Raoul Pal: “We’re Completely F**ked & Nobody Realizes It…” (Raoul Pal: “The system broke in 2008”)

“You are being slaughtered, and you don’t realize it. It all happened already in 2008. The world stopped. The whole debt system blew up, so we are paying the debts by printing money—pure debasement. The system broke in 2008. We then changed the financial system with the Basel III agreements, which forced the banks to lend less and to hold more treasury. Why? There’s going to be a lot of supply of treasuries. The whole system—everybody’s aware that it’s broken. It broke.”

It’s nice to hear people finally telling the truth about 2008. Raoul Pal also has a similar view on AI that he explains at the end of the video, just as I’ve tried to explain in many posts. However, he is not fully honest as he took part in misleading people, especially in this part of the video:

6:28 – “Politics has gone like this because everybody’s so bloody angry. They can’t figure out who’s screwing them, and they’re blaming each other. What screwed them is that there were too many old people, and they borrowed too much money.”

It’s not that there were too many old people borrowing too much money; it’s that the banks were borrowing money to everyone, even to people who couldn’t pay it back, knowing they would be able to sell that debt. Even if some of these loans were not sold and at risk of default, the banks were deemed too big to fail. Since nationalization is not possible—because it’s seen as socialism, and in the minds of Americans, that’s the primal evil—it could not happen. So they got a bailout for free instead of being nationalized. But it’s not normal people’s greed that caused this; it’s the banks’ greed that allowed it to happen.

All of this started with the removal of the Glass–Steagall legislation. (See: Glass–Steagall legislation). The basics of it all are well explained in this video:

History

To get the full picture, we need to go back to America in 1995. During this year, the fight was on to help low-income earners. The U.S. government passed laws to decrease discrimination against poorer home borrowers. Banks lowered lending requirements, offering packages such as reduced payments for several years.

Soon after, in 1999, the U.S. government repealed a law that stopped commercial banks from participating in investment banking activities. This law was the Glass-Steagall Act. Ironically, this law was enacted in 1933 to stop the speculation that fueled the Great Depression. Its repeal in 1999 was a fatal mistake. From that point on, banks that had previously managed conservatively turned to riskier and riskier investments, all in an effort to increase their returns. Banks cared less about their customers and more about Wall Street profits. According to Nobel economics laureate Joseph Stiglitz, this move played a significant role in the financial collapse that was to come.

But why worry? At the time, things seemed good. It was the late 1990s, and there were seemingly no economic problems in sight for America. The internet had taken over everyone’s minds, and investment banks were throwing money behind anything that had a “.com” at the end. The result was the launch of companies like Pets.com. The banks didn’t care, though. When the stock went up, they would sell and make their profit. This was the dot-com bubble, and it had arrived in full force. People quit their jobs to trade stocks, and shares went crazy. For example, shares of Qualcomm rose by 2,619 percent in 1999 alone. In America, there was money to be made, and life was good.

But something started to happen. Soon, investors realized that these internet companies had no cash flow and couldn’t actually make any money. By March 2000, it all came crashing down. The next year, the September 11th attacks occurred, followed by the Enron and WorldCom corporate accounting scandals. After these events, the public and the markets lost trust in the economy. Spending trended downward, and it looked like the economy was heading for a recession.

To avoid this, the Federal Reserve decided to lower interest rates down to one percent.

Real Economy

The low-interest rates would increase spending and recover confidence in the American economy. With a low one percent interest rate and no systemic problems in the real economy, the recovery was rapid, and economic growth was ample. Eventually, speculation started to migrate from stocks into real estate. By 2003, everyone with a good credit score and a good job already owned a home. If you were in the business of giving out home loans, this was a bad sign. To save their profit margins, mortgage lenders relaxed credit scores to get more people in the door and increase profits. These were called subprime loans. As the money flowed in and time went on, the lending standards got lower and lower. Soon, there were mortgage deals that required no income, no job, and no assets. They stopped checking whether the income was even real. They turned to low and no-doc loans, so-called liar loans—no income, no job, no assets—and they were still willing to lend. But help me out here: How does that make sense for the lender? It would seem to be reckless in the extreme.

It was, but the key assumption was that home prices would keep going up forever. In fact, home prices nationwide had never declined since the Great Depression. People like acupuncturist Rula Geosmos became real estate speculators.

“How many properties did you buy in this last five-year period?”

“I believe in the last five-year period, I bought about six properties.”

“And what did you buy them for?”

“For investments.”

If a subprime customer defaulted, it was no problem—just sell the house because it was going to go up in value, so you’re going to still make a profit.

CDOs

This next part is a bit in the weeds, but I need you to bear with me because it’s crucial to the story. Wall Street was looking at this situation and saw an opportunity. There were two groups of people that could be linked here. On one side were the mortgage lenders who were profiting from a newly found market. They wanted to get rid of these risky loans because they knew these loans were junk and had huge liability. On the other hand, institutional investors were looking for ways to increase their returns. Since interest rates were low at one percent, high-yield products were off the table. The Wall Street banks had an idea, and they got to work offering the perfect high-yielding product: the mortgage-backed security.

These were a bundle of individual mortgage debts sold as shares. These shares would give back to the investors who bought them a safe fixed income. Some rather devious bankers realized that they could use an old financial tool in combination with mortgage-backed securities to make unimaginable amounts of money. If they used this tool in the housing market, they could make tens of billions of dollars in just months. This tool was the CDO, or collateralized debt obligation.

To give you an idea of how these products worked, the bank that invented them went bankrupt due to a massive insider trading scandal. One way to imagine a CDO product is to think of it as a box. This box gets filled with monthly repayments from a group of mortgages and other debt, such as car loans and student loans. The box can generate income to investors who buy it. It’s divided into different levels; each level represents a different risk. A CDO works like three cascading trays. As money comes in, the top tray fills first, then spills over into the middle, and whatever is left into the bottom. The money comes from homeowners paying off their mortgages. If some owners don’t pay and default on their mortgage, less money comes in, and the bottom tray may not get filled. This makes the bottom tray riskier and the top tray safer. To compensate for the higher risk, the bottom tray receives a higher rate of return, while the top receives a lower but still nice return. The aim of this was to diversify the risk, but there was a fatal flaw. Since the box had safe prime home loans mixed in with loans to people who had no job, the whole thing was risky. All of the risk was passed to investors who purchased these debt boxes, while the lenders and the banks profited handsomely by charging high fees. This system was a ticking time bomb. Lenders didn’t care anymore about whether a borrower could repay, so they started making riskier loans. The investment banks didn’t care either; the more CDOs they sold, the higher their profits.

As the financial assets became more complex and harder to value, the majority didn’t understand how these instruments worked. They turned to credit rating agencies for clarity. The hope was that these institutions would do their homework for them and determine risk correctly. But as it goes, the rating agencies completely screwed up. They rated these debt boxes as AAA, the highest possible rating. This signaled that they were extremely safe, good enough for pension funds and the wider economy to invest in. But there’s a question remaining: Why did the rating agencies rate these debt boxes as high quality? Well, sadly, it was because the rating agencies made billions of dollars in doing so. If a bank came to them asking to rate their box filled with junk, a rating agency would know that if they gave the product the true junk rating, the banks would just go to another rating agency down the road to get the AAA rating they desired. Rating all of these boxes AAA meant that the money kept flowing into the rating agencies. This was another key component to the disaster. These false ratings would later spread America’s problems to the rest of the world.

Between 2000 and 2007, the subprime mortgage debt included in these packages increased from 5 to 36 percent. They saw remarkable success, growing from an estimated $20 billion in 2004 to over $180 billion in 2007. Bankers were personally making millions to tens of millions in bonuses. While this was going on, some mad scientists in the financial industry were creating financial weapons of mass destruction. This is where things go insane, and greed was in full swing. The final stage of greed was the invention of the mortgage credit default swap. This was a financial instrument that worked as insurance against failed mortgage debt products.

“So it’s an insurance contract?”

“It is an insurance contract, but they’ve been very careful not to call it that because if it were insurance, it would be regulated.”

“This is actually the security?”

“This is the selling document for the securities.”

“Do you think anybody ever read this stuff?”

“I doubt very many people read it.”

These complex financial instruments were actually designed by mathematicians and physicists who used algorithms and computer models to reconstitute the unreliable loans in ways that were supposed to eliminate most of the risk. Obviously, they turned out to be wrong. Why? Because you can’t model human behavior with math. They are complex, in effect, mortgage science projects devised by these Nobel-track physicists who came to work on Wall Street. And it didn’t stop Wall Street from making billions selling them to banks, pension funds, and other institutional investors all over the world.

“How big is the market for credit default swaps?”

“We really don’t know. There’s this voluntary survey that claims that the market is in the range of 50 to 60 or so trillion dollars. It’s sort of alarming that in a market that big, we don’t even know how big it is to within, say, 10 trillion dollars.”

This enabled banks to bet on the direction of a mortgage price. If they guessed right, they’d make a bunch of money. Think of it for a moment as a football game. People in the stands may also have a financial stake in the outcome in the form of a bet with a friend or a bookie. The new bet that arose over the last several years is a bet based on whether people will default on their mortgages, and that was the bet that blew up Wall Street.

And crazier still, banks could bet on the outcome of the previous bet, and banks could bet on the bet of that bet. Because these are swaps and technically not insurance, the banks didn’t need any cash to back up their bets if they went bad. What could possibly go wrong?

“And it used to be illegal?”

“It was very illegal 100 years ago because it had brought down the market in 1907, and they said, ‘We’re not going to let this happen again.’ And then 100 years later, in 2000, we rolled them all back.”

In retrospect, giving Wall Street immunity from state gambling laws and legalizing activity that had been banned for most of the 20th century should have given lawmakers pause. If it sounds meaningless, it basically is. These products created no value in the economy but were making banks a whole bunch of money. Insurance companies such as AIG saw their profits soar. Financial engineering was running rampant, and there was no one supervising any of these products.

But of course, now it is described by people who took part in it, like Raoul Pal, as the fault of old people borrowing too much money, because it could not be the fault of the banks—where Raoul Pal worked at the time, probably.