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>> The following is a PBS Election 2012 special event.

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>> Tonight, Part 1, "Money, Power and Wall Street."

>> The clouds are still hanging over the global economy, and they're still filled with risk.

>> Inside the epic story of the global financial crisis.

>> Here we are, three years plus after, and very little has changed.

>> Where we are now... >> Wall Street got bailed out, and Main Street didn't.

>> And how we got here.

>> Let's put together a portfolio of credit risk.

>> Now the banks have taken these ideas and applied them in ways that they'd never expected.

>> Once the seed was planted, there wasn't any stopping it.

>> $36 billion in bonuses this year.

>> This kind of cult of more, more, more, grow, grow, grow.

>> The economy is melting, the Bush administration is leaving.

Obama gets a real glimpse of the future.

Disaster is coming.

>> There's real panic in the marketplace.

>> You may have just made the decision that destroyed the world.

>> These banks transfer risk across the Atlantic, outside the purview of American regulators.

>> They turn into a Frankenstein monster.

>> Occupy everything!

>> In an election year... >> Wall Street got away with bank robbery.

>> Is the global financial system any safer?

>> This crisis really never ended.

>> Tonight, Part 1, "Money, Power and Wall Street."

>> NARRATOR: Every day, tens of thousands of workers make their way to Wall Street.

They work for banks, brokerages, hedge funds, insurance companies and mortgage lenders.

It is the largest single sector of the American economy-- an industry that is almost double the size of America's manufacturing sector; a business with enormous power and global reach.

It is the industry that led America and the world into its worst economic crisis since the Great Depression.

The banks say they exist to create wealth-- holding in trust our collective worth, promising to invest the trillions of dollars that stream in from businesses, pension funds and savings accounts that belong to all of us.

One morning in the fall of 2011, bankers arriving in Lower Manhattan were caught by surprise.

>> This is what democracy looks like.

>> The banks got bailed out, we got sold out!

>> Stay on the sidewalk.

You must go on the sidewalk.

>> NARRATOR: The recession had destroyed $11 trillion of Americans' net worth.

A recovery seemed far off.

Occupy Wall Street wanted bankers held responsible.

>> Most Americans think, and with good reason, that Wall Street got bailed out and Main Street didn't.

We have very high unemployment.

We lost 8.5 million jobs in the recession.

People's houses aren't worth what they paid for them.

A lot of them don't have jobs.

Their kids are graduating from college and are moving back in.

>> This is what democracy looks like.

>> NARRATOR: Some protestors were calling for bankers to be prosecuted.

>> It is pretty clear, actually, that there was massive illegality going on.

And if somebody with subpoena power was intent on prosecuting that, I don't think there's really much doubt that they would be quite successful in criminal prosecutions.

>> (chanting): We are the 99%!

We are the 99%!

>> NARRATOR: In a matter of weeks, Occupy demonstrations spread to scores of cities across America and the world, calling for radical changes in the banking system.

>> We are the 99%!

>> NARRATOR: Bankers responded by saying that the answer is to move on and get back to business.

>> Some of our companies made a series of bad mistakes.

And-and-and we all paid for 'em including... and-and it lead to the economic crisis.

>> MARTIN SMITH: But what makes people upset is that...

I mean, you know, a lot of the people that are on the streets demonstrating, Occupy Wall Street, is that the economy hasn't recovered but banks have.

>> If you want a stronger econom you have to have financial services companies that are safe, and sound, and able to lend and able to finance their customers.

Now if you want to have a recession, then go ahead and-and hammer the banks.

And, you know, make sure that they're... that they fail.

Because then you'll have another recession.

>> Do you understand why they're angry?

Do you have any comment?

Mr. Blankfein, can we ask you a question, sir?

Can you give the American people an accounting of how you spent their money?

Do you understand why it is they are angry at bankers?

Do you have any regrets about the way you've spent the taxpayers' money?

>> Absolutely not.

>> NARRATOR: Since the meltdown of 2008, there have been dozens of hearings.

>> And we regret that people have lost money.

And whatever we did, whatever the standards of the time were, it didn't work out well.

>> I would like to ask your opinion of the role that over-the-counter derivatives played... >> NARRATOR: Many questions have been asked... >> ...in contributing to the financial crisis.

>> NARRATOR: ...but there have been few satisfying answers.

>> What goes on at Wall Street and exactly what caused the crisis and how did we get where we are, it's difficult to understand even for professionals.

>> I'm not sure I understand that point.

Maybe you could elaborate.

>> Well, I think it's, in many ways is very simple.

I think our regulators and the industr have to focus on complexity.

>> But at the end of the day, people usually have a pretty good abilit to tell when something's wrong.

>> Somehow we just missed that home prices don't go up forever.

>> What is a synthetic CDO?

>> A CDO is a pool of assets... >> I think finance may have gotten too complicated for anyone to understand.

>> That are pooled together and then can be sliced.

In a synthetic you pool reference securities that are indexed to specific more... pools of mortgages.

>> And that the managers of these large financial institutions in some ways have been given an impossible task that they won't be able to comprehend what it is their institutions are doing.

And that is really, really scary.

>> You created the mess we're in.

And now you're saying, "Sorry.

Trust us."

You created CDOs, you created credit default swaps that never existed a few years ago.

Who was the brilliant person who came and said, "Let's do credit default swaps"?

Find him.

Fire him.

>> NARRATOR: It's hard to pinpoint the origins of America's financial crisis.

But one weekend at this resort in Boca Raton, Florida, is a good place to start.

Assembled here in June 1994 were a group of young bankers from J.P. Morgan.

At the time it all seemed innocent enough.

>> Boca Raton was a gathering of people that were part of the Global Derivative Group at J.P. Morgan, in part as a celebration, in part as an opportunity to relax.

But perhaps much more importantly, as an opportunit to get creative, innovative people together in a room to discuss a whole variety of different topics.

>> And since they were young, mostly in their 20s, and since there was plenty of money floating around and they were full of high spirits, they did what any young bunch of kids would do and they got drunk, they had parties, they threw each other in pools-- you know, this is the normal stuff that happens at conferences.

>> Yes, I went into the pool fully clothed, as did my boss.

Some people drank, some people didn't.

And I'm happy to say that, like, most people stayed reasonably sober.

>> NARRATOR: They played hard but they also worked hard.

They were striving to address an age-old problem in banking: how to reduce risk.

>> The defining problem was that banks were unable to adequately deal with their own credit risks.

>> We're thinking about how to manage risk.

We were thoughtful and deliberate and careful.

We had a responsibility not just to make a profit for the shareholders, but to look after the financial system as a whole.

>> NARRATOR: Over two days of meetings, they looked at whether they could find a wa to make their loans less risky.

The first journalist to tell the full story was Gillian Tett.

>> They began to look for ways to enable financial institutions to pass risk between them.

One way to do that was to sell loans.

Another way, though, was to separate out the risk of a loan going bad from the loan itself.

And out of that came this drive to develop credit default swaps.

(shouting) >> NARRATOR: Credit default swaps, a kind of derivative that insures a loan against default.

This was a very new concept.

Traditionally derivatives were a way to bet on the future value of something.

For hundreds of years, farmers have traded derivatives to protect themselves against fluctuating crop prices.

It is this type of derivative that has been traded on the commodities exchange in Chicago, along with the futures of fuels, currencies and precious metals.

In Boca Raton, the J.P. Morgan team realized that they could use credit derivatives to trade their loan risks.

>> Bankers borrowed one set of ideas that had been developed in the commodities market and applied it to loans for the first time.

This idea was essentially created under the banner of making the financial system safer.

>> NARRATOR: The first big credit default swap was engineered by Blythe Masters and involved Exxon.

>> Exxon was the client at the bank and we had credit exposure associated with that relationship.

>> The Exxon Valdezspewed almost 11 million gallons of oil into Prince William Sound.

>> NARRATOR: In the wake of the Exxon Valdez oil spill and a rash of lawsuits... >> A civil trial... >> Returned a five-count indictment... >> NARRATOR: ...Exxon took out a multibillion-dollar letter of credit with J.P. Morgan.

>> A letter of credit creates credit risk.

If Exxon were to fail on their obligations, then J.P. Morgan would have to step in and make good on those obligations on their behalf.

It was a large amount of exposure, and there was a significant amount of risk associated with that.

>> NARRATOR: And that risk is a big drain on a bank.

>> Every time a bank makes a loan, under banking regulations, they're required to set aside certain reserves of capital for the loan.

So J.P. Morgan, when they made the loan to Exxon, would have had to set aside some capital.

>> J.P. Morgan has to hold certain capital relative to the size of that loan in the event the loan is not paid off at 100% as you expect.

Well, of course if you don't have to do that and you're a bank, you'd prefer not to do that.

>> SMITH: Because then you can finance more freely, you can take on more debt?

>> Right.

>> NARRATOR: So Masters started looking at who could take on their loan risk and free up J.P. Morgan's capital.

She found a taker in London-- the European Bank for Reconstruction and Development.

The EBRD.

>> EBRD would receive compensation from J.P. Morgan for taking on or assuming credit risk and felt that that was a good risk/reward proposition.

And so risk was essentially dispersed.

And why did J.P. Morgan do that?

Because we wanted to free up our capacity to do more business.

>> NARRATOR: This was a major financial innovation.

Credit derivatives made it possible for a bank to skirt capital requirements.

>> And that's what actually happened.

Is the amount of capital that banks had to hold got less.

And so banks became able to create more and more credit.

They could make more loans.

>> The innovative element of swaps is that they allow companies, financial institutions, governments, to shed the risks that they don't want to take and take on other risks that they would prefer to be exposed to.

>> NARRATOR: The Exxon deal was just the beginning.

Demonstrating that risk could be offloaded and capital freed up.

J.P. Morgan had struck gold.

In 1998, they decided to ramp up their credit derivatives operation.

That year, another young banker joined the team, Terri Duhon.

>> Part of my job was to come in as a trader and to build a credit derivative trading book, including all the risk management around the more exotic products.

That was what I was brought in to do.

>> NARRATOR: Previously J.P. Morgan had written credit swaps on single companies like Exxon.

Duhon was asked to write swaps on bundles of debt.

>> The idea was let's put together a portfolio of credit risk.

A portfolio of names.

>> NARRATOR: Her first trade was a credit default swap on 306 corporate names on J.P. Morgan's books.

>> And that list of 306 entities, they were very highly rated.

They had very low credit risk.

>> SMITH: And the credit default swap was ensuring J.P. Morgan against default by those 306 entities.

>> That's correct.

>> SMITH: Many of them Fortune 500 companies or other... >> It would have been your... some of your most well-known household names.

And so we were giving investors an opportunity to, in effect, invest in our loan portfolio.

>> J.P. Morgan did a lot of work, did a lot of due diligence to assemble this portfolio of loans.

And you can get it in one easy, bite-size piece.

>> NARRATOR: And the bank facilitated this by slicing up the portfolio into different risk levels, or tranches.

Investors could choose how much risk they were willing to take.

>> Different investors wanted different levels of risk.

There were some investors that wanted to earn a big return on really risky stuff.

And there were some investors that wanted to earn a little return on stuff that wasn't risky at all.

>> NARRATOR: From there, the bank looked to expand their business even further.

>> So along comes this idea-- what if we could create a market where people were able to buy and sell freely, independently of the companies themselves, the risk associated with lending to those companies.

>> NARRATOR: And so they began selling derivatives that were simply bets on any and all portfolios, whether the bank owned them or not.

These products came to be known as synthetic collateralized debt obligations-- synthetic CDOs.

>> There were investors who were able to invest in some entities that they had not had access to before.

>> SMITH: By buying a credit default swap.

>> By investing in a credit default swap because it was a name that they hadn't previously had access to.

So there was a lot of... a lot of very positive reinforcement of the market.

And it just grew.

It grew very naturally.

Once the seed was planted, there wasn't any stopping it.

>> NARRATOR: It was the beginning of an unfettered brave new world of banking.

>> SMITH: This was pretty new stuff.

>> This was... (laughs) This was incredibly new stuff.

It was amazing.

It was clearly a product that was in need.

We had identified a need.

>> NARRATOR: Most of the members of the Global Derivatives Group at J.P. Morgan were in their 20s, including Masters and Duhon, but with the creation of the credit default swap market, they had made banking history.

>> What in the long run this all meant was that credit, which is a vital part of the lifeblood of any economy, the global economy, became a more readily available asset.

And the thinking was that that would be an unambiguously positive thing.

Credit helps drive growth, helps companies deploy capital, helps employment, et cetera.

It wasn't any longer just an idea in a room in Florida, it was the creation of an entire marketplace.

>> NARRATOR: Risk could now be easily traded.

It fueled a worldwide credit boom.

Soon other banks got excited about the money to be made writing credit derivatives.

Paul LeBlanc was a derivative salesman at Morgan Stanle who remembers the pressure to get more deals done.

>> The volume of transactions was just exploding.

I mean, I used to know all the statistics, because they used to talk about it every meeting, how this is a growing market.

You have to get your customers involved.

They can make money.

We can make money.

It was a massively important sector for us to focus on, derivatives.

>> NARRATOR: And importantly it was a private market-- unregulated and out of view.

>> See, unlike an exchange-traded market, where all the banks can see all the positions, there's no public market for these derivatives.

You can't look in the newspaper and get a price for them.

These are all private, off-exchange markets.

And nobody else in the market knows what's going on.

>> NARRATOR: And because this market was opaque, the spreads-- the difference between what banks could charge for derivatives and what it cost to provide them-- could be huge.

>> SMITH: How much were these things making for the bankers that were selling them?

>> The spreads on derivatives are several times larger than on comparable cash securities, just as a general rule.

And that's why the banks trade them.

>> SMITH: Cash securities being those that are... >> Equities, bonds.

>> SMITH: Well, paint some picture of that and the kind of money that people were making.

>> The best reference that you could give is that if you look at, say, the spread that a bank might earn doing an IPO for Facebook, they're gonna maybe make one percent to bring out that IPO, very hot IPO.

If you were doing the same-sized deal in a derivative security, you might make ten times the fee.

>> And the basic business that they created was immensely profitable.

But there's a problem with all of this.

Most people in finance assume risk can be eliminated; but all you can do is move it around from one party to another party.

>> NARRATOR: There was growing concern in Washington.

>> We are moving towards greater risk.

We must do something to address the regulation of hedge funds and especially derivatives in this country-- $33 trillion, a substantial amount of it held by the 25 largest banks in this country, a substantial amount being traded in proprietary accounts of those banks.

That kind of risk overhanging the financial institutions of this country one day, with a thud, will wake everyone up.

>> NARRATOR: Proposals circulated to rein in the banks and to regulate derivatives.

>> What are you trying to protect?

>> We're trying to protect the money of the American public, which is at risk in these markets.

>> NARRATOR: The head of the Commodity Futures Trading Commission, Brooksley Born, led the charge.

>> We are the regulator which has been given the authorit to oversee the major derivatives markets.

>> Brooksley Born was absolutely right because what she said is, "If you don't have transparency and regulation of derivatives, "the risk is gonna build up and they're gonna lead to "a financial crisis that's gonna cause massive taxpayer bailouts."

>> NARRATOR: The banks lobbied hard for no derivative regulation.

>> The banks didn't want anyone to know how much risk they were taking on.

They didn't want to have to quantify it on their balance sheet.

They wanted to be able to push it off and hide it, and that was why they lobbied so hard to make sure that swaps and derivatives would be treated differentl from other kinds of financial products.

>> NARRATOR: Others wanted them to be regulated like insurance.

>> One of the most heavily regulated products in the country are insurance products, for all the obvious reasons.

If you're gonna... if you're gonna write insurance, you have to have enough money to pay off that insurance.

>> SMITH: But if you write a credit default swap, you don't have to have that same amount of money on hand?

>> Or anything else, including, importantly, no disclosure.

>> SMITH: So you're saying it's a kind of under-the-table insurance agreement that avoids regulation?

>> It's an insurance product designed not to be regulated as an insurance product and designed to avoid regulation at all.

And one thing we do know is that when a product of any type is designed with minimal regulation, capital and activity moves into that area.

And it expands dramatically.

>> Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.

>> NARRATOR: The chairman of the Fed, Alan Greenspan, sided with the banks.

>> Alan Greenspan was coming from a very libertarian tradition.

Keep your hands off everything.

The markets will sort themselves out.

And if there's a problem, then we'll clean up afterwards.

And now that really was the way the Federal Reserve operated under his leadership for almost 20 years.

>> NARRATOR: On Capitol Hill, supporters of bank deregulation made urgent, stark pleas.

>> The future of America's dominance as the financial center of the world is at stake.

>> NARRATOR: Before them was legislation to lift restrictions on how banks could do business.

>> ...if we didn't pass this bill, we could find London or Frankfurt or Shanghai becoming the financial capital of the world.

>> This bill is going to make America more competitive on the world market and that's important... >> NARRATOR: And legislation to prevent oversight of credit derivatives.

>> ...on high-paying jobs, not just on Wall Street in New York City, but it affects every business in America and it benefits every consumer in America.

And we do it by repealing Glass-Steagall.

>> NARRATOR: The campaign to roll back Glass-Steagall, a Depression-era set of reforms, was led by the country's biggest bank, Citicorp.

>> They felt it was in their way and persuaded lawmakers, both Democratic and Republican, that Glass-Steagall should be repealed.

It also symbolized when everything really started to go wrong.

>> It's the most important example of our efforts here in Washington to maximize the possibilities of the new information age global economy.

>> NARRATOR: In the end, banks would get larger and derivatives would remain in the shadows.

>> The derivatives market went into darkness, almost no transparency and no regulation.

And what you see is this explosion in the growth of derivatives in the United States and throughout the world.

>> We're only sitting on a couple of mill... >> NARRATOR: The banks had won the day.

Credit default swaps would now be introduced to new markets.

>> The next application of this same technolog was to portfolios of consumer credit risk, and in particular mortgage-related credit risk.

>> NARRATOR: And the higher the risk, the better.

>> What everyone is trying to create is something that has a high rating and a high yield.

That's the holy grail.

That's the goal, is to mix together assets in some wa so that you come out with a triple A and a big return.

>> NARRATOR: And so Wall Street discovered the rewards of funding the American Dream.

Just as they had bundled corporate loans, bankers now bundled mortgages.

>> You would buy these big pools of mortgages, and these credit default swaps enabled you to bundle all this stuff together, bring it in house, in order to get it ready to put through the sausage-making machine and create these securities.

>> NARRATOR: Bankers spread their investing dollars across the country, but especially in states seeing historic levels of population growth.

Places like Florida, Nevada, California... and here, in Georgia.

>> Well, Atlanta was one of the hottest markets in the country, the Atlanta region.

>> NARRATOR: Roy Barnes is the former governor of Georgia.

>> Georgia was the fourth- fastest-growing state at the turn of this last century and the fastest-growing state east of the Mississippi.

So it was a hot market to start with.

>> I put my house on the market on a Tuesda and it was gone Thursday.

>> NARRATOR: Elected in 1998, Barnes is renowned for having taken on Wall Street over subprime lending-- a market the Street had traditionally avoided.

>> Subprime lending has been around for a long time and is supposed to be lending done to people whose credit is inferior.

>> And in the '80s there was no place for subprime.

Nobody wanted it.

The banks wouldn't buy it because there was a higher risk.

>> City Mortgage, may I help you?

>> I've been having trouble with my credit.

>> That's no problem.

We'll give you the best rate possible.

>> The subprime market was originally a niche market.

Originally it was not the major banks.

It was the mortgage brokers who were specialists in this market.

>> Subprime loans in Atlanta jumped by more than 500% during a five-year period, >> What really changed the appetite for subprime mortgages was you could securitize and you could sell it on Wall Street.

They do it in tranches, and then they wrap it up so they could be packaged together and have an overall higher yield.

>> Nearly half of all new single-family home construction is in the South, now more than 50,000 a month.

>> And, of course, Moody's says triple A.

So it was just a feeding frenzy.

I mean, it was just an absolute feeding frenz for subprime mortgages.

>> With the economy strong, homebuyers are willing and able to spend double what they did just two decades ago.

>> And you could just about drive by a bank and they'd throw a loan paper in your car as you passed by.

Became very loose.

Became very loose.

>> NARRATOR: But what big banks on Wall Street did not or would not see was what was happening on the ground around the U.S.-- a wave of lending abuses.

>> It's a phrase you're likely to hear in the future: predatory lending.

>> We trusted mortgage companies... >> We say that we were swindled... >> ...the situation have caused me to go into the state of bankruptcy.

>> This is what you call robbing somebody without a gun.

>> The Wild West experience in home mortgages was well underway.

>> 41-year-old Hessiemay Hector, mother of three, agreed to a second mortgage at 27.5%.

>> We were creating mortgages that we had never seen before.

And they were being created faster and faster.

>> The interest rate on these loans was as high as 42%.

>> We saw borrowers given loans that were greater than the value of their home.

Home buyers were getting loans that had no income.

The borrower-- particularly the elderly or the low income-- had no clue as to what they signed.

There was a tremendous growth of mortgages that we knew made no sense financially.

>> When you have a high interest rate, then you have high points, then you have pre-payment penalties.

When you have balloon payments, when you have adjustable-rate mortgages and when you layer those bad practices on top of a high interest rate, it becomes predatory.

>> Black homeowners in Atlanta have become such frequent targets of unscrupulous lenders that counselors regularly hold community meetings to issue warnings.

>> You end up with monthly payments that you can't afford.

>> And why did they sell them to people that they were not good for?

They did it because they could.

>> We've got to fight, fight, fight, fight!

>> NARRATOR: Housing advocates around the countr took on predatory lenders.

But one of the fiercest fights was here in Georgia, over what was called the Georgia Fair Lending Act.

>> But we don't need rhetoric... >> NARRATOR: The bill was sponsored b state senator Vincent Fort... >> We need action, now.

>> People are tricked into owing more money that they could ever dream.... >> NARRATOR: ...and backed by Governor Roy Barnes.

>> ...talked into believing there's a way out.

>> Governor Barnes and others are making a last ditch effort... >> NARRATOR: The bill targeted high-cost loans and predatory lenders with a series of rules and prohibitions.

>> It's up right now on the House floor, a governor's bill to crack down on so-called... >> NARRATOR: The mortgage lenders and the banks struck back.

>> None of these people have a clue of what's going on.

Nobody here understands the business and they didn't let us speak.

>> You would have thought I had recommended that we repeal the plan of salvation.

And why were they so opposed to it?

Money.

Money.

>> This bill will cripple the mortgage business, it's gonna cripple real estate sales, it's gonna absolutely devastate the home market in Georgia.

I can guarantee you.

>> There were threats that the residents in Georgia wouldn't be able to get mortgages anymore, because investors would not buy the mortgages in Georgia.

And if that were true, no bank would create a mortgage in Georgia.

>> NARRATOR: Despite the efforts of the mortgage lobby, Barnes and Fort got the bill passed in April 2002.

>> Georgia now has the toughest predatory lending law in the nation.

>> NARRATOR: The mortgage lobby feared that similar legislation could pass in other markets like California.

They opposed Barnes' re-election.

They funded his challengers and lobbied to rescind the law.

>> Right after Governor Barnes' defeat in November, one of the top legislative priorities for the new governor and the new legislature was to gut the Georgia Fair Lending Act.

I think it was about two weeks into the new legislative session and it was gutted.

>> NARRATOR: But for a seven-month period, predatory lending in Georgia declined.

It may have been the last chance to slow the housing boom.

>> I would like to sit up here and tell you that I was like Nostradamus, that I saw that the world was going to come to an end because of all this.

But I could never have foreseen the difficulty that existed.

Never have... could I have foreseen that.

>> I think we still would have seen an unrealistic bubble.

But it wouldn't have gone up as fast and it wouldn't have collapsed as fast.

We would not have been in as deep a hole today as we are if we hadn't had these funny mortgage products.

>> No let-up in the housing boom, which is good for the economy.

Homes were selling last month at a record clip, the main reason low mortgage rates... >> NARRATOR: The big banks continued to package and sell more mortgage portfolios.

And more and more of these CDOs contained high-risk subprime debt.

To keep the rating agencies on board, more credit default swaps were sold.

>> Let's say I have a pool of mortgages-- I have a thousand mortgages from California and I want to package these up.

But I decide, "Well, some of these mortgages may be subprime and I want to buy a little bit of credit default insurance."

>> SMITH: And by doing that, you improve the profile... >> In theory, yes.

>> SMITH: ...of your CDO... >> That's right.

>> SMITH: ...so that you can sell it better.

>> I could go get a rating for it, too.

I could go to Moody's and say, "Look, I have laid off two percent of the risk "on this portfolio.

"Shouldn't I get a better rating than if I just sold the pool as it was?"

>> SMITH: So you take a lot of crap... >> That's right.

>> SMITH: ...a lot of mortgages that are... >> Hideous crap.

>> SMITH: But you insure it and the credit agency says, "Hey, that's a good idea."

>> Yes.

Yes.

>> And it seems that in the housing market many investors actually began to take more risks precisely because they thought that they had bought protection with credit default swaps.

>> New home sales jumped 13% over a year ago, while existing home sales rose 4.5%... >> NARRATOR: The team at J.P. Morgan was also dabbling in mortgage debt but they weren't sure it made good sense.

>> We traded mortgages.

We had some mortgages on our books.

We certainly understood the mortgage-backed security market.

But we had a lot of trouble getting comfortable with that risk.

The big hang-up for us was data.

We had years and years of historical data about how corporates performed during business cycles.

But we didn't have that much data about how retail mortgages performed during different business cycles.

>> We knew how much money people said they were making.

We saw that UBS and Merrill Lynch had securitized products earnings that were growing faster than ours.

And we asked ourselves the question, "What are we doing wrong?

"What are we missing?

Have we not figured out how to lay off some of this risk?"

And honestly, we couldn't figure it out.

What we never imagined was that those firms weren't doing anything at all.

They were just taking the risk and sitting with it.

>> The first wave of J.P. Morgan bankers who had developed these original ideas in the 1990s, when they saw what was starting to happen-- essentially other banks were taking these ideas and applying them in ways that they had never expected-- some of them began to get very worried.

>> We were just about to say "Done" on a transaction.

We had a global phone call and we were discussing the risk that we were about to do and we had discussed it over and over and over.

And finally someone on that phone call said, "I'm nervous."

>> Twice as many home buyers are getting adjustable mortgages.

>> We almost had stopped thinking and stopped reassessing the risk as we went along.

And suddenly we found ourselves with a product that was vastly different from where we started.

And every little tweak along the way we had all said, "Oh, that's okay.

That's okay.

That's okay."

Until suddenly we all looked up and said, "Hang on, it's not okay."

>> The world is still living with a lot of big, unresolved problems.

>> NARRATOR: Other banks were not so cautious.

They aggressively sold subprime CDOs to customers all over the world.

London became a second beachhead for their trading and sales operations.

>> The stock market's on the rise and economic statistics... >> The city of London actually did yeomen's service in creating some of the nastier structures.

They did this offshore.

These were not SEC-registered deals.

These were all private placements.

So they were going through the legal loopholes.

(bells chiming) >> NARRATOR: A group of state-run banks in Germany known as Landesbanks were among the biggest customers.

Desiree Fixler, who worked at J.P. Morgan, says she was amazed by these banks' appetite for subprime mortgages.

>> You knew that a core group of banks in German would buy anything.

We strongly believed they were very na瘹e.

We were amazed that they would buy this.

It was...

I mean, every single person, every salesperson, was envious of that particular salesperson that was able to cover the Landesbanks and IKB because you were in one of the hottest seats, globally.

You were gonna generate tremendous profit margin.

They were big buyers.

>> IKB was very convinced that they were one of the strongest bank in that area.

They were running around telling people how good they are in investing.

>> NARRATOR: Multinational Deutsche Bank did several deals with IKB.

>> SMITH: Did you think, at the time, that your products were helping IKB, that these were good things for them to buy?

>> Yeah, absolutely.

Otherwise we wouldn't have manufactured these products and sold it to them.

>> SMITH: So you were bullish on subprime mortgages in the U.S. >> We were bullish on the mortgage market in general, and subprime, which was a element of it.

We were not overly aggressive but we were a part of that market, absolutely.

>> Americans are buying real estate in record numbers.

That demand... >> NARRATOR: By the end 2005 the total outstanding value of credit default swaps around the world was measured in trillions of dollars and was doubling every year.

>> SMITH: Did top management at J.P. Morgan understand credit derivatives?

>> Yes, they did.

Absolutely they did.

>> SMITH: Did they at other banks?

>> No.

Not all other banks.

Certainly not.

>> SMITH: Did the regulators understand them?

>> I don't think the regulators understood.

I don't think the credit ratings agencies, the bankers or the regulators fully understood all of the kinds of credit instruments that we're talking about.

>> SMITH: In other words, some big banks simply didn't know what they had in terms of risk.

>> Certainly, they didn't... they didn't know some of the forms of risk that they had.

That's exactly right.

>> Sales were higher than most regions, up more than 40% in the West and Northeast... >> NARRATOR: Housing prices continued to soar.

Banks packaged more and more CDOs.

Theoretically, there was no limit.

An investor didn't need to own any actual mortgages.

So-called synthetic CDOs allowed investors to bet many times over on someone else's portfolio of debt.

>> It allowed participants-- either buying or selling, so on either side of the market-- to take their positions without being constrained by the size of the underlying market.

>> In synthetic CDOs, all you had to do was make a side bet based on what would happen to this group of mortgages and have that be the basis of the CDO.

The fact that someone had done it one time wouldn't stop you from doing it again and again and again.

>> SMITH: So how is that different than betting on the outcome of the Super Bowl?

>> Or a horse race or a craps table?

There's no different at all.

It's just a pure bet by somebody who has no economic interest in what they're betting on.

You're gonna bet on the outcome of the Super Bowl, you're gonna bet on the outcome of a horse race, or you're at the craps table or you're betting on which way the dice are gonna go.

>> I'm pretty confident that the housing market's not going to down at all.

It's just going to go up.

>> Within a decade, you have the most phenomenal machine anybody's ever seen.

>> New homes are selling at the second highest rate on record.

>> We are in a housing boom.

It's quite strong right now and housing prices are going up at a rapid rate.

>> ...profit soared at 93%... >> ...expected to dole out $36 billion in bonuses this year.

>> Everyone was high-fiving.

It seemed to be brilliant.

The combination of free markets, innovation and globalization appeared to have delivered this incredibly heady cocktail of tremendous growth.

>> Top executives will earn as much as $20 million to $50 million... >> NARRATOR: Between 2003 and 2006, Dick Kovacevich, CEO of Wells Fargo, remembers attending meetings with bankers and regulators.

>> Oftentimes what would happen at these meetings is regulators would be there, like Chairman Bernanke, and there might be, I don't know, 30 to 40 bankers.

And they would often go around the room and say, "Well, what are you guys seeing out there?

"What's working?

Are you concerned about housing?"

Trying to get input.

And when they came to me, I would say, "This is toxic waste.

"We're building a bubble.

We're not going to like the outcome."

>> SMITH: What did your fellow bankers say to you when you told them that you thought this stuff was toxic?

>> Well, the ones that were in it said I was wrong.

And everything is fine.

We don't see any losses occurring in this.

But we saw risk all over the place.

We didn't even participate in the exotic subprime side of the mortgage because we knew this was absolutely wrong for our customers if we would have done it and would have been wrong for us because we think this thing was going to blow up.

>> There's a great set of adages on Wall Street about where risk will flow.

And if you ask people, they're basically split between two camps.

One says that risk will flow to the smartest person, the person who best understands it.

And the other says that risk will flow to the dumbest person, the person who least understands it.

And at least based on my experience and my understanding of what has been happening in the derivatives market, it's the latter.

>> I was amazed at the interest on the part of investors to invest in a product that was highly complex and very risky on top of it.

>> SMITH: So let me get this straight, you were-- you were first to the party.

You developed this tranching of stuff.

>> That's right.

>> SMITH: And writing credit default swaps on it.

But now, everybody else has jumped into the game.

>> Everybody wants to do it.

>> SMITH: But your team decided to stop?

Why did so many others keep going, marching towards the cliff?

>> Um, the...

I mean, there... Look, very simply, there are certainly some investors, some banks, some borrowers, who are a bit greedier than they should be.

>> Goldman chief Lloyd Blankfein will take home $53 million.

>> NARRATOR: No one wanted the party to end.

Most banks believed housing prices would never go down, let alone crash.

>> To imagine losses of that severity required very significant assumptions about the path of the economy, which were just not in people's mind.

So it required things like assuming that house prices in the United States fell by 25%.

People weren't thinking that wa and as long as house prices never fell, then these risks would never come home to roost.

And that ultimately was obviously very flawed logic.

>> As interest rates rose early this year, home sales slowed and after years of record appreciation, prices are now dropping... >> The cost of borrowing is going up... >> NARRATOR: The unraveling began in late 2006.

>> Big trouble for millions of American... >> NARRATOR: When housing prices started to drop, only a very few bankers could see the bubble they were trapped in.

>> ...the housing market has turned some mortgages into time bombs.

>> By 2007, 2008, all the smart mone knew the game had ended and all the banks tried to effectively repackage what they were stuck with as quickly as possible and get it off their books.

But there was a second parallel movement which was going on which was all about, "How can we take advantage of it?"

>> NARRATOR: One of the Wall Street banks that took advantage of a declining market was Goldman Sachs.

According to a Congressional investigation, the bank created a series of CDOs containing toxic subprime and then sold them to customers... >> We at Goldman Sachs distinguish ourselves by our ability to get things done on behalf of our clients.

>> NARRATOR: ...while Goldman Sachs, using credit default swaps, bet against them.

>> They bet against their own clients so when their clients lost money, Goldman was making money.

Goldman has a little slogan that the clients come first.

No, they didn't.

Not in these transactions.

Goldman came first, second and third.

They were really, I think, the only major bank which made money when the housing bubble burst.

>> NARRATOR: In a settlement with the SEC, Goldman admitted that some of their marketing materials did not disclose important information, but Goldman claimed that their investors were highly sophisticated institutions.

One customer was that German Landesbank IKB.

>> ...anyone associated with the subprime market is going to pay the price.

>> Even when there was a downturn in the markets, they were still buying.

I mean, the market is telling them.

It's on the screen.

There are headlines everywhere: "Danger."

But they still wanted to go ahead.

>> SMITH: Did you feel there was an obligation on your part to tell them that, "Look, wake up, the markets are going down.

Maybe you should stop buying this crap"?

>> Those discussions-- the word "crap" wasn't used.

But, I mean, those discussions definitely happened.

But they felt that this was just a temporary glitch in an overall bull market.

"It will recover; it has to recover."

>> NARRATOR: In July 2007, the German bank IKB, stuffed with subprime, was the first bank to fail.

It was only a matter of time before the crisis came back to Wall Street.

>> That could hurt the value of homes nationwide.

>> We knew that the housing bubble had burst.

But we'd been reassured that the problem had been contained.

But by the beginning of 2008, it was becoming clear that this was a much, much bigger problem than anybody anticipated.

>> There was a broad misperception of the risk in housing prices.

The widespread view that we could have a regional decline in housing prices but never a national decline in housing prices proved to be horribly wrong.

>> ...last week was a difficult time in the mortgage business.

There was talk about problems in funds that were invested.

>> ...there are people talking about even pulling funds from Bear.

That's the problem... >> NARRATOR: In New York, banks were trying to unload what they could.

But there was confusion.

At Citigroup they were running in circles.

>> One of the incredible things about CitiGroup we now know was although it was tossing these risks off its balance sheet, those risks came right back, almost like a boomerang.

Without knowing it, they had set up one business to offload risk, and then completely reversed that business, taking those risks back onto its balance sheet.

>> It was quite clear to me that a number of really quite large financial institutions had not had the kind of management information systems which allowed them even to know what all their risks were.

>> SMITH: That was astounding to you.

>> It was astounding to me.

>> ...the sort of origination of the subprime loans, the creation of the CDOs-- that business is gone.

All those credit default swaps... >> NARRATOR: It would all come down to those credit default swaps.

Would they pay off as they were designed to do?

>> We have known for generations that banks are susceptible to runs.

Banks can't function if everybody comes and wants their money at the same moment.

>> ...Merrill Lynch, devastated by losses... >> Lehman Brothers and the fire sale of Merrill Lynch... >> NARRATOR: This time it would be a run on an insurance company.

AIG was on the hook for $440 billion worth of credit default swaps.

>> Remember an insurance contract is only as good as the credit quality of the insurer.

They have to pay you.

And if they can't pay you for whatever reason, then this whole process of risk transfer breaks down.

>> ...we need to stabilize this industry.

It can spread throughout the economy; it could be a very, very dangerous... >> September 18 of 2008, when...

I have a conference of my CEOs.

And CEOs traditionally don't read their BlackBerrys during meetings.

But I kept looking around and noticing that a number of 'em were.

And so I turned to one, we recessed, and I said, "You look like the world has ended."

And he said, "I think it has."

>> ...the enormity of the situation-- a financial nuclear holocaust.

Some $400-odd billion of credit default swaps... >> Another government bailout-- AIG securing an $85 billion... >> AIG could not conceivably have paid off all of those credit derivatives, because it had misunderstood the risks and did not have what we'd call a balanced book or nearly enough capital to back their losses.

>> SMITH: Didn't everybody know that AIG was holding a lot of CDSs?

>> No.

There was no disclosure.

That's the whole point.

They haven't reported this to anyone else.

The other dealers have no idea what's going on.

The other banks don't know.

Nobody knows.

The banks turned this market into their own private game.

>> It was, in fact, a financial shell game where we were manipulating banking results by moving the risk out through one door but bringing it back into the banking system by another door.

The risk was not leaving the banking system.

And everybody in the world was connected through these chains of risk.

Any if any part of that chain breaks down because they can't honor the contract, the entire system implodes.

>> NARRATOR: The idea dreamed up by a group of young J.P. Morgan bankers at a weekend retreat many years ago was supposed to reduce risk.

>> Their original idea had been taken and it turned into a Frankenstein monster, which they never dreamt would become so big and spin out of control to that degree.

>> It was a very scary time.

We were in totally new territory and the notion that Lehman Brothers could be filing for bankruptc and AIG could be at risk of the same fate was absolutely unprecedented.

And the implications, thinking through the implications of that, for the health not just of the U.S. economy, but the world-- I mean, it wasn't really conceivable to do that.

I couldn't get my mind around it, I know others couldn't.

>> We never saw it coming.

We never saw that coming.

And I was disappointed.

Hugely disappointed.

I mean I was part of a market that I believed was doing the right thing.

And maybe I was idealistic, maybe I was young, maybe I didn't fully appreciate where we were going, but there was a whole system going on, all the way from the borrower of the mortgage, all the way through to the investor.

There's a whole system of people who maybe were turning a blind eye.

Maybe were, you know, just, I don't know, it's--it's frustrating to see, certainly.

>> It shouldn't have happened.

Most of our financial crises in the past is due to some macroeconomic event-- an oil disruption, war.

This was caused by a few institutions, about 20, who, in my opinion, lost all credibilit relative to managing their risk.

And the sad thing is it should never have happened.

The management should have stopped it before it got big, and people are suffering for something that should never have happened.

>> NARRATOR: Today, the fallout is felt mostly in places that had seen the highest growth, like Georgia.

Ground zero of the subprime crisis: local neighborhoods, city streets.

>> Cities throughout the United States are seeing a rise in vacant and abandoned properties.

And that's where the neighbors feel it.

As neighbors, we're concerned not so much with the complexities of the subprime mortgage market and derivatives; these things we will hardly ever understand.

What we feel on the street is the fact that the house next to us is vacant, abandoned, partially burned.

And we wonder how long it's going to be there, how long we will pay the price for that abandonment.

A neighborhood cannot survive long when it has a growing inventory of vacant, abandoned properties.

>> NARRATOR: Sometimes no one even knows who owns the properties.

>> It's hard to know who owns it because it's been sliced and diced so many ways by investors that it could be somebody in Ireland who owns it.

You have these securitized pools, where investors own pieces of it.

The investors are around the world, literally, and so it's just in no-person's land.

It's a vacant property, mostly vandalized, and it just sits here, and we can't do anything with it.

And the reality is that that plays out across this neighborhood hundreds of times.

>> That house has a loan that is somewhere lost in a huge financial vehicle put together by some young turks on Wall Street.

It's lost in that billion-dollar package, because there's nobody assigned to look after it.

And there are whole subdivisions like this, by the way, that are just lost in this great morass.

And so it affects Main Street because Wall Street was too greedy.

The greed of Wall Street broke Main Street.

>> Coming up next, Frontline's four-part investigation of the financial crisis continues.

>> Concerns about shaky home mortgages are triggering fears of a financial meltdown on Wall Street.

>> Inside Washington's struggle to respond to the meltdown.

>> The Dow tumbled 240 points, while the NASDAQ sank 46.

>> They were all very afraid of the possibilit of a bank failure.

They didn't know what it would lead to.

>> Fears of a global liquidity crisis have intensified today.

>> Inside the critical decisions... >> The stock market dropped by hundreds of points right... >> The policymakers have sent inconsistent signals, so the marketplace doesn't know what to expect.

>> Everything freezes, and that's what causes the crisis.

>> Turmoil in markets around the globe.

>> I thought we may be presiding over the second Great Depression.

>> The politics of a bailout.

>> They had to throw their principles out the door and save the economy.

>> America, you should be outraged about what Washington is about to do.

>> And the education of a future president.

>> The economy is melting, the Bush administration is leaving... >> And all eyes are now on Barack Obama to turn it around.

>> Obama gets a real glimpse of the future.

Disaster is coming.

>> "Money, Power and Wall Street" continues right now.