It was the White House and the Congress of the Clinton-era who began to deregulate the financial markets in earnest. Prior to the Clinton era, banks were bound by depression-era regulations that required them to keep a set amount of cash in reserve to back loans. These "reserve requirments" kept banks from taking on too much leverage. A bank that was highly leveraged was riskier to itself and to the financial community. In the late 90's, JP Morgan sought ways around the leverage restrictions, because reserve requirements cut into potential profits.
"As is so often the case, there had been a Depression-era law in place designed specifically to prevent this sort of thing. The commodities market was designed in large part to help farmers: A grower concerned about future price drops could enter into a contract to sell his corn at a certain price for delivery later on, which made him worry less about building up stores of his crop. When no one was buying corn, the farmer could sell to a middleman known as a "traditional speculator," who would store the grain and sell it later, when demand returned. That way, someone was always there to buy from the farmer, even when the market temporarily had no need for his crops.
In 1936, however, Congress recognized that there should never be more speculators in the market than real producers and consumers. If that happened, prices would be affected by something other than supply and demand, and price manipulations would ensue. A new law empowered the Commodity Futures Trading Commission — the very same body that would later try and fail to regulate credit swaps — to place limits on speculative trades in commodities. As a result of the CFTC's oversight, peace and harmony reigned in the commodities markets for more than 50 years.
All that changed in 1991 when, unbeknownst to almost everyone in the world, a Goldmanowned commoditiestrading subsidiary called J. Aron wrote to the CFTC and made an unusual argument. Farmers with big stores of corn, Goldman argued, weren't the only ones who needed to hedge their risk against future price drops — Wall Street dealers who made big bets on oil prices also needed to hedge their risk, because, well, they stood to lose a lot too.
This was complete and utter crap — the 1936 law, remember, was specifically designed to maintain distinctions between people who were buying and selling real tangible stuff and people who were trading in paper alone. But the CFTC, amazingly, bought Goldman's argument. It issued the bank a free pass, called the "Bona Fide Hedging" exemption, allowing Goldman's subsidiary to call itself a physical hedger and escape virtually all limits placed on speculators. In the years that followed, the commission would quietly issue 14 similar exemptions to other companies."
JP Morgan argued that if they bought CDS protection for enough of the investments in their portfolio, they had effectively moved the risk off their books. Therefore, they argued, they should be allowed to lend more, without keeping more cash in reserve. A whole host of regulators — from the Federal Reserve to the Office of the Comptroller of the Currency — accepted the argument, and Morgan was allowed to lend money in excess of reserve requirements, as long as it bought CDSes.
Since the reforms of the Great Depression, commercial banks where allowed only to take deposits from and lend to businesses and investment banks where allowed only to raise money by issuing and selling securities.
The Glass-Steagall Act, passed during the Depression, prevented commercial banks from doing investment banking activity and vice-versa. In 1999, Representative Phil Gramm co-sponsored a bill that repealed the meat of the Glass-Steagall Act, smoothing the way for the creation of financial megafirms like Citigroup. This meant that commercial banks which were now competing directly with investment banks for customers. Both entities were driven to buy credit swaps to loosen capital in search of higher yields.
Gramm also wrote and sponsored the Commodity Futures Modernization Act that repealed depression-era laws preventing banks from trading credit default swaps. In 2000, on its last day in session, Congress passed the Commodity Futures Modernization Act The bill was inserted at the last minute into an 11,000-page spending bill, with almost no debate on the floor of the Senate. "By ruling that credit-default swaps were not gaming and not a security, the way was cleared for the growth of the market," said Eric Dinallo, head of the New York State Insurance Department. Commercial banks were now free to trade credit default swaps.
Commercial banks needed insurance on their mortgage backed securities. All that was left to complete the plan was a group of insurers who would be willing to issue and back such insurance.
As luck had it, one insurance comapny was willing to write insurance on nearly all the bets placed by wall streets bankers, and that company was AIG. Enter AIG and Joseph Cassano. Cassano became the head of a 400-person unit called AIG Financial Products, or AIGFP. Selling credit default swap insurance generates premium income. So long as defaults on the underlying securities remained unlikely, AIG collected huge premiums by selling insurance for the disaster it thought would never come.
Cassano transformed the credit swaps market into the world's largest bet on the housing boom. Cassano went on a selling spree and in only seven years, he sold $500 billion worth of CDS protection. Because selling credit default swap insurance doesn't require capital, AIG didn't have even a fraction of that amount of cash on hand to cover its bets, but neither did it expect it would ever need any reserves.
Initially, at least, the revenues were enormous: AIGFP's returns went from $737 million in 1999 to $3.2 billion in 2005. Over the past seven years, the subsidiary's 400 employees were paid a total of $3.5 billion; Cassano himself pocketed at least $280 million in compensation. Everyone made their money — and then it all went to shit.