Q&A with Les Leopold, author of The Looting of America

Jun. 4, 2009
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What was more horrifying than last year’s financial implosion: That it happened, or that the average person couldn’t make sense of it?

Fortunately, Les Leopold was already looking into the complex financial instruments that nearly brought down the economy and, incidentally, the retirement funds of five Wisconsin school districts, which may be on the hook for $200 million in bad investments. The result of Leopold’s work, The Looting of America: How Wall Street’s Game of Fantasy Finance Destroyed Our Jobs, Pensions, and Prosperity, is an easy-to-understand explanation of what went wrong, and why. How clear and confident is Leopold’s prose? I finally feel like I understand what the Wall Street masters of the universe were up to—and I’m angry. I highly recommend this book.

Leopold was kind enough to speak to me this morning about his book and what we face next. Here’s the transcript:

Shepherd: Why did you use the financial problems of the five Wisconsin school districts as the thread running through your book?

Leopold: My in-laws live in Glendale. Our family has been visiting there since 1978. I must have gone to Whitefish Bay hundreds and hundreds of times. Plus, my father-in-law—who’s 90 years old now—is a retired school principal in the Milwaukee school system. The fact that there was something going on that was impacting retirement benefits, although not his, caught my attention. In Whitefish Bay—it kind of blew my mind.

I started to try to figure out what was going on. These derivatives, these complex things that were going on, and that completely engulfed these five school districts and were causing them to potentially lose $200 million—I soon realized that I didn’t understand them. Everyone kept saying that these were some opaque and impossible to understand. Two years ago, even before I caught wind of Whitefish Bay’s problems, I started to look at them. About a year ago, I thought, “Gee I should start writing about this.” I was watching the Whitefish Bay stuff. But I couldn’t figure it out. [laughs] It’s complicated. I dropped it.

But as the Whitefish Bay situation got more serious, and the economy got more seriously in trouble, I thought, I’ve got to do something about this. So I jumped in. And this time, more time had gone by and more was written about it and I found more people who could help me figure it out. So that was step one. I had a personal connection with Whitefish Bay. How many times have I been at the theater and Sendiks and taking the kids to the park overlooking the lake, and going on Lake Shore Drive looking at the beautiful homes at Christmas? We go there at least three times a year. It was a personal thing.

The next thing that happened was that I was invited to speak at the NEA’s staff in New Orleans about the economic crisis. There were some people from Wisconsin there. So they invited me to meet with the folks at the Kenosha Education Association. I sort of consulted with them to help them—they wanted the school district to become part of the TARP [Troubled Asset Relief Program]. I helped them investigate it. I think I figured out that what they bought was the same stuff that AIG was doing. And the government was helping to get the same kinds of derivatives off of the books of AIG and it was basically the same stuff that was on the books of the school districts. So it was a very, very logical thing that they were doing.

So by getting involved at that level I was able to get a lot more detail about what happened in Wisconsin. Now I was sure that the fiasco that involved the school districts was directly connected to the fiasco in the economy. And that’s what created the thread that runs through the book. Plus I was knowledgeable enough, I had further information. I listened to the tapes of school board meetings. I spoke to the journalists writing about it. I spoke to the lawyer who was defending the school districts. I was able to get information as well as what was written. I was pretty cocksure that I knew what had happened there.

Shepherd: Very simply, what did the five school boards do to land them in such financial trouble?

Leopold: They got sold a product that was so complicated and so dangerous that it shouldn’t have gotten anywhere within a thousands yards of a school district, just like drugs. It was so inappropriate for schools, I can’t even begin to tell you how inappropriate it was for their kind of investing. But both the guy who sold it to them and the people who were knowledgeable on the school boards, neither side knew what they were buying or selling. That’s how much blindness there was to these opaque instruments.

They bought something that was basically a bet. They didn’t buy anything real. They basically insured somebody’s bad debt. They bought an insurance policy and for the privilege of buying the insurance policy they gave the seller $11.5 million in fees. They didn’t even know that they were doing that. There were huge fees embedded in this process up and down the line. They didn’t really understand that. They were way in over their heads, as was the broker, who was also local, this guy David Noack. He was in over his head. They were part of this enormous fantasy finance con game that was going on across this country.

And they didn’t even invest their own money. They borrowed it.

Leopold: All of it was borrowed money. To pull this off, they first had to do general revenue bonds, to borrow their down payment. They had to put up equity. So they put out bonds, which they’re stuck for. They have to pay that back. It’s easier to talk about this collectively [the five districts]. They put out general revenue bonds, collectively for about $35 million. Then they borrowed another $165 million. That’s how you get up to $200 million. Then they went to buy this enormous insurance policy. They thought they were buying like a kind of mutual fund of real things, real corporate debt and things like that. They thought they were buying a piece of the rock. But they bought, basically, air. The idea was that the return would be a little bit less than 1% more than the debt so they would be able to pay off all of their debts, and then they would have a little money left over to cover the post-employee retirement benefits.

Shepherd: How much money have they lost? How much could they lose?

Leopold: Kenosha’s $37 million piece is worth now $900,000. The $200 million is probably worth $6 million. They’ve lost, at least on paper, about $194 million. [groans]

Shepherd: I can imagine losing some sleep over that.

Leopold: I think a lot of them are having restless nights. The reason why it’s worth so little is that the way that this insurance policy works is that as the defaults within the debt that they insured start rising to a certain level, it’s like a trigger. And that’s when the money starts literally going from their investments directly to pay off the people who hold the default, the other side of the bet. It’s right about there. Actually, I have a call in to the lawyer to see if they’re about to cross the threshold. Once it crosses the threshold it’s going to be worthless. They’re going to lose all of their money.

Shepherd: How were these school districts able to put their money into something so risky? Aren’t the required to invest in very conservative funds?

Leopold: They were told that these were rated AAA and AA investments.

Shepherd: How were these crazy fantasy assets able to be rated so high?

Leopold: That story takes you into the whole history of the last 20 years. It comes down to the fact that Congress and Wall Street and the entire business community fell in love with the magic of financial engineering. They believed that these financial engineers on Wall Street could slice dice and rearrange all of these financial instruments so that the risk was scattered so broadly and widely that it disappeared. And you will hear it right now in the press; they will be talking about the great innovations of Wall Street.

It’s like the emperor has no clothes. You don’t know he doesn’t have any clothes until it happens. Well, it happened. It turns out that the risk was really there. The school districts are just small bit players in huge drama of people falling for the emperor has no clothes.

By the way, the emperor makes a lot of money along the way. This was an enormously profitable scheme, making these financial instruments. It was the most profitable thing Wall Street had ever done, ever. It dwarfed the money it made from other kinds of enterprises. AIG put out $450 billion worth of the same bets that the school districts were involved in. They wouldn’t let AIG collapse because if it didn’t pay its bets all of these other companies all over the world, all of these banks and financial institutions including the biggest ones in the United States, would have crashed. Unfortunately, the government is not doing the same thing for the school districts and they really should. They should help them.

Shepherd: The theory—which even Alan Greenspan believed—was that these financial instruments would spread the risk around and that would make the system safe.

Leopold: It was even slicker than that. The easiest way to view this is to imagine a wine bottle, and it collects all of the wine, or payments, from a pool of very risky subprime mortgages. So let’s say you have a thousand subprime mortgages and you know that some of them are going to default. But you take a thousand of them and you put them into a wine bottle. Then you create an upside down pyramid of glasses, three rows of glasses—seven glasses, then two, then one. The top row gets the first wine. So no matter how much wine is collected you fill the top row first.

Never, ever did anybody expect that 30% of the mortgages wouldn’t pay. The most historically was 10%, 12%, 14%. But not 30%. So they poured the top row of glasses of wine first, and those got AAA ratings because they were going to get paid. Then AA, maybe, for the next two glasses. They called the bottom glass “toxic waste.” But it was only one. They gave a low interest rate to the top row, a medium interest rate to the middle, and a very high interest rate to the bottom.

That’s how they created a silk purse from a sow’s ear. They engineered a new security on top of all of these subprime mortgages that they convinced everyone it wasn’t risky. Well, they weren’t that risky until housing prices started to tank, which was inevitable, because they were rising astronomically. Then all of a sudden there wasn’t enough wine to go around.

Shepherd: And the bigger the risk, the bigger the return.

Leopold: Oh yes. And here’s where it gets really interesting. Let’s say you have toxic waste slice. You have to be fancy here—you have to say tranche. [laughs] Once you have the bottom tranche, you’re making some nice money. You could be getting a 30% return, assuming there’s enough wine to pay you.

Well, it’s getting 30% and it’s risky, and maybe you can get someone to insure it for you. You might give them 5% right off the top to insure it. Now it’s guaranteed. AIG figured if they insure thousands of those bottom tranches, they can’t all go bad at the same time, right? Because they’re all different housing markets. It’s all scattered. They’re not all going to go south at the same time, are they? So AIG was making money hand over fist while it lasted. And then they had to pay their insurance premiums and they couldn’t.

Shepherd: But aren’t the real culprits the people who took out subprime mortgages on homes they couldn’t afford? That’s what CNBC and FOX News argue.

Leopold: No matter what you think of them, no matter what they did, they [the homeowners] have almost nothing to do with what happened. The proof of it is that for $300 billion we could have bought all those mortgages away from those people. We could have ended the problem with $300 billion. But the problem is $2 trillion more. The $700 billion TARP program is twice as large as the subprime problem. Didn’t do it. And they still don’t know what to do with the toxic waste.

They [the homeowners] were cannon fodder in all of this. Yes, you can find some individuals who got in over their heads. You can find a lot of unscrupulous brokers that sold them terrible products. You can go to the Fed and the government, who refused to regulate those products. But you can’t put out mortgages without real money. And that money came through these magical financial instruments that Wall Street created. And those instruments were piled on high like planes stuck at Kennedy airport. There were no assets underneath it. It was one ontop of each other all keying onto the same subprime mortgages. They were selling the subprime mortgages two or three times. So when one went sour, three, four, five securities went sour. That’s what the financial engineers did. Wall Street cannot get off the hook by blaming low-income people. And they know it.

Shepherd: Surely these things are outlawed or regulated based on what we know now.

Leopold: At this moment they are not regulated. There are still no regulations. You and I can bet on whether or not your boss’ house is going to burn down. We can get a derivative to allow us to do that, to do anything.

Shepherd: You liken this to fantasy baseball.

Leopold: I do. Fantasy baseball is a synthetic derivative. If you have fantasy baseball fans, it’s almost exactly what the school districts got stuck in. Think about it. There are only 30 major league baseball teams. There are perhaps 100,000 fantasy baseball teams? A million fantasy baseball teams? All of them are referencing the same baseball players. The baseball teams get statistics based on what goes on in major league baseball. Supposedly they have teams that “own” these players. They don’t own them. They just act as if they own them. They actually set up betting leagues where “owners” in these fantasy baseball leagues compete against each other.

The real baseball players have no idea. They’re not impacted by this. They play their game and all of these fantasy baseball teams pretend that they own these guys.

I think there’s something like 15 million people that play fantasy sports. Let’s say 10 million are playing fantasy baseball right now. What happens to all of those fantasy leagues, and all of the people who write books for them, and all of the websites that cater to them if the major leagues go on strike? Which they have done in the past. All of a sudden all of the fantasy leagues, every last one of them, is worthless. Game over. They can’t play. Because their game is a derivative of the real thing.

Well, when the housing prices went down, it was the equivalent of the major leagues going on strike. And all of those synthetic financial products tanked in value because they were referenced to the same underlying phenomena. When they talk about leverage, they’re not just talking about borrowing money. That’s not what’s going on here. It’s creating all of these derivative securities that are based on nothing. You don’t own a piece of a player. You don’t own the underlying mortgage. You have nothing. You’re just referencing it. That is dangerous, we’ve learned.

Shepherd: What was the source of all of the money that was invested in these massive schemes?

Leopold: That’s the heart of the story. Between WWII and the early 1970s, every year, virtually, the economy got more productive—more output per worker hour. That’s what the wealth of nations is based upon. The more productive you are, the more your economy grows.

As the economy grew during this period, which it did very nicely during the post-war period, the average worker wage after inflation grew at the same rate. So the average standard of living grew remarkably after World War II. My parents and grandparents had a much better life.

In the mid 1970s, something strange started to happen. The productivity rise and wages decoupled. The economy kept growing. As a matter of fact, between now and then, productivity has grown 90%. Wages have actually declined —real wages, after inflation—by about 10%. You can imagine these two lines diverging, the economy getting bigger and bigger and the wages are not growing anymore. You’ve got a huge gap, an enormous gap in wealth that grows and grows every year.

Where does the money go? It went to the top, to the tippy-top. And every year more and more went to the top. The free-market theory was that that’s the investor class. You give them money and they take it and invest it in goods and services and that will lead to more jobs and more wealth. They invested some of it in goods and services. They invested a lot of it in goods and services all over the world, in fact.

But they ran out of good investments because there’s a finite number. They ran out of things to buy. So they wanted to invest their money in something. Wall Street created these new fantasy finance instruments to suck up the money. There was such an enormous amount of money. There was a lot to suck up.

That’s how Wall Street started to grow and grow and grow until it became the most profitable sector in the economy. The financial sector was 40% of all of our profits in the entire economy. Now you start getting this very lopsided economy. The goods and services sector was kind of shrinking in relationship to the financial sector. This boom in the financial sector was really producing these fantasy finance instruments, so the money came from the wealthiest among us.

In fact we are now fairly certain, there’s enough research to support this and I’m certain of it, that if you want to create an unstable, crash-prone economy, then redistribute money to the richest people. That will create the conditions for fantasy finance casino. And no matter what you do with regulations they will find a way to create instruments for that money. It’s money that is looking for a home and the home ought to be back with working people who actually spend their money in the real economy. They may gamble it sometimes at Potawatomi, but they aren’t going to buy derivatives.

Shepherd: Obama inherited the TARP program and the rest of the mess. So how do things stand now?

Leopold: They did a lot to patch up the hole, the gaping hole, in the economy. One thing I want to stress is that no matter what happens in the economy right now the problem was the crash on Wall Street. It’s not GM or Chrysler or this or that industry. Yes, they may have had problems. But the precipitating cause, the gaping hole in the economy, was caused by the crash in the fantasy financial sector. Keep that in mind.

The first thing they [the Obama administration] had to do was to keep the sector from completely crashing like it did during the Depression. They may have succeeded. It’s not clear yet. The second thing was that there was such a huge hole in the real economy the stimulus money had to be thrown out there in a hurry. Otherwise you’d get a downward deflationary cycle, where prices would decline but people wouldn’t want to buy things because they’d rather wait until prices got even lower. It feeds a terrible, terrible cycle. So they wanted to do what they could to stop that. They may have—may have—done something there. I’m not 100% sure it’s going to work.

But the underlying problem has yet to be addressed. There are two fundamental things that have to happen. We have to find ways to move money from the financial sector to the real economy, and from the top of the income ladder to the middle and lower income. You have to switch tax policies to move money from the top to the middle and bottom. You have to tax the rich and superrich steeply—nobody needs a billion dollars. Once you start getting over some number you’ve got to really raise the rates like we had in the 1950s. That’s not happening. They’re talking about caps on salaries on Wall Street, which is good, because that will discourage people from going into those industries and they may end up going into education and science and medicine, things that we need in the real economy.

But they’re putting a lot of loopholes in there. They need to regulate these derivatives. The banking lobby is incredibly strong. They were able to stop the bankruptcy provision that would allow the judge to reset the mortgage. Can you imagine that? They were able to do that.

Now there’s a war going on I think between Wall Street and the rest of us about the nature of reforms. And the jury’s out. It’s going to depend on what the rest of us do. If we just sit by and pray and worry that it all works out, it just might for a while. Right now, this morning, we found out that there are between 14 and 25 million people are unemployed or underemployed. That’s a lot of people. Maybe it’ll get better for a while. It depends on us, whether we demand change. If Congress and Obama don’t get pressure from below, they’re going to succumb to the pressure from Wall Street. The money is still there. They can hire a lot of lobbyists to swarm the weaker members of the Democratic Party.

Shepherd: What else do we need to know?

Leopold: It’s very easy to blame the Whitefish Bay school board and the other school boards. But I think we’ve got to keep our eyes on the prize. What happened there is part of a much, much bigger problem. If we get diverted and start blaming individuals we’re going to miss the bigger picture. We’ve got to do something dramatic to change business in this country. They’re an example of a huge problem. I don’t want to exonerate anybody but I don’t think we’re going to get anywhere if we just shoot arrows at people. We have to go for the big picture.


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