This era of goodwill, this summer of giving and plenty, turned out to be the high point of American economic life. This was the crest of the wave after a decade of growth. Nobody knew this at the time, but the wave was about to crash. There were signals of trouble even in July of 2008. Oil prices were high, the housing market was slowing down, and a big investment bank had just failed. But only in retrospect would people realize just how good things were at that time. Things would not be that good again in America for at least another decade.
The first signs of trouble were detected by traders in Houston, on Koch’s trading floor. It was difficult, however, to piece together the bigger picture from these early signals. First came the unmistakable signs of weakness in the housing market. Orders started to slow at Georgia-Pacific, which churned out plywood, insulation, and gypsum building panels that were installed in new homes and buildings around the country. Even as early as 2006, the market was slowing. By 2008, it seemed as if new home construction was grinding to a halt. Gasoline prices were rising too high, too quickly, and the market was growing white-hot as speculators pushed up prices because of demand from China and other developing nations. In 2007, crude oil was trading for less than $60 a barrel; by July of 2008, it was trading for a record $145 per barrel. The extraordinarily high prices forced consumers to ration their use, pushing down demand and cutting into Koch Industries’ sales of gasoline. As consumers cut back their spending, it hurt retailers and restaurants.
More lights started flashing red on the trading screens during the late summer weeks. By then, many people were predicting a recession. But very few predicted the true extent of what was about to happen.
Cris Franklin, the young trader in Houston, watched it unfold. By 2008, he was working on a trading desk called the FXIR, or Foreign Exchange and Interest Rates. As such, he spent his days in the vortex of international finance and had a front-row seat as those markets seized up. While Franklin did not work with Koch’s large stock-purchasing desk—the entity that bought and sold millions of shares of stock in companies around the country—he was later able to review data from that operation. It was almost sad, in retrospect, to see what unfolded in those numbers.
“There were warning signs, in hindsight,” Franklin recalled. “Afterwards, being able to look at the price action of their trading strategy . . . that’s a clear sign that the market was unwinding its risk over a period of time before the crash took place.”
The risk, as it turned out, was everywhere.
* * *
The risk extended all the way into the foundation of the economic system—the households occupied by working people like Steve Hammond and Travis McKinney at the Georgia-Pacific warehouse in Portland. These households had not seen a significant pay increase for many years, but they continued to increase their standard of living in line with what they expected it should be. The gap between what they earned and what they spent was met with debt. The amount of US household debt exploded between 2000 and 2008. At the beginning of the decade, the total household debt was equal to about 100 percent of the entire nation’s annual gross domestic product, meaning the value of everything created in the economy that year. By 2008, household debt was about 140 percent of the GDP. It was difficult to find any comparable debt increase in the nation’s history.
Most of this debt was carried in the form of home mortgages. The mortgage had once been the cornerstone of a household’s wealth. Home prices were once thought to obey a simple law, rising incrementally and permanently. But during the 2000s, home prices pulled away from the course of incremental growth and ballooned. This was driven, in large part, by the Federal Reserve, which kept interest rates at a historically low level for a historically long period of time. The cheap interest rates made it much easier to borrow money for a home, and a whole industry sprung up to feed the new demand. Companies like Countrywide Financial sent agents out into every corner of the country to find any customer who might be willing to sign mortgage papers. The loans became exotic and loosely governed. People signed on the line without thinking through what the complex financing terms might mean down the road. This was the era of teaser rates and balloon payments and interest-only adjustable-rate mortgages. The deluge of cheap money and easy loans inflated a circus tent above the once-sleepy real estate industry and turned everybody into a speculator.
This alone might not have destroyed the economy. But it was coupled with the shift of financial trading into the black box of a shadow banking system. When people borrowed mortgages, for example, those loans were instantly sold off to a financial trader somewhere, rather than being left to sit on the balance sheet of a bank. Then the loans were packaged into complicated debt structures, such as collateralized debt obligations, or CDOs, that were bought and sold. The CDOs, in turn, became a fertile resource to make yet more money as traders bought and sold a type of insurance on CDOs called a credit default swap. All of these financial instruments were essentially just varied forms of the derivatives contracts that Brenden O’Neill learned how to trade when he joined Koch Energy Trading in Houston. O’Neill made millions buying calls and puts, but in the world of shadow banking, his trades were considered conservative. Across the globe, countless options contracts and derivatives agreements were traded, based on the underlying value of home mortgages, consumer credit card debt, and even the debt of corporations like General Electric.
All of these derivatives bets were opaque. They were often made during a phone call between two people, and the nature and size of the derivatives bet were recorded in secret, only by the two parties. This did not happen by accident. The derivatives market was built in very much the same way that Steve Peace helped build California’s electricity trading market back in the 1990s. It was built by overworked legislators, working in bland hearing rooms, writing complex legislation that was bird-dogged at every step by well-paid lobbyists.
In the late 1990s, a Clinton administration regulator named Brooksley Born, who was head of the Commodities Futures and Trading Commission, argued that derivatives should be regulated by the CFTC and traded on transparent exchanges. She was effectively shouted down by Clinton’s Treasury secretary, Robert Rubin, who was a former trader with Goldman Sachs, along with Rubin’s deputy Larry Summers and Fed chairman Alan Greenspan. Born was painted as an unsophisticated Washington insider who didn’t quite understand the benefits of modern finance, in much the same way that early critics of California’s power trading system were criticized for not understanding the benefits of allowing Enron and Koch to trade electricity by the megawatt-hour.
The financiers and their advocates won out in both cases. The Clinton administration ensured that the derivatives market would remain dark, outside the view of regulators and exchanges, when it passed the Commodity Futures Modernization Act of 2000, which exempted derivatives from CFTC oversight. The functioning of the derivatives market was left to the best judgment of whoever made the bets. The black box financial system swelled during the 2000s. In 1992, there was roughly $11 trillion worth of derivatives contracts, according to the estimate of one industry trade group. By 2001, there was $69 trillion worth of derivatives. By 2007, there was $445 trillion.
In late 2008, nobody knew what liabilities had been accrued by anybody else. People were making derivatives bets over the phone and being left to guess what other bets their counterparty might also be making. A derivatives bet removed a certain kind of risk called price risk—it gave you a kind of insurance against wild price swings in the market. But it introduced a deeper kind of risk that people overlooked, called counterparty risk, meaning the risk that whoever took your derivatives bet might go broke before they could pay their obligation.