The Financial Crisis Blame Game

(page 4 of 4)

Related Items

• Forget Adam Smith, Whatever Works
• How to Get Growth Back on Track
• Views on the Bailout, From Harlem to Wall Street
• Stocks Fall, Capping Wild Week
• Paulson's $250 Billion Bank Buy
• Audio: Wall Street Pioneer Dan Lufkin on the Crisis

The idea for "The Financial Crisis Blame Game" came from BusinessWeek reader Joe Lacenere, who works in supply chain management for a leading multinational. Joe has been a loyal reader of BusinessWeek for at least 15 years.

Story Tools

• post a comment
• e-mail this story
• print this story
• order a reprint
• suggest a story
• digg this
• save to del.icio.us

Too Much Leverage

Another big risk that financial firms took was in borrowing heavily. Many firms were employing leverage—debt used in investing—of 30 to 40 times their core holdings. Previously, the SEC had kept firms to leverage ratios of 10 to 15 times their core holdings, but the agency loosened the rules for investment banks in 2004. With leverage, "you can make fantastic income when things are going the right direction," Tabb says. "When things go against you, it unwinds very quickly."

Why did Wall Street ever take such dangerous risks?

The big reason, obviously, is greed. Wall Street bankers were taking home a lot of money by making these gambles. The chief executive of Lehman, Richard Fuld Jr., for example, earned $34.4 million in 2007. "Once this business model gets going, it's very hard to stop," Tabb says. Firms had hired risk managers who should have spoken up, but they were not supposed to "get too much in the way of generating revenue."

Many also have criticized the way Wall Streeters are paid. "People [were] compensated on the returns they got, and so there was a motivation to take more risk," Aggarwal says. In the record year of 2006, Wall Street executives took home bonuses totalling $23.9 billion, according to the New York State Comptroller's Office. Wall Street traders were thinking of the bonus at the end of the year, not the long-term health of their firm, Tabb says.

The whole system—from mortgage brokers to Wall Street risk managers—seemed tilted toward making short-term risks while ignoring long-term obligations. The most damning evidence is that most of the people at the top of the banks didn't really understand how those credit default swaps and other instruments worked.

"Regulators Didn't Regulate"

Finally, all this risk-taking by firms added up to a big gamble for the entire financial system, which only became fully apparent as the crisis unfolded. Because no firm knew of other firms' exposures to toxic assets or complex derivatives, it was difficult to predict how problems would flow through the system. "It's very hard to tell the risks various parties are exposed to," says Bittlingmayer. "We don't have transparency."

As the crisis approached, few in government spotted these problems. And no one in a position of power moved to prevent them.

"The regulators as a whole didn't regulate," Ried says. Some officials, often at the state or even city level, did warn of the risk but were ignored (BusinessWeek, 10/9/08). Ried blames regulators for relying on a "free market philosophy" that "just let things go."

But Wall Street also made it worth Congress' while to look the other way. According to the Center for Responsive Politics, the securities and investment industry, including donors at Goldman Sachs (GS), Morgan Stanley (MS), Merrill Lynch (MER), Lehman, and Bear Stearns, gave $97.7 million to federal political candidates for the 2004 election, and another $70.5 million for the 2006 congressional election.

A big reward for Wall Street came in 1999, when Congress passed, and President Bill Clinton signed, legislation loosening New Deal-era bank rules, including the Glass-Steagall Act creating strict separation between investment banks and commercial banks. Commercial banks, which rely on deposits for funding, were allowed to encroach on investment banks' turf. That, in turn, spurred investment banks to take on even more leverage and risk to survive.

"Investment banks started operating more like hedge funds," Aggarwal says.

In the End, Basic Bad Banking

The complexity of the people, actions, and instruments behind the meltdown are truly mind-boggling. But strip things down to their essence and you are left with some surprisingly simple notions.

Investment banks and corporations engaged in basic bad banking, says Robert Ellis of the financial consulting firm Celent. They broke a cardinal rule: "Never borrow short to lend or invest long." Firms were relying on short-term funding sources for long-term obligations. When the crisis froze up short-term markets, these institutions ran dangerously short of cash.

Even more basic was the mistake of taking too much risk. More risk allows for bigger payoffs for participants, but it put the whole system in jeopardy.

Finally, even as problems were becoming apparent, few spoke up. Maybe it was because everyone assumed that someone smarter than them understood how it all worked.

"There were so many financial incentives and political incentives that were aligned toward making this work," Tabb says. "It was very difficult to stop it."

For more on who's to blame in the financial crisis, see BusinessWeek.com's slide show.

Business Exchange related topics:
U.S. Financial Crisis
Mortgage Crisis
U.S. Stock Market
Housing Market

Steverman is a reporter for BusinessWeek's Investing channel. Bogoslaw is a reporter for BusinessWeek's Investing channel.