The Black Swan: Financial Crisis

The Black Swan: Credit Derivatives and the Financial Crisis in the United States and European Union

Ownership has been separated from control; and this separation has removed many of the checks which formerly operated to curb the misuse of wealth and power.  And, as ownership of the shares is becoming continually more dispersed, the power which formerly accompanied ownership is becoming increasingly concentrated in the hands of a few.  The changes thereby wrought in the lives of the workers, of the owners and of the general public are so fundamental and far-reaching as to lead these scholars to compare the evolving ‘corporate system’ with the feudal system; and to lead other men of insight and experience to assert that this ‘master of institution of civilized life’ is committing it to the rule of plutocracy.

--Justice Brandeis, Dissent in Louis K. Liggett Co. v. Lee[1]

Introduction 

In 1933, Justice Brandeis delivered a famous dissenting opinion in a case involving corporations in Florida he felt were becoming more powerful than even the states, claiming the corporate system was slowly moving toward a plutocracy.  In the case, the Supreme Court struck down a statute that taxed Florida businesses on a graduated scale; the tax slowly growing as certain chains produced more and more stores.[2]  These types of taxes were being used to reign in control of a corporate system the nation had seen run out of control.  Less than four years prior Wall Street had come crashing down into the Great Depression after Black Tuesday, and shown the unseen dangers of a corporate America without stricter rules. Capitalism, the dream the United States (US) believed it had perfected, and indeed the one that pushed it ever so closely to superpower status, was proving that growth was not infinite and greed could easily put a cog in the system.  States such as Florida began enacting certain statutes to reign in the ability of businesses to grow without real thought to how the statutes operated. Chapter 15624 of the Laws of Florida, passed in 1931, “declare[d] it unlawful for any person, firm, corporation, association, or co-partnership, foreign or domestic, to operate any store within the state without first having obtained a license,” as well as procedures for registration and renewal of these licenses.[3]

In essence, the statute allowed the State to heavily monitor expanding businesses that had put the economy in so much peril only two years before.  In fact, Florida, like so many other states, still had the bitter taste of the Panic of 1907 in their mouths, when the New York Stock Market dropped nearly fifty percent.[4]  Banks attempting to help aggressive corporations corner the market on the United Copper Company were left in a major liquidity crisis when the bid failed and the banks attempted to call in as much cash as possible.[5]  This led to a run on the banks and a major market liquidity problem.  With the help of J.P. Morgan (the man, not the bank) the US was able to stave off major depression.  The panic eventually led to the creation of the Federal Reserve System (Fed), a much more stable lender of last resort.[6]  Of course, the problem worsened with the credit extensions of the Roaring Twenties and by Black Tuesday, the US saw the consequences of what a real depression was like.  With three decades of economic turmoil since the Morgan rescue, the States no longer felt the capitalistic system could go unchecked.  Plutocracy had taken its toll on the American public and the American economy.  It is not surprising then, that Justice Brandeis took such a hard line with regard to the Supreme Court’s decision to nullify such laws.  Not only was this stretching the court into what he clearly saw as a state’s right to control its commerce, but it left wide open the door that had previously led to economic disaster. 

Despite the legal and government changes, the inability of the Fed to handle a business cycle for over sixty years since the Great Depression led the government to attempt deregulation, leading the US into a very similar, albeit much more globalized, situation.  In some ways this depression is similar, but in one very important way it is different.  While overextensions of credit and massive leveraging of banks again played a very large role, what took this depression to whole new heights was the use of a financial tool so complicated even those selling them do not really understand what they were: credit derivatives.  While Mathematical Economics majors sat in back rooms thinking of new mathematical derivatives to sell to an unknowing world, the salesman in the foreground could not wait to take advantage of the unsuspecting buyers.[7]  Traders know that, “[t]o enter the world of derivatives trading is to enter a realm of beautiful lies,” ones many in the market believed to be true.[8]

Legal and Historical Analysis

            In March of 1999, then Chairman of the Federal Reserve Alan Greenspan remarked to the Futures Industry Association:

By far the most significant event of finance during the past decade has been the extraordinary development and expansion of financial derivatives.  As we approach the twenty-first century, both banks and non-banks will continually reassess whether their own risk management practices have kept pace with their own evolving activities and with changes in financial market dynamics and readjust accordingly.  Should they succeed I am quite confident that market participants will continue to increase their reliance on derivates to unbundle risks and thereby enhance the process of wealth creation.[9]

Arguably the most powerfully man in the financial world considered derivatives to be something to be relied on, given that they would remain in check by those who used them.  This unregulated idea of capitalism took hold when in 1999 Congress passed the Gramm-Leach-Bliley Act, effectively repealing the Glass-Steagall act of 1933.[10]  The most important aspect of the repeal was removal of the law that had prohibited bank holding companies from owning other types of financial institutions.[11]  This statutory provision had kept apart two situations that, if melded, created the perverse incentive. It allowed major banking institutions with large amounts of capital, all ultimately insured by the lender of last resort in some aspect, to get into the market of financial speculation.  Less than ten years later the situation that so worried Congress back in 1933 came to fruition.  Banks such as Chase, AIG, and other large lenders were now able to own and operate an extra financial arm, investment institutions, as a subsidiary of the bank holding company.  The question now became whether the bank was working for the customer or the subsidiary attempting to make large amounts of quick cash in the financial markets.

            Combined with this Act was case law that helped further the opaqueness of the financial services industry and allowed companies to use credit derivatives unchecked. A few years after the Gramm-Leach-Bliley Act, the Securities and Exchange Commission (SEC) attempted to pass what became known as the Hedge Fund Rule.  Hedge funds immediately challenged the rule that would force them to register with the SEC and other regulatory agencies, and the D.C. Circuit court struck down the law.[12]  Decades before this Congress had attempted to regulate these investment advisors.  After the Great Depression, Congress enacted the Investment Advisor’s Act of 1940 (the Advisor’s Act), a similar statute to the Investment Company Act.[13]  Enacted by Congress to “substitute a philosophy of full disclosure for the philosophy of caveat emptor” in the financial services industry, the Advisor’s Act is at its core a registration and anti-fraud statute.[14]  Non-exempt “investment advisers” are forced to register with the SEC, and are prohibited from involvement in fraudulent or deceptive practices.[15]  Hedge fund partners fall under the definition of “investment adviser” in the Advisor’s Act but for sixty years they satisfied the “private adviser” exemption from registering.[16]  The section exempts “any investment adviser who during the course of the preceding twelve moths has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor as an investment adviser to any investment company” already registered under the Investment Company Act.[17]  Because the SEC had interpreted limited partnerships and other similar entities as the investment adviser’s client, even the largest hedge fund managers have always been exempt because most do not run more than fifteen hedge funds.

            Another way the financial services industry, in particular hedge funds, has been able to use credit derivatives frivolously are because of case law involving fiduciary duty.  Because investors in private funds do not receive any investment advice directly (they merely add money to the pooled investment), their roles are considered completely passive.  Even though Congress in part passed the Advisor’s Act to create this fiduciary relationship, courts have interpreted it only to exist between the advisor and the fund.  According to the Advisor’s Act, it is illegal for an investment advisor “to engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client,” their fiduciary duty.[18]  In SEC v. Capital Gains Research Bureau, Inc., the Supreme Court held that this provision created a fiduciary duty between the advisor and hedge fund only.[19]

            These case law examples show how regulators have had to consistently fight with an industry that has far more money and resources to challenge any restriction of freedoms.  When those with so much power in the financial service industry owe no duty to actual persons, problems inevitably arise.  Although Congress attempted to bolster the regulations in 2002 with the Sarbanes-Oxley Act, the act proved a weak attack in a political universe where lobbying plays a major role for the financial services industry.  The law only applies to public institutions and provides for increased criminal penalties in situations such as with companies like Enron and WorldCom, but has proven to be little incentive in such massive financial and accounting scandals.[20]  With this final attack, the US political base in Congress again bowed to the renewed plutocracy of Wall Street.  In a book written four years later in 2006 appropriately entitled “Traders, Guns, and Money,” Satyajit Das prophetically writes that “[m]ost banks are too big to fail and can count on government support…Traders can always play the systemic risk trump card.  It is the ultimate in capitalism—the privatization of gains, the socialization of losses,” something the government bailouts have demonstrated. [21]  When you add derivatives into the equation, it truly is a zero-sum game.  The financial industry knows “[t]he lack of transparency lies at the heart of derivatives profitability” and when “you deny the client access to up to date prices, use complicated structures that are hard for them to price, and sometimes just rely on their self-delusion,” easy money is made.[22]

When the biggest players of the financial universe take this viewpoint to heart, the black swan occurs.  The term black swan originally refers to the 17^th century European assumption that all swans are white, which became a symbol for things that are impossible.[23]  In the 18^th century, the discovery of black swans morphed the phrase into something that is merely a perceived impossibility, but something that could actually occur.[24]  In 2007 Nassim Nicholas Taleb phrased his new theory in three parts: a black swan is an event that is a surprise (from the observer’s point of view), it is a major impact, and in hindsight it can be rationalized as if it were expected to occur.[25]  While Taleb meant his theory to apply to such scientific and historical instances as the computer, World War I, and September 11, the term becomes all the more powerful in light of the current financial crisis.[26] What Wall Street considered impossible at the time, the slowing of credit and the unwinding of long-term and highly leveraged financial positions, the derivatives traders proved were a black swan.  While Wall Street in many ways believed that derivatives could be unwound, even in a down economy, it did not anticipate such a perfect storm of a credit crunch, housing downturn, and global financial reset.  Though it could be argued that such a threesome is hardly able to be anticipated, it is little respite for the global public who now know that greed was the main factor in Wall Street’s attempt to make financial gain on such complicated mathematical structures.

Credit Derivatives: Types, Leveraging, and Hedging

            Financial derivatives come in many forms and complexities; so many that even Wall Street could not fill enough books to understand them.  One type of derivative in particular has wreaked more havoc than others though, the credit derivative.   A simple financial derivative is nothing more than an agreement between traders to exchange assets or cash over time, with the transaction being based on an underlying asset, index, value, or condition.  A credit derivative is the same instrument, except the underlying risk is a credit risk based on a bond, loan, or financial asset, such as a mortgage.  They come in a multitude of acronyms, such as CDO, CDS, CLO, CBO, etc.  They provide a trader and other financial professionals a way to hedge other financial positions, as well as leveraging multiple times over what a bank actually holds in capital.  As the banks and traders began to realize, “[a]ll in all credit was just not very liquid or tradable.  Whoever cracked the secret of trading credit would do well—very, very well.”[27]  The problems with credit derivatives, however, are numerous, and a few major ones show up repeatedly. 

First, often times the underlying credit risk is impossible to value, even for those making the initial trade.  For example, the mortgage backed securities market such as sub-prime mortgaging failed to realize that the credit market had become so over-extended.  Companies regularly offered large mortgages backed by the federal government sponsored agencies (GSE) such as Fannie Mae and Freddie Mac to people who could never afford the principal payments.  When loans stopped performing, the entire credit derivatives market of mortgages came to a screeching halt.  Second, credit derivatives often became far more complex than their other financial derivative counterparts.  This had to do with the increasingly recognizable fact that the underlying securities were wrongly or fraudulently valued, often times aided by credit rating agencies.  This was often coupled with the knowledge that other financial positions could be hedged with these derivatives as a sort of insurance policy in case the initial positions taken on the market proved to be wrong.  In many cases, therefore, the derivatives market sought failure in certain underlying credit risk the derivative was based upon.   In fact, in many ways “[d]erivatives are an elegant way to speculate on prices going down.  During every crisis, short sellers swarm like vultures over the wounded country/currency/commodity/company to take advantage of falling prices,” making gains on the money others are losing.[28]  Though these derivatives can also be used as a way for speculation of price increases, economic downturns provide a situation in which it can be questioned whether the upside is enough to make up for such a dramatic downside.

Third, the very essence of credit risk is itself a danger.  Everything a bank does involves credit risk.  When it lends money to someone, such as an institution, it takes a risk it will not be paid back.  Traditionally, credit risk had been the forte of commercial banks only, with investment banks relegated to short term trades, until the credit derivative allowed them to start trading and transferring credit risk.[29]  In doing away with Glass-Steagall, Congress opened a Pandora’s box of conflicts of interest.  The conflict of interest in having universal banks is that commercial banks initially realized that investment bankers could “rape and pillage” their clients and then continue good normal banking of lending money.[30]  Investment banks can move on, taking all of the reward and handing off the risk to the larger credit lender, the commercial side, including small time private investment companies and independent investors. 

Finally, most of the derivatives are allowed to be off-balance sheet, meaning they are not regulated and can be leveraged indefinitely.  Three different laws allow for this situation to occur.  The first two are the Securities Act of 1933 and the Securities Exchange Act of 1934.[31]  Both of these acts have since been amended in order to ensure that the SEC is prevented from regulating CDS’s.  Section 2(a) of the Securities Act of 1933 and Section 3(a) of the Securities Exchange Act of 1934 both provide for further amended definitions of “security” that purposely exclude any sort of CDS’s and other credit derivatives Wall Street feared would hinder its more creative banking practices.[32]  The third law is an amendment to the SEC net capital requirements provision codified in the 1934 Act.[33]  This amendment, later repealed following the collapse of Bear Stearns, allowed for an exemption on capital requirements for certain banks if they would open their parent companies’ books to the SEC.[34]  The entire deal was an agreement between the five major investment banks, the SEC, the US government, and the EU in order to keep the EU from regulating the US banks abroad.[35]   Companies began leveraging themselves at unheard of levels of 60:1 or more, which would leave slightly more than a one percent gap in value that would wipe out the capital of the derivative holder.  Off-balance sheet issues would prove to be the largest problem the world governments would face in even valuing how much was actually lost in this crisis.

The United States Situation

It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.

            --Gordon Gekko, “Wall Street” Film, 1987

The current financial crisis emerged in the US beginning in 1980.  In that year Congress, with the approval of the Carter administration, passed the Depository Institutions Deregulation and Monetary Control Act, which phased out a number of restrictions on banks that had been in place since the Great Depression.[36]   This statute allowed banks to merge and relaxed regulations on the ability of banks to make loans, especially with respect to the mortgage industry.[37]  Two years later Congress passed the Garn – St. Germain Depository Institutions Act, which deregulated the saving and loan industry and helped lead to the savings and loan crisis of the late 1980s.[38]  Congress meant these two statutes to revitalize the housing industry by expanding the availability of home loans, but instead they marked the beginning of the sub-prime mortgage crisis.   It was not long before Wall Street began taking advantage of the deregulatory mindset, wanting even more advantages for themselves. 

In 1999, when Congress passed the Gramm-Leach-Bliley Act, it effectively repealed the final part of the Glass-Steagall Act of 1933.[39]  In doing so, Congress removed the provision that banned bank holding companies from owning other financial institutions.[40]  By removing this safeguard, Congress hoped to allow the creation of the “financial services industry” as we know it today.  In doing so, the act also exempted securities based swap agreements from regulations by the SEC.[41] In a world with a gold standard, conservative reserve banking, and no FDIC, the Act makes a lot of sense.  It allows wealth to grow more easily, and information to be shared across companies that often serve one another.  The problem in this case, though, is that with a fiat standard, the FDIC, and very low amounts of capital requirements, Congress effectively created a way for corporations to run wild in risky business transactions because of the large moral hazard effect.

The two main categories of credit derivatives used in this crisis were credit default swaps and collateralized debt obligations.[42]  Companies used these two main types of credit derivatives to hedge their loans and leverage their investments.  In essence, a credit default swap (CDS) is “a private contract in which private parties bet on a debt issuer’s bankruptcy, default, or restructuring.”[43]  Companies very often use a CDS to hedge their loans they have given out to companies.  Hedging is a way to ensure that when a company makes a bet, it is covered on the down side so it does not lose its money. In fact, Wall Street began using this system in hopes of gaining more money on that so called down side.  For example, assume a bank has loaned $10 million to Company A.  The bank will then enter into a $10 million credit default swap with Company B for hedging purposes. If Company A defaults, the bank loses money on the loan, but actually makes money on the swap with Company B.  If Company A does not default, the bank simply loses some of its loan money by making payments to Company B.  Hedging has been an important practice for Wall Street for many years.  In a 2002 speech to Council on Foreign Relations, Alan Greenspan remarked that, “effectively spread losses from defaults by Enron, Global Crossing, Railtrack, WorldCom and Swiss air…over the past year…from banks, which have largely short-term leverage, to insurance firms, pension funds, or others with diffuse long-term liabilities or no liabilities at all.”[44]  Despite former Chairman Greenspan’s sympathy for such practices, others like Warren Buffett, founder of Berkshire Hathaway, warned in the same year that credit derivatives are “time bombs” and “financial weapons of mass destruction.”[45] It is a well-known fact that across the industry “[d]erivatives were a known unknown—known to be weapons of mass destruction” used against the investors.[46]

According to the most recent ISDA survey, the worldwide usage of credit derivatives in 2009 was $31.2 trillion, up from virtually nothing before the passage of the Gramm-Leach-Bliley Act.[47]  So how can such a “known unknown” become one of the largest markets in the world?[48]  History has shown that in times of high economic growth, such as the 1990s when use of derivatives took off, these questions are often left unanswered. 

The second major credit derivative used was the collateralized debt obligation (CDO).  A CDO is a “pool of debt contracts housed within a special purpose entity (SPE) whose capital structure is sliced and resold based on differences in credit quality.”[49]  Although these can also work in many ways, the most common and well-known example of this type of credit derivative is the mortgage-backed security.  These types of credit derivatives allowed the financial service industry to massively leverage itself.   Even a two percent equity stake in a CDO means you are fifty times leveraged; much higher than the expected ten to twelve ratio that banks had been using for decades.[50]  The main players in this market (outside of the private sector) became the GSE’s of Fannie Mae and Freddie Mac, whose directors began running them like profit seeking enterprises rather than the simple home lending organizations they were created to be.  The overextension of credit during the late 1990s and into the early 2000s was in large part due to the Fed’s falling interest rates.  From November 1999 to June 2003, the Fed dropped the Fed funds rate from a comfortable five and a half percent to an extremely low one percent.[51]  This encouraged a recently unregulated market to extend credit to even the most risky clients.  Still worse was the political pressure from some to “promote home ownership for low income households” that only served to aggravate the situation.[52] 

This overextension in credit and heightened use of credit derivatives began to play itself out in the financial services industry as these interests rates dropped.  Insurance in a CDS is not really insurance; it is a gamble.  Financial services companies are generally forced to have some sort of capital to back up their financial contracts.  In 1988 the G-10 agreed to the Basel Accord, issued by the Basel Committee in Basel, Switzerland.  This committee issued a report of international financial regulatory recommendations.[53]  Over the next decade, the increasing global market forced the group to realize that not enough was done in the initial agreement to protect against systemic risk.  In that vein, Basel II began discussions.[54]  The formula of how capital adequacy is measured is one of the main three pillars of the new Basel II Accord.[55]  The rate is set by dividing the total bank capital by the sum of the credit, market and operational risk of each bank.[56]  The new Accord set the minimum requirement at eight percent.[57] 

Despite this effort, there were no legal requirements in the US for these companies to hold anything against the credit derivatives they sold because they were unregulated and off the books.[58]  Companies began to make incredibly large profits in these so called over the counter  (OTC) derivatives.  When economic times are good, the CDS allows to you “short credit easily, which allows you to profit from the decline in the fortunes of a company…[and] [i]t can be leveraged, infinitely.  It is the killer derivative.”[59]  But many on Wall Street failed to realize, or care, that it is a double-edged sword.  Once a small change in market prices occurs and interest rates go up, your leverage is killed. 

Leveraging is just as dangerous of a business as hedging. In the beginning of the second Bush administration in the US, regulators and other authorities allowed five banks (Bear Stearns, Lehman, Merrill Lynch, J.P. Morgan, and Goldman Sachs) to increase their leverage from 12:1 to 30:1.[60]  A 30:1 leverage means that if an entity were to sustain a 3.3% loss, all of its capital is gone.[61]  When this loss occurred, the banks did not have the money to cover this, and the US government barely had enough to bail them out, able to save only two of the previously mentioned five banks.  The following chart shows how leveraging of banks on a global level has occurred in the past decade.

[62]

The blue area shows the bank assets compared to their common and preferred stock, a relatively safe thing to leverage at 10x, assuming your assets are valued correctly (a very risky assumption with sub-prime lending.)  The red area shows assets to common equity, a slightly riskier gamble given the various ways a bank can actually calculate this number (market values to actual book values can vary widely.)  Then purple, the riskiest and quickest rising leverage rate, is assets to tangible common equity (TCE).  TCE is, at its basest sense, the amount of capital a bank or company has in common stock, which are generally owned by the common man and are the last a bank ever has to pay off.[63]

Leverage using credit derivatives drove the financial services industry in the last decade.  Unfortunately, in 2003 the Fed began increasing interest rates, peaking at a level of 5.25% in 2007.[64]  This move proved disastrous to Wall Street, because when your interest rates go up, your borrowing costs go up.  History has shown that in times of numerous Fed interest rate moves, the stock market is highly volatile.

[65]

When a customer margins, or deposits a certain amount of collateral with a broker when borrowing from the broker to buy securities, the lender typically charges a higher rate than if the customer had bought within its financial means.  If you are going to do this, you either do it for a short period or you make sure you can make more than the higher rate.  Both hedging and leverage actually sought to fix this issue without having to meet it head on.  With stock market volatility, if the underlying assets in a company’s credit derivatives suddenly devalue, it gets a margin call.  The company can then either give the investor more money to cover that amount, or depending on the amount the company has leveraged, it has to sell multiple times the margin amount to cover it.  For example, assume a company has a 3:1 leverage ratio.  If a company has a $5 million margin call, when it sell assets, this lowers its buying power, and it has to sell $15 million to cover it.  The company is still not ahead if the asset devalues even further.  Before the company can recover, capital is completely depleted and it is illiquid and possibly insolvent. 

In the case of the US, defaults on home mortgages, the underlying assets of many of these CDS’s and CDO’s, rose sharply as the business recession began to hit the market.  Creative accounting practices and the extreme complexity of many of these credit derivatives made “proper risk assessment challenging for even the most sophisticated in the market.”[66]  The domino effect known as contagion began to set in.  Despite the numerous uses for credit derivatives, the ones tied to the housing market are what really set the ball rolling.  The CDS and CDO markets in mortgages created a catastrophically large housing bubble.  According to the de Larosiere Report, there was a large deterioration in mortgage lending standards from 2005 to 2007 that contributed to this bubble.[67] 

How could such a large bubble occur?  According to the US Census Bureau, median home prices in the US had not dropped since the Great Depression.[68]  The herd mentality created by this fact allowed credit derivatives to rev up the mortgage lending engine.  What was initially a liquidity problem for these banks when the underlying assets of these credit derivatives devalued quickly became a solvency problem as inter-institution contagion set in.[69] The real incentive problem here was that because all of these mortgages had been backed by the federal government via Fannie Mae and Freddie Mac, a massive moral hazard problem had gone unrealized in the booming credit market.[70]

The financial institutions took all of these mortgages believing the prices would only go up.  They sliced them up and put them into CDO’s and CDS’s, which securitized them.  They would split mortgages up multiple different ways into tranches, and repackage them into CDO’s.  To get a return on this, an investor realizes that each person is paying a certain percentage on his or her mortgage, the cash flow.  But investors and banks wanted a much higher return.  So what the banks figured out was to start packaging in much worse credit rated sub-prime mortgages, which are paying higher interest rates.  The buyer of this CDO will get this return of money, plus the good mortgages to show it is a safer guarantee, along with securities like municipal bonds.  If financial institutions put enough of the good mortgages into the CDO, it would get the necessary AAA credit rating to sell it easily.  Because the banking authorities regulate the banks, the banks would have to create an SPE, which is entirely unregulated, putting the CDO outside the reach of regulators, allowing all of this to occur more easily.[71]

While this practice alone seems risky, banks began to up the ante.  A major problem in the derivatives industry is that companies are competing for an increasingly knowledgeable and smaller market as more and more derivatives are sold.  Here again the moral hazard problem begins to take effect.  Rather than slowing down the practice and moving to other forms of revenue, financial institutions simply became more creative and deceptive.  In the CDO market, this meant disguising the securitization of much riskier CDO’s.  The most common way to strip apart the mortgages was the interest only pieces (IO’s) and the principal only pieces (PO’s).[72] By deceptively pairing certain IO’s with much less valuable zero coupons (single payment bonds at the end of maturity), investment banks could set up derivatives that realized massive front end gains while designating the rest of the zero-sum game, the massive losses, to someone who still owned the zero-coupon decades later.[73] By doing this, investment banks could strip asset backed securities (ABS) like mortgages and pair them with the zero coupons to fool investors and credit rating agencies into giving a highly risky credit derivative bond a AAA rating even though it was almost guaranteed to lose money sometime in the future.

Since there were no capital requirements for these credit derivatives, American International Group (AIG) and others failed. Lehman Brothers failing would cause AIG to fail, AIG failing would cause Goldman Sachs to fail, and Bear Stearns, and others; the ripple effect. These asset swaps “allow[ed] dealers to repackage all manner of junk, moving it from one market to another until it finds a home.”[74]  The credit default swap was a hedge on all of these risky investments, but when everyone is hedged with everyone else, you have a problem. The market for CDO’s became so large and so common, credit rating companies hardly even looked at them anymore. When people with the bad mortgages started to default, the CDO’s that were supposed to pay a certain percentage were no longer getting this high payment.  Companies and even countries involved in these trades had planned on getting this payment, and when the underlying asset loans stopped performing, the expected revenue disappeared, forcing many into bankruptcy.

This is where the leveraging and hedging came together. What happened then is that the traders and banks that originally sold the highly leveraged CDO’s had CDS’s against them as a way of hedging insurance.  By going to companies like AIG, they hedged the bet by giving a certain percentage, say one to two percent, of what the CDO was worth as collateral.  Companies like AIG had trillions of dollars in global CDS guarantees with nowhere near enough equity to back this up in case of default.  The zero sum game of credit derivatives proved itself again.  When no one is creating any wealth, there is not enough to shift around this hedging.  Another example is a company like Goldman Sachs who would sell the CDO to Iceland, and then would go buy a CDS from AIG.  Goldman did this to lower their credit risk.  The problem is that AIG did not accrue anything in case of default.  If all the underlying securities of the CDO’s start to go under, Goldman Sachs starts to lose money on it because the mortgages are becoming worthless, so the CDO’s are worthless.  When they make the margin call to try to collect from AIG, and AIG had no reserves, they are almost immediately insolvent.  So the whole system begins to collapse.

Despite the weight of even recent historical authority to show that credit derivatives needed to be watched, the US government chose to do nothing.  Studies show that in the wake of accounting fraud surrounding companies like Enron, credit derivatives had played a major role in hedging risk.  By one account, Enron used more than eight hundred swaps to hedge $8 billion in credit risk.[75]  While Greenspan saw this as proof that the derivatives did exactly what they were supposed to by hedging risk, he failed to see the larger picture derivatives played in falsely inflating prices to begin with.

Greenspan is not the only one to blame though.  Despite being Chairman of the Fed during the growing years of credit derivatives, many others failed to heed the warning signs.  Companies across the US and the rest of the world became caught up in the credit boom, as access to capital from bank lending reached new heights.   Some of the largest players in the credit derivatives game were hedge funds.  One of the lessons that should have been learned was the complete disaster that was Long Term Capital Management (LTCM) in 1998.  When it lost nearly ninety percent of its capital within weeks the New York Federal Reserve decided to facilitate a private market recapitalization.[76] The General Accounting Office (GAO) points out that in 1992 the SEC observed that “[h]edge funds have the potential to both increase and decrease liquidity in the markets in which they invest.[77]  If this is known in 1992, then why by 2008 did hedge funds account for forty percent of trading in the US leveraged loan market, eighty five percent of the distressed debt market, and eighty percent of some credit derivatives markets?[78]  When a sector of the private industry, particularly one that has no legal requirement of registering before any governmental body and controls such a large portion of the market, systemic risk is something that should be obvious.  LTCM used leverage as its main strategy, eventually achieving a 28:1 balance sheet ratio.[79]  The type of varied trading involved made it virtually impossible for anyone to realize the actual risk LTCM had on its balance sheet.

One could assume that an easy lesson such as this would make the market change its tune. The real lesson learned, however, seems to have been that if you are this important then the Fed will bail you out in order to save the economy from the systemic risk you may pose.  The real answer to the problem is to do exactly what so many investment banks and hedge funds did, become too big to fail.  This moral hazard issue has underlined the entire financial crisis and will not soon go away.  The question the Fed should be asking itself is “[i]f unsuccessful hedge funds are not allowed to fail…if banks believe help will be forthcoming should loans go sour during unsettled market conditions, how will we discipline future decisions of investors and lenders?”[80]  Such intervention in the banking system only proved to make it unstable in the long run.  The use of credit derivatives as a way to hedge risks and leverage balance sheets was no more than a large moral hazard phenomenon seen across the entirety of Wall Street and spanning most of the rest of the globe. 

The European Union Situation

Passions unguided are for the most part mere madness.

            -- Thomas Hobbes, Leviathan, 1651

            While many blame Americans alone for this greed is good attitude, the problem stretched far beyond our borders.  Across the pond the Europeans did not have a much easier time of things, and while many similarities exist, the differences are proving to be disastrous as well.  It is true many of the problems have stemmed from the US, but the European Union (EU) must take a large part of the blame in relation to its lack of banking and financial law homogenization.  European banks’ thirst for leveraging led to an unstoppable contagion problem, regardless of the readiness of EU tools and agencies.  Shown below, multiple European banks overleveraged to dangerous points.

[81]

One of the largest problems in relation to the EU has been European banks’ funding of emerging markets in Eastern Europe, coupled with much higher state control over these banks. With the massive overleveraging of European hedge funds a financial bubble encompassed the entire continent.  The EU needs an entirely new strategy.  Words like competition and pro-business cannot bring a cringe to European faces.  While the EU has brought economic prosperity to many of its countries and small corners of the continent, without a central economic strategy, this crisis will assuredly repeat itself.  As Spanish Prime Minister Jose Luis Rodriguez Zapatero said in late April, there cannot be a “single market, a single currency” without an “economic government with powers, with tools.”[82] While the European Central Bank (ECB) has shown to be a powerful economic tool, without a main financial backing similar to what the Federal Reserve of the United States has, the euro will never be the powerful currency it could be in a situation where almost thirty countries use it.  The EU needs to take on a more pro-capitalist mindset in regards to financial regulations as well.  Regulations putting more emphasis on national governments and less on an already weak European Parliament and Commission will only serve to further divide economic strategies in the future.  Without this more centralized mindset, Europe can never see a stable single market.  In the future the EU and its member states must ask itself whether it will be “all for one and one for all,” or if the every man for himself mentality will continue to prevail.

Credit derivatives were able to exploit this lack of homogeneity with ease.  Leveraging via credit derivatives in the EU has been a much more extended problem and one that in some ways dwarfs the US situation.

 [83]

Here, the problem in the EU as compared to the world is obvious.  Not only has Europe allowed its state controlled banks to have base leverage rates of 30x, but the purple zone rose over the years until banks were leveraged at near 60x in 2008.  This means a loss of capital of as little as 1.5% will completely wipe out European banking capital, effectively bankrupting European banks.  Because of globalization, the EU and US are more connected than ever before.  The sub-prime mortgage crisis in the US quickly affected bank sheets in the EU.  Along with that was a Spanish housing bubble every bit as bad as the US.  But where Europe is much worse off than the US is its reliance on the state and the EU at the same time.  Because US bank assets only matched twice that of the US GDP, the government backed Federal Reserve was able to cover bank losses and, with some creative accounting, save the banks that were “too big to fail.”[84] 

Credit derivatives made this situation far different for the EU. The problem in the EU is twofold.  First, no solid governmental financial body backs the ECB because the EU has no such institution.  Banking involving credit derivatives is done on a national level, and is different in every country.  So the EU member states essentially rely on a bank through the trust levels that accompany the euro as a currency as well as the EU as an institution.  Between Spring 2007 and Spring 2009, the net trust levels of member states within the Eurozone have gone from twenty seven percent to minus one percent, meaning there are more people who distrust the ECB than trust it.[85]  Second is the fact that bank asset-to-debt ratios within the Eurozone are four times that of the GDP.[86]  In other words, the banks are too big to save.  The US sub-prime crisis, combined with the massive overleveraging of loans to emerging markets and the EU’s reliance on fewer banks with more national control created a financial hazard for the EU.  Bank assets everywhere are worth far less than the banks claim them to be and need them to be.  Overleveraging has resulted in a situation where nationally controlled banks cannot afford to pay back any loans.  Eastern European countries debt levels have reached such stratospheric numbers it would be near the equivalent of the US having to have spent $14 trillion on a bailout.[87]  Essentially, all the debt is bad, the ECB does not have anyone willing to step up to the plate and take responsibility, and even if they did, they do not have the money to cover the losses anyway.

            The contagion effect experienced within the EU is a small example compared to the contagion experienced between the US and EU.   A perfect example is that of Iceland.  Although not a EU member, it is heavily interconnected with the United Kingdom (UK) and much of the continental European countries in the financial sector.  This small country off the coast of Greenland is a prime example of what credit derivatives have done to the world.  When the US and EU investment banks decided to operate credit derivative trades in the newly bank savvy Iceland, they decided that it would be necessary to hedge this loaning game they were playing.  In order to do this, they contacted companies like AIG to cover the downside.  When Iceland inevitably failed, and realized it owed 850% of actual assets it held, the downward spiral began.  First, Iceland immediately began defaulting on these loans it had received from investment banks.  These banks then called upon hedging insurance at AIG to cover its back.  The problem was that AIG had overleveraged itself similar to Iceland.  That immediately put the US into turmoil.  Back in the EU, the problem was also fairly apparent.  Many of the assets and liabilities Iceland held on its books were in countries like the UK, Belgium, and Luxembourg.  The UK went so far as to invoke its Anti-terrorism, Crime and Security Act of 2001 in order to take control of Iceland’s main banks’ assets within the UK.[88]  It then chose to guarantee all deposits, even those beyond the normal 50,000 pounds it usually covered.[89]  While this sank Iceland deeper into a depression, even causing the Prime Minister to resign, others in Belgium struggled to find the money to cover their own losses.[90]  Only Luxembourg stood out firmly against these moral hazard issues and refused to cover the losses.   A seamless form of credit derivative contagion had hit the US and EU.

            Iceland is not the only example of credit derivative problems in Europe.  In 2000 the UK had £20 billion in credit securities sold.[91]  By 2007, the UK was trading upwards of £180 billion in credit securities.[92]  Similar to the US, the problem should have been evident when the majority of the holdings of these credit derivatives were on the books of banks and other financial institutions with short-term mindsets rather than end users who would be holding them to maturity.[93]  Just like in the US, this created an inextricable web of deals between multiple financial institutions, all of which had leveraged themselves as highly as the previous graph shows.  A nine-fold growth in the use of credit derivatives in seven years time is far too fast for any stable economic system to hold.  The transparency issues alone are immeasurable and not something the UK was prepared to handle.

            At the same time, the EU felt safer than it should have because of its heavy regulation on financial institutions.  As they would later find out, regulation on the macro-prudential level is much more important and effective than regulation on individual entities.[94]  Although the ECB as well as the European System of Central Banks (ESCB) are being charged with the task, it seems that transparency in the credit derivatives market will need to be achieved before a combination national and multinational system can hope to handle regulating these overleveraged institutions.  The Turner Review shows that well-known Swiss Bank UBS had an assets-to-equity ratio in 2008 close to 100:1. [95]  This type of increase in system leverage on a continental scale cannot possibly be matched with an asset portfolio to back it up.  In essence, the greed is good strategy led the EU, the same as the US, to play the zero-sum game to its logical end.  You cannot create wealth out of thin air forever.

            The UK relied heavily on the US to buy its credit derivatives.  When these investments dried up, much of the UK’s credit extensions disappeared.  During the process of buying derivatives, the UK leveraging ratio had expanded to dangerous levels.[96]  The economic slowdown in the US directly affected the ability of the UK financial system to remain above water.  While the EU has attempted to create a single market system, the Governor of the Bank of England, Mervyn King wisely points out, “global institutions are global in life, but national in death.”[97]  The EU does not have a comparable lender of last resort similar to the US Fed to prevent this. 

            One of the phrases often used in this financial crisis has been the term “shadow banking.”[98]  The term refers to the rapidly increased use of SPE’s and other non-bank financial institutions in the world of money lending.  While the EU had a large network of regulations set up for banks, other financial institutions were often exempt from such regulations and were allowed to work outside the shaky framework the EU had set up.  While the shadow banking system had been able to expand across the US and EU, selling credit derivatives to multiple parties and hedging the leverage risk to others still, the EU has yet to create a satisfactory response to the wide ranging systemic risk.  While the Fed so far has proven at least mildly valuable to the slowing of the US financial depression, it mainly serves to destabilize the US economy, something that would be less likely in the multi-state EU system.  The Lamfalussy Process attempted a change in the regulatory scheme of the EU financial markets, but with much failure.[99]  The process sought to move the EU regulatory model into a supranational being rather than reliance on national governments alone, but studies have shown that most governments merely saw this as an extension of their national regulatory power.[100]  The creation of a European single market cannot be complete without a more solid base.  The EU needs a strong European financial system, not a cross border network as employed now.  The EU spaghetti network of national networks and EU bodies has led to a completely inept system of dealing with financial crisis.

AIG: A Case Study

We're so big, we're never going to swim against the tide. We are the tide.[101]

            --Former CEO of AIG, Hank Greenberg

            In 2007, Fortune Magazine ranked AIG tenth in its annual Fortune 500 rankings.[102] In September of 2008 AIG had lost $32.4 of its $95.8 billion in shareholder equity and the losses were only beginning to be added up.[103]  By the time all was said and done its share prices would drop from $50.15 to less than $1.00 and the US Government would pump $182.5 billion into the dying corporation.[104]  AIG has become a symbol for the US financial crisis, alongside Lehman Brothers, Bear Stearns, and Merrill Lynch as examples of US corporations gone awry.  The Government saw in AIG what the previous twenty-six pages has explained, that opaque bank sheets and the corporate misguidance can cause contagion throughout the financial services industry.  But the smaller details of how AIG ended up in such a mess involve extensive use of credit derivatives and a lesson on why “[t]he emergence of swaps and OTC markets” changed the way the financial services industry operated.[105]

            Hank Greenberg became CEO of AIG in 1968 when it was still a privately held company.[106]  By the time Howard Sosin and Randy Rackson approached him about a joint venture involving a financial services arm of the company in 1986, Greenberg had built AIG into a global company, providing consistent profits for its shareholders based on a tough work ethic and entrance into every last untapped market on Wall Street.[107]  Although Sosin helped build AIG Financial Products into a Wall Street leader, he and Greenberg had a falling out over the direction of the company and the eventually termed “Gang of Four” took over as executives of AIG Financial Products.[108]  Greenberg would not relent control until forced to in 2006.[109]

Greenberg realized in the late 1980s, the moment when the financial services joint venture with Financial Products and AIG was beginning to stun Wall Street, that something was not right.  He realized that transactions AIG Financial Products continuously set up allowed it to receive “its profits upfront, even if the transactions took thirty years to play out. AIG would be on the hook if something went wrong down the road,” a game that would become all too familiar in the credit derivatives industry.[110]  In early 1998 AIG discovered the financial product that would bring the Fortune 500 company to its knees, the credit default swap.[111]  Using a computer model based on decades of historical data involving corporate debt, AIG Financial Products figured that there was a 99.85% chance of never having to pay out any of the debt it was swapping for.[112]  Basically, a depression similar to the Great Depression of the 1930s is the only way AIG would ever have to worry about leveraging themselves to infinity.  AIG Financial Products eventually became entangled in $500 billion in liabilities covered only by $80 billion in highly questionable assets.[113]  While AIG Financial Products had set itself up as an innovator not only because of the risks it took but also because of the culture of “transparency and caution,” by the time the credit crunch hit in 2007-2008, it had become a leader in hedging risk and had no possible way of producing enough cash to cover growing collateral calls.[114]

In 1998 when it began using the CDS market as a way to get in with major investment banks like J.P. Morgan, AIG Financial Products made sure to vary its risk across a wide variety of interest rates in the underlying assets, a structured credit derivative.[115]  Such early success can be deceiving though, especially to the executives who as late as 2007 touted their actions as the formulation and catalyst of what had become the booming credit derivatives industry.[116]  What really cleared the way for AIG Financial Products to begin leveraging itself at an unsafe level was the passage of the Commodity Futures Modernization Act, which exempted CDS’s from state gaming laws as well as excluded many of them from even being securities under the SEC definition.[117]                

Not long after this in 2002, AIG Financial Products became the first company to use SPE’s to unload unwanted assets from other financial services companies.  The first case involved a deal with PNC Financial Services Group, however, they were later forced to pay an $80 million fine on top of the nearly $40 million in fees they were forced to give back.[118]  This signaled the turning point for AIG Financial Products diving head first into the known unknown world of credit derivatives as a major part of the their investment strategy.  Not long after the settlement in 2004, then New York Attorney General Eliot Spitzer began his investigation into AIG Financial Products and Gen Re for accounting fraud schemes thanks to a tipster with insider information.[119]  This time the contract in question involved upwards of $500 million in fraudulent credit derivative transactions between the two companies, with Hank Greenberg at the helm.[120]  Suffice it to say, the culture AIG had built itself on was already coming crashing down, even before the company realized its true perils and risks in the larger credit derivatives game.  By the time Spitzer was done with them, New York indicted four executives from Gen Re and one from AIG on federal fraud charges and AIG ousted Greenberg as CEO, the end of his empire but not of AIG in the credit derivatives fiasco.[121]

By this time there was no stopping AIG from its CDS and CDO business that hedged bets for everyone else and leveraged itself to unrealized levels.  AIG was one of the main companies financing the biggest housing bubble in US history.  Without a company like AIG Financial Products, investment banks like Goldman Sachs and Morgan Stanley, as well as their European counterparts, would not have had the available capital to extend credit so frivolously.  AIG Financial Products allowed the financial services industry to move nearly all of its credit risk off of the books in order to make it seem like the companies were holding enough capital to extend the amount of credit they had been issuing for the past decade.  The healthy market mechanism Greenspan had envisioned, with credit risk spread evenly among the industry became a tool that allowed companies to hide risk in every last dark corner, often times the dark corners of AIG.  The spreading of risk via hedging instead of speculation became nothing more than an overextended system that created no real wealth to begin with, so that sooner or later the zero-sum game would be forced to even itself out.  What happened on Wall Street was a simple confusion of finance theory to agency theory.  Finance theory assumes everyone will act for the common good while agency theory assumes that everyone acts in their own self-interest  It is not surprising that such an intricate web of contracts is necessary in order to resolve the conflicts of interest between these fund managers working with billions of dollars of other peoples’ money every day.[122]

             AIG is an example of what the Gramm-Bliley-Leach Act allowed to occur in the financial services industry.  AIG Financial Products is what caused the company’s near collapse in the fall of 2008.[123]  At one point, AIG Financial Products operated a $1.3 trillion derivatives portfolio.[124]  By the Bank for International Settlement’s (BIS) account, AIG Financial Products had been operating within the $62 trillion (notional value) credit default swaps industry, a sum larger than the entire global economy.[125]  Much of this trading was done in the CDO mortgage markets, particularly sub-prime mortgaging.[126]  This chart shows AIG’s operating income and where the net losses of the second financial quarter of 2008 occurred.  [127]

As can be seen, not only were losses clearly centered on financial services sector, but within that subsidiary, capital markets are the sole reason AIG was losing any money at all. When the mortgage market went south, AIG went with it.  This financial strategy combined with former CEO Hank Greenberg’s “sham transactions” and “material weakness in…accounting” standards proved too much to handle when the economy began to spiral downward.[128]  When the margin calls came, AIG Financial Products began posting collateral against its credit derivatives trades. 

By 2005, AIG Financial Products was the premiere CDS dealer on Wall Street in large part because of its AAA rated parent company AIG.[129]  American companies loved AIG because it helped them fuel the housing boom while European companies loved AIG because they could count the CDS contracts as collateral which freed up capital for them elsewhere, including the bad loans they were making to the rest of Europe.[130]  Unfortunately, the credit ratings negatively affected AIG when Greenberg left.  When financial services companies wish to sell credit derivatives, they need to have a credit rating attached to them, the highest of which is AAA, something AIG prided itself on very much.  In order to sell their products more easily, every company wishes to achieve this standard.  Company’s like Standard & Poor’s and Moody’s Investor’s Service offer this credit ratings on an independent basis.[131]  Unfortunately, with the increased competition over the past decade, these credit agencies began handing out higher credit ratings much more easily, leading to some former trader’s admissions that investment banks simply had to buy the credit ratings from these companies and lawyers in the back room would okay the transaction.[132]  As the credit crunch loomed, the margin calls kicked in.  Credit rating companies initially downgraded AIG to AA following Greenberg’s departure, but as they suddenly downgraded AIG’s overstated portfolios in 2008, margin calls grew to levels AIG’s capital holdings could not support.[133] 

One of the largest problems for AIG Financial Products was that its massive portfolio of credit derivatives was nearly impossible to value accurately.  It had slowly expanded its use of CDO’s in the wave of “securitization” that hit Wall Street in the 21^st century, even involving itself in CDO’s backed by credit card payments, car loans, and student loans.[134]  When a financial services company is allowed to sell trillions in CDO contracts based on varied debt tranches and then sell trillions more in credit default swaps in order to hedge this leveraging, indexing is the only way to possibly attempt to value such a portfolio.[135]  Multiplying this problem is that indexes can themselves be traded.  The best effort at valuing all of this is mark to market accounting standards.  The problem with mark to market accounting on contracts relating to multiyear future transactions comes in the form of present value.  As one trader put it, “[y]ou work out all your cash flows from the contracts that you signed or securities that you own.  Then, you present value the cash flow back to today.  A dollar today is worth more than a dollar in the future, traders know that.”[136]  Essentially what occurs is that massive amounts of present value contracts are overstated to the detriment of the future of those contracts. 

The virtually solid foundation AIG considered itself to be built on meant that AIG Financial Products did not hedge most of its leveraged CDO contracts.[137]  The company maintained that there was no reason to hedge the type of CDO’s they participated in.  The “super senior” tranches of CDO’s, the ones with AAA credit ratings and the least amount of risk, thus the least amount of interest paid, were the only ones AIG Financial Products sold.[138]  The lower tiers were the ones who absorbed the first losses, so the senior tranches seemed the sure bet at the time.  By December 31, 2007, AIG held a total of $521 billion in these senior tranches, with approximately $327 billion of it sold to European financial institutions.[139]  [140]

            Since credit derivatives are nothing more than market speculation, AIG’s heavy use of CDO’s in the mortgage market meant that it had made the very large gamble that real estate prices were sound and that all the underlying mortgages would be paid off in the end.  Regardless of the fact that housing prices had not dropped significantly since the Great Depression, it seems odd that AIG Financial Products gave itself absolutely no protection in case some of the mortgages failed.  Rather, by spreading the risk across differing geographic regions, from Florida to California, it figured at least only part of the portfolio could be at risk at any given time.  What was really happening, however, is that AIG had helped set up the proverbial house of cards that would soon come crashing down as people across the country began defaulting on loans they should have never been given, namely sub-prime mortgages.  By December 2007, AIG Financial Products realized it was exposed to $61.4 billion in CDO’s with sub-prime mortgages in them, which meant tens of billions in collateral needed to cover them in case of default, something the company simply did not have.[141]

While mark to market accounting is an attempt to better realize what companies like AIG actually have on their books, done correctly, it can massively overstate the front end value of assets and undervalue the back end, when the credit derivative actually matures.  Unfortunately for the players, this game can only go so far.  AIG Financial Products had operated since 1986, when the founders set up PASS, their “position analysis and storage system” set up to track derivatives markets and analyze risk at an unheard of level.[142]  The game finally began to catch up with the company as margin calls came in, proving that valuation of assets is key to paying off this necessary collateral. 

In 2007, the house of cards began to fall.  The first company to make calls for collateral to AIG was Goldman Sachs.[143]  At this point, the SEC put out a mandatory ruling that companies like AIG had to immediately mark to market all of their assets, something they had not done in a long time, and something that had been allowing companies on Wall Street to overstate their earnings for years.[144]  AIG’s historical models quickly began to fail.  Because it had relied on the fact that “super senior” tranches had almost no possibility on attaching to other defaults, AIG had not valued its risk allocation in years.[145]  Attaching means that a certain percentage of underlying assets had to default before AIG was forced to cover losses on the senior tranches, and the levels of 12.9% and 22.9% were so absurd by historical models’ standards that no one even considered it a possibility.[146]  Even as the end of 2007 showed a loss of $11.2 billion on the company’s CDS portfolio, a high level executive within AIG Financial Products still claimed, “the probability that it will sustain an economic loss is close to zero."[147]  These comments and others made during a web cast in December of 2007 are part of an ongoing investigation to see whether top-level executives actually misled investors as to the true value of their CDS portfolio.[148]  AIG no longer played the safe and calculated risk game, and it was no longer a company investors could trust, a foreshadowing of what the rest of Wall Street would see in 2008.

[149]

In the first three financial quarters of 2008, the rising credit crunch forced AIG to post losses of $19.9 billion.[150]  When its credit ratings soured, these losses rose by billions more.[151]  In the fall of 2008, AIG’s stock fell rapidly.[152]  What happened to AIG is a much more detailed process than most realize.  While the simple version is that AIG did not have enough capital to back up CDO’s it sold, the complicated version makes one wonder how any company was ever allowed to operate this way.  The first problem began with the SPE entities AIG Financial Products used to sell the CDO’s.  In order to do this, what first needs to happen is for someone to make a loan.  As mentioned before, this can come in many different forms, including student loans, and most notably, home loans and mortgages.  Pools of these loans get sold to companies like AIG in a credit default swap, so that the lenders can hedge their risky loans with those essentially insuring them.  This is where AIG sets up its SPE to sell CDO’s.  The CDO’s are sold as a way to generate cash flow for the SPE so that it can buy the pools of loans from AIG, the original ABS.[153] What the SPE then does is pools these ABS and splices them into tranches based on the underlying assets.[154]  The tranches are based on the credit levels of the underlying ABS as well as a number of other factors including risk indexes and the IO’s or PO’s.  The CDO’s are the cash flow to the SPE, which is the cash flow to AIG in order for it to cover the hedging it originally sold in its CDS contracts.

As already mentioned, AIG had a catastrophically large capital flow problem as the credit crisis hit.  What happened next is a fast moving process that is nearly impossible for a company selling credit derivatives to avoid.  The underlying assets of the CDO’s that the SPE’s sold began to default, creating a major cash flow problem to the SPE.  Next, the credit qualities of the SPE’s and their securities were negatively impacted, which then caused the credit qualities of the CDO’s to be negatively impacted.  Finally, as a result of these three conditions, the spreads on the original CDS contracts AIG Financial Products entered into (the amount of collateral needed to be posted based on margin called) widened resulting in losses to their CDS portfolio no one had taken into account (unrealized losses).[155]  So no one accounted for the capital needed in case such an event occurred, even though this was the one event that could actually cause AIG to lose very large sums of money and require an end total capital injection of $182.5 billion from the US government and the Fed.[156]

AIG Financial Products’ extensive use of credit derivatives stands as one of the greatest arguments for fair value accounting in the entire financial services industry.  According to the Council of Institutional Investors, fair value accounting is a requirement that financial services companies report on an ongoing basis the fair value of assets and liabilities on their books assuming they were to be sold today.[157]  Market to market only forced realization of losses when a transaction occurs, whereas fair value is a periodically updated system.[158]  An even larger problem occurs when you add hedge funds into the mix.  The problem mentioned early in this paper was that hedge funds have far more power in the credit derivatives market than most have anticipated, and short selling by these power players has had a sort of market self-fulfilling prophecy effect.[159]  You have an entire sector of the financial services industry betting that companies do not know where their portfolio is headed, how they are actually valued, and where their risk ratio is.  The already powerful investment banks continued to run overleveraged and undercapitalized while smaller market companies that actually wanted to create wealth were squeezed out because the credit derivatives market had wrongly valued their economic growth possibility.  The only thing left to occur is a major readjustment mechanism in the form of a global recession.

            AIG’s situation shows the interconnected nature of the two major forms of credit derivatives: collateralized debt obligations and credit default swaps.  Though initially the industry participated in them on separate fronts, the legal incentives instituted by Congress in 1999 allowed the financial services industry to combine itself into ways not seen since the Great Depression.  AIG was able to combine its larger purpose, insurance, with an investment side that provided an insurmountable conflict of interest.  Simple banking did not exist at AIG, not when the bottom line combined both sides of the industry.  The government justified the bailout of AIG was because of the OTC swaps drew “the world's major financial institutions and others into a tangled web of interconnections” where the failure of a one of the biggest players could jeopardize the stability of the entire system.[160]  In the end analysts discovered that AIG Financial Products was involved in $2.7 trillion in CDS contracts, totaling 50,000 trades with 2,000 other firms.[161]  As Gerry Pasciucco, vice chairman of Morgan Stanley in charge of sorting AIG’s books said, “[t]here was no system in place to account for the fact that the company might not be a AAA forever," so that no risk assessment even mattered, and none were made.[162]

Conclusion

            The political and legal responses to the global financial crisis have been questionable and the situation has not gotten much better.  If this is truly another Great Depression, as many have predicted, this situation will not resolve itself for many more years.  Companies like AIG are still unraveling their tangled web of CDS and CDO contracts, and it will not be soon before these investments can be settled and truly written off.[163]  One year after the government bailout, AIG traded at $31.80 per share, down 59%, although it is no longer on the Dow Jones Industrial Average.[164]  As of November 30, 2009, AIG stock closed at $28.40, and the future remains bleak when one considers the company authorized a reverse stock split, often a signal of little to no capital reserves.[165] Millions of jobs have been lost across the globe and current unemployment according to the US government is at best 10.2%, though some estimates have it much higher.[166]

            So what has been the response?  In the US, the Fed has read the phrase “exigent circumstances” in the Federal Reserve Act Section 13(3) in an overly broad and possibly illegal manner in order to pass TARP and other government bailout programs that totaled over $1 trillion and created the biggest moral hazard issue in history.[167]  This is easily shown with the latest glance at what Wall Street is up to now, CDO’s on life insurance.[168]  Wall Street is now bundling life insurance packages for those still paying out, essentially betting on when Americans will die off so they can collect larger sums.[169]  Whatever one may think about this practice, it is proof that the game has not stopped. 

In Europe, the EU has been unable to consolidate the single market system; with too much infighting between national governments and the questions about the power of the EU has a whole.  Many different theories have been put forward in an attempt to prevent these problems in the future.  One idea is the creation of four separate executive agencies within the EU structure. A second policy suggestion is focused on extensive reorganization of the EU financial regulation structure.  It involves creating a European System of Financial Supervisors and a European Financial Institute.[170] Following the advice of the de Larosiere Committee, this group would help reform the European banking system and help prepare for more oversight and possible hazard prevention in the future.[171] If the EU thinks more government is the answer, Minnesota Congressional representative Collin Peterson says, “I would have two words: Homeland Security.”[172]  Europe may have to rebuild entire sections of their financial system, but tying up the national governments more bureaucracy will only serve handicap their ability to stave off such major economic inefficiencies in the future.

            Two powerful tools give the US Federal Reserve the largest amount of its power in economic recessions.  First is Section 13(3) of the Federal Reserve Act of 1932, “which permits the Fed, upon declaration of “unusual and exigent circumstances” to lend to anybody against collateral it deems adequate.[173]  Second is the “total freedom to expand its balance sheet,” or essentially, print money.[174]  The statute itself is has proven more complicated than most expected because these two tools have essentially allowed for a system of money to be controlled by one bank.  In the US, one nation with one powerful currency used as a basis for indexes around the world, this power is inefficient and highly corrupt.  When the New York Fed has read this statute to permit creation of SPE’s to funnel money to struggling banks, legal gerrymandering reaches a dangerous level.  Once the central bank has realized the control they have over the perception of the market, playing into the very powerful psychology of $3 trillion in trades a day, who has standing to challenge such tyrannical behavior?  Similar to President Franklin D. Roosevelt’s attempt to press the presidential power beyond constitutional realms, the Fed in this crisis has attempted and so far succeeded in strengthening its incidental authority beyond the reach of the 1913 Act.

The ECB is not anywhere near this powerful.  It does not have the power to issue or hold debt and it only controls fiscal capacity while being handicapped by the ESCB for monetary policy.[175]  These regulations make the role of the ECB highly ambiguous, and other than a supervisory role on price stability, it acts independently from political control.[176]  Though they work in some ways with the ESCB, both the Treaty of Nice and the Protocol on the Statute of the European System of Central Banks and of the European Central Bank make clear that the ECB does not have the ability to supervise banks or any of the financial services industry, effectively delegating it as a price monitory.[177]  The ECSB is left with the responsibility of handling capital flows and other financial movements by controlling the money supply, though this separation from the ECB acts more as a handicap to a group of nations that needs more systemic risk support than a bifurcated system allows for.[178]

While these limitations should be implemented in the US, the EU has not reached the point that the euro is powerful enough to stand on its own in such a complicated system.  These strong capitalistic functions would allow the euro to be more controlled on a multi-national level and much less responsive to the whims of uncooperative state governments as well as trades on the international markets.  These limitations make integration of a multi-state fiscal system much more difficult, not to mention the vast limitations on the ability of the EU to efficiently monitor systemic risk across all twenty-seven nations.  The US system is not perfect, shown by the obvious problems in overleveraging and derivatives trading practices that vastly expanded under Greenspan’s tenure, but the idea does seem to make more sense in the EU presently, within a system of so many countries.  With such a large system of wealth attempting in many ways to essentially consolidate itself as a single trading partner with a single currency, one can only wonder why a more central economic unit to rival that of the Federal Reserve has not been created.  It would behoove the EU to give more power to the ECB in order to press forward the capitalistic goals they are attempting to achieve.

In both the EU and US the risk management process has been unable to keep up with the use of complex credit derivatives.  Capital flow has been aided by the increased use of computers and computer models in the financial industry.  There are several ways this opaqueness can be made more transparent.  One way is the registration of an OTC derivatives market.  Similar the New York Stock Exchange, it would not require the naming of parties involved in hedge funds and so many other high priced markets the participators are worried about.  It would track the buying and selling of OTC derivatives in order to gather the information about the size of the market and where different parts of the industry are moving.  This would allow better allocation and realization of risk, and overall better efficiency in inter-institution trading in the financial services industry.

Another large area that is rarely mentioned is in campaign finance reform.  This would force the public political side to separate from the private sector and better evaluate what is going on.  Washington, DC has been under the thumb of Wall Street for far too long and has allowed the financial services industry to go unchecked.  While capitalism is the best form of business practice, crony capitalism only serves those with enough money to contribute large amounts to the campaigns of powerful persons in Washington, DC.  Other changes that may need to be considered are the re-separation of bank holding companies and other financial institutions to force companies to realign their incentives with the public good.  This involves a whole litany of standards, including possible global homogenization of financial industry rules, something being considered by the world’s largest economic sovereigns.

Whatever it is that is going to be done needs to be done soon.  Those louder voices such as Ron Paul with books like “End the Fed” will not go away easily, and are gaining ground in mainstream America.[179]  Calls for the Fed to open up their books after this crisis and show where they have shifted billions to possibly trillions of dollars are growing louder.  Wall Street still knows the lender of last resort ultimately backs up their practices.  Surely it is necessary, but for the breakdown of the nation itself, to do something drastic to stop this.  We assume that this breakdown will come when firms have overreached every time, but how many different ways can companies exceed limitations and side-step regulatory laws with lobbying or creative legal and accounting teams?  The US government and EU government must learn that the continuance of corrupt practices is detrimental to the true financial and economic health of the globe.  The zero sum games must stop, though it does not look good for the foreseeable future.

Bibliography

AIG, Quarterly Report (Form 10-Q), note 50, at 115 (Nov. 10, 2008).

AIG, Annual Report (Form 10-K), at 122 (Feb. 28, 2008).

Alan Greenspan, Chair, Federal Reserve Board, Remarks before the Council on Foreign Relations: International Financial Risk Management (Nov. 19, 2002).

Alan Greenspan, Chairman, Federal Reserve Board, Remarks before the Futures Industry Association: Financial Derivatives (Mar. 19, 1999).

Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities, 69 Fed. Reg. 34,428-34,460 (June 21, 2004) (to be codified at 17 C.F.R. pt. 200 and 240).

Berkshire Hathaway Inc., Annual Report, at 13 (Feb. 21, 2003).

Bretton Woods Project, Financial Regulation in the European Union: Mapping EU Decision Making Structures on Financial Regulation and Supervision (2008).

Centre for European Policy Studies, Concrete Steps Toward More Integrated Financial Oversight (2008).

Charles F. Sabel & Jonathan Zeitlin, Experimentalist Governance in the European Union: Towards a New Architecture (Oxford University Press, forthcoming 2010).

Christopher Cox, Chairman, SEC, Opening Remarks at SEC Roundtable on Modernizing the Securities and Exchange Commission’s Disclosure System (Oct. 8, 2008).

Daniel R. Amerman, AIG’s Dangerous Collapse & a Credit Derivatives Risk Primer, Sept. 17, 2008, http://news.goldseek.com/GoldSeek/1221672153.php.

Depository Institutions Deregulation and Monetary Control Act, Pub. L. 96-221, 94 Stat. 132 (1980).

Eamon Javers & Victoria McGrane, Collin Peterson, June 18, 2009, http://www.politico.com/news/stories/0609/23874.html.

Euractiv, http://www.euractiv.com/en/opinion/growth-jobs-reshaping-eu-lisbon-strategy/article-183277 (last visited July 30, 2009).

Federal Reserve Act, 12 U.S.C. § 3 (1913).

Felix Roth, The Effects of the Financial Crisis on Systemic Trust (Centre for Eur. Pol’y Stud., Working Paper No. 316, 2009).

Financial Services Authority, The Turner Review: A Regulatory Response to the Global Banking Crisis (2009).

Frank Partnoy, F.I.A.S.C.O. (Penguin 1999).

Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, 75 U. Cin. L. Rev. 1019 (2007).

Garn – St. Germain Depository Institutions Act, Pub. L. 97-320, 96 Stat. 1469 (1982).

Geoffrey Rogow, US Stock Futures Slide as Oct. Unemployment Rate Hits 10.2%, W.S.J., November 6, 2009.

Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

Google.com, Google Finance, http://www.google.com/finance?client=ob&q=NYSE:AIG (last visited Nov. 30, 2009).

Gramm-Leach-Bliley Act, Pub. L. 106-102, § 103, 113 Stat. 1338 (1999).

Henry Blodget, Europe's Crisis, Yahoo! Finance, Feb. 27, 2009, http://finance.yahoo.com/tech-ticker/article/195065/Europe's-Crisis-Much-Bigger-Than-Subprime-Worse-Than-U.S.?tickers=ubs%20%20,cs,db,hbc.

http://www.isda.org/ (enter “credit derivatives” into search; then follow “ISDA Mid-Year 2009 Market Survey Shows Credit Derivatives at $31.2 Trillion” hyperlink).

Investment Advisor’s Act, 15 U.S.C. § 80b-1 (1940).

Jenny Anders, Wall Street Pursues Profit in Bundles of Life Insurance, N.Y. Times, Sept. 5, 2009.

John Mauldin, Europe on the Brink, July 18, 2009, http://www.safehaven.com/article-13946.htm.

Kitty Donaldson & Gonzalo Vina, UK Used Anti-Terrorism Law to Seize Icelandic Bank Assets, Bloomberg, Oct. 9, 2008, http://www.bloomberg.com/apps/news?pid=20601102&sid=aXjIA5NzyM5c.

Maria Woehr, A Closer Look at AIG’s Earnings, November 6, 2009, http://www.thedeal.com/dealscape/2009/11/a_closer_look_at_aigs_earnings.php.

Matthew Karnitschnig, U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up, Sept. 16, 2008, http://online.wsj.com/article/SB122156561931242905.html.

Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable (Random House 2007).

Paul Blustein, The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF (Public Affairs, 2001).

Posting of DCH to http://pictorial-guide-to-crisis.blogspot.com/2008/10/leverage-ratios-at-european-banks.html (Oct. 15, 2008, 18:03 EST).

Robert O’Harrow Jr. & Brady Dennis, What Went Wrong: The Beautiful Machine, The Washington Post, Dec. 29, 2009 available at http://www.washingtonpost.com/wp-dyn/content/article/2008/12/28/AR2008122801916_pf.html.

Robert O’Harrow Jr. & Brady Dennis, A Crack in The System, The Washington Post, Dec. 30, 2009, available at http://www.washingtonpost.com/wp-dyn/content/article/2008/12/29/AR2008122902670_pf.html.

Robert O’Harrow Jr. & Brady Dennis, Downgrades and Downfall, The Washington Post, Dec. 31, 2009, available at http://www.washingtonpost.com/wp-dyn/content/article/2008/12/30/AR2008123003431_pf.html.

Rolf Englund, http://www.internetional.se/conti7105.gif.

Ron Paul, End the Fed (Grand Central Publishing 2009).

Satyajit Das, Traders, Guns & Money (Edinburgh Gate ed., Prentice Hall Financial Times 2006).

SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963).

Secretariat of the Basel Committee on Banking Supervision, The New Basel Capital Accord: an explanatory note (2001).

Securities Act § 2, 15 U.S.C. § 77b (1933).

Securities Exchange Act § 3, 15 U.S.C. § 78a (1934).

Shah Gilani, Collapse of AIG: The Inside Story, Sept. 23, 2008, http://www.contrarianprofits.com/articles/the-inside-story-of-the-collapse-of-aig/5641.

Sophie Morris, Iceland PM is First Global Political Casualty of the Crunch, The Independent, Jan. 24, 2009, http://www.independent.co.uk/news/world/europe/iceland-pm-is-first-global-political-casualty-of-the-crunch-1514527.html.

Stephen Labaton, The Reckoning, The New York Times, Oct. 2, 2008, available at http://www.nytimes.com/2008/10/03/business/03sec.html.

Stephen G. Ryan, Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch (Council of Institutional Investors, Washington, D.C.), July 2008.

StockCharts.com, Dow Jones Industrial Average (1900-1920 Daily), http://stockcharts.com/charts/historical/djia19001920.html (last visited Nov. 23, 2009).

The High-Level Group on Financial Supervision in the EU, Report (2009).

The Privateer, http://www.the-privateer.com/rates.html (last visited Nov. 25, 2009).

United States Census Bureau, Housing and Household Economic Statistics Division (2004), http://www.census.gov/hhes/www/housing/census/historic/values.html.

United States General Accounting Office, Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed (2008).

United States General Accounting Office, Long Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk (1999).

William K. Sjostrom, Jr., The AIG Bailout, 66 Wash. & Lee L. Rev. 943 (2009).

Yolaiki Gonzalez, AIG: 1 Year After its Bailout, Sept. 16, 2009, http://www.cnbc.com/id/32865451.

---

[1] Louis K. Liggett Co v. Lee, 288 U.S. 517 (1933).

[2] Id.

[3] Id.

[4] StockCharts.com, Dow Jones Industrial Average (1900-1920 Daily), http://stockcharts.com/charts/historical/djia19001920.html (last visited Nov. 23, 2009).

[5] Federal Reserve Bank of Boston, The Panic of 1907 4 (1990).

[6] Federal Reserve Act, 12 U.S.C. § 3 (1913).

[7] Frank Partnoy, F.I.A.S.C.O. 75 (Penguin 1999).

[8] Satyajit Das, Traders, Guns & Money 55 (Edinburgh Gate ed., Prentice Hall Financial Times 2006).

[9] Alan Greenspan, Chairman, Federal Reserve Board, Remarks before the Futures Industry Association: Financial Derivatives (Mar. 19, 1999).

[10] Gramm-Leach-Bliley Act, Pub. L. 106-102, § 103, 113 Stat. 1338 (1999).

[11] Id.

[12] Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

[13] Investment Advisor’s Act, 15 U.S.C. § 80b-1 (1940).

[14] SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 186 (1963).

[15] 15 U.S.C. § 80b3(b)(3) (1940).

[16] Id. 80b3(b)(6); 15 U.S.C. § 203(b)(3) (1940).

[17] Id. § 203(b)(3) (1940).

[18] Id. 80b-6(2).

[19] Capital Gains Research Bureau, Inc., 375 U.S. at 180.

[20] Sarbanes-Oxley Act, Pub. L. 107-204, 166 Stat. 745 (2002).

[21] Das, supra, at 139.

[22] Id. at 126.

[23] Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable (Random House 2007).

[24] Id.

[25] Id.

[26] Id.

[27] Das, supra, at 268.

[28] Id. at 31.

[29] Id. at 265.

[30] Id. at 267.

[31] Securities Act § 2, 15 U.S.C. § 77b (1933); Securities Exchange Act § 3, 15 U.S.C. § 78a (1934).

[32] 15 U.S.C. § 77b; 15 U.S.C. § 78a.

[33] Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities, 69 Fed. Reg. 34,428-34,460 (June 21, 2004) (to be codified at 17 C.F.R. pt. 200 and 240).

[34] Stephen Labaton, The Reckoning, The New York Times, Oct. 2, 2008, available at http://www.nytimes.com/2008/10/03/business/03sec.html.

[35] Id.

[36] Depository Institutions Deregulation and Monetary Control Act, Pub. L. 96-221, 94 Stat. 132 (1980).

[37] Id.

[38] Garn – St. Germain Depository Institutions Act, Pub. L. 97-320, 96 Stat. 1469 (1982).

[39] Gramm-Leach-Bliley Act § 103.

[40] Id.

[41] Id.

[42] Frank Partnoy & David A. Skeel, Jr., The Promise and Perils of Credit Derivatives, 75 U. Cin. L. Rev. 1019, 1021 (2007).

[43] Id. at 1021.

[44] Alan Greenspan, Chair, Federal Reserve Board, Remarks before the Council on Foreign Relations: International Financial Risk Management (Nov. 19, 2002).

[45] Berkshire Hathaway Inc., Annual Report, at 13 (Feb. 21, 2003).

[46] Das, supra, at 12.

[47] http://www.isda.org/ (enter “credit derivatives” into search; then follow “ISDA Mid-Year 2009 Market Survey Shows Credit Derivatives at $31.2 Trillion” hyperlink).

[48] Das, supra, at 12.

[49] Partnoy & Skeel, supra, at 1022.

[50] Das, supra, at 91.

[51] The Privateer, http://www.the-privateer.com/rates.html (As of 2009, the rate has dropped to 0.00%) (last visited Nov. 25, 2009).

[52] The High-Level Group on Financial Supervision in the EU, Report 7 (2009).

[53] Secretariat of the Basel Committee on Banking Supervision, The New Basel Capital Accord: an explanatory note (2001).

[54] Id. at 6.

[55] Id. at 2.

[56] Id. at 4.

[57] Id. at 3.

[58] Gramm-Leach-Bliley Act § 103.

[59] Das, supra, at 273.

[60] John Mauldin, Europe on the Brink, July 18, 2009, http://www.safehaven.com/article-13946.htm.

[61] Id. at 2.

[62] Id. at 3.

[63] Id. at 2-3.

[64] The Privateer, http://www.the-privateer.com/rates.html (last visited Nov. 25, 2009).

[65] Rolf Englund, http://www.internetional.se/conti7105.gif.

[66] Report, supra, at 8.

[67] Id. at 9.

[68] United States Census Bureau, Housing and Household Economic Statistics Division (2004), http://www.census.gov/hhes/www/housing/census/historic/values.html.

[69] Report, supra, at 12.

[70] Partnoy, supra, at 222.

[71] Das, supra, at 286.

[72] Partnoy, supra, at 219.

[73] Id. at 223-224.

[74] Das, supra, at 231.

[75] Partnoy & Skeel, supra, at 1033.

[76] United States General Accounting Office, Long Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk 1 (1999).

[77] Id. at 15.

[78] United States General Accounting Office, Hedge Funds: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention Is Needed 1 (2008).

[79] Long Term Capital Management, supra, at 7.

[80] Paul Blustein, The Chastening: Inside the Crisis that Rocked the Global Financial System and Humbled the IMF 324 (Public Affairs, 2001).

[81] Posting of DCH to http://pictorial-guide-to-crisis.blogspot.com/2008/10/leverage-ratios-at-european-banks.html (Oct. 15, 2008, 18:03 EST).

[82] Euractiv, http://www.euractiv.com/en/opinion/growth-jobs-reshaping-eu-lisbon-strategy/article-183277 (last visited July 30, 2009).

[83] Mauldin, supra, at 4.

[84] Id. at 5.

[85] Felix Roth, The Effects of the Financial Crisis on Systemic Trust 3 (Centre for Eur. Pol’y Stud., Working Paper No. 316, 2009).

[86] Mauldin, supra, at 5.

[87] Henry Blodget, Europe's Crisis, Yahoo! Finance, Feb. 27, 2009, http://finance.yahoo.com/tech-ticker/article/195065/Europe's-Crisis-Much-Bigger-Than-Subprime-Worse-Than-U.S.?tickers=ubs%20%20,cs,db,hbc.

[88] Kitty Donaldson & Gonzalo Vina, UK Used Anti-Terrorism Law to Seize Icelandic Bank Assets, Bloomberg, Oct. 9, 2008, http://www.bloomberg.com/apps/news?pid=20601102&sid=aXjIA5NzyM5c.

[89] Id.

[90] Sophie Morris, Iceland PM is First Global Political Casualty of the Crunch, The Independent, Jan. 24, 2009, http://www.independent.co.uk/news/world/europe/iceland-pm-is-first-global-political-casualty-of-the-crunch-1514527.html

[91] Financial Services Authority, The Turner Review: A Regulatory Response to the Global Banking Crisis 14 (2009).

[92] Id.

[93] Id. at 16.

[94] Report, supra, at 39.

[95] The Turner Review, supra, at 19.

[96] Id. at 29.

[97] Id. at 36.

[98] Id. at 21.

[99] Charles F. Sabel & Jonathan Zeitlin, Experimentalist Governance in the European Union: Towards a New Architecture 5 (Oxford University Press, forthcoming 2010).

[100] Id. at 6.

[101] Robert O’Harrow Jr. & Brady Dennis, What Went Wrong: The Beautiful Machine, The Washington Post, Dec. 29, 2008 available at http://www.washingtonpost.com/wp-dyn/content/article/2008/12/28/AR2008122801916_pf.html.

[102] William K. Sjostrom, Jr., The AIG Bailout, 66 Wash. & Lee L. Rev. 943, 946 (2009).

[103] Id. at 17.

[104] Id. at 15.

[105] Das, supra, at 26.

[106] O’Harrow & Dennis, What Went Wrong: The Beautiful Machine, supra, at 3.

[107] Id.

[108] Id. at 7.

[109] Shah Gilani, Collapse of AIG: The Inside Story, Sept. 23, 2008, http://www.contrarianprofits.com/articles/the-inside-story-of-the-collapse-of-aig/5641.

[110] O’Harrow Jr. & Dennis, What Went Wrong: The Beautiful Machine, supra, at 6.

[111] Robert O’Harrow Jr. & Brady Dennis, A Crack in The System, The Washington Post, Dec. 30, 2009, available at http://www.washingtonpost.com/wp-dyn/content/article/2008/12/29/AR2008122902670_pf.html.

[112] Id. at 1.

[113] Id. at 1-2.

[114] Id. at 2.

[115] Id. at 3-4.

[116] Id. at 4.

[117] Id. at 7-8.

[118] Id. at 8.

[119] Id. at 9-10.

[120] Id.

[121] Id. at 10.

[122] Das, supra, at 117.

[123] Maria Woehr, A Closer Look at AIG’s Earnings, November 6, 2009, http://www.thedeal.com/dealscape/2009/11/a_closer_look_at_aigs_earnings.php.

[124] Id.

[125] Gilani, supra, at 1; Daniel R. Amerman, AIG’s Dangerous Collapse & a Credit Derivatives Risk Primer, Sept. 17, 2008, http://news.goldseek.com/GoldSeek/1221672153.php.

[126] Gilani, supra, at 1.

[127] Matthew Karnitschnig, U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up, Sept. 16, 2008, http://online.wsj.com/article/SB122156561931242905.html.

[128] Id.

[129] Robert O’Harrow Jr. & Brady Dennis, Downgrades and Downfall, The Washington Post, Dec. 31, 2009, available at http://www.washingtonpost.com/wp-dyn/content/article/2008/12/30/AR2008123003431_pf.html.

[130] Id.

[131] Gilani, supra, at 2.

[132] Partnoy, supra, at 84.

[133] Gilani, supra, at 3.

[134] O’Harrow Jr. & Dennis, Downgrades and Downfall, supra, at 3.

[135] Id. at 4-6.

[136] Das, supra, at 139.

[137] O’Harrow Jr. & Dennis, A Crack in the System, supra, at 3.

[138] O’Harrow Jr. & Dennis, Downgrades and Downfall, supra, at 4, 7.

[139] Sjostrom, Jr., supra, at 1111-12.

[140] AIG, Quarterly Report (Form 10-Q), note 50, at 115 (Nov. 10, 2008).

[141] AIG, Annual Report (Form 10-K), note 8, at 30 (Feb. 28, 2008).

[142] O’Harrow Jr. & Dennis, What Went Wrong: The Beautiful Machine, supra, at 4.

[143] O’Harrow Jr. & Dennis, Downgrades and Downfall, supra, at 6.

[144] Id. at 6-7.

[145] Sjostrom, Jr., supra, at 956.

[146] Id. at 956.

[147] AIG, Annual Report (Form 10-K), at 122 (Feb. 28, 2008); O’Harrow Jr. & Dennis, A Crack in The System.

[148] O’Harrow Jr. & Dennis, A Crack in The System.

[149] Yolaiki Gonzalez, AIG: 1 Year After its Bailout, Sept. 16, 2009, http://www.cnbc.com/id/32865451.

[150] AIG Sept. ’08 Quarterly Report, note 50, at 114.

[151] Id. at 114.

[152] Gonzalez, supra, at 2.

[153] Sjostrom, Jr., supra, at 952.

[154] Id. at 952.

[155] Id. at 958.

[156] Id. at 970.

[157] Stephen G. Ryan, Fair Value Accounting: Understanding the Issues Raised by the Credit Crunch (Council of Institutional Investors, Washington, D.C.), July 2008, at 4.

[158] Id. at 5.

[159] Gilani, supra, at 3.

[160] Christopher Cox, Chairman, SEC, Opening Remarks at SEC Roundtable on Modernizing the Securities and Exchange Commission’s Disclosure System (Oct. 8, 2008).

[161] O’Harrow Jr. & Brady Dennis, Downgrades and Downfall, supra, at 10.

[162] Id. at 11.

[163] Woehr, supra, at 1.

[164] Gonzalez, supra, at 2.

[165] Google.com, Google Finance, http://www.google.com/finance?client=ob&q=NYSE:AIG (last visited Nov. 30, 2009).

[166] Geoffrey Rogow, US Stock Futures Slide as Oct. Unemployment Rate Hits 10.2%, W.S.J., November 6, 2009.

[167] 12 U.S.C. § 3 (1913).

[168] Jenny Anders, Wall Street Pursues Profit in Bundles of Life Insurance, N.Y. Times, Sept. 5, 2009.

[169] Id.

[170] Centre for European Policy Studies, Concrete Steps Toward More Integrated Financial Oversight (2008).

[171] Id. at 37.

[172] Eamon Javers & Victoria McGrane, Collin Peterson, June 18, 2009, http://www.politico.com/news/stories/0609/23874.html.

[173] Id. at 3.

[174] Id. at 3.

[175] Bretton Woods Project, Financial Regulation in the European Union: Mapping EU Decision Making Structures on Financial Regulation and Supervision 30 (2008).

[176] Id. at 31.

[177] Id.

[178] Id.

[179] Ron Paul, End the Fed (Grand Central Publishing 2009).