Free Inside Job by Charles Ferguson Page A

entirely by the large investment banks that issued them. Since there were only a handful of these issuers, the rating agencies were very
cooperative. But conflicts of interest went even further. The rating agencies also rated the debt of the banks themselves , a crucial indicator of the banks’ stability. But since
downgrading a bank would, again, infuriate a major customer, it was never done. Indeed, the rating agencies started consulting to the banks, receiving huge fees for advising how to construct a
security such that it would receive a high rating. At the individual level, things were even ickier. Rating agencies paid substantially less than investment banks, so employees of rating agencies
tried hard to please the bankers they dealt with, in hopes of getting a job at the bank. Many did.
    The securities insurance companies, especially AIG Financial Products, compensated their employees just like investment bankersannual cash bonuses based on the year’s transactions. So,
again, they had every incentive to sell insurance, either literal insurance or credit default swaps, in order to get their bonuses. Losses five years later would be the company’s problem.
    Incentives among the ultimate buyers of securities were dangerous as well. In the case of hedge funds, compensation at the firm level was so-called 2 and 20: clients were charged fees of 2
percent per year of assets managed, and the fund kept 20 percent of all gains, computedannually. However, the fund did not participate in losses, so fund managers were
incented to take risks. The same was true, to a lesser extent, of other larger institutional investors such as pension funds and mutual funds. They too were compensated annually based on
performance, and they too were rewarded for gains but not punished for losses. This incented them to “reach for yield”, and made them far less attentive to long-term risks. For example,
they started to trust ratings uncritically, rather than examine risks independently.
    And finally, there were the external incentives supplied by the regulatory and policy environment. It was the Clinton administration that first signalled, decisively, that it was suspending
enforcement of the law when it came to the financial sector and even to individuals with substantial financial assets. In addition to supporting legislation—such as the repeal of
Glass-Steagall—that permitted previously illegal activities, the government stopped enforcing the laws that existed. When Alan Greenspan refused to issue mortgage regulations under HOEPA,
nobody complained. When the Internet bubble spawned huge amounts of extremely obvious fraud, nobody investigated and nobody was prosecuted. America was now an open city.
    And then George W. Bush became president. He was not elected, and to a significant extent the American people therefore cannot be blamed for what happened afterwards. Bush lost by over 500,000
votes, and almost certainly lost the state of Florida, so he should have lost the electoral college as well. But through a well-orchestrated public relations and legal campaign, a Florida recount
was avoided and the Supreme Court handed George W. Bush the White House by a 5 to 4 decision.
    With the changes of the 1990s, the conditions for a financial disaster were fully in place. Bush’s ascent to the presidency was just the final nail in the coffin.

CHAPTER 3
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THE BUBBLE, PART ONE: BORROWING AND LENDING IN THE 2000s
    T HE DOT-COM STOCK MARKET bubble peaked in the winter of 2000. Its inevitable collapse was worsened by the 9/11 terrorist
attacks; and yet the resulting recession was short and mild. There were two reasons for this.
    First, the Bush administration embarked on a campaign of massive deficit spending. The government employed tax cuts, particularly for the wealthy, and sharply higher spending, particularly for
the military—for the war in Afghanistan, the invasion and occupation of Iraq, and counterterrorism and