“It’s Like the Emperor Has No Clothes”

What was more horrifying about last year’s financial implosion: that it happened, or that the average person couldn’t make sense of it?

Fortunately, author Les Leopold had already been investigating the complex financial instruments that nearly brought down the economy and, at a local level, 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. The abstract is made painfully real in Leopold’s book, since he uses the investment troubles of five Wisconsin school districts—those of Kenosha, Kimberly, Waukesha, West Allis-West Milwaukee and Whitefish Bay, which are suing Stifel, Nicolaus & Co. and the Royal Bank of Canada for misleading them—as the theme running through The Looting of America.

Leopold, who will appear at Boswell Book Co. on July 8, spoke to the Shepherd about the school districts’ predicament, as well as the bigger Wall Street-created mess. Here’s an excerpt of our conversation, but you’ll find the full interview—in which Leopold compares Wall Street’s games to fantasy baseball—on our Web site at www.expressmilwaukee.com.

Shepherd: Very simply, what did the five school districts 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 thousand 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 [of Stifel, Nicolaus]. He was in over his head. They were part of this enormous fantasy finance con game that was going on across this country.

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

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

Shepherd: How were these “fantasy financial instruments” 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 the huge drama of people falling for the emperor has no clothes.

By the way, the emperor makes a lot of money along the way selling his make-believe clothes. Creating and trading these fantasy finance instruments was enormously profitable. It was the most profitable casino game Wall Street had ever invented. It dwarfed the money made from other divisions that conducted the traditional banking and insurance businesses.

AIG booked $450 billion worth of bets called synthetic CDOs [collateralized debt obligations], the very same securities that the school districts had purchased. The government wouldn’t let AIG collapse because if AIG didn’t pay its bets, many of the major banks and financial institutions, here and abroad, would have crashed. Unfortunately, the government is not doing the same for the school districts and they really should. They should help them.

Shepherd: Surely these financial instruments 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: 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 postwar period, the average worker wage after inflation grew at the same rate. So the average standard of living grew remarkably after World War II.

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.

Shepherd: Where does that money go?

Leopold: It went to the top, to the tippy-top. And every year more and more went to the top. The freemarket 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.

Les Leopold will discuss The Looting of America and sign copies at Boswell Book Co., 2559 N. Downer Ave., on July 8 at 7 p.m.

To read the full interview, go to the Daily Dose blog at www.expressmilwaukee.com.