“Before That, They Made A Lot of Money”: Steps to Financial Collapse

An Interview with Nomi Prins

Nomi Prins is a journalist and senior fellow at Demos, a non-partisan public policy research and advocacy organization. Before becoming a journalist, Prins worked on Wall Street as a managing director at Goldman Sachs, and ran the international analytics group at Bear Stearns in London. She is the author of Other People’s Money: The Corporate Mugging of America (2004).

Multinational Monitor: In retrospect, it is obvious that the financial players made a lot of really bad decisions. Their mortgage loans were bad loans that looked attractive only because of the housing bubble. The related derivative instruments were also bad investments because the underlying asset was going to go bad. Do you think that should have been obvious at the time?

Nomi Prins: It should have been obvious. The firms at every level of packaging and selling to the next buyers above them ignored the risks that were coming into the packages as long as there were buyers. It was like a hot potato. As long as they could get a packaged deal out of their hands and there was demand, whether it was obvious if these things were risky or not, the demand itself was enough to keep the whole pyramid going.

Most of the non-prime loans were packaged into bonds that received triple-A ratings from the rating agencies. Regulators didn't require any of the buyers - whether they were banks or insurance companies - to put up enough capital in reserve to cover the possibility of the loans and packages going bad. They didn't examine what was inside the packages because they were considered to be triple-A, so the buyers just put up the capital required for a triple-A investment, which isn't much.

There definitely should have been more regulatory analysis. Regulators had the ability to look at these assets more carefully than they did. They had the ability to question banks and ask them what they were holding. They simply didn't.

Meanwhile, the mortgage lenders' failure was not just in giving out a single subprime loan, but in giving loans on top of loans to the same borrowers, as lenders did between 2003 and 2006. So they were lending to a subprime borrower, or a borrower who was more risky to begin with. If that borrower had a house that looked like it was going up in value, they would say, "Why don't you take out a second mortgage?" or "Why don't you take out a home equity loan?" And the only collateral that the borrower had was that house.

So it wasn't just that you had non-prime loans. It's that in many cases you had a series of bad loans. And there was nothing in the mechanism of structuring [the loans] that took into account that there was additional risk because of the multiple loans on the same collateral - on that same house. So the loans were bad, and the lending on top of bad lending made it worse.

MM: How do you explain that all of these supposedly sophisticated players did all these stupid things and brought their institutions to the verge of bankruptcy?

Prins: Because before that, they made a lot of money.

The banks and investment banks were hyper-competitive with each other. There was tremendous demand for packaged mortgage instruments. In the five years before 2003, there were less than $5 trillion worth of issuance of these types of products, and they were largely created out of prime loans. Between 2003 and 2007, there were $14 trillion issued and they were largely created out of non-prime loans. There was demand for any level of structuring because every level of structuring created new bonds that were rated like triple-As and therefore required little capital on the part of any buyer.

The problem was made worse because banks and other investors purchased these products with too much borrowed money, or leverage. They didn't take into account the fact that if liquidity in the market stops, no matter what label the assets have, there will be a problem. If there's no buyer for your assets and you have to pay additional money immediately because you borrowed against them when they had more value, and you don't have the money, you go bankrupt.

In the case of Bear Stearns, which was the tip of the iceberg in March, its hedge funds collapsed, not because they bought what appeared to be junk bonds - they bought triple-A, high quality, top layer bonds - but because they had no market to sell to, once they had to raise more cash to back them. They had borrowed heavily against those bonds, and the lenders wanted their money back.

MM: It was obvious that there was a housing bubble. Did the financial players just avert their eyes because the immediate benefits were so great?

Prins: They made the assumption that housing prices would never go down, or if they did, they would be in isolated areas, not everywhere at once. Not only that, as prices were rising, the assumptions they made for what percentage of subprime borrowers would default became lower and lower. In the recession of 2001, subprime loans were defaulting about 10 percent of the time. By 2005, they were only defaulting around 5 percent of the time. The feeling in the market was that subprime borrowers were a better and better bet, which heightened the desire for products that were structured on top of subprime. But again, no one took into account that the market could turn down so quickly.

These subprime borrowers might have been struggling during the bubble, but because they were able to get more and more loans on their appreciating houses, you couldn't tell. Investor models were showing that subprime loans and related instruments were better bets than had been thought, without realizing that subprime home owners were paying their mortgages only by borrowing more.

MM: What was the Glass-Steagall Act?

Prins: The Glass-Steagall Act of 1933, part of FDR's [Franklin Delano Roosevelt's] New Deal initiatives, effectively took the banking industry players at the time and divided them into two separate pieces. One piece was the investment banks that traded, that risked and borrowed against their own capital, speculated, and provided merger and acquisition and other services.

The other part, the commercial banks, were there to accept deposits, to provide secure savings accounts, and to provide simple, normal-looking lender's loans. Because of that division, commercial banks operated with less risk, and a more transparent capital base in those deposits. As part of the New Deal, the government, through the FDIC [Federal Deposit Insurance Corporation], provided insurance to make sure that deposits in commercial banks would be secure for the citizens who had them.

Ultimately, the Glass-Steagall Act divided the landscape into the more risky players and the less risky ones and provided government backing for the less risky ones.

Glass-Steagall was repealed in 1999.

MM: With what consequence?

Prins: With the consequence that now, the investment banking arms - the risky areas of the financial landscape - are combined with the depository institutions - which are backed by the FDIC, an emergency fund for money markets and other protections invoked by the New Deal and Glass-Steagall. Insurance companies are also part of the mix now as well, and permitted to be merged with commercial banks.

All together, the repeal allowed the merging of all sorts of different types of financial institutions into one, which made it more difficult to see what they were doing. Even if there were the rules to regulate them, it made it more difficult to access the information about their assets and their risks. It enabled banks to use their deposits as collateral for making risky bets, which was not the intent of Glass-Steagall. The investment banks that stayed separate had to compete with the banks that had deposits. To stay competitive they created a lot of additional risk to make a lot of money on the back of nothing - that is, borrowed or leveraged money - because they didn't have deposits.

MM: If Glass-Steagall were still in place, would the current problem have occurred? Or would the situation look different?

Prins: If Glass-Steagall had not been repealed, we would have less of the current problem. The conglomerate institutions would not use deposits and their lending capabilities to feed the borrowing and the structured products that some of the investment banks as well as those conglomerates were doing. It would have kept things more separate, and that probably would have been more manageable and more transparent.

Even with Glass-Steagall, a similar problem might have happened, but I think it would have happened in a lesser volume and it would have been clearer to dissect once it did. Right now, we're in this area of non-clarity. The bailout plan is talking about buying toxic assets, and it's very unclear as to how tangled the assets are, not just on the books of the banks trying to sell them, but in relation to all the other banks as well.

MM: How feasible could it be to reinstitute Glass-Steagall, or something like it, given the shifting landscape of the financial sector?

Prins: First of all, the investment banks that are left are going in the precise opposite direction of Glass-Steagall, in that they have been merging while melting down. Merrill Lynch, for example, which continues to post losses and maintain unclear risk, has been allowed to merge with Bank of America. Basically, that creates a larger institution in the weakest possible environment. I don't believe that makes any sense. It's setting up that institution and any institution doing the same thing for a bigger fall.

The Glass-Steagall repeal allowed these institutions to merge and created the mess that we are in right now. Where it's not easy to see the risk, it's not easy to require the right amount of capital behind that risk.

If an act like Glass-Steagall was resurrected, it could have also prevented firms like Morgan Stanley and Goldman Sachs - which are bonafide investment companies with 30-to-one leverage inside them - from calling themselves bank holding companies, which they were allowed to do in September. And as a bank holding company, they will be allowed to buy banks and use depositors' money as collateral for taking on more risk.

It is feasible to have a Glass-Steagall-style system. You could say, "No, Merrill Lynch, you cannot merge with Bank of America, because we don't know what you own. We don't know your risk. We don't even know their risk."

MM: Where commercial banks and investment banks have been integrated for a longer period, would you recommend forced spin-offs? Would you call for breaking up Citigroup, for example?

Prins: I would take a look at trying to divide out the risks of each component of Citigroup, which includes Travelers Insurance and the old Salomon Brothers investment bank, and do the same with JPMorgan Chase. The first question would be whether the risk that they are carrying versus the capital that they maintain imposes too much stress on the FDIC insurance system.

I would force transparency so that we could make that judgment. If a conglomerate company had too much leverage and risk in their investment bank activities, threatening too much of a potential drag on the side of the company that takes deposits and makes loans and backs citizens, then I would force a separation.

MM: What's the policy importance of the compensation schemes in the financial sector, and what kind of regulation would you like to see in place?

Prins: I don't believe that we will see a capped compensation structure because of how compensation generally works in corporate America. It gets discussed in Congress every time there's some corporate catastrophe and a few years later, it's higher than ever.

I do think that it is important to look at compensation with respect to the risk that the company takes on, not for just the company, but for the overall economy. In all of these situations - with the subprime, structured products and derivative risks that all of these institutions took on - there was little questioning of what impact this could have on the general economy. And I think a compensation structure that recognizes the risks being foisted on the overall economy would, at the very least, force some kind of an assessment of the impact of somebody's practices on everyone else.

MM: Is the idea you penalize them for taking on more risk?

Prins: Currently, the reward is for performance, generally measured in stock price. Positive short-term performance was created out of taking on too much risk. I would suggest looking at the downside of that risk and assessing compensation on that basis, on a longer-term basis, rather than looking merely at profit during isolated moments.

MM: It's pretty clear there will be an effort at significant financial sector regulation in Congress next year. What would you think are the top priority reforms?

Prins: As Congress sits down to look at regulations, the first question that needs to be asked is, "What are we dealing with?" We need full transparency and a full understanding of what the toxic assets are, how much leverage was taken by financial institutions in general, how much loss is still out there.

Then, we need to look at regulating a number of things. We need to regulate the credit derivatives market, which is currently a $55 trillion market that is privately traded between financial institutions. It was deregulated in 2000 by the Commodities and Futures Modernization Act. It should be standardized and traded on a public exchange where it would be transparent.

Number two, we need to regulate and create a more transparent way of independently evaluating and rating any kind of structured securities in the future, particularly ones that are packaged and repackaged off of each other.

Third, we should make sure that banks that are involved with other people's money, primarily by taking their deposits, are not allowed to carry securities beyond a certain level of packaging and risk. And if they do buy certain packaged securities, they should be required to hold adequate and stronger amounts of capital against them. That way, if there are unforeseen losses, they can be absorbed within the bank, as opposed to having to be bailed out by the government.

MM: How optimistic are you that far-reaching regulations will be adopted?

Prins: I'm optimistic that capital requirements can be raised. The argument against that from the finance industry will be that they don't have the capital right now, so this would be a bad time to raise the requirements. I think implementing higher capital requirements will take some time for this reason. But I think capital levels can be raised.

I hope credit derivatives can be regulated. There is enough conversation about it and some of the exchanges that regulate other types of trades, like the Chicago Mercantile Exchange, are offering to be a platform where regulated credit derivatives can be traded.

I don't know about examining all the risks or the books of these firms, or restructuring them - I don't think that will play out.

MM: Is there any category of derivatives that you think ought to be prohibited?

Prins: The biggest problem with derivatives is that they are not transparent to regulators. I would prohibit derivatives that aren't transparent, no matter what underlying commodity or security they're based upon.

MM: What does transparent mean in that context?

Prins: That it is known and transparent who traded what, and what the underlying asset is. There should be limits to how much a derivative can be embedded within other derivatives, so there is more clarity as to who took the risk and what the risk is. It's one thing to have one credit contract between two banks that backs some loan between them. It's another thing to have so many layers of derivatives embedded within each other, that it's impossible to know which parties are involved in the chain, you can't see the risk that they're taking, and it inevitably winds up being too large because of that.