Main street America is directing a lot of justifiable anger towards big banks right now. No one is happy with the bailouts that took over a trillion dollars of your money and gave it to institutions that were ‘too big to fail’. Our children’s grandchildren will still be struggling to pay that money back a century from now.
So why did this happen? How did it all come to pass? More importantly who’s to blame? Read on and learn the ugly truth…
How Money is Created- Fractional Reserve Lending
To understand how the big banks earned the label ‘Too big to fail’ you first need to understand how they make their massive piles of money.
Most people understand the basics of how banks operate. You deposit your money and the bank lends it out. Sounds pretty straightforward right? It’s anything but. Using the magic of something called Fractional Reserve Lending a bank literally invents the money that it loans out.
Let’s say Joe deposits $1,000 into a savings account at his local bank. Most people assume the bank pays Joe interest on that money, and that they lend it out at a higher rate so they can make money. That’s partly true. They do pay Joe interest on his $1,000. However, instead of lending out that $1,000 the bank actually loans out $10,000.
Joe’s $1,000 is still sitting in his savings. The bank creates all $10,000 out of thin air, and then loans it out at interest. They keep the money they created and the interest they charge for it. So when you take out a loan they’re loaning you money they never even had.
Let me recap that in case it didn’t sink in. A bank makes up the money it lends for your car or home, and it charges you interest for the privilege.
If you can’t pay back this new money guess what they get to do? Come and take your house or car. If you fail to pay back the money that the bank made up, you lose your very real home or vehicle. They have no skin in the game, but they come out owning your property.
Bear in mind the money they keep in reserve isn’t lost when they make a loan. So if the bank has $25,000 in reserves and you want a $250,000 loan for your home they keep the 25k. They also get all $250,000 they just made up as well as the interest on it.
Sounds pretty shady doesn’t it? It gets worse.
Bank Created Inflation
Do you remember how much a movie ticket cost when you were a kid? How about a gallon of gas or a new car? How much do those things cost now?
Remember when the idea of a million dollars meant you could retire? Now you can barely buy a house with it. In some areas a million dollars won’t even do that much.
From 1933 to the present the U.S. dollar has lost over 96% of its value due to inflation. How and why did this happen?
Inflation happens when the money supply increases. In other words the more dollars there are, the less each dollar is worth. Every time a bank writes a loan it creates more dollars, which causes inflation. So in addition to raking in profits from the money they make out of thin air banks are also making the money in your wallet worth less.
Sounds pretty bad doesn’t it? Banks are creating money from nothing, causing inflation and making incredibly massive profits. All of that is supposed to come at a price though. If a bank makes bad decisions its supposed to go out of business.
Instead the public was forced to bail them out, because we were told they were ‘too big to fail’.
Too big to fail?
Right before the great depression several very powerful banks made risky financial decisions that led to an economic crash larger than anything the U.S. had ever seen. Two of the largest were JP Morgan Chase and Goldman Sachs. Does this sound at all familiar?
In 1933 congress realized that letting the big banks run rampant was a really bad idea. They created the Glass Stegal act. In a nutshell the law said a bank can only lend. It couldn’t own stocks or bonds or deal in any sort of risky trading. Basically it outlawed the very things that led to the great depression, and to banks being considered too large to fail.
Makes sense doesn’t it? The banks in the early 1900s played with our money and crashed the economy, so we made laws to stop it from happening again. For the next sixty five years these laws kept the banks in check, and all was well.
In 1999 the Glass Stegal Act was repealed. Now instead of making their money lending the banks could once again own stocks, bonds or other assets. In essence they could gamble using the money we deposited, but that’s ok because they’re professionals and they’d never make bad bets, right?
Their profits were higher than ever! The problem is that in their rush to make an ever increasing pile of money they started taking more and more risks. Less than a decade after the removal of Glass Stegal the economy collapsed under the weight of their greed.
As we are all painfully aware the ‘professionals’ on Wall Street made some really bad bets. They dabbled in incredibly risky ventures that any sane person should have shied away from.
So how exactly did the banks get themselves into trouble?
The Advent of Mortgage Backed Securities
Before Glass Stegal was repealed banks owned the loans they made. If you borrowed $250,000 for a home loan from Bank of America you made your payment directly to them. If that loan went bad Bank of America lost money, so they were careful only to lend to people that could pay it back.
All that changed with the advent of something called a Mortgage Backed Security. Many people have heard the term, but very few understand exactly what they are.
Basically a MBS is a little piece of somebody’s mortgage. Banks bundled up people’s mortgages into giant pools, usually $30,000,000 or more. They’d sell stock in this pool, and anyone could own a piece. People were eager to do this, because you could make up to 10% interest. At the time a CD only paid about 4%, so it was definitely a smart investment.
We knew this, because these Mortgage Backed Securities were given the highest credit grade by the most reputable ratings agencies in the world: Moody’s, Standard & Poor and Fitch all stamped them with an AAA approval, the highest they offer.
They claimed these were the safest investment money could buy. Safer than stocks. Safer than bonds. Which means if you’re an investor you’d be a fool not to buy them. They offered a higher rate of return than any comparable investment, and were safer to boot. Is it any surprise that every investor in America suddenly had a voracious appetite for them?
Now why was this whole Mortgage Backed Security thing a problem? Because it removed accountability.
As I mentioned before when a bank made a loan they were very careful to make sure the borrower could repay. When they were suddenly able to sell those loans on Wall Street they no longer cared if the person could repay the loan, because if it went bad it already belonged to someone else. All they cared about was funding as many loans as possible so they could increase their profit margin.
At first Mortgage Backed Securities were made up of what’s called A Paper. The A in A Paper refers to the credit rating of the borrower, and meant the people in question had excellent credit. This meant there was very little risk in owning those securities, because you knew the borrowers would make their payments on time.
The thing is there were only a limited number of those people in the United States, and eventually all of them had loans. Yet demand was greater than ever, so banks of all sizes were under enormous pressure to provide more securities at any cost.
More on the Rating Agencies
Remember the ratings agencies I mentioned earlier? As the credit worthiness of the Mortgage Backed Securities dropped, they should have downgraded the rating from that vaunted AAA. They didn’t. They kept right on giving them that top grade stamp even after the financial crisis began in 2007.
Why? It has to do with their business model. The ratings agencies are actually paid by the very companies they rate. The agencies get paid by the people they rate, so if they give them a bad rating those companies won’t use them anymore. Can you say conflict of interest?
Is it any surprise that Moody’s, Standard & Poor and Fitch all lied about how safe Mortgage Backed Securities were? They turned a blind eye to the fraud, because it was profitable for them to do so.
Here Comes the Fraud
I worked for a mortgage bank from 2001 to 2007, so I had a front row seat for the circus that came next. When banks ran out of A Paper loans they started soliciting people with bad credit and/or people who didn’t make enough money to afford the homes they were buying.
Brokers would present loans that appeared to be A Paper, but were really a house of cards. If their borrower didn’t have good credit the broker would help them improve their score until it was high enough to qualify for a loan.
Did their borrower work at starbucks? No problem! They’d just lie and say the person owned a franchise and made $10,000 a month. Did the borrower only have $50 in the bank when the lender required $10,000 in assets? No problem! The broker just lied and said the borrower had the money.
How was this sort of fraud possible?
Banks were so desperate to fund more loans they created something called a stated/stated loan. Borrowers wrote down their salary and their savings, but the lender didn’t check either number. They just took their word for it. As you can imagine almost no one told the truth, which meant billions of dollars in fraudulent loans were funded.
Between 2003 and 2005 the level of fraud increased drastically. To make matters worse a new craze started for ‘subprime’ mortgages. Remember when I mentioned A paper before? Subprime loans were made up of D paper. Think about grades in school, and you have some idea of the difference between an A and a D.
Wall Street was so desperate for more Mortgage Backed Securities that they were willing to accept loans where the borrowers had really, really bad credit. By this time people in the know began to get really nervous, and whispers began about the ‘housing bubble’.
Most people scoffed at the idea, but savvy investors stopped buying Mortgage Backed Securities. This created a huge problem as literally hundreds of billions of dollars of these securities were still being created. Since the investors on Wall Street weren’t buying them, who was? You’re not going to like the answer.
You were. You’re probably wondering how that’s possible.
If you have a 401k there’s about a 90% chance it was invested in a mutual fund. A mutual fund is run by a financial investor who invests money for dozens, hundreds or even thousands of people all at once. Long after the investors on Wall Street stopped buying Mortgage Backed Securities the companies running your 401k still were.
They used your retirement to buy bad mortgages which are now worth pennies on the dollar. Chances are you saw a huge drop in the value of your 401k over the last three or four years. That’s probably because at least part of it was invested in Mortgage Backed Securities.
As bad as Mortgage Backed Securities are, at least they made some level of sense. They weren’t the only thing the big banks were involved in though. Wait until you hear about Credit Default Swaps.
Credit Default Swaps. Are you kidding me?
Repealing Glass Stegal allowed banks to buy a whole alphabet soup of financial instruments most people will never understand. The worst were called Credit Default Swaps, or CDS for short. In a nutshell a CDS was an insurance policy, but with some important differences.
Normally an insurance company is required to keep reserves. So if I’m an auto insurance company and I want to write you a policy on your car I need to make sure I have money set aside to pay for that car if you get in an accident.
With a CDS I can write a policy that says I’ll pay you a million dollars if AIG goes bankrupt. But I don’t have to actually have a million dollars. I didn’t even need to have five dollars. I could write as many of these policies as I wanted without having the ability to make good on any of them.
There’s one other important difference between a CDS and a typical insurance policy. When you get insurance you get it on your car or your house. With a CDS you could effectively insure your neighbor Phil’s car, so if he got into an accident you got paid.
Do you see how this could lead to problems? Anyone could make a CDS without being able to pay on the promise it made, and anyone could buy one even if they had no vested interest in the bet.
In 2007 over two trillion dollars of CDSs existed. Over 90% were made between the largest five banks in the nation, all of which are now household names. Goldman Sachs, JP Morgan Chase and AIG are the most famous.
Remember when the taxpayers bailed out AIG to the tune of 160 billion dollars? Guess where that money went? AIG created a bunch of Credit Default Swaps and sold them to Goldman Sachs and JP Morgan Chase. Many said that if Bear Sterns went under they’d owe them billions of dollars. Only AIG didn’t have billions of dollars, so when Bear Sterns suddenly collapsed they had no way to pay out these policies.
So who paid for all these bad policies? You did. Your tax dollars were used make good on AIGs debts. Not because the government cared about AIG, but because otherwise Goldman Sachs and JP Morgan Chase would have gone under.
Without the bailout AIG would have declared bankruptcy. That would have meant companies like Goldman Sachs would have had to accept debt settlement, which pays them a cut of what AIG owed but nothing near what they would have gotten otherwise. Instead we bailed out AIG so Goldman and JP Morgan got the full value of all the CDSs AIG made with them.
That’s your tax dollars at work.
So what would have happened if the banks hadn’t been bailed out?
The taxpayers gave over a trillion dollars to the banks in the last few years. Stop and think about that for a minute. A trillion dollars is $3,000 for every man, woman and child in the United States. It’s enough to pay 25 million people a $40,000 salary for a year. It could have rebuilt every road, bridge and levy in the U.S. Instead we gave it to the banks.
When the TARP bill was placed before congress for $700,000,000,000 every poll showed that over 90% of the public was against it. Hundreds of thousands of letters were sent to congress begging them not to do it. They did it anyway, because they didn’t care what we thought. Why should they? We aren’t the one paying millions of dollars to fund their campaigns. The banks are.
Congress told us that without the bailout our country would be in financial ruin. They lied.
What actually would have happened is that all the banks who made bad decisions would have gone out of business. Goldman Sachs, JP Morgan Chase, Bank of America and Citibank would have imploded. How much would that have effected people on Main Street USA? We barely would have noticed.
We were told that credit would have frozen up entirely. That simply isn’t true. Local banks and credit unions who’d made more conservative choices, and hadn’t made such risky loans would have picked up the slack.
That’s not to say that everything would have been rosy, but would it have been worse than what we’re going through right now? How secure do you feel about the economy, your job and your family’s financial health? Did bailing out the banks do anything to help you directly? Of course it didn’t.
Had they been allowed to fail our country would have gone through a much needed economic correction. People would have learned to live within their means again. It would have been painful, but it’s a normal part of the boom / bust cycle capitalistic societies go through. The banks and credit unions that did things right would have grown, and in time they’d have replaced those the government called too big to fail.
Instead of punishing the people who caused the economic crisis we bailed them out and made sure they still got their bonuses. We made sure they can still live in their mansions, drive their Ferrari’s and live in complete luxury. The cost? We sold our children into perpetual debt slavery. Our national debt is now so large that it cannot be paid off in our grandchildren’s lifetimes. But those banking executives on Wall Street are ok so it was worth it right?
Congress terrified us with tales of our economy grinding to a halt. We were told that we couldn’t let those banks fail, or all lending would stop. Yet those banks did stop lending, even after we gave them our children’s future. Instead they used the money to snap up their smaller rivals, making the too big to fail banks even bigger. They bought up homes, cars, businesses all while the average citizen is struggling to afford food and rent.
It’s a despicable situation. So what can we do about it? It’s clear that congress won’t listen to us, so voting won’t solve the problem. We need to adopt more fundamental changes if we want to rebuild our communities, and get away from the debt slavery the banks are pushing us into.
The good news is that there’s something incredibly basic that all of us can to do help fix the problem. The first step? Join your local credit union.
Credit Unions to the rescue
Rampant greed led to the financial crisis. Everyone wanted to make a profit, and they did whatever it took no matter who they hurt in the process.
That sort of greed isn’t possible with credit unions, because they are not-for-profit organizations. They literally cannot make a profit, so unlike banks they are not motivated by greed. Each member of the board of directors for Bank of America makes between six and thirty million dollars. Why do you think they are paid so handsomely? Because they excel at maximizing profits.
Credit union boards are made up of volunteers who are not paid for their time. They serve out of a desire to help their communities. Which group would you rather have running the institution you bank at?
Don’t get me wrong credit unions do use Fractional Reserve Lending, just like banks. The difference is the profit they would have made is funneled back into your community. They support local charities like the United Way and youth outreach programs.
More importantly they make small business loans, provide low interest rates and offer a safe place for you to invest your money. They are federally insured just like banks are, and offer nearly all the same services.
If you’re tired of giving your money to big banks more interested in next quarter’s profits than in the community make the switch to your local credit union. Put your money to work for you and your neighbors instead of having it siphoned off by shareholders that may not even live in the United States.
So where do we go from here?
Why did the banks get away with their reckless behavior? Why hasn’t a law been passed to prevent the use or sale of Credit Default Swaps? Why do we continue to bail out these banks? Most importantly of all why aren’t our leaders listening to us?
These are difficult questions with even more difficult answers. I can’t tell you how we’re going to get out of the mess we’re in, but I can say this. It begins with you. It begins with me. If we want to see real change we’re going to have to work together to make it happen.
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