A Look At Wall Street's Shadow Market

60 Minutes: How Some Arcane Wall Street Financial Instruments Magnified Economic Crisis

(CBS)  On Friday Congress finally passed - and President Bush signed into law - a financial rescue package in which the taxpayers will buy up Wall Street's bad investments.

The numbers are staggering, but they don't begin to explain the greed and incompetence that created this mess.

It began with a terrible bet that was magnified by reckless borrowing, complex securities, and a vast, unregulated shadow market worth nearly $60 trillion that hid the risks until it was too late to do anything about them.

And as correspondent Steve Kroft reports, it's far from being over.

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It started out 16 months ago as a mortgage crisis, and then slowly evolved into a credit crisis. Now it's something entirely different and much more serious.

What kind of crisis it is today?

"This is a full-blown financial storm and one that comes around perhaps once every 50 or 100 years. This is the real thing," says Jim Grant, the editor of "Grant's Interest Rate Observer."

Grant is one of the country’s foremost experts on credit markets. He says it didn't have to happen, that this disaster was created entirely by Wall Street itself, during a time of relative prosperity. And they did it by placing a trillion dollar bet, with mostly borrowed money, that the riskiest mortgages in the country could be turned into gold-plated investments.

"If you look at how this started with the subprime crisis, it doesn't seem to be a good bet to put your money behind the idea that people with the lowest income and the poorest credit ratings are gonna be able to pay off their mortgages," Kroft points out.

"The idea that you could lend money to someone who couldn't pay it back is not an inherently attractive idea to the layman, right. However, it seemed to fly with people who were making $10 million a year," Grant says.

With its clients clamoring for safe investments with above average return, the big Wall Street investment houses bought up millions of the least dependable mortgages, chopped them up into tiny bits and pieces, and repackaged them as exotic investment securities that hardly anyone could understand.

60 Minutes looked at one of the selling documents of such a security with Frank Partnoy, a former derivatives broker and corporate securities attorney, who now teaches law at the University of San Diego.

"It's hundreds and hundreds of pages of very small print, a lot of detail here," Partnoy explains.

Asked if he thinks anyone ever reads all this fine-print, Partnoy says, "I doubt 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 a way that was supposed to eliminate most of the risk.

"Obviously they turned out to be wrong," Partnoy says.

Asked why, he says, "Because you can't model human behavior with math."

"How much of this catastrophe had to do with the instruments that Wall Street created and chose to buy…and sell?" Kroft asks Jim Grant.

"The instruments themselves are at the heart of this mess," Grant says. "They are complex, in effect, mortgage science projects devised by these Nobel-tracked physicists who came to work on Wall Street for the very purpose of creating complex instruments with all manner of detailed protocols, and who gets paid when and how much. And the complexity of the structures is at the very center of the crisis of credit today."

"People don't know what they're made up of, how they're gonna behave," Kroft remarks.

"Right," Grant replies.

But it didn't stop ratings agencies, like Standard & Poor's and Moody's, from certifying the dodgy securities investment grade, and it didn't stop Wall Street from making billions of dollars selling them to banks, pension funds, and other institutional investors all over the world. But that was just the beginning of the crisis.

What most people outside of Wall Street and Washington don't know is that a lot of people who bought these risky mortgage securities also went out and bought even more arcane investments that Wall Street was peddling called "credit default swaps." And they have turned out to be a much bigger problem.

[north45]

I like the transcript of the videos, speakers are identified and I can look up exact quotes.

These comments are not a real blog. In real life I''m 45north not north45 (rules). The rule against html is a constraint.

[notassmartas]

Well, now it is mathematicians and physicists who are the *bad* guys. If so, one wonders why there were no well paying jobs in math and physics for them and they had to work in the corporate world of finance?

[tracysmom39]

Who sets the million dollar ceo bonus. The stock holders certainly cannot agree that golden parachutes should be given to a ceo who has departed after damaging the company. Is it a I''ll scratch your back, if you scratch my back amoung upper management.

[nkhunt]

Re Your story on October 5 on "...Wall Street''s Shaddow Marrket." The thrust of your story was that the current economic crisis was caused entirely by Wall Street malfeasance. You failed to mention that the federal government was complicit in this fiasco. You cetainly knew that. Are you so enamored with liberal politicians, that you have lost your journalistic integrity?

[hur451]

This segment should be shown as a psa on every station in the country to expose this mess ,it should also be shown to the senate and congress. Mr. Kroft an excellent report.

[babooph]

Keep the Somali pix in the news-it portends the USA future with the BUSH legacy.

[deanhix]

The problem lies not with the fat cats. Some might have taken advantage but the problem lie with Fannie/Freddy. lending instutions were required by Fanny/Freddy to carry subprime housing loans. their strong arms were Acron and liberials in congress

[deanhix]

The 2005 reregulation bill of freddie mae offered by john mccain was killed in senste by dem, it takes 60 votes to pass bills. all dems voted against and all rep voted for. there are only 49 rep in senate.

[johnb92711]

This is why I tell people to have at least 3 to 4 months (or more) of food on your shelves. Buy only what you use anyway, so you don''t waste money. If things get alot worst, you''ll be ready. Prices could go up alot more or even shortages. It does not hurt to have extra food. You don''t want to be dependent on someone else for your next meal. This also buys you some time. If nothing happens, so what, you don''t go shopping for awhile. You''ve saved money. If things do get worst, you''re ready and you have something to trade with.

[bobnjersey]

[john mccain tried to stop this mess in 2005 and his bill was blocked by the liberals in the senste including obama. 60 minutes removed my comments. CBS is in the tank for obama]
[Posted by deanhix at 11:07 AM : Oct 07, 2008]

did john mccain resist the lobbying efforts of wall street to keep the credit default swaps from remaining unregulated ... being the man of deregulation that he so proudly used to state?

what party controlled congress when mccain called for legislation to control freddie/fannie? why didn''t the republicans push the limits thru?

[epicflux]

The CEO of that derivatives company was hilarious blaming the underlining securities.

The metaphor in my mind is like a gambling addict trying to explain to his therapist & family that it''s not his bets that are losing him money, but the horses he''s betting on. It''s a skewed logic that only an addict could understand.

"If only the horses would win, I would win, CAN''T YOU SEE!"

[maine11111]

Bilical times people, can everyone say ONE WORLD GOVERNMENT!!!!!

[pakaal]

"These complex financial instruments were actually designed by mathematicians and physicists, who used algorithms and computer models to reconstitute the unreliable loans in a way that was supposed to eliminate most of the risk."

The start of that sentence should include "mathematicians and physicists _working for financial houses_" and end with "eliminate most of the risk to themselves _and the corporations they worked for_."

And judging by some of the hundreds of millions being paid out to the execs who are now leaving the burning buildings cash in hand, it looks like they did their jobs well.

[suriko]

I am so angry. Just where is the $60 Trillion dollars or is it all just worthless paper too? I''ll join the class action suit. I''ve worked hard all my life and I want justice for the American people. Don''t forget to VOTE...

[onedayatatim]

Is it just me or does anyone else wish they could slap the smirk off of ISDA''s CEO, Robert Pickel? I would love to see that association investigated.

[onedayatatim]

onedayatatim

[cbsisafraid]

Why was there no mention of JP Morgan in the 60 minutes story? They are the largest holder of derivatives.
$80 Trillion or so in notional value according to the government agency that monitors banks

http://www.occ.treas.gov/deriv/deriv.htm
Where did you see $80 trillion?
The tables are in "millions" and JP shows
total Derivatives of $83,436,951,000.

[deanhix]

If you want to know what happened see the video "no Money" on youtube.com/themouthpeace

[deanhix]

I posted a comment about the basic cause of this being the social engineering of fannie mae. john mccain tried to stop this mess in 2005 and his bill was blocked by the liberals in the senste including obama. 60 minutes removed my comments. CBS is in the tank for obama

[julietteg]

Do I, as an Americal citizen, have the right to file criminal charges against those who took such incredible risk with the economy resulting in the current situation and/or do we have the right, as the American people, to file a class action lawsuit against the same? If any of them had a conscience, and obviously none do, they would return the money - it just didn''t disappear.