All on Red: How Wall Street Gambled Big and Lost

Most people go to Las Vegas to gamble. Surrounded by flashing lights and luxurious casinos, there is something alluring about sitting at a blackjack table for hours on end. I am sure that the free drinks might have something to do with it too.

But when I looked at a recent Reuters article, I read facts that reaffirmed my belief that people on Wall Street are different. They are not like most people. Instead of rolling the dice, they would rather "gamble" on complicated financial instruments or presidential elections. And with the results of this election over, it was clear. Wall Street crapped out.

In late July 2010, President Obama signed Dodd-Frank, a financial regulation law, named after the two Democrat legislators who sponsored the bill. It became immediately clear that the banks on Wall Street were not happy. One paper stated that, "within minutes of the bill signing, several Wall Street groups were leveling criticism at the new regulations, reflecting Mr. Obama’s increasingly fractious relations with corporate America."

Their criticism did not end with harsh words. In the presidential election, Wall Street gave over $150 million to Romney, or Super PACs whom supported Romney. Wall Street put it all on red and the ball ended up on blue. 

What caused the animosity between the financial services industry and the White House? Was it only because of the monumental financial reform bill?
 
You may have read that the financial crisis was brought on by the housing bubble. However, you may have missed the fact that the banks on Wall Street were the ones putting the batteries in the bubble machine. In creating collateralized mortgage obligations, or the securities that were later known as "toxic," the banks accomplished what they always do best - make sure that someone else bears the risk.

The main idea behind these securities was that it would be less risky. The banks would bundle up a bunch of mortgages, label them as high-risk or low-risk, and put them in their respective tranches. Investors would buy them according to how risk-averse they were. It was the perfect way to lend to prospective home buyers because it was supposed to spread the risk among a number of parties. Or so they thought.

With the help of rating agencies listing most of the securities as triple-A,  the prices of these "toxic" instruments went up as demand increased. The banks sold them faster than a casino sells drinks. Instead of having the borrowers pay the banks directly, the banks sold the complex securities to investors, whom were to be paid from the borrowers. The banks shifted the risk of default and foreclosure to the investors.

It didn't end there. Before the fall of Lehman Brothers, some banks began to purchase credit default swaps. These instruments acted as insurance. The banks would pay a premium, and in the event of a mortgage default, the issuer of the swap would have to pay the bank. They were betting against the very securities that they were selling.

The bubble eventually burst when people realized that the values of homes across the country were inflated. More homeowners began to default on their loans and the securities bought by investors lost their face value. The consequence of these events led to the Great Recession, in which millions of Americans would become unemployed or underemployed.

When things began to settle, laissez-faire "fiscal conservatives" already had their fingers pointed to the ones responsible - the government and the indigent. Their main theory, the one you've probably heard from your conservative friend, is that Fannie Mae and Freddie Mac ("GSEs") encouraged subprime lending to people who couldn't afford it. It's these irresponsible borrowers and government enablers who shoulder the blame.

The problem with this conservative theory is that it doesn't have evidence or facts to support it. The primary holders of the "toxic" assets were the private banks. Moreover, many economists and authors pointed out that, "the GSEs’ overall purchases and guarantees were much less risky than Wall Street’s... their default rates were one fourth to one fifth those of Wall Street and other private financial firms." So, in effect, the banks ran wild, but somehow still found a way to persuade some Americans that it was the fault of poor people.

President Obama didn't buy it and he explained his position on financial services and the need for regulation. At times, he even called the Wall Street bankers "fat cats." The bankers must have had some self-image issues because they were deeply hurt. One Wall Street exec said it wasn't so much what the President did, but the "vibe they get."

Dodd-Frank was historic in its ambition and scope. It created the Consumer Financial Protection Bureau, the "Volcker rule," which will limit proprietary trading by the banks, credit default swaps regulations, and a number of other safeguards to protect financial stability. The legislation put Main Street back as America's number one priority, much to the dismay of Wall Street.

The gamble to oust President Obama may not have gone in Wall Street's favor. But I know they aren't done. They can spend just as much on challenging the law in the courts. I bet money that they'll try.