The financial crisis of 2008 left a damaging mark on the world economy, which still persists today. Equally as confusing as the future course for global finance is understanding the complex role Wall Street banking and investment firms played in wrecking whole economies. A detailed look at the situation reveals trends in economic behavior for the past few centuries, which begs one to question whether the 2008 financial crisis was a causative result of the free market capitalistic structure that has propped up Wall Street, or whether the 2008 financial crisis was a necessary step towards the idealistic positive effects free-market capitalism can afford modern societies. The negative effects of the economic downturn, however, was clearly a result of widespread corruption within the major firms of Wall Street and a long string of deregulation within the United States (US) financial sector.
In order to understand the role Wall Street played in the financial crisis of 2008 one must define Wall Street. Geographically, Wall Street is an eight-block street in lower Manhattan that houses some of the world’s largest privatized financial securities and investment firms, as well as the New York Stock Exchange. Symbolically, Wall Street has become emblematic of free-market capitalism and the drivers of global economies. Prior to the financial crisis of 2008, the major firms were Bear Stearns, JP Morgan Chase, Citigroup Incorporated, Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman Brothers. At the time Wall Street employed about 200,000 people, yet the financial services industry comprised about 22% of New York City’s annual revenue (McGeehan 1). The entity that is popularly dubbed “Wall Street,” is a powerful body of influence at the heart of the free-market capitalism.
So why is such a body of influence necessary? Well, inherent to a globalized financial system is a hub of important actors. Wall Street is that hub today because it has grown concurrent with the political, social, and military growth of the US. Its effect on the world economy is not an indicator of its derogatory properties, but of its absolute relevance in today’s world. In the free market, its services are required: capital, allocation, valuation, and the relationship-building aspects of connecting buyers and sellers (Hooke 23). Free market capitalism allows private ownership of trade, industry, and production with the sole goal of maximizing profits. Even in niche markets where social responsibility and humanistic values are used by privatized capitalistic entities, these are tools to maximize profits. Profits, then, are not tools to maximize social responsibility or humanistic endeavors. The problems that led to the 2008 financial crisis were a result of wall street firms creating fictional “securities” and allowing different competitors to gamble with each other despite not actually owning any material possession, nor capital against risky loans (Santoro and Strauss 21). Certain gamblers had insurance against this risky business, and those few remain today.
The breakdown of economies linked to these major Wall Street firms that still exist unfolded prior to 2008. In December 2006 the Ownit mortgage solutions company declared bankruptcy and set in motion a swing of divestment in a number of risky financial gambles. In February 2007 Freddie Mac, the government-organized investment and loan provision firm, announced it would no longer deal with high-risk subprime mortgages. In June 2007 Bear Stearns, one of the major Wall Street investment firms, saw two of its most important hedge funds collapse as a direct result of investment in risky subprime mortgages. On June 11, 2008, it was announced that Bank of America would absorb Countrywide, a major real-estate firm. These events were indicative of a large problem. Such movement, entity absorption, and divestment is a trend that generally precludes the bursting of some investment bubble. In 2008 this investment bubble would be the coinciding bursting of the housing bubble and the large-scale investment in bundles of high-risk residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDO). The primary indicator of the difficult economic times to come, throughout the world, was the drop in the value of Washington Mutual’s stock between 2007 and 2008. Washington Mutual, a major financial services bank, had gambled with RMBS and CDO. As the mortgages decreased in value homeowners began defaulting on their high-risk mortgages, and Washington Mutual depositors withdrew over $26 billion. The result was a drop in the value of Washington Mutual’s portfolio, prompting the US government to enact some sort of change. The problem, however, would soon be realized. The rampant investment of large firms in packages of risky debt was allowed to persist due to significant deregulation measures that had run throughout the US government for the previous few decades. By the time the government attempted to step in, too much damage had been done.
In retrospect, the US Senate commissioned a report to detail the steps that led to the breakdown of Washington Mutual, the housing market, and the world economy as a whole. In their report, they cited four primary reasons: high-risk lending, failures in the regulatory process, inflated credit ratings, and abuses by large banking firms. In order to show the power of one firm and the popular “too big to fail” mantra they detailed the timeline of Washington Mutual. In their case study, they underlined how one bank, undertaking the principles of free-market capitalism, led to the securitization of hundreds of billions of dollars of high risk, poor quality mortgages (“Wall Street and the Crisis” 48). Washington Mutual embarked on a lending strategy using high-risk loans in 2004, which by 2006 began taking on large rates of delinquency and default, a result of homeowners’ inability to pay their high principle, high-risk loans. The same thing happened to Washington Mutual’s mortgage-backed securities, and downgrades and losses dropped the value of their portfolio. In 2007 fraudulent loans and low-quality securities compounded the problems in the portfolio, and in 2008 the US government forced the sale of Washington Mutual to JP Morgan Chase. If the sale had not been forced the US Senate concluded that “Washington Mutual’s failure might have exhausted the entire $145 billion Deposit Insurance Fund” (“Wall Street and the Crisis” 2).
Failures in the regulatory process compounded the problem further. The two major regulatory bodies leading up to the financial crisis of 2008, the Office of Thrift Supervision (OTS) and the Federal Deposit Insurance Corporation (FDIC) were largely implicated. From 2004 to 2008 alone the OTS identified over 500 securities and investment discrepancies in Washington Mutual’s portfolio, yet did nothing. In fact, it did not fail to act, it actually took steps to slow down regulatory measures of the secondary regulatory body, the FDIC (“Wall Street Crisis” 209).
This type of failure to act was not isolated within the OTS. Other agencies likely held the same culture of seeing its thrifts as constituents instead of subordinate responsibilities. This forced agents within OTS and other agencies to expect internal regulation over high-risk securities and investment packages instead of interfering themselves. Of course, internal regulation did not occur. Short term quarterly gains in these banks likely veiled the OTS. If such enormous firms were producing such great quarterly reports, the basic principles must be right, right? Unfortunately for the world economy, the firms were engaging in the same practices that led to Washington Mutual’s eventual demise. It is unlikely that OTS agents and the agents of other regulatory bodies like the FDIC completely missed this. It is more likely that they allowed these types of risky banking practices to continue for personal gain or as a result of a culture of accepted ignorance that propagated the financial regulatory mechanism for the two decades leading up to the financial crisis of 2008.
A lack of proper regulation was not the only corrupt practice taking place at this time. Inflated credit ratings affected significant change within the US financial sector, and around the world, by “masking the true risk of money mortgage-related securities” (“Wall Street Crisis” 5). The two credit reporting agencies that were implicated most were Moody’s Investors Services, Incorporated and Standard & Poor’s Financial Services LLC. These two agencies gave AAA ratings, the top rating, to Wall Street firms like Washington Mutual, Bear Stearns, and JP Morgan Chase for bundles of RMBS despite their obviously caustic properties. As the housing bubble burst and homeowners felt a continued threat of foreclosure, eventually defaulting on their loans, a large-scale sell-off of RMBS and CDO occurred. This created a liquidity crisis. In July 2007 these agencies downgraded thousands of bundles of these RMBS and CDO. The result was a continued crisis of decreased liquidity in the derivatives and other investment markets.
Goldman Sachs and Deutsche Bank were two of the top mortgage holders in the US real estate market at this time and felt the pull of this liquidity crisis more than any other firm. Rightly so, they were also the most boisterous pushers of risky financial instruments like RMBS, CDO, and credit default swaps (“Wall Street Crisis” 7). Not surprisingly, they were two of the first firms to create these types of risky financial instruments. The outlying effects of the 2008 financial crisis are almost impressive in its breadth, but the numbers make it understandable. Between 2004 and 2008 firms like Goldman Sachs and Deutsche Bank issued about $2.5 trillion in RMBS and over $1.4 trillion in CDO securities (“Wall Street Crisis” 7). Such a revenue stream makes it understandable why regulatory agencies did not understand what was going on, or so they said. The major problem was in the profit scheme that was set up: these firms charged as much as $8 million to act as an underwriter of a high-risk mortgage and collateralized debt package. These fees created divisions within the banks to push high-risk bundles and allowed them to profit from the initial success of the RMBS and CDO (“Wall Street Crisis” 8). The key element, here, was in the setup of these divisions. By creating separate entities the firms were able to pit clients against each other and actually profit off of the failure of RMBS and CDO.
These steps that led to the financial crisis of 2008 were contemporary for the times, but the general structure of the crisis was not novel. High-risk lending, failures in the regulatory process, inflated credit ratings, and abuses by large banking firms are common components of financial downturns following significant booms in some industries. The industrial revolution and the development of railroads throughout the expanse of North America provided great wealth and thousands of jobs, as did the utility of electricity and the use of automobiles. With the railroad boom, millions were pumped into the thousands of miles of track, yet train traffic to the west was lacking and backers were not repaid (Baker 22). In the 1920’s radio stocks did not pay off for nearly two decades, and only for those investors who weathered the depression. Along with the investment in all of these technologies came the growth of financial instruments and the aggregate use of these instruments by increasingly powerful financial institutions. Financial forecasting based on contemporary trends and the subsequent increase in investment was followed, eventually, by a bust of sorts as production capacity hit a ceiling that few financial sector actors predicted.
The Great Depression that began in 1929 was a result of such financial sector meddling with a lack of oversight or regulatory pressure. Incapable of weather the credit and stock speculation that led to the depression, oversight, and regulatory pressures were enacted. The Securities Act of 1933, the Securities Exchange Act of 1934, the Commodity Exchange Act of 1936, and the Glass-Steagall Act required transparency, decreased financial-political cronyism, required organized exchanges, and separated insurance companies, investment banks, and commercial banks. The Dodd-Frank Wall Street Reform and Consumer Protection Act that the first Obama administration enacted can be considered a distant cousin of these post-Depression reforms. The five-decade process of deregulating post-Depression reforms, however, would not be required to deregulate the Dodd-Frank Act. This Act was setup and hailed as an answer to the lack of regulatory oversight that pushed the original financial crisis of 2008 over the proverbial cliff. In his investigation into how Wall Street lobbyists worked to deregulate the Act, Matt Taibbi cites three primary reasons for Dodd-Frank: an end to predatory lending in mortgage markets, crack-down on hidden fees and penalties in credit contracts, and the creation of a Consumer Financial Protection Bureau (Taibbi 1). Taibbi also cites a four-point strategy enacted by those lobbyists that effectively crushed the regulatory aspects of the Dodd-Frank Act. The first is that regulatory concepts survived the law writing process, but bank lobbyists had stripped them of much of their strength. The second is the defeat of a proxy access rule that allowed shareholders to depose, more easily, the heads of organizations. Wall Street firms did away with this by stalling and suing government regulatory agencies in court. The third is the push of Wall Street to have congress freeze the budget of the Commodity Futures Trading Commission (CFTC). Meanwhile, the derivatives market that the CFTC was supposed to regulate rose from $40 trillion to $340 trillion in the time its budget was frozen (Taibbi 4). Finally, Wall Street pushed hard to pass a number of new loophole laws that allowed their previously deviant behavior to again be legal.
So where does this leave future considerations for the global economy, and what role will Wall Street play? Likely the same, but that isn’t necessarily a bad thing. Reform, Stacey Bumpers states, must encompass Wall Street Firms and the consumers they serve alike. In her look at the financial crisis of 2008, she cited home buyers as part of the problem, just as high-risk lending, failures in the regulatory process, inflated credit ratings, and abuses by large banking firms pushed the issue. Homebuyers played a risky game of taking on risky, high principle loans, despite an inability to pay them in the long term. A certain level of greed persisted as home buyers hoped to see appreciation in the value of their investments, which would decrease the principal risk. This was possible due to non-traditional mortgages “that offered low introductory rates and minimal initial costs such as no down payments” (Bumpers 1). When the liquidity crisis struck the housing real estate market the value of these mortgages decreased significantly. The problem of corruption, it seems, was ubiquitous.
The financial crisis of 2008 affected significant change in the world economy. Its source was the few Wall Street giants that were seemingly too big to fail. When they did fail, however, they took a great deal of weight with them. This is indicative of widespread corruption, but it is not indicative of Wall Street being some evil force the world must be rid of. Free market capitalism has allowed for significant gains in the quality of life throughout the world. While atrocities do exist, they do not exist on the scale they once did. Wall Street is not evil, but it becomes evil when its agents act in corrupt ways. Individuals who buy into this system may wind up being victims of abuses, but as Stacey Bumpers points out the financial crisis of 2008 was everyone’s fault. The future of the world economy will rely on a continued effort to increase necessary regulatory mechanisms, decrease widespread corruption, and increase the financial responsibility of consumers across the board.
Baker, Dean. Plunder and Blunder the Rise and Fall of the Bubble Economy. Sausalito, CA: PoliPointPress, 2009. Print.
Brenner, Robert. The Boom and the Bubble: the U.S. in the World Economy. London: Verso, 2002. Print.
Bumpus, Stacey. "The Financial Crisis Was Caused by You, Not Big Banks." Banking. GoBankingRates, 22 May 2012. Web. 24 Feb. 2014.
Hooke, Jeffrey C. Security Analysis on Wall Street: a Comprehensive Guide to Today's Valuation Methods. New York: Wiley, 1998. Print.
McGeehan, Patrick. "City and State Brace for Drop in Wall Street Pay." New York Times 26 July 2008: New York Region. Web. 24 Feb. 2014.
Santoro, Michael A., and Ronald J. Strauss. Wall Street Values: Business Ethics and the Global Financial Crisis. Cambridge: Cambridge University Press, 2013. Print.
Taibbi, Matt. "How Wall Street Killed Financial Reform." Rolling Stone Magazine 10 May 2012: 1-5. Politics. Web. 24 Feb. 2014.
Wall Street and the Financial Crisis: Anatomy of a Financial Collapse. Washington, D.C.: United States Senate, 2011. Print.
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