Where did all the money go in the financial crash?

In my class on Partnership Taxation we were discussing the fact that hedge fund managers are taxed on their multi-million or billion dollar incomes at lower rates than tax rates paid by ordinary middle-class working Americans. This is because the hedge fund managers take most of their compensation as distributive shares of the gain generated by investment partnerships, characterized as lower-taxed capital gains, rather than as higher-taxed ordinary income.

The injustice of that got me thinking about where all the money went in the recent financial crash which has left homeowners unable to pay their mortgages, businesses unable to pay their employees, and state and local governments unable to meet their contractual obligations to employees and retirees. Because of the disappearance of money from our economy, labor unions are demonstrating daily against the elected government of Wisconsin, and enormous suffering has been experienced by Americans and others around the world.

Where did all the money go? Did it just disappear down a black hole? Did it vaporize, reducing people’s life savings and retirement funds to next to nothing? Or did somebody steal the money?

Michael Lewis’s book “The Big Short’ suggests an answer. The book is mainly about those few quirky hedge fund managers who had the foresight to see the crash coming when everyone else just saw continuing prosperity and rising prices for real estate and other investments. These few economic dissenters were able to arrange and place enormous bets against the market. They in effect bet on a crash and, of course, won their bets.

In order to win their bets they had to withstand withering ridicule from the mainstream of the market, and from their own clients who withdrew funds from their hedge funds as the market continued to rise while they bet on a crash. Because of the widespread economic optimism, Lewis’s protagonists had no difficulty finding mainstream bankers willing to take the other side of their increasingly bigger bets against the economic future.

When the crash came, of course, these individuals reaped huge rewards on their bets, beyond their, or anyone’s, wildest dreams. So that’s where some of the money went, facilitated by the U.S. government’s Troubled Asset Relief Program (TARP) which insured that every bet actually got paid in full.

But the surprise at the end of the book, for me the real punch line, is what happened to the bankers who made the bad side of the bets, the top people at Lehman Brothers and Bear Stearns and AIG who led their firms into a financial abyss, and those top people at the rating services that got it so wrong at Moody’s and at Standard & Poor’s and at Fitch.

The surprising answer is that they all got fabulously rich, too! They all got to keep the hundreds of millions or even billions of dollars they accumulated before the crash. Because they were betting with Other People’s Money, the people who made the worst bets were actually rewarded for making those bets and escaped unscathed. Wall Street was structured then, and as far as I know still is, to reward everyone who reaches its top pinnacles regardless of performance.

No one has been prosecuted. No attempt has been made to “claw-back” the huge compensation unjustly paid out at Lehman or Bear Stearns or AIG or any of the other big losers, or at the rating agencies. The world class failures as investment managers have been allowed to retire with their riches to their estates on Long Island and the Caribbean.

That’s where the money went.

Read “The Big Short”. See the movie “Inside Job”.