Business as Usual: The Roots of the Global Financial Meltdown

Chapter 4: A Turning Point or Business as Usual?

A Turning Point or Business as Usual? 113 We are all Keynesians now. —Milton Friedman, quoted in Time, December 31, 1965 I. A Local Story with Global Implications In the spring of 2009, as the crash of 2008–9 seemed to be dragging the US economy toward a new depression and the entire world was following , I talked to some knowledgeable bankers in the state of Washington about the fall of Washington Mutual (WaMu) in 2008, the largest bank failure in US history up to that time.1 (Lehman’s collapse was bigger and more consequential, but that was because it was much more than a bank. Other likely candidates for collapse among banks bigger than WaMu, Bank of America and Citi, were saved by government intervention.) I asked them to explain what had happened. Their stories were all much the same. WaMu’s chief executive, ousted in 2008 as his bank was about to fail, was primarily a financial expert whose chief accomplishment was to acquire a large number of small to medium-sized banks (mostly thrifts specializing in mortgages) throughout the United States, thus turning his own bank into a giant. He further increased WaMu’s business by Chapter 4 A Turning Point or Business as Usual? Daniel Chirot 114 Chirot then acquiring mortgage companies, especially in the five years prior to his bank’s collapse. This included mortgage companies in Southern California, where an enormous housing-price bubble was developing. Maintaining the momentum of growth and keeping up profits was critical to keeping the stock price high. Falling or even stagnant profits would cause the stock price to decline, thus making WaMu itself vulnerable to being taken over by another giant. Bonuses for top executives and maintaining their own self-esteem as successful executives were dependent on keeping up the stock price. In order to maintain and even increase profits, WaMu had to initiate an increasing number of mortgages, as this was its principal business. By acquiring banks and mortgage companies throughout the country, it could increase its depository base and leverage this to make yet more loans. Aside from never efficiently integrating the operating procedures and systems of the many institutions that WaMu took over, a problem that made it ever harder to control what these branches were doing, WaMu began to run into an even deeper quandary that was spreading throughout the global financial system. Keeping up profits was becoming increasingly difficult as the real economy’s stock of investment opportunities was not growing fast enough, except through various kinds of financial speculation and in the mortgage market. To keep on generating rising profits, WaMu had to find ways of continuing to grow a housing market that was increasingly saturated and overpriced. Too much money was going into new constructions of ever-larger houses, more office space, and bigger shopping malls. But if there were too few other places to invest, this is where business had to be increased. So the bank pressured its executives to find new ways of increasing loans, and this led to a catastrophic decline in lending standards. Loans with absurdly small short-term payments were peddled to buyers with weak credit, who were promised that when their rates were increased, as specified in the contracts they were given to sign, they would be able to refinance or sell at a profit. (How this was done in a way that made it seem legitimate is detailed in the next section.) Of course, lending more money to ever more insecure borrowers made that much more cash available to buy property, thus increasing demand and inflating real-estate prices. But this could not go on indefinitely. Rising prices stimulated more speculative building until the combination of too much supply and ever more unrealistic prices caused the bubble to A Turning Point or Business as Usual? 115 break. Then, collapsing prices created problems for those who were suddenly faced with higher interest rates as their short-term low-rate periods expired. Large numbers of loans went bad, and WaMu began to collapse. The question I asked bankers who knew about WaMu’s dealings, and those of other banks in the years before 2008’s crash, was whether top executives at WaMu knew what they were doing. And, if so, was this deliberate fraud? Was it like the case of Bernard Madoff ’s sixty-plusbillion -dollar fraudulent investment company that never invested but...