BY ANDREW FISH
Investment giant Lehman Brothers went bankrupt on September 15, 2008, and the federal government began its bailout of the world’s largest insurance conglomerate, AIG, a day later. Cut to 2010 and record numbers of Americans have lost their homes and our unemployment rate now flirts with 10% in the aftermath of an economic meltdown. Millions of investors had poured trillions of dollars into mortgage-backed securities — within bundles called CDOs — and then witnessed an unparalleled number of homeowners fall behind in their payments. Years of subprime home mortgages going to those who ultimately couldn’t afford them, coupled with a longtime trend of predatory lending, had come to a head. As the value of these bundled securities dropped steeply in parallel with the delinquent mortgages, both the investors and the former homeowners were left in the dust. And though Lehman Brothers had been allowed to fail, other financial conglomerates were bailed out by the taxpayers. In his new documentary, Inside Job, director Charles Ferguson lays bare the world of investment banking and guides us step by step through the events that have led to our current condition. Via uncompromising interviews with economic advisors, executives, government officials, journalists, authors, professors, a lobbyist, a psychologist, and even an escort madam, the filmmaker illuminates the missteps, misplaced trust, shortsightedness, corruption, and greed that continue to permeate our financial system.
With a Ph.D. in political science from M.I.T., Ferguson has authored several books including High Stakes, No Prisoners: A Winner’s Tale of Greed and Glory in the Internet Wars. During his postdoctoral research at MIT, he consulted with the White House, the office of the U.S. Trade Representative, and the Department of Defense. He also founded the software company, Vermeer Technologies, which developed FrontPage, a widely used website development tool which he sold to Microsoft in 1996. His previous screen effort was No End in Sight: The American Occupation of Iraq (2007), which was nominated for an Academy Award for Best Documentary. When we connect with Ferguson, we’re treated to a clear and instructive tutorial on the systemic problems within the financial sector. Read the interview, then go see Inside Job.
The term “financial innovation” sounds like a good thing. What does it mean and how does it relate to the current crisis?
In principle, financial innovation means any kind of design of new financial product, structure, or system, and there have been a number of good financial innovations over the last century. Over about the last 20 years, though, it has come to primarily refer to something much different and much more specific. What it refers to is the use of mathematics and statistics to design very complex financial products that enable various forms of speculation, gambling, and in some cases insurance — derivative products such as credit default swaps. So when securitization, when CDOs were invented [about 30 years ago], that was regarded as a financial innovation. And that whole class of innovations, mainly derivatives, have turned out to be very dangerous for several reasons. One reason is that they were, and still in large measure are, totally unregulated. They are a little bit more regulated now as a result of the financial reform bill that was just passed, but not much. And until that bill was passed they were completely unregulated. The second reason they were dangerous is that financial innovation over the last 30 years has come primarily to mean various ways to play tricks to “game” the system, as opposed to doing really productive things. A productive financial innovation — which is not a new one, it’s about 60 or 70 years old — is a venture capital partnership. Something that allows venture capital investments into startups; that was a productive financial innovation. But these things are mainly to enable people to gamble, to speculate, to avoid taxes, to avoid regulation, to avoid capital requirements. And the third reason that financial innovation has become so dangerous is that it was associated with compensation schemes whereby people get immediate cash bonuses when they sell complicated financial products, regardless of whether those products do well or not. The combination of those factors led to financial innovation turning out to be an incredibly dangerous thing, and rendering the financial system much more unstable and much more dangerous than it previously had been.
And that kind of gambling includes credit default swaps where a security can, technically, be insured by an infinite number of clients who don’t even own that security?
Yes. There are several dangerous things about credit default swaps, and one of them is that people who don’t own the security are able to purchase insurance on that security. And they can potentially purchase a very large quantity of insurance on that security, and that actually gives them an incentive to make that security fail. Or if they’re the ones who created it in the first place, to design one that fails. People in the traditional insurance business have known this for a long time. An insurance company will not let you insure your million-dollar house for a hundred million dollars because they know that if they allow you to do that, you have a very strong incentive to burn your house down. And for similar reasons, traditional insurance contracts have deductibles so if you have a million-dollar policy on your house, you have to pay the first two-hundred thousand dollars so you still have an incentive not to let your house burn down. In the derivatives world, that’s not true. So you get this situation as with Goldman Sachs, where Goldman Sachs has an incentive to design and sell bad securities, and it also has an incentive to purchase so much insurance on them that somebody selling the insurance could go bankrupt. In fact, what Goldman Sachs then did is it realized that it had purchased so much insurance from AIG that AIG could well go bankrupt, and it started purchasing insurance against an AIG bankruptcy so that it could continue to purchase yet more insurance from AIG.
Were they actually betting on the failure of AIG?
It didn’t seem as if they were going so far as to bet on the failure of AIG, but they were certainly insuring themselves against the possibility of an AIG failure, so that they could continue to purchase more insurance from AIG and could be confident that they would collect. In the end what happened was that the situation was so bad, because AIG had sold insurance to so many other people also, in such large quantities, that even that would not have protected Goldman Sachs if the government hadn’t bailed them out. But the government did bail AIG out, and when it did, it instructed AIG to pay a hundred cents on the dollar for all of the insurance contracts, the CDS [credit default swap] contracts, that it had sold.
According to the anti-regulation camp, derivatives help protect the market. What was the ideology behind that?
Well, in principle it would be irrational for AIG’s senior management to sell gigantic quantities of insurance on irrational or bad terms, so it would never happen. But what the free-market theory economists didn’t take into account ... they didn’t take into account many things, but one of them was that the compensation schemes inside these companies were such that people got immediate cash compensation for short-term sales events, for selling these things and booking them irrespective of whether they went bad five years later. And as a result, people had incentives to do dangerous things, even to the extent of ending up destroying their own companies. Another thing that economic theory didn’t take into account is that it was possible for people to conceal information from others, so Goldman Sachs could successfully conceal the fact that it was betting against the securities it was selling from the people that it was selling them to. So it sold these securities to people who had absolutely no idea that Goldman Sachs was simultaneously betting against either that individual security or that whole class of security. Those two conditions — these compensation structures and the ability to conceal information from people that you were selling things to — meant that, in fact, these derivatives turned out to be extraordinarily dangerous.
What were some of the other economic ideologies that were trusted during the events that led up to the crisis?
They were all kind of the same. There was this dominant view in the economics discipline that markets always gave you the right answer, and that they were always efficient, and that people would never do anything irrational or dangerous because the market would immediately punish them for it. So these economic theories all assumed that everybody has equal and perfect information and they all neglect, or don’t talk about, or don’t address the issue of compensation structures. That was the most important thing that [economics professor] Raghuram Rajan pointed out in the paper [“Has Financial Development Made the World Riskier?”] that he wrote and delivered in 2005, warning about the possibility of an economic crisis. Another thing to be said, though, is that the economics discipline didn’t just make an innocent mistake here. As I point out in the film, a lot of the economists who argued these theories and defended the financial services sector were in fact being paid large amounts of money by the financial services sector at the same time. So their objectivity is, to put it mildly, suspect.
How were all of these industry professionals, government officials, and academics so blinded to the inevitable outcome of all this? Or did they know and just not care as long as they could keep their winnings?
Oh, many of them clearly did know and didn’t care as long as they could keep their winnings, and there’s a lot of evidence of that. There have been several studies of the financial behavior of the senior executives at investment banking firms in the period leading up to the crisis. And both with Bear Stearns and with Lehman Brothers — and it was also true with a number of other firms— their senior executives took enormous amounts of cash out of the company in the years leading up to the crisis. In the case of Countrywide, [former CEO] Angelo Mozilo actually had Countrywide borrow billions of dollars from the open market and then Countrywide used that money to prop up its stock price, temporarily, by repurchasing its own stock on the open market at the same time as Angelo Mozilo and other senior executives at Countrywide were selling their personal stocks and turning it into cash — because it would appear they realized that their company was heading into serious trouble. So they cashed out. In the case of Mozilo, he took out a total of almost half a billion dollars in cash and over a hundred million of that he took out in the year before Countrywide collapsed. That’s a very extreme case but similar things were true of the senior management of Bear Stearns and Lehman Brothers. They took out very large quantities of cash in the years immediately before the collapse of their firms.
What is the underlying philosophy or psychology behind this behavior that would destroy their own companies?
Well, greed. [laughs] Amoral greed would certainly be part of it. Now, in some cases it seems as if they didn’t think that their companies were going to completely collapse. They probably were aware that the bubble was going to end and that there was going to betrouble, and that their company stock price would certainly decline, but in at least some cases they probably didn’t think their companies were going to collapse completely — for a combination of two reasons, I would say. One is that — and this is an interesting thing — there’s no single place where there’s a complete repository of data about the market positions of the investment banking industry. If you wanted to look globally at the total behavior and the total positions of the investment banking sector, you can’t do that right now because there’s nowhere that has all of the data in one place. One thing that many people have proposed as an important reform is that governments start collecting that data. That has not occurred. Another reason, and we go into this in the film, is that during the bubble these guys made so much money that they really became somewhat disconnected from reality. They were so wealthy that they were so far away from the concerns of ordinary people, even their own employees. They had private jets, they had private elevators, they had private helicopters, and gigantic mansions, and they really just lost touch with the rest of the economy and with the real world. They lived in a kind of bubble, and I think that that probably had something to do with it as well.
Do they still have those kinds of lives, or have the numbers of helicopters and mansions decreased?
There’s been a decrease, but by our standards, by the standards of the other 99.99% of the population, they’re still enormously wealthy and very disconnected from the rest of the population. Indeed because, as I said, they took out so much cash in the years leading up to the crisis that these people still have hundreds of millions of dollars each.
I was reading about the chair of the U.S. Commodity Futures Trading Commission who went to work for Enron after setting up an energy derivative anti-regulation policy. The line between government and Wall Street is really blurry. Has it always been this way or is this a new development?
It’s been getting worse. There has always been some element of it but it’s been getting much, much more extreme than it used to be. It’s a very disturbing development. And you’re absolutely right, the woman you’re referring to is Wendy Gramm, who — even worse — when she went on the Enron board after being at the Commodity Futures Trading Commission, she was married to Senator Phil Gramm, Republican of Texas, chairman of the Senate Banking Committee, who had a major role in banning the regulation of derivatives upon which Enron and its frauds heavily relied. So, yes, it’s a very bad situation.
A lot of the governmental officials responsible for quelling regulation are still in power.
Many of my friends and I were tremendously disappointed by the personnel appointments that President Obama made. He appointed to the senior economic and regulatory positions people who had been responsible for creating the crisis and the policies that led to the crisis, and that was a very disheartening and surprising thing to many of us. I had personally been a supporter of President Obama when he was campaigning. I contributed to his campaign, I supported him publicly, I helped raise money for him, and I know many other people who did as well and then were very disappointed when they saw his personnel appointments.
What are your thoughts on the reform bill that passed?
Well, it’s kind of a joke. Someone in the film’s response is, “Ha!” And, unfortunately, that’s correct. What the bill does for most of the critical issues is it sets up two-year long study periods after which the organizations and people conducting the studies will make recommendations for what regulators should then do, and it will then be up to the regulators to create whatever regulations they see fit. And that’s not the way this should be handled. We already know in many cases what should be done now, in the first place. In the second place, the people in charge of the regulatory organizations are unfortunately, for the most part, the people who created the problem so they’re not likely to turn around and solve the problem. And then finally, in several major areas the bill basically didn’t do anything at all. The bill basically has done nothing about the rating agencies, it’s basically done nothing about the structure of executive compensation in the financial services industry, so people are still free to pay very large quantities of cash for decisions that five years down the line could cause crisis.
And what about the problem of betting against the same securities you’re selling?
It is still legal to bet against the same securities that you’re selling. Depending again on what regulations are enacted, there probably will be some additional disclosure requirements [so] banks or financial institutions selling securities will now have to retain a portion of those securities — a small portion. Now it’s about five percent. So there has been a little bit of progress in that domain but not nearly enough. It still is a very bad situation and it still would be legal, for the most part, for people to behave the way that they did in the years leading up to this past crisis.
In your opinion, is there any credibility to the scores given by the credit rating agencies like Standard and Poor’s, Moody’s, and Fitch?
“No” would be the simple answer. Because of the crisis and because of the public attention focused on them, they probably are going to be more careful for another couple of years, but the basic problem that manifested itself during the bubble and during the crisis is still there. They are still paid by the issuers of the securities and they also still rate the issuers of the securities. And that is a very dangerous place to be. It’s not the way it used to be; it’s relatively new. Until about 30 years ago, rating agencies were paid by the purchasers of securities, not by the issuers — and that change is what led to the corruption of the ratings system.
According to your film, one of the other changes was when investment banks went public and became less concerned about their own funds, since they now had the stockholders to disconnect them from losses.
Yes, when the investment banks switched from being partnerships to being publicly held companies — and in principle a publicly held company can still have incentives to have people behave responsibly — but when they made that switch, gradually what also occurred was that they changed the way they handled their senior executives’ compensation. And gradually over time the senior executives of investment banks no longer had to invest as much of their own money in the company and a higher and higher fraction of their compensation was in short-term cash as opposed to long-term stock or deferred compensation. So yes, over the last 20 or 30 years, these compensation structures emerged where people are given very large quantities of cash every year for short-term performance, irrespective of its long-term consequences.
And there hasn’t been any move to rectify this?
In the United States it’s still perfectly legal and there has been no move to rectify it. Recently the European Parliament passed a law, and now in Europe financial industry compensation is much more heavily regulated and a substantial fraction of it has to be in long-term compensation and/or stock. So Europe has already taken very strong action on this. What the Europeans did, it’s not quite perfect but it certainly is a big, big step forward. And all the major European governments and finance ministries supported this. In contrast, the United States has done nothing whatsoever.
Your film also points out that the banking companies are now more consolidated and larger than ever. Which ones are left?
J.P. Morgan, for sure. Bank of America has become much larger because it purchased both Merrill Lynch and Countrywide. Wells Fargo has become larger, and then of course the remaining investment banks: Goldman Sachs and Morgan Stanley.
They’re the last ones standing and holding most of the cards?
Yes. The U.S. financial system is now more concentrated than it has ever been in its history.
In your opinion, what needs to be done in the U.S. in terms of regulation?
Several things. First of all, I think — many or most people think — that it should be illegal to purchase insurance on financial products in which you have no interest, that you don’t own. So-called “naked” credit default swaps. The derivatives industry and market in general should be much more heavily regulated. Secondly, the largest banks should be broken up and the U.S. financial system should become much less concentrated. Thirdly, there should be serious regulation of the structure of financial industry compensation, so that people can’t take out enormous quantities of cash for making decisions that destroy their own companies a few years down the line. And then — [although] this isn’t quite in the domain of regulation but it might even be the most important, single thing — many of us think, and I believe, that it’s very important to appoint an independent special prosecutor to investigate what happened during the bubble and the crisis and to prosecute people criminally where they in fact violated the law. And it’s clear that there had to have been massive violations of the law. It is just not credible to believe that all this could have occurred without people committing fraud.
Do you think there should be regulations or laws put in place in terms of who can serve in government with respect to their corporate interests?
Yes, and there are various ways to do that. Many Americans think that this is just something you have to put up with, that there is noway around this problem; it’s just an inevitable consequence of having a large, private economy. That is not true. There are other countries that deal with these questions in different ways and that do not have these problems. When I was traveling around the world looking at these questions and talking to people about these questions for the film, that was very striking. I remember very well, for example, my interviews in Singapore, where I asked people both in the government and in the private sector about lobbying and lobbyists and they kind of laughed at me and they said, “We don’t have lobbyists here. There’s just no space, no place, no respect for them, and we wouldn’t pay attention to them. And one reason they probably don’t exist is because they know that we wouldn’t pay attention to them.” So why don’t you pay attention to them? “Well, our senior regulators are paid over a million dollars a year. They don’t have to think about going to the private sector. They’re very happy where they are. They’re completely financially secure, they have no incentive to be corrupt, they have no incentive to leave for private industry after a few years in government. They’re extremely well-compensated for doing a good job.” So I think that would be important, to pay senior career civil-service regulators extremely well so that you could attract and retain good people who would not be tempted by private-sector salaries. And then of course there should be very tight disclosure requirements and there should be controls on what people do after they leave public life. I would say the same thing, analogously, of academia. There should be very strict disclosure requirements on what professors do, how they make money outside of their academic income, and there should be limits on income derived from the same industry that they’re studying in. If a professor wants to make money on the side by writing mystery novels, fine. But consulting to the banks that he’s doing research on and making policy statements about, first of all it should be completely required to disclose it, and secondly there should probably be limits on it.
With all of the changes that need to be made, what can we do to push them forward and what will happen if these regulations are not implemented? What’s the next crisis?
We don’t know what the next crisis is going to be, but we can be, unfortunately, pretty certain that unless we do something about the situation, there will be one. For almost half a century the United States did not have financial crises and then we started deregulating in the early 1980s, and since that time about every 10 years we’ve had a significant financial crisis — and they’ve been getting worse. That’s kind of a scary thing. As to what has to happen and how this will get fixed, for sure it’s not going to get fixed by the people in charge of economic policy in the current administration. It’s going to get fixed one of two ways. Either President Obama, personally, is going to realize that it’s important for him to do something about this, and the measure of his taking this seriously is whether he appoints an independent special prosecutor and whether he replaces his economic team. And if President Obama does not take action then it’s going to be up to the American people and I think that’s probably, unfortunately, what’s going to have to happen. It’s happened before. There have been plenty of other times in American history when the American people have finally gotten fed up with their leaders doing something bad and the people have forced their leaders to follow. I hope that that happens again and that’s part of why I made the film.