wars above $3.1 trillion dollars. One low-
end Congressional Research Service estimate in July 2010 put the total cost at $1.3 trillion.
Imagine any US politician asking for an anti-stimulus that was more than 1.3 to 3 times the size of
the 2009 stimulus package (“My fellow Americans, let’s de-stimulate and weaken our country with a
blow to our economy three times stronger than the positive stimulus shot we took in 2009! After all,
there’s a band of a few hundred terrorists in Torah Borah we need to kill or capture.”). Many
mainstream economists don’t like to acknowledge that there is a direct connection between the US
military action, with its resulting fiscal irresponsibility, and the financial and economic crisis in
2008.27

 The US provides security to the rest of the world, a “peace dividend”, at huge cost to itself:
The US military has between 700 to 800 bases or installations worldwide, in 156 countries. The
military sucks away $400 billion to $620 billion a year to keep up military, of which about $102
billion goes toward running its network of overseas bases. Some of this cost overlaps with the wars
mentioned above, but much is structural and independent. So while the US provides security to
many regions of the world, and just wastes resources in other regions (227 bases in Germany), it
has little to show for it economically at home (besides promises from foreign policy hawks about
“global stability”, while they sit at think tanks and defense companies benefitting from this
spending).28 One problem with this argument is that the counterfactual is hard to show; if the US
pulled all its bases, would nothing happen? Or would destabilizing oil wars break out and disrupt
the world and US economy by much more than $100bn per year? It’s difficult to know.

27
Amy Belasco. ―The Cost of Iraq, Afghanistan, and Other Global War on Terror Operations Since 9/11,‖
Congressional Research Service, July 16, 2010, http://www.fas.org/sgp/crs/natsec/RL33110.pdf. ―U.S. CBO estimates $2.4
trillion long-term war costs,‖ Reuters, Oct. 24, 2007,
http://www.reuters.com/article/politicsNews/idUSN2450753720071024. Richard Wolf, ―Afghan war costs now outpace
Iraq's‖, USA Today, May 13, 2010, http://www.usatoday.com/news/military/2010-05-12-afghan_N.htm. Vivien Lou Chen
and Thomas Keene. ―Economist Stiglitz Says Iraq War Costs May Reach $5 Trillion.‖ Bloomberg, March 1, 2008,
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=acXcm.yk56Ko. Joseph E. Stiglitz and Linda J. Bilmes. ―The
true cost of the Iraq war: $3 trillion and beyond.‖ Wa. Post, September 5, 2010, http://www.washingtonpost.com/wp-
dyn/content/article/2010/09/03/AR2010090302200.html.
28
David Vine. ―Too Many Overseas Bases,‖ FPIF, February 25, 2009,
http://www.fpif.org/articles/too_many_overseas_bases. Hugh Gusterson. ―Empire of Bases.‖ Bulletin of the Atomic
Scientists, March 10, 2009, http://www.thebulletin.org/web-edition/columnists/hugh-gusterson/empire-of-bases.

17
3) Short term catalysts for the financial crash

a) Low interest rates and weak mortgage regulation: this enabled

speculation leading to the mortgage boom and real estate bubble
 Low interest rates and even lower regulation for mortgages lead to fraud: The mortgage
interest rate for a 30-year conventional mortgage dropped to 30-year lows after 2000 (as all interest
rates dropped). As Americans felt burned by the stock market, they saw arbitrage opportunities in
real estate and started piling in. Companies started offering better and better loan terms till the
infamous “NINJA” loans (“no income, no job, no assets”) were being offered at low teaser interest
rates, and with no principal payments.29 Real estate buy-to-flip schemes based on “home price
appreciation” (HPA) became so common that most mortgage lenders de-emphasized the down
payment (as a security cushion) or a borrower’s history (showing likelihood and ability to repay).
Many economists felt the Fed artificially kept interest rates too low after the 2001 tech bubble burst,
hence sowing the seeds for the next bubble. John Taylor, a Stanford economist, gave the strongest
academic critique and concluded: “The evidence is overwhelming that those low interest rates were
not only unusually low but they logically were a factor in the housing boom and therefore ultimately
the bust.”30 Poor regulation from OFHEO, the FHA, and the Fed contributed to financial
“innovations” that in the end hurt both borrowers (who couldn’t pay) and lenders (who had bad,
defaulted assets underwater). The recklessness of the bubble is captured well in Michael Lewis’s
book “The Big Short.”31 Meanwhile, key officials at the Fed (the primary regulator) failed to
acknowledge and act to stem the bubble and fraudulent lending, dismissing it with “efficient free
market theories.”
 Fed Chairman Greenspan responding to a question after a speech on the bubble in 2005:
“At a minimum, there's a little froth” in the housing market.32 In October 2004 Greenspan
dismissed talk of a housing bubble: “While local economies may experience significant
speculative price imbalances, a national severe price distortion seems most unlikely.” He even
encouraged exotic mortgage products: “American consumers might benefit if lenders provided
greater mortgage product alternatives to the traditional fixed-rate mortgage.”33
 Fed Chairman Bernanke on the bubble refuses to acknowledge the monetary policy role,
even ex-post (after the crisis) in 2010, but does admit to global imbalances and monetary
policy inducing complacency (a long mea culpa and defense, worth reading): “Some
have argued that monetary policy contributed significantly to the bubble in housing prices, which
in turn was a trigger of the crisis. The question is a complex one…The Federal Open Market
Committee brought short-term interest rates to a very low level during and following the 2001
recession, in response to persistent sluggishness in the labor market and what at the time was
perceived as a potential risk of deflation. Those actions were in accord with the FOMC's
mandate from the Congress to promote maximum employment and price stability; indeed, the
labor market recovered from that episode and price stability was maintained.

29
Steven Pearlstein. ―No Money Down' Falls Flat.‖ Wa. Post, March 14, 2007, http://www.washingtonpost.com/wp-
dyn/content/article/2007/03/13/AR2007031301733_pf.html.
30
Steve Matthews. ―Taylor Disputes Bernanke on Bubble, Blaming Low Rates.‖ Bloomberg Businessweek, January 06,
2010, http://www.businessweek.com/news/2010-01-05/taylor-disputes-bernanke-on-bubble-blaming-low-rates-update1-
.html.
31
Michael Lewis. The Big Short: Inside the Doomsday Machine. New York: Norton, 2010.
32
David Leonhardt. ―2005: IN A WORD; FROTHY.‖ NY Times, December 25, 2005,
http://query.nytimes.com/gst/fullpage.html?res=9806E6D81530F936A15751C1A9639C8B63.
33
Paul Krugman. ―Greenspan and the Bubble.‖ NY Times, August 29, 2005,
http://www.nytimes.com/2005/08/29/opinion/29krugman.html.
18
Did the low level of short-term interest rates undertaken for the purposes of
macroeconomic stabilization inadvertently make a significant contribution to the housing
bubble? It is frankly quite difficult to determine the causes of booms and busts in asset
prices; psychological phenomena are no doubt important, as argued by Robert Shiller,
for example. However, studies of the empirical linkage between monetary policy and
house prices have generally found that that that linkage is much weaker than would be
needed to explain the behavior of house prices in terms of FOMC policies during this
period.

Cross-national evidence also does not favor this hypothesis. For example, as documented by
the International Monetary Fund, even though some countries other than the United States had
substantial booms in house prices, there was little correlation across industrial countries
between measures of monetary tightness or ease and changes in house prices.10 For example,
the United Kingdom also experienced a major boom and bust in house prices during the 2000s,
but the Bank of England's policy rate went below 4 percent for only a few months in 2003. The
evidence is more consistent with a view that the run-up in house prices primarily represented a
feedback loop between optimism regarding house prices and developments in the mortgage
market.

In mortgage markets, a combination of financial innovations and the vulnerabilities I mentioned

earlier led to the extension of mortgages on increasingly easy terms to less-qualified borrowers,
driving up the effective demand for housing and raising prices. Rising prices in turn further
fueled optimism about the housing market and further increased the willingness of lenders to
further weaken mortgage terms. Importantly, innovations in mortgage lending and the easing of
standards had far greater effects on borrowers' monthly payments and housing affordability than
did changes in monetary policy.

The high rate of foreign investment in the United States also likely played a role in the
housing boom. For many years, the United States has run large trade deficits while some
emerging-market economies, notably some Asian nations and some oil producers, have
run large trade surpluses. Such a trade pattern is necessarily coupled with financial
flows from the surplus to the deficit countries. International investment position statistics
show that the excess savings of Asian nations have predominantly been put into U.S.
government and agency debt and mortgage-backed securities, which would tend to lower real
long-term interest rates, including mortgage rates. In international comparisons, there appears
to be a strong connection between house price booms and significant capital inflows, in contrast
to the aforementioned weak relationship found between monetary policy and house prices.
International investment position statistics show that the United States also received significant
capital inflows from Europe in the years before the crisis. Europe's trade has been about
balanced over the past decade or so, implying no large net capital flows on average. However,
substantial gross flows occurred in the years running up to the crisis. Notably, European
institutions issued large amounts of debt in the United States, using the proceeds to buy private-
sector debt, including securitized products. On balance, the effect of these sales and purchases
on Europe's capital account balance approximately netted out, but the combination led to
growing European exposures to the kind of distress in U.S. private-sector debt markets that
occurred during the crisis. The strength of the demand for U.S. private structured debt products
by European and other foreign investors likely helped to maintain downward pressure on U.S.
credit spreads, thereby reducing the costs that risky borrowers paid and thus, all else being
equal, increasing their demand for loans.

Even if monetary policy was not a principal cause of the housing bubble, some have
argued that the Fed could have stopped the bubble at an earlier stage by more-
19
 aggressive interest rate increases. For several reasons, this was not a practical policy option.
First, in 2003 or so, when the policy rate was at its lowest level, there was little agreement about
whether the increase in housing prices was a bubble or not (or, a popular hypothesis, that there
was a bubble but that it was restricted to certain parts of the country). Second, and more
important, monetary policy is a blunt tool; raising the general level of interest rates to manage a
single asset price would undoubtedly have had large side effects on other assets and sectors of
the economy. In this case, to significantly affect monthly payments and other measures of
housing affordability, the FOMC likely would have had to increase interest rates quite sharply, at
a time when the recovery was viewed as "jobless" and deflation was perceived as a threat. A
different line of argument holds that, by contributing to the long period of relatively
placid economic and financial conditions sometimes known as the Great Moderation,
monetary policy helped induce excessive complacency and insufficient attention to risk.
Even though the two decades before the recent crisis included two recessions and
several financial crises, including the bursting of the dot-com bubble, there may be some
truth to this claim. However, it hardly follows that, in order to reduce risk-taking in financial
markets, the Federal Reserve should impose the costs of instability on the entire
economy.”34[Emphasis added]

 Fraud levels were high and the regulators did little to nothing: One strange element of the
boom was that front-line lenders encouraged fraud, as they could re-sell loans into securitization
pools and make big fees. The end investors who did little or no diligence would end up holding the
bag. The FBI’s mortgage fraud statistics tell a story of unchecked fraud, and its numbers can be
checked with the Mortgage Asset Research Institute. It was no coincidence that the states with the
largest real estate bubble had the most fraud, as the chart below from the FBI’s 2009 Mortgage
Fraud Report shows.35 This was simple white collar crime at the basic level, but on a massive

34
Chairman Ben S. Bernanke. ―Causes of the Recent Financial and Economic Crisis.‖ Before the Financial Crisis Inquiry
Commission, Washington, D.C., September 2, 2010,
http://www.federalreserve.gov/newsevents/testimony/bernanke20100902a.htm.
35
Federal Bureau of Investigation. ―2009 Mortgage Fraud Report ‗Year in Review.‘‖
http://www.fbi.gov/publications/fraud/mortgage_fraud09.htm.
20
 scale, including brokerage, lender, escrow, title, and appraisal offices. One great study looked at
interview data with originators and examined the problem.36

b) Bad bank balance sheets due to excessive risk-taking and agency costs:
Weakening regulation of large banks causes re-consolidation and
dangerous investment bank debt levels

 Banks took too much poor risk and failed: Big “money center banks” at the center of the US
financial system, like Bank of America, Merrill Lynch, Morgan Stanley, Goldman Sachs, etc. took
too much risk and basically imploded with too many bad debts (and too much short-term funding).
The US government (under both Bush and Obama), decided to bail out the banks with direct funds
(TARP monies and asset purchase programs) and indirect subsidies (low interest rates and capital
loosening requirements) – one estimate put the total loans and guarantees to banks at $12.8
trillion.37
 From 2004 to 2007, the top five US investment banks each significantly increased their financial
leverage and so susceptibility to a financial shock. These five institutions reported over $4.1
trillion in debt for fiscal year 2007, about 30% of US nominal GDP for 2007. Lehman Brothers
was liquidated (after failing to receive aid), Bear Stearns and Merrill Lynch were sold at fire-sale
prices, and Goldman Sachs and Morgan Stanley became commercial banks, subjecting
themselves to more stringent regulation. All the banks required or received government support.
Accounting companies helped most banks hid their true leverage levels. Finally, some research
suggests both bank management and even shareholders had an incentive to take excessive
risks (with bondholders or US taxpayers picking up the final tab).38 This is knows as an agency

36
T. H. Nguyen. and H. N. Pontell. ―Mortgage origination fraud and the global economic crisis.‖ Criminology & Public
Policy, 9: 591–612, 2010.
37
Mark Pittman and Bob Ivry. ―Financial Rescue Nears GDP as Pledges Top $12.8 Trillion.‖ Bloomberg, March 31, 2009,
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=armOzfkwtCA4.
38
Michael J. de la Merced and Julia Werdigier. ―The Origins of Lehman‘s ‗Repo 105‘.‖ NY Times Dealbook, March 12,
2010, http://dealbook.blogs.nytimes.com/2010/03/12/the-british-origins-of-lehmans-accounting-gimmick/. Justin Fox.
21
 cost, when those in charge of resources (bank management) do what’s in their personal interest
(big bonuses, perks) and not what the resource owners (depositors, taxpayers) want.

 Two key types of regulation were instrumental to the failures: First, in November 1999,
Congress under Bill Clinton repealed the Glass-Steagall Act of 1933, which prohibited risky and
reckless investment banks (which issue and trade securities and derivatives) from joining with
stodgy commercial and retail banks (which take deposits and make loans). The Glass-Steagall
law was enacted after the 1929-1933 depression experience showed that financial risk-takers
shouldn’t be able to loot the deposits of stable “utility” or “narrow” banks, where depositors just
want their money to be safe, but don’t have the sophistication to watch it and monitor the bank.39
Second, in 2004 the SEC relaxed the “net capital rule,” allowing investment banks to take on a lot
more debt and get to a dangerous place (Bear Stearns, Lehman Brothers, Merrill Lynch, and
Morgan Stanley loaded debt up to leverage ratios near 30x).40 A former SEC official has testified
that the changing of this arcane rule allowed large broker-dealer banks to more than double their
leverage.41 This led to three of them, Bear Stearns, Lehman Brothers, and Merrill Lynch, failing
within a short period and triggering the acute part of the crisis. To add insult to injury, many banks
secretly lowered the leverage ratio and hid debt using repo transactions.42

―Banks Took Big Risks Because Shareholders Wanted Them To.‖ Harvard Business Review Blog, June 8, 2010,
http://blogs.hbr.org/fox/2010/06/maybe-shareholders-were-to-bla.html.
39
Joseph E Stiglitz. "Stiglitz-Capitalist Fools". Vanityfair.com. October 20,
2009http://www.vanityfair.com/magazine/2009/01/stiglitz200901. Retrieved May 1, 2010.
40
Stephen Labaton. "SEC Concedes Oversight Flaws". New York Times, September 27, 2008.
http://www.nytimes.com/2008/09/27/business/27sec.html?em. Retrieved May 2, 2010. Labaton, Stephen (October 3, 2008).
"The Reckoning". The New York Times. http://www.nytimes.com/2008/10/03/business/03sec.html?em. Retrieved May 2,
2010.
41
Julie Satow. ―Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers.‖ NY Sun, Sept. 18, 2008,
http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130/.
42
Alistair Barr. ―Do other firms use Lehman's accounting 'drug'?‖ CBS Marketwatch, March 12, 2010,
http://www.marketwatch.com/story/do-other-firms-use-lehmans-accounting-drug-2010-03-12.
22
c) Black-box derivatives: The development of a complicated and unstable,
even destabilizing, derivatives market
 Explaining derivatives (theory): A derivative is a security that tracks another asset, like a
primary security or hard asset. Futures track the prices of standardized lots of commodities.
Options can track the price of stocks, or credit default swaps (a type of standardized insurance
contract protecting against default) can track the price of bonds. Derivatives in theory help to
make financial markets more “efficient” and “complete.” Completeness means more types of
transactions can be done by cutting risk and securities into finer slices, and efficient because
presumably the real world of business needs a more “complete” set of investment options to run
effectively. This is the standard finance theory espoused, for example, in the first two chapters of
the textbook “Options, Futures, & Other Derivatives” by John Hull.43 And it’s true that derivatives
are neutral tools that can be helpful or hurtful. Yet many academics don’t honestly assess the
risks. One notable academic view is that “derivatives contracts that offer no real hedging value to
any side are unlikely to be successful on a larger and longer, at least as long as people learn.”44
Unfortunately, this is incorrect as it fails to take into account behavioral biases, not to mention
stupid and irrational investors. The same academic notes: “Derivatives (& securitization) may be
one of the major reasons why the securities sector grew in size roughly ten times more than any
other sector.”45 (Translation: The large tax of the financial industry would be lesser without an
active derivatives market).

 Derivatives in practice are abused and dangerous: In practice Wall Street has used derivatives
for two reasons. First, to help entities lever up (get much more debt) than they normally could, and
also hide the debt. Second, to help entities avoid government regulations made to protect the
entity, a consumer, or the integrity of the markets themselves. Two excellent account by scholar-
practitioners on the abuse of derivatives show the actual ways Wall Street uses derivatives. The
first is Frank Partnoy’s “FIASCO: Blood in the Water on Wall Street” (one of the best books on the
dangers of Wall Street and who the suckers at the table are). His basic point is that derivatives are
sold more to cheaters (like Greece), and less to widows and orphans.46 The second excellent
account is Janet Tavakoli’s “Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall
Street.” As Portnoy states:
 Without derivatives, leveraged bets on subprime mortgage loans could not have spread so far
or so fast. Without derivatives, the complex risks that destroyed Bear Stearns, Lehman
Brothers, and Merrill Lynch, and decimated dozens of banks and insurance companies,
including AIG, could not have been hidden from view. Without derivatives, a handful of financial
wizards could not have gunned down major mutual funds and pension funds, and then pulled
the trigger on their own institutions. Derivatives were the key; they enabled Wall Street to
maintain its destructive run until it was too late. Read his full account here: Portnoy on
“derivative dangers.”47

43
John Hull. Options, Futures, & Other Derivatives. New York: Prentice Hall, 2007.
44
Jean–Pierre Zigrand. ―An Economist‘s View on Derivatives and Financial Stability.‖ Presented at the Conference on
DERIVATIVES IN CRISIS: SAFEGUARDING FINANCIAL STABILITY Organised by the European Commission‘s DG
Internal Markets and Services. September 25, 2009, http://ec.europa.eu/internal_market/financial-
markets/docs/derivatives/conference092009/zigrand_en.pdf.
45
Ibid.
46
―World According to Frank Partnoy.‖ Derivatives Strategy, Nov. 1997,
http://www.derivativesstrategy.com/magazine/archive/1997/1197fea6.asp.
47
Frank Partnoy. ―Derivative Dangers.‖ NPR, Sept. 7, 2010.
http://www.npr.org/templates/story/story.php?storyId=102325715.
23
  Derivatives are profitable for their peddlers: Derivatives are also one of the most profitable
lines of business of Wall Street. The CEO of JP Morgan estimated in 2010 that derivatives reform
would cost his company $700 million to $2 billion annually in revenues.48

 The world’s best investors consider derivatives dangers “weapons of mass destruction”:
Warren Buffett and George Soros are considered among the world’s best investors. Both have
used derivatives and find them to be dangerous (theoretically useful, but dangerous in actual use).
Soros has called for banning one major type of derivatives, credit default swaps, as toxic and
dangerous instruments of death. His analogy was that “It's like buying life insurance on someone
else's life and owning a license to kill.”49 Buffett has a longer, yet equally interesting perspective,
which he relates in his 2002 annual report (I excerpt the entire section because it’s excellent):
 Charlie and I are of one mind in how we feel about derivatives and the trading activities that go
with them: We view them as time bombs, both for the parties that deal in them and the
economic system. Having delivered that thought, which I‟ll get back to, let me retreat to
explaining derivatives, though the explanation must be general because the word covers an
extraordinarily wide range of financial contracts.

Essentially, these instruments call for money to change hands at some future date, with the
amount to be determined by one or more reference items, such as interest rates, stock prices or
currency values. If, for example, you are either long or short an S&P 500 futures contract, you
are a party to a very simple derivatives transaction – with your gain or loss derived from
movements in the index. Derivatives contracts are of varying duration (running sometimes to 20
or more years) and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends
on the creditworthiness of the counterparties to them. In the meantime, though, before a
contract is settled, the counterparties record profits and losses – often huge in amount – in their
current earnings statements without so much as a penny changing hands.

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it
seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be
settled many years in the future, were put on the books. Or say you want to write a contract
speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you
will easily find an obliging counterparty.

When we purchased Gen Re, it came with General Re Securities, a derivatives dealer that
Charlie and I didn‟t want, judging it to be dangerous. We failed in our attempts to sell the
operation, however, and are now terminating it. But closing down a derivatives business is
easier said than done. It will be a great many years before we are totally out of this operation
(though we reduce our exposure daily). In fact, the reinsurance and derivatives businesses are
similar: Like Hell, both are easy to enter and almost impossible to exit. In either industry, once
you write a contract – which may require a large payment decades later – you are usually stuck
with it. True, there are methods by which the risk can be laid off with others. But most strategies
of that kind leave you with residual liability.

Another commonality of reinsurance and derivatives is that both generate reported earnings that
are often wildly overstated. That‟s true because today‟s earnings are in a significant way based
on estimates whose inaccuracy may not be exposed for many years. Errors will usually be

48
Michael Scherer. ―The Trader's View On Derivatives Reform.‖ Time (Swampland Blog), May 6, 2010,
http://swampland.blogs.time.com/2010/05/06/the-traders-view-on-derivatives-reform/#ixzz0yskPP0Fi.
49
Alan Wheatley. ―UPDATE 1-Ban CDS as "instruments of destruction" – Soros, Reuters, June 12, 2009,
http://www.reuters.com/article/idUSPEK34367320090612.
24
honest, reflecting only the human tendency to take an optimistic view of one‟s commitments.

But the parties to derivatives also have enormous incentives to cheat in accounting for them.
Those who trade derivatives are usually paid (in whole or part) on “earnings” calculated by
mark-to-market accounting. But often there is no real market (think about our contract involving
twins) and “mark-to-model” is utilized. This substitution can bring on large-scale mischief. As a
general rule, contracts involving multiple reference items and distant settlement dates increase
the opportunities for counterparties to use fanciful assumptions. In the twins scenario, for
example, the two parties to the contract might well use differing models allowing both to show
substantial profits for many years. In extreme cases, mark-to-model degenerates into what I
would call mark-to-myth.

Of course, both internal and outside auditors review the numbers, but that‟s no easy job. For
example, General Re Securities at yearend (after ten months of winding down its operation) had
14,384 contracts outstanding, involving 672 counterparties around the world. Each contract had
a plus or minus value derived from one or more reference items, including some of mind-
boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have
widely varying opinions. The valuation problem is far from academic: In recent years, some
huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and
electric utility sectors, for example, companies used derivatives and trading activities to report
great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related
receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly
“mark-to-myth.”

I can assure you that the marking errors in the derivatives business have not been symmetrical.
Almost invariably, they have favored either the trader who was eyeing a multi-million dollar
bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were
paid, and the CEO profited from his options. Only much later did shareholders learn that the
reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run
into for completely unrelated reasons. This pile-on effect occurs because many derivatives
contracts require that a company suffering a credit downgrade immediately supply collateral to
counterparties. Imagine, then, that a company is downgraded because of general adversity and
that its derivatives instantly kick in with their requirement, imposing an unexpected and
enormous demand for cash collateral on the company. The need to meet this demand can then
throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades.
It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that
layoff much of their business with others. In both cases, huge receivables from many
counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of
receivables, though we‟ve been in a liquidation mode for nearly a year.) A participant may see
himself as prudent, believing his large credit exposures to be diversified and therefore not
dangerous. Under certain circumstances, though, an exogenous event that causes the
receivable from Company A to go bad will also affect those from Companies B through Z.
History teaches us that a crisis often causes problems to correlate in a manner undreamed of in
more tranquil times.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of
the Federal Reserve System. Before the Fed was established, the failure of weak banks would
sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing
them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is
25
 no central bank assigned to the job of preventing the dominoes toppling in insurance or
derivatives. In these industries, firms that are fundamentally solid can become troubled simply
because of the travails of other firms further down the chain.

When a “chain reaction” threat exists within an industry, it pays to minimize links of any kind.
That‟s how we conduct our reinsurance business, and it‟s one reason we are exiting derivatives.
Many people argue that derivatives reduce systemic problems, in that participants who can‟t
bear certain risks are able to transfer them to stronger hands. These people believe that
derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual
participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I
sometimes engage in large-scale derivatives transactions in order to facilitate certain investment
strategies.

Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large
amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few
derivatives dealers, who in addition trade extensively with one other. The troubles of one could
quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer
counterparties. Some of these counterparties, as I‟ve mentioned, are linked in ways that could
cause them to contemporaneously run into a problem because of a single event (such as the
implosion of the telecom industry or the precipitous decline in the value of merchant power
projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems. . . .
[Buffett‟s 2002 prediction ended up being spot on, as derivatives caused the world‟s largest
insurance company, AIG, to go under in September 2008, imperiling the global financial system]

One of the derivatives instruments that LTCM [a hedge fund failure run by Nobel Laureates]
used was total-return swaps, contracts that facilitate 100% leverage in various markets,
including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for
the purchase of a stock while Party B, without putting up any capital, agrees that at a future date
it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of
derivatives severely curtail the ability of regulators to curb leverage and generally get their arms
around the risk profiles of banks, insurers and other financial institutions. Similarly, even
experienced investors and analysts encounter major problems in analyzing the financial
condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish
reading the long footnotes detailing the derivatives activities of major banks, the only thing we
understand is that we don‟t understand how much risk the institution is running.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly
multiply in variety and number until some event makes their toxicity clear. Knowledge of how
dangerous they are has already permeated the electricity and gas businesses, in which the
eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere,
however, the derivatives business continues to expand unchecked. Central banks and
governments have so far found no effective way to control, or even monitor, the risks posed by
these contracts.50

50
Warren E. Buffett. ―Chairman‘s Letter 2002.‖ Berkshire Hathaway Annual Report, 2002,
http://www.berkshirehathaway.com/letters/2002pdf.pdf.
26
d) Trader mentality in the US:

 After 1990 investors stopped investing; rather they traded and speculated: Ben Graham,
the dean of security analysis, once compared investment to speculation: “An investment operation
is one which, upon thorough analysis, promises safety of principal and an adequate return.
Operations not meeting these requirements are speculative.”51 I would argue that another
distinction comes from the time period and intentionality of the investor. An investor seeks returns
from the asset itself based on what the asset yields over a period of time. The analogy is a farmer
who buys land to make money from the fruit of the land and the farming operations, not from
flipping the farm for more cash in 6 months. A speculator or trader seeks returns from selling the
asset at a higher price in the near future to another buyer. The analogy is a man at the market
who buys wheat at one stand and then sells it to another down the alley for a higher price.
Investors want the asset to fructify and reward them; traders want momentum or volatility to boost
them. Unfortunately, the short-term price appreciation and momentum mentality of most
professional “investors” today makes them speculators, not real investors. The average holding
period for stocks has fallen from 8-10 years (pre-1960 average) to 4 years (pre-1980 average). It
peaked at under 3 years in 1990 and has fallen to about six months in 2009. There are very few
true investors left; some venture capitalists and corporate M&A departments would fall into that
category.

 Asymmetric incentives for “investors” (speculators), bank heads, and corporate

managers: As mentioned above, the focus on “liquidity creation” and not long-term investment
encourages a short-term mentality. Also incentive contracts for corporate management are too
often based on short-erm price appreciation or easy-to-manipulate earnings numbers and not true
long-term variables (free cash flow growth, cash balances, etc.).

51
Benjamin Graham. The Intelligent Investor, 4 ed.. New York: Wiley, 2003, Chapter 1, page 18.
27
e) Extreme financial fragility through 2007 into 2008:
 First act of the financial crisis had three scenes: The first act of the financial crisis in the US
had three phases. Scene one began with investor doubt about subprime mortgages and a return
to optimism. Scene two commenced when investor doubt spread regarding larger areas of debt
(all mortgage debt, and possibly other asset classes) leading to uneasiness leading to a massive
failure but an unwillingness to accept the logical consequences. Scene three proceeded with
failure, capitulation, and fear (all asset classes expect high-grade government bonds crashed). A
financial system is fragile if a small shock has a large effect, such as volatile prices and negative
feedback loops. As the structural causes above lead to economic and financial fragility, the actual
triggers of the crisis below caused a phase shift.52

 Scene One, A Minsky Moment and the Failure of the Shadow Banking System (January
2007 to February 2008): A hiccup in the subprime mortgage market in January 2007 spooked
savvy traders. This eventually led to a Minsky moment in June 2007, when two Bear Stearns
hedge funds trading subprime assets failed, or alternatively in August 2007 (August 9th, some
would say), when the shadow banking system started to implode (causing an old-time bank run
witnessed by people in the securities markets but not most observers).
o A Minsky moment: This is a point in time in which investors who have borrowed too
much are forced to sell even good assets to pay back their loans. While they may be
asset rich, they have cash flow problems due to spiraling debt they have incurred in
order to finance speculative investments. At this point, a major selloff begins. No
counterparty can be found to bid at the high asking prices previously quoted, leading to a
sudden and precipitous collapse in market clearing asset prices and a sharp drop in
market liquidity. Exotic MBS, CDO, and ABS were at the core of the Shadow Banking
System; these securities hit a peak in August 2007.53
o The Shadow Banking System: This was a parallel, unregulated, global banking
system, with debts, loans, and deposits that were structured in a thoughtless way for
short-term profits and long-term losses. Its size fell from over $10 trillion to under $5
trillion from late 2007 to mid-2009.54 The big broker-dealers were active makers in and
participants in the system. Bill Gross and Paul McCulley of Pimco give explanations
here: Gross on “Beware our Shadow Banking System” and McCulley on “After the
Crisis: Planning a New Financial Structure Learning from the Bank of Dad.”55 The best,
detailed explanation of the failure of the Shadow Banking System, a full bank run
happening in the darkness of securities markets, is given by Yale’s Gary Gorton in
“Questions and Answers About the Financial Crisis” and Brunnermeier’s “Deciphering

52
Franklin Allen and Douglas Gale. ―Financial Fragility, Liquidity and Asset Prices.‖ Wharton Financial Inst. Center,
January 23, 2003, http://fic.wharton.upenn.edu/fic/papers/01/0137.pdf.
53
John Cassidy. ―The Minksy Moment.‖ The New Yorker, Feb. 4, 2008. Minsky, Hyman P., ―The Financial Instability
Hypothesis‖ (May 1992). The Jerome Levy Economics Institute Working Paper No. 74. Available at SSRN:
http://ssrn.com/abstract=161024 or doi:10.2139/ssrn.161024
54
Manmohan Singh and James Aitken. ―The (sizable) Role of Rehypothecation in the Shadow Banking System.‖ IMF
Working Paper, July 2010, http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf.
55
Bill Gross. ―Beware our shadow banking system.‖ Fortune, Nov. 28, 2007,
http://money.cnn.com/2007/11/27/news/newsmakers/gross_banking.fortune/. Paul McCulley. ―After the Crisis: Planning a
New Financial Structure Learning from the Bank of Dad.‖ Pimco Global Central Bank Focus, April 15, 2010,
http://www.pimco.com/Pages/Global%20Central%20Bank%20Focus%20May%202010%20After%20the%20Crisis%20Plan
ning%20a%20New%20Financial%20Structure.aspx. Timothy Geithner. ―Reducing Systemic Risk in a Dynamic Financial
System.‖ FRBNY Speech, June 9, 2008, http://www.newyorkfed.org/newsevents/speeches/2008/tfg080609.html.
28
 the Liquidity and Credit Crunch 2007-08” (both papers are highly recommended for
savvier readers).56

 Scene Two, an Inflection Point that Began with Bear Stearns Failing and Ended with
Fannie and Freddie Failing (March 2008-September 2008): The shift from the denial/boom
phase to the “recognition phase” of the problem came with the failure of two key institutions.
First, in March 2008, Bear Stearns effectively failed and was forcibly sold to JP Morgan with the
generous monetary assistance of the Fed ($30 billion). While markets were in denial about the
precarious position of most of the nodes of the banking system, the two largest financial
institutions in the US came closer and closer to failure. By September 2008, the major inflection
point was the failure of Fannie Mae and Freddie Mac (Fannie/Freddie, or the government
sponsored agencies, GSEs).
o Failure of Bear Stearns, the weakest and worst investment bank: Bear Stearns was
always knows as the weakest major investment bank in NYC. It attracted the scrappiest
people and had the lowest profit margins compared to its 4 larger competitors.
Unfortunately, Bear ended up being the first big bank to actually go under in at least two
decades (Drexel Burnham Lambert’s failure in 1990 was the last notable one). It
showed that the US basically had no mechanism to deal with the failure of a systemically
important bank (a major broker-dealer). Darrell Duffie has written an excellent paper on
that topic: “The Failure Mechanics of Dealer Banks.” 57 The actual bailout was crude but
effective; more importantly, it shook the confidence of financial markets. The best
explanation of that failure is William Cohan’s book, “House of Cards.”
o Failure of insolvent Fannie/Freddie: These were the largest financial institutions in the
US (maybe the world) based not on their actual balance sheet, but their guarantee
liability for mortgages (nearly $5 trillion combined, almost as large as the next 5 biggest

56
Gary B. Gorton. ―Questions and Answers About the Financial Crisis - Prepared for the U.S. Financial Crisis Inquiry
Commission‖ February 20, 2010. http://ssrn.com/abstract=1557279. Markus K. Brunnermeier. ―Deciphering the Liquidity
and Credit Crunch 2007–2008.‖ Journal of Economic Perspectives—Volume 23, Number 1—Winter 2009—Pages 77–100.
57
Darrell Duffie. ―The Failure Mechanics of Dealer Banks.‖ June 22, 2009. Rock Center for Corporate Governance at
Stanford University Working Paper No. 59. Available at SSRN: http://ssrn.com/abstract=1439908.
29
 banks combined at $8 trillion, such as Bank of America, JP Morgan, Citigroup, Wells
Fargo, and Goldman Sachs). At the core, the only way they could have such a large
explicit debt ratio (and even larger implicit one) was an implicit (not stated, assumed but
not written) government backing to bail them out. Fannie/Freddie guaranteed the
mortgage market (with very little capital), and the US government guaranteed
Fannie/Freddie (with the full faith and credit of the US). These “too big to fail” institutions
were known as such for at least a decade before the crisis, and their feckless regulator,
OFHEO, was both incompetent and powerless to do anything, due to a Congressional
policy to encourage more mortgage issuances and guarantees. From 2003 to 2007,
these GSEs guaranteed a lot of “junk debt” such as home equity loans, alt-a loans,
subprime loans, and jumbo loans, with overvalued collateral. Only when the crisis hit in
2008 were the forced to step back and issue mere conventional loans (and arguably
FHA loans with low standards). Unfortunately, there is no authoritative account on the
failure of Fannie/Freddie, and views are still conflicted, though even as early as 2006
some analysts saw the systemic risks posed by these poorly run, GSEs.58 Peter
Wallison at AEI was especially prophetic about the dangers of Fannie/Freddie,
especially to the US taxpayer. The two charts below from a recent “Conservator’s
Report” on the GSE show just how miserably these behemoths failed.59

58
Nick Timiraos. ―Views Conflict on Fannie Meltdown.‖ WSJ, April 14, 2010.
http://online.wsj.com/article/SB10001424052702304024604575173623669689564.html. Robert A. Eisenbeis, W. Scott
Frame, and Larry D. Wall. ―An Analysis of the Systemic Risks Posed by Fannie Mae and Freddie Mac and an Evaluation of
the Policy Options for Reducing Those Risks.‖ FRB Atlanta, Working Paper 2006-2, April 2006,
http://www.frbatlanta.org/filelegacydocs/wp0602.pdf.
59
Federal Housing Finance Agency. ―FHFA Releases First Conservator‘s Report on the Enterprises‘ Financial Condition.‖
August 26, 2010, http://www.fhfa.gov/webfiles/16591/ConservatorsRpt82610.pdf..
30
  Scene Three, a Phase Shift in the Failure of the Insolvent Lehman Brothers and Illiquid
AIG Caused Market Capitulation and Meltdown: The end was near when one of the four
remaining largest broker-dealer banks, Lehman Brothers, failed and the world’s largest
insurance company, AIG, failed too, one after the other (another large broker-dealer bank,
Merrill Lynch, came close to failing and was effectively bailed out). It was a miraculous
weekend. This caused a financial and economic “phase shift.” Basically, the markets and
economy were on one track due to broader de-leveraging, but they shifted to another track and
collapsed faster than normal because of bad policy choices to not save Lehman and more
aggressively pre-empt a credit market shutdown. Richard Koo of Nomura Bank has a great
graphic showing this.60
o Lehman went bankrupt: Lehman was likely insolvent (assets were less than liabilities).
Yet it was certainly illiquid, in that its short term liquidity pool of about $2.5 billion wasn’t
enough to meet short-term obligations of $16 billion on Monday, September 15, 2008
(despite Lehman’s lying to markets that it had $32 billion available). Lehman was
bankrupt, as creditors were unwilling to grant it a reprieve. A great short analysis of
Lehman’s failure is a blog post here: “Anatomy of Lehman’s Failure.” The best thorough
examination is the “Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner’s
Report” in 2010, conducted by Anton Valukas at the law firm Jenner and Block, not to
mention Andrew Ross Sorkin’s book “Too Big to Fail” and McDonald’s book “A Colossal
Failure of Common Sense.”61 The Friday before Lehman failed, most market
participants thought it would be bailed out like Bear Stearns. A bad assumption. It’s
failure trigged a complete shutdown of most credit markets, a drop in all equities, and the
failure of AIG.

60
Richard Koo. ―Global economic slowdown grows more pronounced.‖ Nomura Securities Research, August 17, 2010.
61
Anton R. Valukas. ―Lehman Brothers Holdings Inc. Chapter 11 Proceedings Examiner‘s Report.‖ Filing for the Chapter
11 case No. 08-13555 in the US Bankruptcy Court in the SDNY, March 11, 2010, http://lehmanreport.jenner.com/.
31
 o AIG went bankrupt, in style: There’s an old saying attributed to the billionaire J. Paul
Getty or the economist John Maynard Keynes: “If you owe the bank $100, that’s your
problem. If you owe the bank $100 million, that’s the bank’s problem.” Essentially, AIG
had guaranteed trillions of dollars of securities against default, not unlike Fannie/Freddie,
to other major banks and securities firms. So when Lehman went bust and the credit
market seized up, threatening many other firms, AIG was billions of dollars under and
couldn’t meet its immediate payment obligations to Goldman Sachs, BNP Paribas, and
other important firms. AIG was illiquid (but likely solvent over the long-term). While AIG
didn’t formally file for Chapter 11 like Lehman, and instead received government aid like
Bear Stearns, it essentially went bust. The best description of AIG’s failure is a piece
written by Michael Lewis titled “The Man Who Crashed the World,” about the small team
in AIG that made most of the reckless bets.62

62
Michael Lewis. ―The Man Who Crashed the World.‖ Vanity Fair, August 2009,
http://www.vanityfair.com/politics/features/2009/08/aig200908.
32
4) Bluto’s revenge in the movie “Animal House”
In the American comedy “Animal House”, members of a college fraternity (the Deltas) live
joyfully but irresponsibly over the course of a year. Eventually, their poor behavior of stealing,
womanizing, cheating, and failing classes gets the fraternity kicked off of campus. Most
members expelled from school by their nemesis, Dean Wormer of the college and a rival
fraternity, the Omegas. Though the Deltas initially give up after their expulsion, one member,
Bluto rouses them with an impassioned speech (“Was it over when the Germans bombed
Pearl Harbor? Hell no!”). They decide to take revenge on Wormer and the Omegas. Using a
rogue parade float, the Deltas wreak havoc on the annual parade for the town in which the
college resides. During the ensuing chaos, the futures of many of the main characters are
revealed. Bluto, the fat, jocund, and drunk anti-hero played by John Belushi, goes on to
become a US Senator. This isn’t too far off from reality. If you survey the fraternal ties of the
current US Senate, I would wager over 60% belonged to at least one “brotherhood” in their
past.

This letter points out that much of the American political leadership in the last 30 years has
behaved like Bluto. They chose the easy, irresponsible, and even reckless policy options at
the expense of doing the prudent thing. George Bush Senior and early Clinton may have been
exceptions for 6-8 years, as the debt ratio flatlined under their Presidential watches (total debt
still increased). The problem is that key people in three government agencies (the Treasury
Department, SEC, and to a lesser yet troubling extent, the Fed) have sought to please bankers
and not serve middle class Americans.

One big problem has been political capture; the financial industry in the US seems to have
“captured” the US government. As a member of the industry, I see it in numerous ways every
year. Under the standard political science theory of regulatory capture, this happens when a
regulatory agency created to act in the public interest instead acts in favor of the commercial or
special interests that dominate in the industry or sector it is charged with regulating. In the
US’s case, the entire federal government (Congress, the Presidency, and to a lesser but still
noticeable extent, the courts) seems captured by the financial industry. Unfortunately, the US
financial industry has been focused on generating oligopolistic profits for “too big to fail” banks
(and resulting payouts to key players) and not for economic value creation for American
citizens or industry. Three recent books describe this well:
 Simon Johnson’s “13 Bankers: The Wall Street Takeover and the Next Financial Meltdown”
 Nobel Laureate Joseph Stiglitz’s “Freefall: America, Free Markets, and the Sinking of the World
Economy”
 Larry Koltikoff’s “Jimmy Stewart is Dead: Ending the World's Ongoing Financial Plague with
Limited Purpose Banking.”

The future, however, is an open set of choices. While I’m cynical about the current set of
American leaders making the right policy choices to undo the structural causes of the crisis, in
a future letter I will discuss some of the best proposals. These have been raised by
economists like Joseph Stiglitz, Nouriel Roubini, Paul Krugman, Greg Mankiw, Marty Feldstein,
Larry Koltikoff, Raghu Rajan, Richard Koo, Willem Buiter, and so on. Unfortunately, the
Obama economics team has shut off proposals from these thoughtful economists. Meanwhile,
GOP opposition at best pays lip service to some ideas of change while engaging in
unproductive obstructionism.
33
Your crisis-watching analyst,

Alpha
alpha@riskoverreward.com
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