A Nightmare On Wall Street

By Andrew Beattie AAA



Edgar Allan Poe found horror in the possibilities of a room that could be locked, cemented shut or otherwise turned into a trap. Were he alive today, I'm sure Poe could find ample inspiration in our modern banks. A bank vault is nothing more than an airtight room that locks from the outside; this in itself is cause for morbid thoughts, but it's the people who work among the vaults who commit the horrors in the following tales.

Charles Keating the S&L Puppet Master
The causes of the 1980s savings and loan collapse are too diverse to be laid at the feet of one person. In an era of inflation, deregulation, policy change and revolutionary accounting, savings and loans went from being timid institutions to leveraging themselves like investment banks to make a profit. In this mess, some emerged as larger villains than others, and Charles Keating was the king of the thieves among them.

It started when Keating purchased Lincoln Savings and Loan through his company, American Continental Corp. He took full advantage of the chaos during the market's period of deregulation and gave significant gifts to politicians to keep savings and loans protected from further legislative restrictions.

Free of scrutiny, Keating started skimming depositors' money by offering financial instruments through a thrift that funneled money into a parent company for investment purposes. Now flush with unsuspecting depositors' hard-earned cash, he started speculating in real estate and other direct investments. Not only were the "investments" misrepresented to clients, but Keating often inflated the values and falsified returns to attract more from his client's accounts.

When the collapse hit the market, Keating's thoroughly looted institution went under. The investments purchased through the parent company proved to be worth mere pennies on the dollar, much to the shock of depositors. While the depositors' accounts were covered by federal insurance, the investments were not. Thousands of Average Joes saw their life savings vanish through Lincoln alone, and the overall collapse cost more than $100 billion of taxpayers' money to clean up. (Find out more about which of your accounts are safe at Bank Failure: Will Your Assets Be Protected?)

E.F. Hutton Burned by Red Hot Paper
From 1980 to 1985, E.F. Hutton & Co. ran the biggest check-kiting scam in history. The brokerage and financial services firm necessarily kept accounts at many banks all over the country and constantly transferred funds between them to meet its business needs.

In doing this, Hutton employees rediscovered an old check-writing scheme that essentially allowed them to take out billions in interest-free loans from hundreds of banks. Since checks had a significant processing lag time, Hutton employees would write checks between accounts that they knew exceeded the amounts in the accounts, but that could be covered by the time the checks were processed.

Simply put, instead of taking out loans or entering the commercial paper market, Hutton used this fraud as an interest-free solution to any short-term capital needs. Knowingly passing bad checks is, of course, as illegal for firms as it is for individuals. The banks being swindled caught on when the amount of checks being passed reached billions.

The government swooped in and forced Hutton to pay the banks for lost interest to the tune of $8 million, along with a $2 million fine, but no one was jailed as part of the plea bargain. The most horrifying part of the scandal was that management was fully informed and egged their employees on - which threw a wrench in the notion of in-house supervision.

Mary Shelley's Mortgage Meltdown
Every monster worth its salt rises from the dead for the next movie, and every financial crisis has its sequel. The savings and loan crisis got its equivalent of a Hollywood remake as the mortgage meltdown unfolded from 2006 to 2008. At the root of the crisis were the mortgage-backed securities that allowed housing loans to be sold as financial instruments, freeing up the issuing banks to loan out more money. In this credit glut, lending standards fell and credit was being extended to people who shouldn't have received it. (Get all the details on this credit crisis in our Subprime Mortgage Meltdown special feature.)

Much like giving children a loaded gun to play with, it was only a matter of time until something bad happened. The easy mortgages, especially the "Alt-A" and subprime loans, fueled a housing bubble that popped in 2007, as all bubbles ultimately do. (To read more on bubbles, see Why Housing Market Bubbles Pop.)

The default on the mortgages turned the MBS portfolios "toxic", which in turn made many investors, including banks, insolvent. Bear Stearns was the first big name to fall when it was purchased by JPMorgan Chase (NYSE:JPM) through a government brokered deal in March 2008. July saw Indymac Bank go into receivership and credit markets dried up as financial institutions started hoarding cash to shore up their reserves against subprime losses. Unfortunately, it was a case of too-little-too-late for Merrill Lynch, Lehman Brothers, Washington Mutual and Wachovia. In a bloody September, the Federal Reserve took over Fannie Mae and Freddie Mac, Lehman Brothers filed for bankruptcy, Merrill Lynch was sold to Bank of America (NYSE:BAC), Washington Mutual was seized by the FDIC and sold in chunks to JPMorgan Chase, and Wachovia was snapped up by Wells Fargo (NYSE:WFC).

Trick or Treat
The collapse of banks and other financial institutions unleashed financial shock waves that shook markets worldwide. The bloodletting led to a succession of bailout packages in the U.S. as well as worldwide intervention. The problem was no longer exclusively attached to the securities created out of subprime loans, but the reluctance for the players with capital to lend or invest.

By taking over Fannie Mae and Freddie Mac in September of 2008, the government took responsibility for trillions in debt and then added to the pot with the $900 billion in short-term loans to banks to ease the LIBOR rates. In October, the government began directly investing in financial institutions to the tune of $1.3 trillion. All the financial candy was not without a catch as many CEOs will likely find the strings of their golden parachutes cut, and untangling the government from the banking system will take decades. Some companies understandably chose private investors like Warren Buffett rather than turning to the government for handouts.

The Finger of Death
The question became who to blame, as much as what to do. This time, there was no Charles Keating to bear the brunt, so multiple rounds of finger-pointing took priority.

Everybody involved shared the fault: Fannie Mae and Freddie Mac, because their rapid conversions of mortgages into MBS for sale, without monitoring underlying default risks, ramped up available credit; banks, because they fought with each other to issue more loans, forgetting risks and becoming too loose with their lending; and the people who took out a mortgage they didn't understand, or bought more house than they could afford, because even though banks offered an easy way for people to overreach their finances didn't mean people had to take it. (See more about who's responsible at Who Is To Blame For The Subprime Crisis?)

If made into a horror movie, the mortgage meltdown would be Mary Shelley's Frankenstein. It would star the misunderstood MBS: a decent financial instrument at heart that is hounded and abused by all until finally turning on its creators.

The Happy Ending
If there is a ray of light in these tales, like a night-light to keep the monsters in the closet, it's that there are more good banks and bankers than bad. This isn't because banks are bastions of moral perfection, but because it's in the best interest of the banks to act correctly, a la Adam Smith's "invisible hand". A common thread through these stories, as much as the damage wrought, is the undoing of the culprits.

Lincoln Savings is no more, and Keating went to jail. Hutton's management and employees escaped jail, but the company's reputation was shattered and it soon chose to be absorbed by rivals rather than go insolvent. The mortgage meltdown brought low the worst perpetrators and tightened lending practices back up - in fact, it tightened them so much as to lead to a credit crisis.

In short, the bad perish by their own hands, and the good survive. True, the cure may prove harsher than the disease, but moral hazard is vital to keeping everybody on the up-and-up and out of the down-and-outs.



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