Wall Street Hustlers Built a $100 Trillion House of Cards and Stuck You with the Fallout

Debate over who is most to blame for the financial meltdown rages on against a backdrop of economic pain and anxiety that's unprecedented in the post-war era.

The bottom line: There was a feeding frenzy that drove housing prices far beyond what the fundamental laws of supply and demand would dictate. People certainly got in over their heads, but the ultimate responsibility for that lies with the investment bankers who cooked up exotic new ways to make risky investments look more secure than they actually were (I wrote about it recently here).

While the U.S. housing market is worth somewhere in the neighborhood of $10 trillion, it was Wall Street's wheeler-dealers -- and their lobbyists and allies who kept regulators out of their business -- who built a house of cards out of "exotic" mortgage-backed products and other "derivatives" worth as much as 60 times that figure -- paper wealth backed by little more than the irrational belief that what goes up will never come down.

It was the investment bankers who pushed those debt-backed securities hard to investors who were looking for huge returns on their dollars -- much better than they could get putting their money in old-school investments like stocks and bonds. Their hard sell created so much demand that it encouraged lenders to write loans to just about anybody for just about anything; loans, after all, were the raw material for the alphabet soup of "exotic" investment vehicles -- the "collateralized debt obligations," "credit default swaps" and other innovative products that have now turned "toxic."

That gets to one of the hardest pieces of this whole mess to understand -- why would Wall Street want lenders to push out billions of dollars worth of loans that were inherently risky?

Here, a bit of context is crucial. The financial industry first started churning out derivatives in the early 1980s. As I've written before, that was part of a larger move away from traditional investments -- manufacturing, agriculture and (long-term) commodities -- and into the speculative economy as the returns on money put into the "nuts and bolts" economies of the advanced world began to dwindle in the 1970s.

At first, investors mostly gambled that interest or currency exchange rates would go up or down. Then, during the 1990s, when interest rates were low around the world, the demand for more exotic "structured" investments -- including various derivatives and swaps based on debt -- skyrocketed.

This brings us to a key issue in the banking mess, one that has serious ramifications for how we move forward in the future. Obscured by the finger-pointing is a simple question: How could a drop in the value of the American housing market -- even a 20 percent drop in home prices -- threaten to bring down the entire global economy?

Part of the answer is "leveraging" -- using a limited amount of cash to buy a much larger position in an investment. Leveraging is a common investment tool, but there are rules in effect in regulated markets like the major stock and bond markets that limit the amount that an investor can leverage -- for example, the SEC says you have to put up at least 50 percent of the cost to buy a stock on American stock exchanges. But these fancy debt-backed investments are contracts between two gamblers and are not subject to those rules. They're traded "over the counter" -- in an opaque and largely unregulated exchange.

Business reporter Andrew Leonard scoffed at the idea that at the heart of the crisis were either borrowers getting in over their heads or lenders writing sketchy loans. Beginning in the 1990s, he wrote, "the incentive for everyone to behave this way came from Wall Street ... where the demand for (securities based on subprime loans) simply couldn't be satisfied. Wall Street was begging the mortgage industry to reach out to the riskiest borrowers it could find, because it thought it had figured out a way to make any level of risk palatable." He added: "Wall Street traders, hungry for more risk, fixed the real economy to deliver more risk, by essentially bribing the mortgage originators and ratings agencies to ... make bad loans on purpose. That supplied (Wall Street) speculators the raw material they needed for their bets, but as a consequence threw the integrity of the whole housing sector into question."