The real-life "Big Short" and the 2008 financial crisis | 60 Minutes Full Episodes

It was another nervous week for the world's financial markets and on Wall Street. In the last six months, Americans have seen their investments shrink, their property values plummet, and the country edge closer towards a recession.

And at the heart of the problem is something called the subprime mortgage crisis, which began last summer and continues to ricochet through the economy. It sounds complicated, but it's really fairly simple. Banks lend hundreds of billions of dollars to home buyers who can't pay them back. Wall Street took the risky debt, dressed it up as fancy securities, and sold them around the world as safe investments. If it sounds a little like a shell game or a Ponzi scheme, in some ways it was a house of cards ripe with corruption, greed, and negligence.

And it started in places like Stockton, California. Stockton, California is a city of 280,000 people in the Central Valley, 80 miles east of San Francisco, 80 miles north of San Jose. In many ways, this is ground zero for the current financial crisis and a microcosm for everything that went wrong. A few years ago, it was one of the hottest real estate markets in the country. Today, it's the foreclosure capital of America.

"If you see a real brown lawn, sometimes you can determine whether or not it's a foreclosure."

"How many properties do you have right now?"

"102."

"All in foreclosure."

"Every single one of them."

Real estate agent Kevin Moran gave us a tour of the wreckage in one subdivision called Weston Ranch.

"There's a foreclosure."

Block after block of vacant and abandoned houses.

"If you see a for sale sign in this neighborhood, that probably is a sign of distress, right?"

"I would say that, yeah, two out of three of all the sales are probably foreclosed properties and or people who are in distress."

The for sale signs and the overgrown lawns in Weston Ranch are only a small part of the picture. To get a real overview, you need to look at this map from Shauno Tool's website, foreclosur.com, which tracks distressed properties in Stockton and other California communities.

"And the light blue um circles are folks that have gone into default. Uh, that means that's the first step of the foreclosure process. The dark blue are auction properties. That means an auction date has been set for the property. And the red icons are properties that were sold at auction, had no bid, and therefore went back to the lender."

As of last week, there were 4,200 Stockton homes either in default or foreclosure. $1.4 billion in bad loans in just one California community. And it's far from over.

"Two months from now, what's this map going to look like? How many of those light blues are going to be red?"

"So, we'll probably see at least 60, 70% of these light blues turn red, and we'll see at least this many light blues again."

"Start the week today at just 239."

Banks are auctioning off houses all over California and in South Florida and in Nevada and in parts of Ohio and Texas. The result of a huge real estate bubble that began forming in Stockton back in 2003 when people priced out of the Bay Area and Silicon Valley discovered that you could buy a four-bedroom home here for just $230,000. Developers started turning asparagus fields into subdivisions and lenders handed out free money to anyone who wanted to buy.

"What do you mean by free money?"

"I mean free money. I mean, you had to apply not to get a loan, almost."

Jim Grant is the editor of Grant's Interest Rate Observer and one of the country's foremost experts on credit markets.

"When you opened your mailbox in 2004, 2005, you could barely unstick it. People were pressing on you if you were not institutionalized, all manner of schemes in which to expand your personal debt. You could, and many did, borrow more than 100% of the price of a house with the most fragile set of financial bonafides. It's hard to prove your income, self-employed, foreclosure or bankruptcy."

Most of the mortgages issued in Stockton, and half of those now in default or foreclosure, were something called subprime loans, meaning less than prime quality. The borrowers often had sketchy credit, were financially strapped, or lacked sufficient income to qualify for a standard mortgage. After a year of artificially low payments, the interest rates on subprime loans jumped all the way to 10 or 11%.

But Jerry Abbott, who runs the Coldwell Banker Office in Stockton, says it didn't concern the borrowers, many of whom were getting mortgages for more than their houses were actually worth.

"Well, they were getting loans in excess of 100% of the value of the property. So, most of them were actually putting a little bit of money in their pocket at close of escrow."

"Really?"

"Yes."

"So, they were getting paid to buy a house."

"They were getting paid to buy a house. Yes. Yeah."

And strangely enough, it didn't seem to bother the lenders either, who were collecting huge fees just for lending the loans.

"Whatever they wanted to state for their income, the bank accepted that at face value and made the loan based on that income."

"Just gave them the money."

"Just gave him the money."

"No down payment."

"No down payment."

Jim Grant calls it an invitation to fraud.

"You apply to a bank or a mortgage broker for a loan. And you would fill out a form and you would say, 'I have an income of, oh, $400,000 a year.' They say, 'You do? Fine. Sign right there.' Because they're being paid not by the veracity of the information, but by the consummation of the deal. And lending officers say, 'Ah, you have verified this?' 'Well, yes, we have.' And the lending officer would say, 'Great. So do I.' And he'd pass it on to Wall Street."

"And he got a cut, too."

"Yes. Oh, yes. Everyone gets a cut."

Almost all of the people involved in the transactions made huge amounts of money, then passed the risk on to somebody else. Instead of keeping the dicey loans in their own portfolios, the big banks and giant mortgage companies that originally underwrote them sold them off to big New York investment houses. Firms like Bear Stearns and Merrill Lynch sliced the loans into little pieces, packaged them up with other investments, then sold them to their best customers around the world as high-yield mortgage-backed securities, turning sows' ears into silk purses, all with the blessing of the rating agencies like Standard and Poor's.

"At every step in the way, somebody has his or her hand out getting paid. Uh, the broker got paid, he or she was happy. The lending officer, ditto. Uh, the rating agencies got paid for passing judgment on these securities. They too were pleased, and the stockholders were happy, and on and on, and it would never end, except that it did."

It was all predicated on the idea that real estate prices would keep going up and up and up. And for a long time, they did. But by the summer of 2005, speculators flipping houses in Stockton helped drive the price of that four-bedroom house to more than $400,000. And the market began to soften, then to tumble. All of a sudden, those subprime borrowers who had taken the free money found themselves upside down, owing more on their new house than it was worth.

It's not exactly clear how a mortgage broker was able to qualify Phil Fontenot and his wife Kim Monroe for this $436,000 house from which they run a small daycare center. The couple say they wanted to move to a better neighborhood. When the broker approached them, the Fontenots told her that they could afford at most $2,500 a month, but the monthly payment on the adjustable-rate mortgage she gave them quickly jumped to $4,200 a month.

"Did you understand any of this? Do you... did you understand, um, what was going on?"

"No, not really. Not much of it."

"Did you have a lawyer look at it or anything?"

"No, I didn't."

"But you knew this was a big decision, right? You were borrowing hundreds of thousands of dollars."

"I didn't really look at it like that."

"How did you look at it?"

"I looked at it as far as my family, I can get my family off of this block, and that we could pay the payments that she said that we could pay. But after it was all said and done and the paperwork was drawn up, it was something different."

Matt and Stephanie Valdez say they knew exactly what they were doing when they bought this small two-bedroom house for $355,000. They could afford the initial payments and planned to refinance the mortgage before the interest rate jumped to 11%. They couldn't do it because the value of the house had fallen below what they owed on the mortgage. They say they can afford the higher payments but see no point in making them.

"You know, the housing keeps going down, payments keep going up. Where's the logic in that? And, uh, and how can we fix it? And if we can't fix it, then what do we do?"

"Why pay a $3,200 payment on a 1,200-foot home? It makes no sense."

"That's what you agreed to do when you bought the house."

"Fine. If, if the value is going up, the value is going down. It makes no sense because we will never be able to refinance and get a lower payment. There's no way."

"You're saying essentially that you're going to stop making payments on it. You're just going to let it go into foreclosure."

"You know, that's the only advice we've gotten so far is, is walk away from the home. We don't want to do that to our credit. Why can't our mortgage company work with us?"

"You see the tire on that car parked in front is flat."

"There is a certain cold logic to just walking away."

"So, that would lead me to believe there is most likely not an occupant in the property."

And Kevin Moran, the real estate agent who gave us the tour of foreclosed houses in the Weston Ranch subdivision, says it's happening every day.

"They were never really invested. Most of them who lost their houses didn't lose any money because they never put any money down."

"They took $60,000 out of the house."

"Correct."

"Though their credit is damaged and they could face legal action in some circumstances, they got to live in a new house for a couple of years, and some of them even managed to take some money out with home equity loans or by refinancing."

"Nobody seems to be saying, 'Look, I made a contract with you. I borrowed money from you. I'm going to do everything I can to pay off that obligation.' People just seem to be saying, 'Look, take the house. Goodbye. I'm leaving.'"

"Yeah."

"There was a time, I think, when people felt really bad about not paying off a debt. In those days, loans were made by your local banker or building and loan association or savings and loan. They're guys you saw in the grocery store. They were on the Little League team with you, the PTA, the school. And I think as mortgages became securitized and Wall Street became involved, they became very transactional, and there was no relationship built with the borrower and the lender. And I think that makes it easier for someone to see it as an anonymous party at the other end of a transaction and just walk away from it. Just a business decision."

"A business decision that has to be made. What's in the best interest of my family at this point in time moving forward?"

Turns out that if you give people free money, they will take it without really worrying too much about giving it back because, after all, it was free. Greed. Greed. Sure. Greed on both sides of the table.

"What do you mean?"

"Uh, lenders and borrowers. So everybody was gaming the system. Everyone was gaming the system."

"How many are close to default?"

"That's not to suggest that there aren't huge losers in all of this and much suffering on the part of hardworking people who have lost their dream."

"Are you here for counseling, ma'am?"

"Home values are plummeting, and the housing sector, one of the largest and most vital parts of the American economy, has ground to a standstill, pushing the country towards recession."

"Okay, try not to cry. We're going to, we're going to get you some assistance."

Wall Street and foreign investors are now stuck with millions of distressed properties. The unsold condos in Miami, the unfinished apartments on the Vegas Strip, the developments in Atlanta that are sitting idle, and the thousands of Stockton houses in Stockton. Not even Kevin Moran, who has copies of the foreclosed mortgages, can figure out exactly who owns them.

"That's the fascinating question of this entire debacle we're in. Mortgages are sold in mortgage-backed securities, so they're pooled. I have seen anything from some of the largest financial institutions in the country, and then you'll see Deutsche Bank and a series of numbers and letters and the reference to the mortgage pool the mortgage is in."

The pools are part and parcel of those high-yield mortgage-backed securities everyone gobbled up a few years ago and are now stuck in the windpipe of the world's financial system. No one wants to buy them. No one can sell them. Bonds marked AAA are now quoted at 50 cents on the dollar, 40 cents on the dollar, some of them much less.

"How much on the dollar do you think?"

"Some of them are worth nothing on the dollar. Nothing on the dollar. You know, it is, uh, about the worst thing that's happened to Wall Street in a very long time."

"How many of these securities are out there?"

"In a round number, you can say a trillion with a T, plus."

"And who owns them? Who bought them?"

"You know, um, uh, state pension funds, hedge funds bought them. Uh, foreign, yeah, right, foreign central banks own some of these things, if you please, you know. So the, the, the ownership is very widely dispersed, which accounts for the, the high level of anxiety and the persistence of anxiety."

"10:52 OFFERS."

It's that anxiety that spooked the world's stock markets last week. That, and the knowledge that things are likely to get worse, at least for a while.

"Still houses going into foreclosure."

"Yeah, I don't think we're 40% into this. I think we got a long way to go."

"Good morning, everybody. We're ready to go on the repo home tour."

There's already a two-year supply of properties on the market in Stockton and so many foreclosures that real estate agent Cesar Diaz decided to start the repo bus to take bargain hunters and bottom feeders on a weekly tour to see some of them. He got the idea from taking the Hollywood tour of the stars.

"We have two shuttle buses."

The day we went along, there were two busloads checking out houses that are now up to 70% cheaper than they were when the crisis began.

"This property, semi-new. It was previously listed at 307. I believe they reduced it a little bit."

The consensus seemed to be that prices are going to drop still further. Not particularly encouraging news for the past two chairmen of the Federal Reserve Board. Alan Greenspan and his successor, Ben Bernanke, would say over and over that it's contained. The problem is contained. It turns out it is contained only on planet Earth. That's it.

In the past few months, Wall Street's top investment banks have written off more than $120 billion in losses related to mortgage-backed securities, and some of them are now under new management. Two of the fired CEOs responsible for some of the biggest losses rode into the sunset with some free money of their own. Charles Prince of Citigroup collected $29 million on his way out the door, and Stan O'Neal of Merrill Lynch left with $161 million.

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 it's far from being over. It started out 16 months ago as a mortgage crisis. Then it slowly evolved into a credit crisis. Now it's something entirely different and much more serious.

"What kind of a crisis is it today?"

"This is a full-blown, uh, financial storm, and one that comes around perhaps one every 50 or 100 years. This is a real thing."

Jim Grant is the editor of Grant's Interest Rate Observer and one of the country's foremost experts on credit markets. He says it didn't have to happen. That this disaster [music] 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 going to be able to pay off their mortgages. 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."

With clients clamoring for safe investments with above-average returns, 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.

"This is actually the security. This is the selling document for the security. So this is..."

We looked at one of them 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 with a lot of detail here. Think anybody ever read this stuff?"

"I doubt very 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 ways that were supposed to eliminate most of the risk.

"Obviously, they turned out to be wrong."

"Why?"

"Because you can't model human behavior with math."

"How much of this catastrophe had to do with the instruments that the, that Wall Street created and and chose to buy and sell?"

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

"Right. But it didn't stop the rating agencies like Standard and Poor's and Moody's from certifying the dodgy securities investment grade. And it didn't stop Wall Street from making billions, 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 the 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've turned out to be a much bigger problem. They are private and largely undisclosed contracts that mortgage investors entered into to protect themselves in case their investments went bad, part of a huge unregulated market that's multiplied the losses. They've already helped bring down three of the biggest firms on Wall Street and threatened the ones that are left.

But before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they're much simpler than they sound.

"What is a, a credit default swap?"

"A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution or a financial instrument fails."

"So it is, it's an insurance contract."

"It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a swap, which by virtue of federal law is deregulated."

"So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy. A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument."

"But there was a problem."

"Oh, there was a big problem."

"What was the problem?"

"Well, the problem was that if it were insurance, or or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap and not insurance, there was no requirement that adequate capital reserves be put to the side."

"Now, who was selling these credit default swaps?"

"Bear Stearns was selling them. Lehman Brothers was selling them. AIG was selling them. You know, the names we hear that are in trouble. City Group was selling them."

These investment banks were not only selling [snorts] the securities that turned out to be terrible investments. They were selling insurance on them.

"Well, it made the, it made it easier to sell the terrible investments if you could convince the buyer that not only were they going to get the investment, but insurance."

But when homeowners began defaulting on their mortgages and Wall Street's high-risk mortgage-backed securities also began to fail, the big investment houses and insurance companies who sold the credit default swaps hadn't set aside the money they needed to pay off all the insurance contracts they'd written. Bear Stearns was the first to go under, selling itself to JP Morgan for pennies on the dollar. Then Lehman Brothers declared bankruptcy. And when AIG, the nation's largest insurer, couldn't cover its bad debts, the government stepped in with an $85 billion rescue.

"What role did the credit default swaps play in this financial disaster?"

"They were the centerpiece, really. That's why the banks lost all the money. They lost all the money based on those side bets, based on the mortgages."

"How big is the market for credit default swaps?"

"We really don't know. There's this voluntary survey that claims that the market is in the range of 50 to 60 or so trillion dollars. It's sort of alarming that in a market that big, we don't even know how big it is to within, say, 10 trillion."

"But $60 trillion?"

"$60 trillion. I know it seems incredible. It's four times the size of the U.S. debt, but that's the size of the market according to these voluntary reports."

"And the market's totally unregulated."

"And this market is, um, almost entirely unregulated."

The result is a huge shadow market that may control our financial destiny. And yet, the details of these private insurance contracts are hidden from the public, from stockholders, and from federal regulators. No one knows what they cover, who owns them, or whether or not they have the money to pay them off. One of the few sources of information is the International Swaps and Derivatives Association, a trade organization made up of the largest financial institutions in the world. Many of them are the very same companies that created the vast shadow market, lobbied to keep it unregulated, and are now drowning there because of unanticipated risks. The CEO, Robert Pickel, says there's nothing wrong with credit default swaps. The problem was the underlying mortgage securities.

"Well, there's clearly something wrong with the system if all of these leveraged bets, hidden leveraged bets, caused a collapse in the financial system. It's, it is something that we all need to look at and learn lessons from, and we all need to work together to understand that in the f, and and design a structure in the future that that works more effectively."

"Yeah. My, my point is, the people that made these mistakes are the people you represent in your organization, and many of them sit on the board. I mean, if they didn't get it right, who would?"

"These, these people understand, uh, the nature of these products. They understand..."

"Obviously they didn't, or they wouldn't have bought them, they wouldn't have used them."

"These are very, uh, useful transactions, and people do understand the nature of the risks that they're entering into."

"Well, if they're so, if they're so useful, how come they brought down the financial system?"

"Because perhaps they didn't understand the underlying risk, uh, and nobody, nobody really saw the effects that were going to flow through from the subprime lending situation."

That chapter is not over, and there is much suspense and fear on Wall Street that there are other big losses out there that have yet to be disclosed. They already dwarf what's been lost on those original risky mortgages. As bad as the mortgage crisis has been, 94% of all Americans are still paying off their loans. The problem is Wall Street placed its huge bets and side bets with all those fancy securities on the 6% who are not.

"We wouldn't be in any of this trouble right now if we had just had underlying investments in mortgages. We wouldn't be in any trouble right now."

"It's all the side bets."

"It's the side bets. You've got all these big Wall Street firms, Bear Stearns, Lehman Brothers. You got insurance companies like, like AIG. They all lost a ton of money on this. Everybody's lost a ton of money. They're supposed to be the, the smartest investors in the world, and they did it themselves."

"They did it all on their own. That's the most incredible thing about this crisis is that they pushed the button themselves. They blew themselves up."

"Now, how much of this was just incompetence on the part of Wall Street, the people who ran it?"

"The truth is that on Wall Street, a lot of people just weren't very good at their jobs. It's as simple as that."

"These people were being paid $50 to $100 million a year. Some of the guys that were running the places."

"There is no defending, uh, the, a trainee making $45,000 a year would have had the common sense not to bet the firm on mortgage contraptions that no one in the firm actually understood. That is not a deep point to comprehend. Somehow, through, I will call it, criminal neglect and incompetence, the people at the top of these firms chose to look away, to take more risk, to enrich themselves, and to put the shareholders, and indeed the country itself, ultimately the country's economy, at risk. And it is truly a, not only a shame, it's a crime."

We requested interviews with top executives at Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, Goldman Sachs, and AIG. They all declined.

The world's financial system teetered on the edge again last week, and anyone with more than a passing interest in their shrinking 401k knows it's because of a global credit crisis. It began with the collapse of the U.S. housing market, and it's been magnified worldwide by what Warren Buffett once called "financial weapons of mass destruction." They're known as credit derivatives or credit default swaps. And we did a story on the multi-trillion-dollar market three weeks ago, but there's a lot more to tell. Essentially, they are side bets on the performance of the U.S. mortgage markets and the solvency of some of the biggest financial institutions in the world. A form of legalized gambling that allows you to wager on financial outcomes without ever having to actually buy the stocks and the bonds and the mortgages. It would have been illegal during most of the 20th century, but eight years ago, Congress gave Wall Street an exemption, and it's turned out to have been a very bad idea.

"The term derivative is almost becoming a household word."

"The cat's kind of out of the bag here."

"This is not the American dream. It's an American nightmare."

While Congress and the rest of the country scratched their heads trying to figure out how we got into this mess, we decided to go to Frank Partnoy, a law professor at the University of San Diego, who's written a couple of books on the subject.

"Can you explain to me what a derivative is?"

"Yes. A derivative is a financial instrument whose value is based on something else. It's basically a side bet."

Think of it for a moment as a football game. Every week, the New York Giants take the field with hopes of getting back to the Super Bowl. If they do, they'll get more money and glory for the team and its owners. They have a direct investment in the game. But the people in the stands may also have a financial stake in the outcome in the form of a bet with a friend or a bookie.

"We could call that a derivative. It's a side bet. We don't own the teams, but we have a bet based on the outcome. And that a lot of derivatives are bets based on the outcome of games of a sort, not football games, but games in the markets."

"Whether interest rates are going to go up or down."

"Yes. And the new bet that arose over the last several years is a bet based on whether people will default on their mortgages."

And that was the bet that blew up Wall Street. The TNT was the collapse of the housing market and the failure of complicated mortgage securities that the big investment houses created and sold around the world. But the rocket fuel was the trillions of dollars in side bets on those mortgage securities called credit default swaps. They were essentially private insurance contracts that paid off if the investment went bad. But you didn't have to actually own the investment to collect on the insurance.

"If I thought certain mortgage securities were going to fail, I could go out and buy insurance on them without actually owning them."

"Yeah. The irony is, though, you're not really buying insurance at that point. You're just placing a bet."

Eric Dinallo is the insurance superintendent for the state of New York. He says that credit default swaps were totally unregulated and that the big banks and investment houses that sold them didn't have to set aside any money to cover their potential losses and pay off their bets.

"As the market began to seize up, and as the market for the underlying obligations began to perform poorly, everybody wanted to get paid, had a right to get paid on those credit default swaps, and there was no, there was no money behind the commitments, and people came up short. And so that's, to a large extent, what happened to Bear Stearns, Lehman Brothers, and the holding company of AIG."

In other words, three of the nation's largest financial institutions had made more bad bets than they could afford to pay off. Bear Stearns was sold to JP Morgan for pennies on the dollar. Lehman Brothers was allowed to go belly up. And AIG, considered too big to let fail, is on life support thanks to a $123 billion investment by U.S. taxpayers.

"It's legalized gambling."

"It's legalized gambling. It was illegal gambling, and we made it legal gambling. And with no regulatory controls."

"With absolutely no regulatory controls. Zero, as far as I can tell."

"I mean, it sounds a little like a bookie operation."

"Yes. And it used to be illegal. It was very illegal 100 years ago."

In the early part of the 20th century, the streets of New York and other large cities were lined with gaming establishments called bucket shops, where people could place wagers on whether the price of stocks would go up or down without actually buying them. This unfettered speculation contributed to the panic and stock market crash of 1907, and state laws all over the country were enacted to ban them.

"Big headlines, huge type, the front page of the New York Times."

"'No Bucket Shops for New Law to Hit.'"

"So they'd already closed up because the law was coming. Here's a picture of one of them. And, uh, they were like, uh, they were like parlors. See?"

"Betting parlors."

"Betting parlors. Yeah. It was a felony. Uh, well, it was a felony when the law came into effect because it had brought down the market in 1907, and they said, 'We're not going to let this happen again.' And then a hundred years later, in 2000, we rolled them all back."

"A bill to reauthorize and amend the commodity exchange act."

The vehicle for doing this was an obscure but critical piece of federal legislation called the Commodity Futures Modernization Act of 2000. And the bill was a big favorite of the financial industry. It would eventually help destroy. It not only removed derivatives and credit default swaps from the purview of federal oversight. On page 262 of the legislation, Congress preempted the states from enforcing existing gambling and bucket shop laws against Wall Street.

"It makes it sound like they knew it was illegal."

"I would agree. They did know it was illegal, or they knew it was prosecutable."

In retrospect, giving Wall Street immunity from state gambling laws and legalizing activity that had been banned for most of the 20th century should have given lawmakers pause. But on the last day and the last vote of the lame-duck 106th Congress, Wall Street got what it wanted. The Senate passed the bill unanimously.

"The Senate stands adjourned."

"There was an awful lot of, 'Trust us, leave it alone. We can do it better than government,' without any realistic understanding of the dangers involved."

"Can I get on?"

Columbia University law professor Harvey Goldschmid is a former commissioner and general counsel of the Securities and Exchange Commission. He says the bill was passed at the height of Wall Street and Washington's love affair with deregulation, an infatuation that was endorsed by President Clinton at the White House and encouraged by Federal Reserve Chairman Alan Greenspan.

"That was the wildest and silliest period in many ways of, now again, that's with hindsight, because the argument at the time was, these are grown-ups. They're institutions with a great deal of money. Government will only get in the way. Fears it will be taken overseas. Leave it alone. But it was a wrongheaded argument and turned out to be, of course, extraordinarily unwise."

"What role did Alan Greenspan play in all of this?"

"Well, he made clear in his public speeches and book that a libertarian drive was part of the way he looked at the world. He's a very talented man, but that didn't take us where we had to be."

"He was, uh, another former, uh, commissioner told us, 'Hard to argue with at that point.'"

"Alan was the most powerful man in Washington, in a real sense, uh, certainly a rival to the president, and had enormous influence on Capitol Hill, and he was at the height of his power."

"He was at the height of his power."

Within eight years, unregulated derivatives and swaps helped produce the largest financial services economy the United States has ever had. Estimates of the market for credit default swaps grew from a hundred billion to more than 50 trillion. And you could bet on anything from the solvency of local communities to the fate of General Motors. They also helped produce a huge transfer of private wealth to Wall Street traders and investment bankers who collected billions of dollars in bonuses. A lot of the money was made financing what seemed to be a never-ending housing boom, selling mortgage securities they thought were safe and credit default swaps they believed would never have to be paid off.

"The credit default swaps was the key to what went wrong and and what created these enormous losses."

"Is it your impression that people at the big Wall Street investment houses knew what was going on and knew the kind of risk that they were exposed to?"

"No, my impression is the contrary, that even at senior levels, they only vaguely understood the risks. They only vaguely followed what was going on. And when it tumbled, there was some genuine surprise, not only at the board level where there wasn't enough oversight, but at senior management level."

"They didn't know what was going on."

In part because credit default swaps were totally unregulated. No one knew how many there were or who owned them. And there was no central exchange or clearing house to keep track of all the bets and to hold the money to make sure they got paid off. Eventually, savvy investors figured out that the cheapest, most effective way to bet against the entire housing market was to buy credit default swaps. In effect, taking out inexpensive insurance policies that would pay off big when other people's mortgage investments went south.

"I know people personally who have taken away more than a billion dollars, uh, from having been on the right side of these transactions."

Jim Grant is the publisher of Grant's Interest Rate Observer and one of the country's foremost experts on credit markets.

"If you can, and you could lay down cents on the dollar to place a bet on the solvency of Wall Street, for example, as some did when Wall Street became evidently insolvent, that cents on the dollar bet, uh, went up 30, 40, and 50 fold. Uh, not everyone who did that wants to get his name in the paper. Uh, but there are some spectacularly rich people who came out of this and who got richer, who got, well, who got, who got richer, who got, became fantastically richer."

A lot of them were hedge fund managers. John Paulson's credit opportunities fund returned almost 600% last year, with Paulson pocketing a reported $3.7 billion. Bill Ackman of Pershing Square Capital Management said he plans to make hundreds of millions. Both declined our request for an interview.

"It is a betting game, folks. It's a betting game."

Congress now seems shocked and outraged by the consequences of its decision eight years ago to effectively deregulate swaps and derivatives.

"This is casino capitalism. That's what it is. It's casino capitalism."

And various members of the House and Senate have hauled in the usual suspects to accept or share the blame.

"Were you wrong?"

"Credit default swaps, I think, have serious problems associated with them."

It appears to be the first step in a long process of restoring at least some of the regulations and safeguards that might have prevented or at least mitigated this disaster, after the damage has already been done.

"Where do we go from here?"

"We need the most dramatic rethinking of the regulatory scheme for financial markets since the New Deal. If anything has demonstrated that imperative, it's the economy right now and the tragic circumstances we're in."

"How much danger is still out there, do you think?"

"We don't know. Part of the problem of the lack of transparency in these, in these markets has been, we don't really know."

If you had to pick someone to write the autopsy report on the Wall Street financial collapse 18 months ago, you couldn't do any better than Michael Lewis. He is one of the country's preeminent non-fiction writers with a knack for turning complicated, mind-numbing material into fascinating yarns. He wrote his first bestseller, Liar's Poker, about his experiences as a young Wall Street bond trader when he was still in his 20s. And he has since followed up with seven more bestsellers on subjects ranging from Silicon Valley in The New New Thing to Sports in Moneyball and The Blind Side. His new book, called The Big Short: Inside the Doomsday Machine, comes out later this week, and it explains how some of Wall Street's finest minds managed to destroy $1.75 trillion of wealth in the subprime mortgage markets. We spent two days debriefing him at his home in California.

"This was an episode where capitalism was almost destroyed just by the capitalists. And in the most, uh, sensational way, um, they were sort of destroyed by their own folly. What happened? The incentives for people on Wall Street got so screwed up that the people who work there became blinded to their own long-term interests, and because their short-term interests were so overpowering, and so they behaved in ways that were antithetical to their own long-term interests."

Michael Lewis, a one-time wonder boy on Wall Street, is about to turn 50 now, ensconced in this hillside compound in Berkeley, California, which has a main house and three cottages. And he is much happier writing about business than actually conducting it.

"What was the book that bought this place?"

"This would have been The New New Thing that bought this place."

"How many books have you sold now?"

"Um, some millions. I don't know how many millions. Not John Grisham millions, but millions."

He lives here with his wife, former MTV News correspondent Tabitha Soren, and their three children: a three-year-old son and two young daughters, who he takes to all of Cal Berkeley's women's basketball games. It's one of the few breaks that Lewis allowed himself over the past 18 months as he dug into the idiocy and negligence that produced the worst financial crisis since the Great Depression.

"I'm afraid that our culture will come to the conclusion, because it's always the easy conclusion, that everybody was just a bunch of criminals. I think the story is much more interesting than that. I think it's a story of mass delusion."

Lewis's forte has always been discovering little-known facts and characters that change people's perception about a story. So when he finally sat down at his computer with sacks full of research to write about this calamity, he had no interest in Treasury Secretary Hank Paulson or Ben Bernanke or the CEOs of Wall Street's big investment banks, who he believes had no clue what was going on while it was going on. He wanted to tell the story through the eyes of people who were paying attention and who knew that a financial disaster was inevitable.

But there were a handful of characters who actually had seen it coming and made a fortune off of it. And I, and there were so few of them, and there were so many people who, who had been on the other side, uh, that I thought they, that I kind of wondered who they were and why they got themselves into that position.

"What they saw..."

"What they saw. Almost more how they saw. How many people were there, do you think, in the world that understood what was going on?"

"Between 10 and 20 investors, uh, at most. And this is from a universe of tens of thousands of people who could have conceivably made that bet."

The first one to see that something was seriously amiss in the burgeoning subprime mortgage market was Dr. Michael Burry, a California physician with only one good eye. He lost the other one to cancer as a child and also suffers from Asperger syndrome, a condition related to autism that often produces an aversion to social contact. Uncomfortable dealing with patients, Burry quit medicine and started a hedge fund in Cupertino, spending most of his time in a darkened office glued to his computer screen.

Beginning in 2003, he turned to something that no one else in America was doing: reading and analyzing the pools of risky subprime mortgage loans that Wall Street had been buying up and bundling into highly profitable mortgage-backed securities, which they were selling to investors around the world.

"I called up the prospectuses and I read the prospectuses and I looked at these pools. I could see the credit standards within these pools deteriorating just quarter to quarter. First,..."

"How could you tell that?"

"There was essentially crappier mortgages being put into these pools, and it didn't seem investors seemed to care, and it didn't seem the ratings agencies seemed to care."

"Do you think many people read these, read these prospectuses?"

"I think the lawyers that put them together, to an extent, maybe."

"Do you think the executives at the big Wall Street firms who were issuing these bonds had read them or understood them?"

"I don't think they read them. No. I think that, uh, there were probably junior analysts that were given the task of reviewing the, these issu, these documents. However, I think that, um, this was a profit center. Um, it was a profit center. It was something the organization wanted to do."

In effect, Lewis writes, Michael Burry was doing the first real analysis of the creditworthiness of the subprime borrowers and the structure of the complicated Wall Street mortgage securities, the kind of work that was supposed to have been done by bond rating agencies like Standard and Poor's and Moody's so that investors could accurately judge their risk.

"What you were doing sounds to me like the job that the rating agencies should have been doing. And there's no way the ratings agencies had anywhere near the manpower to look through all that was being issued."

"Yeah, but you're one guy."

And you found it. [snorts]

You, you would think that even if they just looked at a sample, maybe they would have come to a realization. But by 2005, Michael Barry had come to the realization that the Wall Street bond market had lost its mind. It was buying up hundreds of millions of dollars in dicey loans to unqualified buyers who were, in Michael Lewis's words, one broken refrigerator away from default. Barry concluded that the subprime market would collapse in 2007.

He notices for the first time that there are pools there; they're mortgage bonds supported by pools of loans, and most of the loans are what are called negative advertising interest-only loans, which means that you, the homeowner and buyer, you borrow the money, and you not only don't have to repay your principal, you have to—you don't even have to repay the interest. And if you just don't pay anything, they just, they just add to your loan. So you can't lose your house. You, you can't lose your house, right? In theory, right? And so he figures, we've reached the end of the road in the insanity of lending. They, they're scraping the bottom of the barrel. Now is the time to lay a bet. It's before anybody does.

Barry figured out that these mortgage-backed securities would become worthless if just a small percentage of the dicey loans went bad, and he wanted to bet against the worst of them. He decided that the best way to do it would be to get Wall Street to sell him inexpensive insurance contracts on the securities that would pay off big time if they failed. The contracts were called credit default swaps. He conceives that they are going to invent on Wall Street credit default swaps on subprime mortgages, essentially insurance contracts on the bonds before they even do. And he helps; he participates in the creation of this instrument, and Michael Barry is the first one in.

Barry assumed a lot of people would figure out what he was up to, but very few did. It took 2 years for the drama to play out, but the subprime mortgage market finally collapsed in 2007, just as he had predicted.

"So you made a ton of money?"

"Made a ton of money, much more than I ever imagined, you know, I'd ever have. We made 725 million, I think, on the funds in 2007."

Michael Barry's advantage was he wasn't part of the collective. He, he was just this guy in a t-shirt and shorts with a glass eyeball and Asperger's syndrome, looking at the numbers, and when nobody else really was.

"How can they not look at the numbers? I mean, how can Wall Street be selling all of these, buying all of these mortgages and repackaging them and not realizing that they're not very good mortgages?"

Wall Street is able to dilute itself because it's paid to dilute itself. That's the one of the lessons of this story: that people see what they're incentivized to see. If you pay someone not to see the truth, they will not see the truth. And Wall Street organized itself so people were paid to see something other than the truth. And that's one of the central messages of the story. You have to be very careful what, how you incentivize people, because they will respond to the incentives.

And all of the incentives in Wall Street's largely unregulated bond market were geared toward keeping the subprime money machine humming. Shortly after Michael Barry decided the people there had lost their minds, Wall Street's most influential investment bank convinced the financial products division of insurance giant AIG to join the party. A decision that would destroy the company. They insured tens of billions of dollars of subprime mortgage loans without even knowing they were doing it. Goldman Sachs persuaded them to insure these piles of loans without them ever investigating what was in the pile. So there's an additional level of incompetence. They didn't even know the mistake they were making.

Over a period of just a few months in 2005, Goldman Sachs got AIG to insure $20 billion worth of subprime mortgage securities that the rating agencies had graded AAA. But in fact, Lewis says, the pools contained some of the worst debt on the market.

"Do you think the big banks like Goldman Sachs played AIG for a patsy?"

"That's exactly what they did. I mean, I don't—I think even Goldman Sachs would would admit that to themselves, which is saying something. I, yes, absolutely. Using the cover of 'we're all big boys in this market.' The big investment banks have long sought to exploit their customers."

"What role did the rating agencies play in this?"

"They were handmaidens to Wall Street. The ratings agencies get paid by Wall Street, by Merrill Lynch, by Credit Suisse, by Morgan Stanley, by Goldman Sachs to rate the bonds that Wall Street creates. This creates a certain moral hazard."

"You write in the book that Goldman essentially took the worst stuff that they couldn't sell, they repackaged it and took it to Moody's and got Moody's to rate AAA."

"Correct."

"How, how did they know that Moody's was going to rate it AAA?"

"Yes, they had helped design the models, I'm sure, that Moody's used to rate the bonds. And I've spoken with people at Morgan Stanley and Goldman Sachs who said, 'We helped the ratings agencies understand these things.'"

"They were the educators."

"Yeah, they were the educators."

Lewis calls the Goldman Sachs-AIG deal one of the original sins of the looming financial crisis. Other Wall Street firms were so jealous of the Goldman deal, they got AIG to insure another $30 billion of what turned out to be worthless securities. But Lewis thinks the fiasco had more to do with Wall Street stupidity than corruption. They didn't understand these things. Not well enough. They, um, I mean, there's a wonderful little vignette in The Big Short about the leading subprime mortgage bond trader at Morgan Stanley, a fellow named Howie Hubler, who manages to lose somewhere between—it's hard to know, but seven and 12 billion dollars in a matter of six or eight months, more than any single trader has ever lost in the history of Wall Street, and no one knows his name.

According to Lewis, at the end of 2006 and the beginning of 2007, when the commercial bank JP Morgan became the first to recognize the danger and fled the subprime market, Hubler was gobbling up $16 billion worth of subprime mortgage bonds that would be worthless in 9 months. He did not understand the forces at work in his own market. And he is supposed to be the smart guy. I mean, what, what were the dumb guys doing? So I, I think that it's really clear that, um, that the firms themselves did not understand the machine they created.

"What happened now with Hubler?"

"He's allowed to resign from Morgan Stanley. And he takes with him millions of dollars in back pay, tens of millions of dollars in back pay. It was all hushed up, basically."

"Did most of the people who made these terrible decisions leave a lot of money?"

"Yes, they all did. I, I did not run across a single character who didn't get rich. Anybody above a certain level in all these firms made huge sums of money by any standard. And the people who were, I mean, this is where it gets a little creepy. The people who were most instrumental in building the subprime mortgage machine also happen to be the ones who have the most detailed understanding now of the securities in the rubble, and they're being paid all over again to sort through the mess because they are the experts. That is an age-old trick on Wall Street. Just generally speaking, people who create disasters make a lot of money cleaning up the disaster because they're the ones who know about the disaster."

"What about the CEOs?"

"From Stan O'Neal at Merrill Lynch and Chuck Prince at Citigroup are the most obvious examples, but they were paid not tens, but into the hundreds of millions of dollars to run their firms into the ground."

By the fall of 2008, with AIG and all of the big investment banks at some risk of going under, the government stepped in to bail out the very firms that had caused the crisis. A decision was made that AIG was too big to let fail, and that its gambling debts would be paid off 100 cents on the dollar. And the company that benefited the most was Goldman Sachs.

"Do you believe it had anything to do with their political connections?"

"It's hard to know. There's no proof, but it certainly didn't hurt. It certainly didn't hurt that the Secretary of the Treasury was a former Goldman CEO. Certainly didn't hurt that a lot of people at the table were former Goldman employees. It certainly didn't hurt that the air they, everybody breathed, contained the assumption that we can never do anything to harm Goldman Sachs. So, sure. I mean, I, I can't really see how their political influence didn't have anything to do with it."

When we come back, a look at Wall Street's bonus culture and why Michael Lewis thinks it's become unsustainable.

Wall Street's bad bets nearly brought down the financial system in 2008. One thing that didn't end, Michael Lewis says, was the bonus culture and the sense of entitlement in the financial industry. According to the New York State Controller, Wall Street employees split $20 billion in bonuses for 2009. That's up 17% over last year, but it's not a record. In fact, it's a third less than the $33 billion Wall Street divided up in 2007, the same year everyone on Wall Street began to acknowledge the subprime mortgage losses that would reach $1.75 trillion. The size of the bonuses has left Michael Lewis appalled, but not really surprised.

More than 20 years ago, Lewis collected a couple of bonuses himself as a young trader at Solomon Brothers, and he still can't figure out what he did to deserve them.

"I got my Wall Street bonus in—I got two bonuses in 1986 and 1987, and it was like winning the lottery. It was the money was so shocking, even though it seems in retrospect so quaint. It was a couple of hundred thousand, but I was 24, 25 years old. It was incredible that someone was going to give me a couple of hundred thousand for what I just done, because I couldn't figure out what was so terribly useful about what I just done."

And Lewis feels the same way about the latest round of bonuses that were paid out on $55 billion of Wall Street profits that he thinks wouldn't have been made without help from Uncle Sam. Once the government decided the banks were too important to fail, Lewis says the only way to get them back on their feet was to give them money.

"I think they assumed that in response for this gift of life that they were giving these Wall Street firms, the people who ran the Wall Street firms would behave responsibly in a way that didn't attract these—"

"Meaning what? Meaning not pay themselves huge sums of money, perhaps not even pay themselves anything? Just say thank you, um, and rejigger their compensation systems."

"Instead, they did not. Instead, they used the market as an excuse for paying themselves. 'If we don't pay our employees of Goldman Sachs huge sums of money, they're gonna leave and go to JP Morgan.' And the JP Morgan people say, 'Well, if we don't pay these special people huge sums of money, they're gonna leave and go to go Goldman Sachs.' And, uh, and you, you kind of want to back away from it and say, 'Well, wait a minute. Why are they so valuable in the first place?' And really, what's going on is the people at the top of the firm want to make a lot of money. And if they're going to make a lot of money, they got to pay the people under them a lot of money. So it's a very elegant form of theft, right now."

"Well, their argument has been, look, we're entitled to these bonuses this year because we made all of this money. No one ever asked them. They never explained how they made all this money. If you look at their businesses right now, they're heavily government dependent. That if you were Goldman Sachs or Morgan Stanley or JP Morgan, you have access to a 0% loan in virtually unlimited quantities from the Federal Reserve. You can take that money and reinvest it in treasury bonds or in, in government agency securities, and you will get the spread, and you could, you could do it over and over. You're essentially borrowing from the government, lending to the government, and taking out, taking a cut. And—"

"So the government's let them make the money."

"Well, the government is still subsidizing these firms because the losses were sensational. I mean, in the financial system, there are now $1.75 trillion dollars of losses from the subprime mortgage bonanza, and that's, uh, they're firms that really, they look, they really shouldn't exist. If the market had been allowed to function, they would not exist. They'd be failed enterprises. I mean, even now, if the government said, 'We have nothing to do with these places anymore. We're going to let them fail if they fail. They no longer have this effective government guarantee. And by the way, we're going to cut out these subsidies that we're handing them under the table.' Most of them would fail."

But none of that has changed the Wall Street bonus culture. Lewis says there is a sense of entitlement to outrageous compensation that he thinks is way out of proportion to its contribution to the U.S. economy.

"How did that happen that somebody thinks they're worth automatically millions of dollars a year?"

"Well, when you're surrounded by a lot of other people who are being paid millions of dollars a year, you, you're not thinking, 'Oh, it's outrageous for someone to pay me millions of dollars a year.' You're thinking, 'It's outrageous that Jim got $500,000 more than me.' That they are, they're looking to each other as reference points rather than to the larger society."

"Are they worth that kind of money?"

"What do you mean, 'Are they worth that kind of money?' Do they deserve all that money?"

"Again, what do you mean, 'Do they deserve it?' Did they, did they, they worked really hard? They spent a lot of hours in the office. So you can't begrudge someone who starts a company and employs lots of people and so on and so forth for making a lot of money. I don't mind people making a lot of money. On Wall Street, the business has become very obviously divorced from productivity, from productive enterprise. So in that sense, no, they don't deserve it. They didn't earn it. They, what they did was finagle it. They, they managed, they were very good at putting themselves in the middle of large financial transactions that probably shouldn't have happened in the first place and taking out little pieces of it. They generated trillions of dollars of subprime mortgage loans that should never have been made, but the world would be better off if that whole industry had never existed. So that, that's crazy."

Lewis says the more people learn about what happened, the angrier they become.

"What about reform? I mean, do you see anything? You see anything happening?"

"There are several things that obviously should be done that have not been done, and you can't explain to my mother why they haven't been done. Only a really smart person on Wall Street can explain why they haven't been done. But for example, all right, one of the things at the bottom of this crisis, we had these ratings agencies that called a lot of things AAA, gold-plated securities that were worthless. And the ratings agencies are paid, of course, by the Wall Street firms for their ratings. Why is that allowed? Why can you buy a rating? That seems like a very obvious thing to change, and people talk about it, but it hasn't happened. Credit default swaps, insurance contracts that we trade freely, but it's not classified as insurance. This market is the closest thing to sort of ground zero of the recent calamity. And yet nothing has been done to change the market. Nothing's been done to make it more transparent. Nothing's been done to make it more like what it is, an insurance market. That's an obvious reform. From the time I was at Solomon Brothers, it was incredible to me that the firm could advise customers what to buy and sell at the same time they are betting on the things that they're trying to sell their customers. So, I might call you up and say, 'Wow, these, these subprime mortgage loans, they look really, really good. This pile over here, you ought, you ought to invest in that pile.' And meanwhile, the traders behind me are betting against it."

Lewis believes the financial industry is living in a world so disconnected from American life that it can't be sustained. He thinks it may take a while, but he believes that Wall Street as we know it has done itself in.

"The leaders on Wall Street completely lost any sense of their responsibility to the society. And if you know you're going to blow up AIG by putting $20 billion of bad subprime mortgage risk into it, even though it's going to be very profitable for you, you should stop and say, 'This shouldn't be done.'"

On September 15th, 2008, Lehman Brothers, the fourth largest investment bank in the world, declared bankruptcy, sparking chaos in the financial markets and nearly bringing down the global economy. It was the largest bankruptcy in history, larger than General Motors, Washington Mutual, Enron, and WorldCom combined. The federal bankruptcy court appointed Anton R. R. Antonucci, a prominent Chicago lawyer and former United States attorney, to conduct an investigation to determine what happened. Included in the nine-volume, 2,200-page report was the finding that there was enough evidence for a prosecutor to bring a case against top Lehman officials and one of the nation's top accounting firms for misleading government regulators and investors. That was two years ago, and there have been no prosecutions. Antonucci has never given an interview about his report until now.

"This is the largest bankruptcy in the world. What were the effects?"

"The effects were the financial disaster that we are living our way through right now."

"And who got hurt?"

"Everybody got hurt. The entire economy has suffered from the fall of Lehman Brothers."

"So the whole world?"

"Yes, the whole world."

When Lehman Brothers collapsed, 26,000 employees lost their jobs, and millions of investors lost all or almost all of their money, triggering a chain reaction that produced the worst financial crisis and economic downturn in 70 years. Antonucci's job was to provide the bankruptcy court with accurate, reliable information that the judges could use to resolve the claims of creditors picking over Lehman's corpse.

"Had you ever done anything like this before?"

"I've never done anything like Lehman Brothers, and I don't think anybody else has ever done anything like Lehman Brothers."

"So your job, I mean, in some ways your job was to assess blame."

"Our job is to determine what actually happened. Put the cards face up on the table and let everybody see what the facts truly are."

Antonucci's team spent a year and a half interviewing hundreds of former employees and pouring over 34 million documents. They told of how Lehman bought up huge amounts of real estate that it couldn't unload when the market went south. How it had borrowed $44 for every one it had in the bank to finance the deals. And how Lehman executives manipulated balance sheets and financial reports when investors began losing confidence and competitors closed in.

"Did these quarterly reports represent to investors a fair, accurate picture of the company's financial condition?"

"In our opinion, they did not."

"I mean, isn't that against the law?"

"It certainly, in our opinion, was against, uh, civil law, if you will. There were colorable claims that this was a fraud. Yes."

By "colorable claims," means there is sufficient evidence for the Justice Department or the Securities and Exchange Commission to bring charges against top Lehman executives, including CEO Richard Fuld, for overseeing and certifying misleading financial statements, and against Lehman's accountant, Ernst & Young, for failing to challenge Lehman's numbers.

"They'd fudge the numbers. They would move what turned out to be approximately $50 billion of assets from the United States to the United Kingdom just before they printed their financial statements. And a week or so after the financial statements had been distributed to the public, that $50 billion would reappear here in the United States, back on the books in the United States."

"The next financial statement, they would move it overseas again and file their report and then move it back."

"Right."

"It sounds like a shell game."

"It was a shell game. It was a gimmick. Lehman misused an accounting trick called repo 105 to temporarily remove the $50 billion from its ledgers to make it look as though it was reducing its dependency on borrowed money and was drawing down its debt. Lehman never told investors or regulators about it."

"This is really deception to make the company look healthier than it was."

"Yes."

"Deliberate."

"Yes."

"How are you so sure of that?"

"Because we read the emails in which we observed people saying that they were doing it. We interviewed the witnesses who wrote those emails, or some of those emails, and asked them why they were doing it, and they told us they were doing it for purposes of affecting the numbers."

"Do you think Lehman executives knew that this was wrong?"

"For some of them, certainly, there were concerns being expressed by at high levels about whether this is appropriate, what happens if the street finds out about it? So, you know, there was a concern that there's a real question about whether we can do this, whether this was right or not."

One of those people was Matthew Lee, who had been a senior executive at Lehman and the accountant responsible for its global balance sheet. Lee was one of the first to raise objections inside Lehman about the accounting trick known as Repo 105.

"It sounded like rat poison, Repo 105, when I first heard it. Um, so I investigated what it was, and I didn't like what I saw."

"Was there a point in which you saw the accounting principles employed by Lehman Brothers change?"

"November 30th, 2007, was the end of our fiscal year. And I fully expected us, you know, to make a loss that year, like everyone else. Um, and when I saw we made money, it was a record year, in fact. I thought, 'That doesn't sound right.' You knew the markets were doing badly, so why wasn't Lehman doing badly? And every time I found something and I went to my boss or whoever, no response."

That was 10 months before Lehman Brothers went bankrupt. Lee's position required him to sign off on the accuracy of the firm's accounting practices every quarter. But in November of 2007, he declined to do it.

"By refusing to sign it, you were saying that you didn't believe the numbers?"

"Correct."

"That this wasn't a fair and accurate representation of the financial condition of Lehman Brothers?"

"Right. Something's up here. Why can't people answer my questions? You know, why has Repo 105 doubled? Give me an answer. No, you know, nothing was said."

Lee continued to press people for more information, but nothing changed. And four months before Lehman collapsed, he sent this letter to Lehman's top executives.

"I've been telling you all year, I've been banging my head against the wall. I'm now putting it in writing. Says it requires me to bring to the attention of management conduct and actions on the part of the firm that I consider to be possibly unethical and unlawful."

"Yeah."

"What were you talking about specifically?"

"Well, in that particular letter was general. There were so many specifics I could have written, a laundry list."

"What kind of a response did you get from this letter?"

"It was like throwing a grenade. I wanted to wake somebody up, at least to address the topics."

It worked. Six days after he sent that letter, Matthew Lee was downsized, let go after 14 years. But Lehman executives couldn't ignore the letter and asked their accountants from Ernst & Young to interview Matthew Lee.

"And in those interviews, we have the notes, which are part of the report. He says very specifically, '$50 billion repo transactions moving money off the balance sheet at Porter.' So our conclusion was Ernst & Young certainly knew it as of that time and did nothing with it."

Antonucci says Ernst & Young was legally bound to make sure that Lehman's audit committee and its board of directors knew about Lee's allegations of unethical and unlawful accounting practices, but they never did.

"Did the audit committee know?"

"No."

"Did the board of directors know?"

"No."

"Did Dick Fuld know?"

"Did Dick Fuld know? Well, he says no."

The only place Lehman's CEO Richard Fuld has publicly answered questions about his firm's bankruptcy has been in front of Congress.

"I have absolutely no recollection whatsoever of hearing anything about or seeing documents related to Repo 105 transactions while I was the CEO of Lehman."

"He said the same thing to me face to face."

"Do you believe him?"

"There was evidence which would show that that's not accurate. The president of Lehman Brothers told us that in fact he had conversations with Dick Fuld about this, and documents were shared with him which would reflect the Repo 105 transactions and how they were being used. Richard Fuld's view on that was that he has no knowledge of it. You have other evidence that he did. A jury would have to decide who's telling the truth."

But so far, there's been no jury to hear the evidence. Despite Antonucci's findings and the supporting documents and testimony to back them up, the Securities and Exchange Commission has not brought any charges of any kind against former Lehman executives. For the past few months, we made numerous requests to interview the SEC's head of enforcement. All of those requests have been declined.

"The Securities and Exchange Commission has not brought a case."

"No, they have not."

"Does that bother you?"

"I'm not permitted to be bothered by that. I'm, you know, my job was to set out the facts, lay it out. They have to make their own prosecutive decisions."

There is one plausible explanation why the SEC hasn't gone after top Lehman executives. As it turns out, some of Lehman's most egregious accounting shenanigans took place right under the noses of government regulators.

"How closely was the SEC monitoring Lehman Brothers during this time?"

"They were on premises. They were talking to the Lehman people daily. They officed there."

It was not widely known at the time, but during the last six months of Lehman's existence, teams of officials from the SEC and the Federal Reserve took up residence inside the firm to monitor its precarious financial situation. They were inside the building when Matthew Lee wrote his letter to Lehman executives alleging unlawful accounting practices. And they were there when the practices took place. Antonucci says the SEC also knew that Lehman was being less than truthful when it said that it had enough assets to survive the crisis, but that and other damaging information was never disclosed to investors who continued to pump billions of dollars into the firm.

"Should it have been disclosed?"

"Absolutely."

"Isn't the government, the SEC in this case, the people who were supposed to protect the investors?"

"Yes."

"Aren't they charged with informing investors?"

"Yes."

"Why didn't they do it?"

"They may not have had the expertise necessary to understand the material they were receiving. They were getting the material. Whether they understood it is another question."

The very fact that government regulators were inside the company with access to its books and records would complicate any prosecution of Lehman officials. Until four months ago, David Kotz was the SEC's Inspector General. Over the previous four years, he'd issued more than 100 reports about major deficiencies in the way the SEC did its job.

"If the SEC knew about some of these problems at Lehman Brothers and they weren't disclosed, doesn't it make it difficult for the SEC enforcement division to come back and bring action against Lehman Brothers?"

"They were there. They saw it."

"Yeah, I think that that's definitely an impediment to a potential case. And certainly if you go before a jury, the defense lawyers can make a big point about the fact that you were there, you knew about it. Why didn't you do anything at the time? Now you're coming after them."

In fact, former Lehman CEO Richard Fuld seemed to be trying out that defense when he testified before Congress in 2008.

"Throughout 2008, the SEC and the Federal Reserve conducted regular and at times daily oversight of our business and our balance sheet. They saw what we saw in real time."

"Let's just assume for a moment that Antonucci's findings are true. I mean, isn't this just a free ticket for executives to say, 'Well, look, you know, Lehman did so and so and nothing happened to them'?"

"Right. No, I think absolutely that's a serious problem. I mean, obviously, there has been a tremendous financial crisis. The people who engaged in improper behavior need to be punished. I think it's critical for the SEC to go after not just companies, but also individuals where they have the evidence to do so."

When Lehman's bankruptcy was finally settled, there were claims against it for $370 billion. The creditors settled for about 20 cents on the dollar. Former CEO Richard Fuld now runs a consulting business in Manhattan. He lost most of his fortune and is embroiled in a raft of litigation, but is still a wealthy man. Most of his senior colleagues at Lehman have landed on their feet. Ernst & Young, Lehman's accounting firm, is now being sued by New York State for aiding in a massive fraud. And Matthew Lee, the senior accountant who blew the whistle at Lehman, is still looking for work, unconvinced that much has changed in the world of finance over the last four years.

"You know, the entrepreneurs of Wall Street are continually getting more and more sophisticated, and they don't necessarily want regulators or auditors to fully understand what they're doing."

"Do you believe the balance sheets of big Wall Street firms if you read them now?"

"These numbers are so big, and the financial instruments are so complex, that, you know, nobody stands a chance really of understanding. I'd have more fun investing in crap tables in Las Vegas than Wall Street firms."

Banks are supposed to lend money, and when they stop, as they have in recent months, the workings of our entire economy are threatened. Credit became so frozen, the government had to step in this past week and take an ownership stake in the country's biggest banks. On Monday, Treasury Secretary Henry Paulson summoned the CEOs of the nine largest banks to Washington and gave them a massive amount of money so that they would start lending again. The largest of the banks is Bank of America, now partly owned by the United States of America.

The head of Bank of America is Ken Lewis. He says when he and the others met at the Treasury Department, it became clear that Secretary Paulson's offer was an ultimatum.

"No negotiation was allowed."

"No negotiations."

"No."

"So in other words, take it or take it."

"Right. Right."

"One of those—"

"It said that he told the bankers, and you, this is your patriotic duty. I don't remember if he used the word, but but there was an element to that, that this was the right thing for the for the American financial system, and therefore it was the right thing for America."

"Did you feel that? Was that a persuasive line of—"

"Absolutely. I, I deeply believe that. I think he was right on."

"Now explain why it was so important to the government that everybody agree that the nine largest banks are all in this. If you have a bank in that group that really, really needed the capital, you don't want to expose that bank."

"In other words, stigmatize it so everybody knows that they're not as good as somebody else."

"Most of you were just stunned by the amount of money that the government put on the table."

"Yeah. At least I, I was, and I think most everybody else was."

The total was $125 billion of taxpayers' money. Bank of America, Lewis says, didn't need the money, but got $25 billion anyway.

"Do you have any choice in this? In other words, can you take the money and not lend?"

"We wouldn't want to do it that way because you can make more money lending. And so it, the intent will be to use it to grow loans and to make more net income."

But under the Treasury plan, there's no requirement that a bank use the money to lend. It could use it to acquire weaker competitors or put it in treasury bills. One of the few strings Paulson attached relates to salaries. A bank would have to pay more taxes if it paid an executive over $500,000 a year. One of the bankers in the meeting objected and started arguing with Paulson. And that's when Ken Lewis, a critic of excessive executive compensation, spoke up.

"I did make the point that we needed to stop talking about executive comp and get on with this, because that should not stop the deal."

"Actually, you're quoted as saying, 'If, if this is what's going to stop this, you're out of your mind.'"

"I did use, I did use the phrase 'out of your mind.'"

"Because why?"

"Because you thought if it got out publicly that—"

"No, that the importance of this deal getting done versus these elements of executive comp were just out of sync. I mean, this was so much more important, and all of us can take a little less money."

With his salary and lucrative stock and options, Lewis took home $25 million last year, but he's one of the few in the business who can be fired without a golden parachute. And he thinks executives on Wall Street have made too much money.

"I think they were overpaid. It's more egregious in financial services than any other industry that I know of. We need to cut back compensation in this industry."

"So this is a question everybody wants answered. Is this socialism? Have we now sort of stepped, taken a huge step away from the kind of free-wheeling capitalism that we've known for the last 30 or so years?"

"I don't know what we'll call it, but it will be different, and there will be more regulation. The era of the golden era of financial services is over, in my opinion."

"But why isn't it socialism? If, if the government starts owning our banks—"

"And that will not last forever. We will, we will pay off the preferred stock at some point and come back to not being owned partially by the government."

"Can you give us, what's your sense of how long it's going to take?"

"Yeah, I think somewhere between three and five years we'll pay it off, and then, and then you go back to more toward capitalism."

It's said that one of the main reasons the bank is doing well is because of your decision not to get into subprime mortgages.

"In, in 2001, my first year as CEO, um, we decided that we just didn't like the business. It was, it was too risky, and so we decided to get out of it."

He makes it sound like a routine decision, but getting out of most of the financial products that brought Wall Street crashing down was significant. And now Lewis runs one of the country's healthiest banks, which just keeps growing.

"We saw the strongest growth in deposits in the third quarter we've ever seen in our history."

He told us that during this crisis, people are taking their money out of other banks and putting it in his.

"We, we bank every other American family, you know, in America. You—"

"What?"

"We bank every other American family in the United States."

"No."

"Yeah."

"Half of the American families—"

"Does business with us in some form or fashion. You mean credit cards, auto loans, deposits, checking?"

"Half the country."

The way BA accomplished this was by buying the number one company in virtually every category of banking. For instance, it bought Countrywide in mortgages and MBNA in credit cards. Now, it's a nearly $3 trillion conglomerate, the Walmart of banking. This is the iconic image of Wall Street, 600 wheeler-dealers buying and selling. But this is BA's trading floor, and it's 600 miles south of New York. The biggest bank in America is headquartered in Charlotte.

"Some people don't even know what state Charlotte's in, whether it's North or South Carolina. Am I insulting you?"

"No. In fact, I always say Charlotte, North Carolina, just so that I don't have to ask the question."

"You have this building, this building, that building, that building. Then there's one next to us, that building."

Not surprisingly, BofA seems to own Charlotte, and the town grew with the bank. Hugh McColl was the bank's CEO before Lewis.

"Now, it started out as a, as a relatively small regional bank."

"Well, we didn't like being small. I mean, there's nothing really attractive about being small."

He set out to expand the bank's reach from coast to coast and make Charlotte a financial powerhouse.

"I think we have this sort of southern underdog of wanting to be masters of our own fate and not be dependent on northern capital."

"When you were growing and you'd go to New York, did they not treat you well? Is that, did they treat you like sort of the country bumpkins?"

"I guess when I was a young man, I always felt a little uncomfortable in New York. This uncomfortable feeling that they, they weren't respecting you."

"Did you have it in your head, 'I'm going to conquer New York'?"

"Well, that would overstate New York. I was more interested in America."

"Did you really think that you could overtake Wall Street?"

"Well, have you ever played tennis? It's, once you size up the competition and decide whether you can beat them or not."

"Hey."

"And you thought you could."

"I thought I could."

And they did. The crowning victory came last month when Wall Street's most famous investment houses were collapsing under the weight of their toxic portfolios and needed rescuing. They went hand in hand to Charlotte, North Carolina.

"Everybody thought you were going to buy Lehman Brothers Friday night. That was the buzz. Monday morning. [laughter] It's not Lehman Brothers. It's Merrill Lynch. What happened between Friday night and Monday morning?"

"I had talked to Secretary Paulson that, uh, that Friday and basically said we didn't think we could do the deal without government assistance."

"With Lehman?"

"With Lehman. That we, we couldn't do it without some help. And then about 10:30, John Thain called."

"It was Saturday morning, September 13th. John Thain, the CEO of Merrill Lynch, was on the line. Lehman was on its deathbed. Merrill Lynch was said to be next."

"You always wanted Merrill Lynch."

"We've always thought that was the best."

"You were drooling for Merrill?"

"We have always thought it was. Yeah."

Deals of this magnitude take months of due diligence and vetting. This deal was thrown together over a weekend with Bank of America spending $50 billion to buy one of Wall Street's emblematic companies. But now BA is exposed to Merrill Lynch's poisonous investments and continuing losses. The question is, did Ken Lewis pay too much?

"Some think that we should have waited till Monday and see if they would have gone bankrupt."

"You're saying that if you'd waited, they would have, they might have gone bankrupt."

"Some think, some think we would have gotten it for, you know, dirt cheap. But my point is, you would have had a tarnished brand. You'd have had chaos. You would have had a court ruling over all of the sale of assets. And that, that it was worth it to us to pay a more market price so that we could not have that happen."

"So what about Merrill's 17,000 brokers? Lewis has said their salaries are too high."

"Is New York going to lose a lot of jobs, do you think?"

"I don't think a lot. I mean, obviously, we have to, we have $7 billion of cost savings to get, and so that means that there will be jobs eliminated."

"$7 billion?"

"$7 billion in cost savings."

"Oh my God. So the government's rescue isn't helping everyone on Wall Street. What about Main Street? Has the lending started? Did this jump-start lending again?"

"It should. It's only been a few days, obviously, and it will make a big difference."

"It will. We're sitting down with you Wednesday."

"Uh, the market is at this moment going down again. The market's going down, and what's worrying me is the fact that we've gotten the financial system in much, much better shape, but the economy is still a question mark. And we are in a recession by any standard other than maybe some technical standard. It feels like a recession, and we think it's going to take some time before, you know, it gets better."

Bank of America is the largest mortgage lender in the country.

"So when do you think the housing problems are going to bottom out?"

"Our best guess now is that toward the end of the first half of next year, we'll start to see signs either signs of the bottoming or the actual bottoming."

"What, what about credit card debt? Is that going to be the next shoe to drop?"

"It, uh, in some ways already is, because credit card losses have risen pretty substantially."

Credit card debt and auto loan defaults are part of why the bank's third quarter earnings dropped nearly 70%. Lewis called the situation a damn disaster.

"Do you think your job is secure?" [laughter]

"I, I haven't—it must, I must think that because I don't, I don't think about that question."

"It doesn't enter your mind. I threw you a zinger, didn't I?"

"Yeah, you did."

"Did you defeat Wall Street?"

"No. To some degree, we're we're part of it. So I don't, I don't know that we defeated it, but—"

"Well, if you're number one—"

"All right."

"And if the idea was to compete with New York or Wall Street, um, you won."

"We, we have, yes, we have won in that sense."

A lot of people are worried about their bank these days. While devastated giants like Citigroup get bailed out again and again and again, many smaller banks are failing. The federal agency that takes over unsound banks is the Federal Deposit Insurance Corporation. The same people who guarantee that depositors won't lose their money. Most every Friday now, the FDIC is seizing several banks. You haven't seen these takeovers happening because they're done secretly at night to make sure that there's no needless panic by depositors. But last week, we were given extraordinary access to one of these operations because the FDIC wants you to see what happens to your money when your bank has failed.

"They're going to start at one branch, pull the cash out, take it inside the bank. This is a team of FDIC agents preparing to seize a bank outside Chicago. What we need to do is we need to pull the corporate records."

They've checked into this hotel under a fictitious name, CB and Associates, to prevent a run on the bank. They don't want anyone to know who they are or why they're here.

"You all know that this is for the closing of Heritage Community Bank." Cheryl Bates and Arthur Cook are in charge of the operation that has been given the code name Happy. Strange, considering what they're about to do.

"Do not discuss outside of this room what is going on, what we're here for."

They're here to seize all five branches of Heritage Community Bank, a 40-year-old local bank providing savings, student loans, mortgages, and checking. But like so many others recently, Heritage made ruinous bets on real estate. Sheila Bair is chairman of the FDIC.

"How many banks failed last year?"

"25."

"How many do you expect to fail this year?"

"It's going up. There have been 16 already, now. And so our, our loss projections are going up. We're having to increase premiums on banks to address the loss projections going forward. It's a very distressed environment right now."

"I wonder if you have a number in mind of how much the FDIC is prepared to pay for bank failures in 2009."

"Well, uh, we have, we make a five-year projection that for the next five years, we project that we'll lose $65 billion on bank closings."

"$65 billion?"

"$65 billion."

Some of that was about to be spent on the imminent failure of Heritage Community Bank. It held 12,000 deposits totaling more than $200 million. The FDIC team waited for the last—

customer to leave. Cheryl Bates prepared to go in.

>> What sorts of specialists do you have on this team?

>> We have accountants. We have asset specialists who specialize in loans. We have uh people who specialize in just the physical facilities. And we have a group uh of investigators that come in and do a review on the reasons for the bank failure.

Really? Your whole team could come in and run the bank?

>> Yes.

>> Four months ago, the FDIC and state of Illinois ordered the bank to stop risky lending and raise cash, but Heritage couldn't find new investors. The night of February 27th, no one at the bank knew that the end was minutes away. The FDIC walked into all five branches at once. The chief executive, John Sapphir, was told that the bank that was his life's work was no longer his. We waited outside as they delivered the news to the employees.

>> With Heritage Bank, your pay stopped at 6:00 p.m. At 6:01, you went on a pay which was paid by the FDI. Unused vacation time, you will be paid for it. You will not lose it.

In that moment, Operation Happy looked pretty grim.

>> Correct. Because I would say a large majority of the employees don't know that the bank is in trouble and that it's about to close.

>> We want it to be as seamless as possible for your depositors so no depositor loses any money at all. And they reacted uh somewhat with dismay and shock that we were there. Um and it's it it is a very trying period for them. So it is an end to that whole chapter of their lives.

>> When we walk in, we are appear to be the bad guys.

>> I mean, some of those people have been there more than 20 years.

>> And those are the ones who take it the hardest because they feel that they have put their life into it and now it's no longer there.

>> Make sure that no one comes in without FDIC badges.

>> The employees now work for the FDIC. A public notice went up and that was the signal to a team of nearly 80 people to take over the bank. They took control of the bank website and added a notice that all deposits were safe. Then they started an inventory of all the assets and liabilities.

What's happening right now?

>> We're getting the bank personnel assigned with their FDIC counterparts. The accounting people are meeting with our accounting managers and then we have an investigations group that comes in and does a review of the bank.

>> They broke the news to the media and prepared to reopen the bank Saturday morning as usual.

>> What do you expect from the customers?

>> I think the customers will some of them will come in with a sense of of fear.

>> Fear created the FDIC in 1933 after the depression set off panics that wiped out even healthy banks. We've been around for 75 years. Nobody's ever lost a penny of insured deposits.

>> No depositor has ever lost a penny since the FDIC went into business.

>> That's right. Of insured deposits. That's absolutely right. Which is why you need to make sure you below the insured deposit limits. But no, no one's ever lost a penny.

>> And the insured deposit limit is what?

>> Right now it's 250,000. That's the base limit

>> when the FDI comes in and makes depositors whole at a bank that has failed. Right.

>> Is that tax money?

>> No, it is uh it is money from our reserves which and we are funded by insurance premiums that are assessed on banks. So no, it is it is not taxpayer money.

FDIC chairman Sheila Bear is a former Treasury official and professor of finance who's written children's books on the wisdom of saving.

>> Maybe some of the CEOs on Wall Street should have read the children's books.

>> Maybe so. [laughter] Maybe so. Bayer warned two years ago that bad mortgages threatened the financial system. Now she's managing the biggest bank failures in years, including the collapse of Washington Mutual and last summer's sudden failure of India in California.

>> We were told we would get in,

>> stay open.

>> When Indie failed, you were watching these scenes on television of people lining up outside the bank like it was 1932.

>> Yes, it was. What did you think of that?

>> So, I think people just forgot that banks do fail and how the FDIC works. Their money was safe. It was safe. It was probably the safest place in the world to have your money because we we were operating institution at that point.

>> What sort of hit was that on your balance sheet?

>> I think we ended up take uh it was over $9 billion for a $33 billion. Yes, it was very stiff.

>> The question becomes, how many times can the FDI do that? At what point is the FDI broke?

>> The FDI is backed by the full faith and credit of the United States government. So if we need to, we try not to and don't want to, but if we need to, we can borrow from Treasury to make up for any shortfall.

>> So the FDIC never goes broke.

>> We don't go broke. No, we're we are the government. We're backed by the full faith and grant of the United States government.

>> But customers at the former Heritage Community Bank outside Chicago weren't so sure about the safety of their money. On Saturday morning, the bank reopened on time.

>> And the FDIC's Ricky McCulla stood at the front door.

>> The people who were coming in this morning, what were they asking you? Can I still write checks? Uh, can I access my safe deposit box? Uh, can I use my ATM machine?

>> And to all of those questions, you answered what?

>> Yes.

>> Customer Bill Hess showed up on a mission with an empty briefcase. He intended to leave with all of his money.

>> We'd be glad to ask any questions for you.

>> I don't care anymore.

>> He said, I don't care anymore.

>> And so I became a little concerned. So I I came inside and one of the things that he told me as he opened up his briefcase, he said, well, I don't have a gun in here. So I said, "Well, that's good account." Wait.

>> McCulla explained to Hess and his wife Audrey that their savings were safe.

>> So if you have a single account, that's 250. If you have a single account, that's 250. So now that's 500.

>> Hess's briefcase was empty when he came in and empty when he [music] came out.

>> We just thought we were going to see closed and the doors locked,

>> you know.

>> So how do you feel now that you talked to them?

>> It's fine.

>> Assured.

>> Yeah.

>> Assured. Yes.

>> You feel assured?

>> Yes. Yes.

>> You had confidence in the FDI. See, right. Yeah. Now, if they can't pay you, then I won't have confidence in them either. [laughter]

>> One customer did take most of her money out,

>> but for many, their concern was for the bank employees.

>> I hope you all stay and I hope they don't let anybody go.

>> We're fine.

>> Good.

>> You just keep coming back to see us.

>> There are three ways the FDIC takes over a bank. It can close it and pay off depositors, run the bank itself, or more often, it'll try to find a buyer.

>> We do have bids from five different parties.

>> A few days before the takeover of Heritage Community Bank, we were at the FDIC office in Dallas where they were holding a secret online auction in hopes of finding a buyer for Heritage.

>> I wanted to congratulate you. We've uh chosen to accept one of your three bids. The winner was MB Financial, a $9 billion Chicago bank. The night of the takeover, all of Heritage Communities branches became MB Banks. Mitchell Fer is MB CEO. It's almost as if nothing had happened. Uh, almost nothing did happen. Uh, it's it's the same products. It's the same services. It's the same people taking care of the same customers.

>> It was a sweet deal for Figer. The FDIC paid MB Financial $3.5 million. MB got all of the deposits, customers, and loans. If some of those loans go bad in the future, the FDIC will pick up at least 80% of the losses. We wondered what Figer thinks of the health of banking today.

>> You have to believe that dozens and dozens and dozens of more banks have to fail. But it's okay. What do you mean it's okay?

>> It's okay. Because I think the process is smooth. depositors are fully protected by by an industry funded FDIC insurance. Um uh and I think that uh taking out the weak players and taking some capacity out of the industry is good. It's good for the industry. It's good for the survivors. It will produce at the end a much healthier banking system.

>> If you can put Heritage Community Bank

>> out of its misery,

>> why can't you do the same with Cityroup?

>> First of all, I I don't talk about open operating institutions. We can only uh uh deal with the resolution of a bank, a federally chartered or state chartered depository institution and uh these very large institutions that are creating the headlines. Now, these are really very large financial organizations. So, they have it's more than a bank. It's a broker dealer. It's offshore operations. It's foreign deposits.

>> We noticed that while giant banks get bailed out, investors in failed community banks like Heritage get wiped out. Ben Bernani, the chairman of the Federal Reserve, says that the system is unfair for smaller banks and that's just the way it is.

>> Well, uh I think that's true and going forward I think we need to really review the size of these institutions and uh whether we should do something about that.

>> Bear surprised us when she suggested that maybe the mega banks, those bailed out by the taxpayers shouldn't be allowed to exist in the future. You

>> know, I think that may be something Congress needs to think about. actually limit how big a bank can be?

>> Yeah. Well, you know, I think taxpayers rightfully should ask uh uh that if an institutions become so large that there is no alternative except for the taxpayers to provide support should we allow so many institutions to exceed that kind of threshold.

>> And the idea would be that no bank would grow so large that it posed a systemic risk to the economy. That'd be a very different world. It would be a different world.

>> Because Heritage Community Bank was bought by MB Financial, the FDIC didn't have to pay depositors. Even accounts over the insurance limit were safe. For Cheryl Bates, it was her fourth closing this year, but certainly not her last.

>> What do you want people to think when you tell them you're from the FDIC? I always want them to think that I'm one of the the good guys and that we want to make sure that they get their money back should their bank fail, that they are going to be okay because the FDIC is there. When President Obama spoke of the winter of our hardship in his inaugural address, no one in America understood that better than the folks we met in Wilmington, Ohio. Their people in the grip of a brutal series of layoffs at DHL, the shipping company, and their experience was part of the news this past week that new claims for unemployment benefits are the highest in 26 years. Since the economic crash of '08, taxpayers have committed to more than a trillion dollars in various bailouts of Wall Street. But not much of that is reaching families in crisis. On kitchen tables, headlines from Washington and New York lie beside unpaid tuition bills and foreclosure notices. After all the speeches and parties of inauguration day, what were the families in Wilmington asking?

>> Are we going to lose our home? you know, are we going to be able to pay our property taxes? What are we going to do for for insurance? What are we going to do for food? You know, and these are questions that you you'd never think that you'd ask yourself, you know, and now they're discussions in the home.

>> Bear hug. Big

>> I love you, buddy.

>> Michael Mockerly is losing the job that helps support four children and a grandson.

>> They always say that uh God closes a door, he opens another one. We have faith that he will.

>> Faith is what sustains Wilmington now. Settled by Quakers 200 years ago. It's a community with such an all-American look that it seems like a movie set. About 12,000 people live here and many like Omacherly work in the last industry you'd expect in a laid-back town. In 1980, Airborne Express turned Wilmington's abandoned Air Force base into a hub for overnight shipping. DHL 934 Wilmington Tower

>> 8,000 people found work at what they call the Air Park. Then in 2003, a German company, DHL, bought Airborne in an effort to win a big piece of the US market. It didn't work. The merger was rocky. There were service interruptions. customers left. And with last fall's economic crash, DHL was losing $6 million a day in the US. Layoffs started coming by the hundreds.

>> Is everybody a Thursday layoff? Everybody got laid off on Thursday. Most every

>> people who have worked here for decades found themselves in DHL sponsored meetings learning about unemployment.

>> We could tell you what we did on a daily basis, but you wouldn't believe it. You load boxes in a big container and it'll weigh 800 lb. You push it out the door through 8 in of snow and push it up on a barge. And we were idiots enough that we did it by ourselves. We worked as a team and we had a good We had a good friend right alongside of us.

>> You're losing a lot more than a job.

>> Our friends, it's crazy. You'll never understand it, but we loved it. I remember people with scarves breathing through ice and just unreal eyelashes frozen. And I started in 81 and when you worked, you worked. Why weren't we bailed out?

>> DHL is spending $260 million on severance pay and health insurance that will keep many workers going for several months. But there is a feeling in town that the German company wrecked a successful American business and wiped out thousands of jobs. I was educated here, Wilmington City Schools, and then at Wilmington College.

>> And now you're the mayor.

>> And now I'm the mayor. There were 576 hourly employees.

>> For months, Mayor David Resque has been getting layoff notices. By federal law, companies have to notify local government when layoffs are coming. And RK is getting a new letter from DHL every week or so, adding a few hundred at a time to the growing list of lost jobs. It's got classifications and numbers on it, but there's not names and addresses and who their wife or their family or their children are. And uh so you look at these and uh at the end of the day you think that's 800 and some people folks live here, work here. You know,

>> the mayor told us one out of three households has a family member working at the airpark. You are what people around here call an Air Park family.

>> Absolutely.

>> Angela and John Pika are raising four children on two Air Park salaries. Angela started at Airborne Express when she was 19. Now as a supervisor, she walks laid-off workers to the company gate and takes their ID badges away.

>> I escorted five individuals out today. Um last week I think I escorted three. What's the last thing you say to them?

>> Um, I tell them that I wish them the best and um, it's been a pleasure working with them and it has been a pleasure working with every one of them because they're a great bunch of people and them. They deserve so much better than this.

>> For a town this small, it's like the trauma of Katrina without the physical damage. People like to say their jobs drive them crazy, but for many, work keeps them sane. On November 2nd of 2003, my son was killed over the skies of Fallujah in a Chanoke helicopter that was shot down and he died with 16 other soldiers

>> in Iraq.

>> Yes.

>> At that time, Michael Mockerly was working at a plant making parts for new cars.

>> And uh the outgoing vice president um from Airborne Express, he knew I was having some problems and he said, "Yeah, we need bus drivers. Come on back out." The job at DHL

>> after his death

>> meant a lot to you.

>> Yes. I was working uh at a machining line at a factory and all I could see was his face all day long and it was killing me inside. And this job meant that I could see different people and talk to people and and kind of become human. By [bell] Christmas, the mayor had received 14 layoff letters and 3,000 people were out of work. 5,000 were still on the job at DHL, but things were getting bleak for them, too. About this time, a lot of people in the air park began to see their schedules cut. Instead of working eight hours a day, they were working four. And of course, that cut their income by half. They weren't unemployed, they were undermployed. And it turns out in this country that the number of people who are undermployed is roughly the same as those who have no job at all. Combine the numbers, call it the suffering index, and it comes to about 13% nationwide. It is certain to get worse. Jerry Lynn Thomas and Bruce McKe saw their hours cut in half.

>> I just can't afford my house. I can't afford the payment. And I had to look at, you know, trying to just feed my family, my kids. That that's my priority.

>> When was the last time you made a house payment?

>> It's been 3 months ago.

>> You start stocking up on groceries. You buy an extra can of soup or something or toilet paper, packaged toilet paper, peanut butter and stuff that you can stock in your cabinets and stuff in your freezer.

>> You've been building a stockpile of food.

>> Yes. So, you just have to start doing and you do without things and your son drops out of college early. You just do what you have to do.

>> He dropped out of college. Yeah, we had to we had to pull him. Um, he didn't go the fall and winter sessions this year. We don't have the money.

>> Did you go to college?

>> No.

>> Your husband?

>> No.

>> So, this was your dream?

>> Oh, yeah. It was my dream for my kids to have better than I had and now they're not going to.

>> Dreams are closing on South Street as one layoff creates another. I think one in five small businesses would will fail or could fail.

>> Mayor David Rusk also worries about what happens when thousands of people lose their health insurance.

>> Approximately $8 million worth of revenue for our local hospital was derived from the insurance. Now, if you take away that $8 million plus how much charity care is going to increase because people don't have insurance, you could put the hospital out of business. You think about that.

>> Our whole staff uh had a meeting and they said that they would take a pay cut. And

>> in town meetings, businesses are begging for help. US Senator Sherid Brown is asking for $100 million in federal aid for distressed communities all around the country. And he's trying to get DHL to at least donate the air park to the city.

>> There's hurt. There's a sense of betrayal.

>> Betrayal is a strong word. DHL came in uh and made promises and I don't think they lived up to their side of the bargain. That's the past. We can't dwell on that. We need to move forward. DHL we hope is going to help us with the air park.

>> In the meantime, the Sugar Tree Ministries soup kitchen is expanding.

>> We're we're actually building um remodeling our room over here. Um adding 200 more seats.

>> That would be about double what you're doing now.

>> Exactly. We should be able to feed about 350 people a day.

>> You can talk about possible medical options. You can talk about

>> DHL workers in their meetings just heard that the state unemployment benefit fund went broke last week. The federal government rushed in with an emergency loan of $500 million just to keep the checks coming. The feds are also spending $4 million here to train workers in computer skills, but that doesn't mean there will be jobs. The laid-off workers are guaranteed access to health insurance for a year and a half under a federal law called COBRA. But there's a catch.

>> We got the Cobra and it was going to be like a little over $1,500 a month.

>> That's a lot of money

>> for my healthcare. Well, you know, my unemployment is going to be $200 a week. That's not even going to make a dent.

>> When you're looking forward now, what questions are on your mind?

>> Come on. All right.

>> Where you going to go to next?

>> Where are you going to go to next?

>> Yeah. Basically,

>> we got two families living in my house right now. My husband and mine and [snorts] my youngest daughter and her husband and little baby and another one on the way. They can't make it on their own or we can't make it.

>> And Scott, you have to ask a question. John Pika may have a DHL job in another city, but they can't sell the house in this market. Angela, the DHL supervisor, is so worried that she's been looking for work, too.

>> Not one call back.

>> No.

>> How many places have you applied at this point, would you say? Roughly,

>> I would say between 35 and 40. I've been applying for everything. Everything in retail and um supervisor positions, warehousing positions. Um, I don't think anything's beneath me to do. So, but I I still haven't received any call backs.

>> Three weeks later, Angela, who spent months walking laid off workers to the gate, found herself among them.

>> Today is my last day. They'll be uh surrendering my badge to my manager today after 18 years. It's a little I'm 37, so that's almost half of my life I've been there. So, it's real now.

>> Yeah.

>> And I see they took your badge.

>> Yeah.

>> What are you thinking?

>> I just can't believe it's over. I'm not going to see a lot of these people again.

>> And with his job as a DHL bus driver ending, Michael Mockerly is relying on himself. He's turning a hobby into a business, making engraved hunting knives for collectors.

>> I'm an old school kind of guy and uh I'm looking at maybe like on Tuesday nights we're going to have no electricity Tuesday nights we're going to light the oil lamps and play checkers and and read books by the candle light and just talk to each other and maybe we'll become a tighter family through it.

>> This week, DHL will shut down all its US shipping except international service. Altogether about 10,000 people are losing their jobs.

>> Call it ground zero. Wilmington is ground zero. We've got to get back to being America because right now we're losing sight of what my son died for and what those other 16 soldiers died for. We're losing sight of it. We need to fight hard to get it back. Two years ago, most Americans voted for change. And if the polls are to be believed, they're about to do it again. In the latest CBS News New York Times poll, 80% said they want most incumbents out of Congress, regardless of whether that incumbent is a Democrat or a Republican. There is a grim mood among people who were counting on a recovery that's now fallen flat. The economists who decide such things say that the Great Recession ended back in June of 2009, but since then we've lost another half million jobs, which helps explain why there is so much anger in the land. We saw a lot of it right in the middle of the country among the people who've endured the recession longer than anyone. What surprised you the most about this recession?

>> I think the depth of it and the length of it. I think what surprised me the most about this one is it just doesn't want to end.

>> You know, the economists say that the recession's over. Really, it should come to Newton, Iowa. [laughter]

>> Dave McNeer's advertising company is like a lot of small businesses, it's getting smaller. Maxim Advertising in Newton, Iowa puts its customers logos on nearly anything. And business had only grown for 22 years until 2007. And what was all of this?

>> Um, this was filled May.

>> May invented its washing machine in Newton 103 years ago. 5,000 people worked for May Tag here. But Newton lost all of those jobs. MAG was bought out and by 2007 the factory was closed. Many of the jobs went to Mexico. No one knew it then, but these were the opening days of the Great Recession. Now layoffs that started with corporations are cascading into mom and pop shops.

>> How many employees did you have at the top?

>> 22.

>> And today

>> 10.

>> Do you remember the first person you had to lay off?

>> One of the very hardest days of my life. Uh my wife and I stayed up all night long. We we we talked, we prayed, we we struggled. And you know what, man? That's that's that's a gut-wrenching feeling. You hate it. I hate it. And I never wanted to have to do it again.

>> I wonder when you look forward now what you think about rehiring people.

>> When we hire somebody, we're we're definitely going to need them. I mean, we're not going to hire one person until we need two or three. And we're probably not going to hire two until we need four or five.

>> And that's why the recovery is lifeless, big and small. Businesses have settled into doing more with fewer people.

>> You ask people to step it up and and you know, work harder, work longer, make less.

>> Is it sort of a new normal?

>> I think for now it is. Take a quick look around Newton. Gary Forbes laid off half of his 60 employees, closed two locations, and switched from selling top quality furniture to scratched and dented. Website designer Cindy Bruner laid off six of her 14 employees. This was the Chrysler dealer, the Chevy dealer, the Tractor Supply Company. Since the recession, we've seen a lot of troubled towns in the country, but nothing that looks quite as broken as Newton. Even the local chapter of the Optimus Club has closed.

>> You know, I want to tell everybody that we're a company town or the company left, but we're going to thrive.

>> Chaz Allen is the mayor of this town of 15,000 people. It's a part-time job. Pays about $4,000 a year. Allan walked us through an abandoned May Tag plant that at its peak held 2500 factory workers building washers and dryers. If anyone out there is interested, the mayor has more than 1.7 million square ft to rent.

>> It is available. It is available. Make a good deal.

>> The mayor's been trying to pull new jobs into town. He made a run at Green Energy and got a company that makes wind turbine blades. But every time he gets a few hundred jobs, he seems to lose a few hundred. This fall, a telecom company called Windstream had two layoffs. It was 60 and then it was 146 the next time.

>> How's that affect people around here?

>> You know, it's it's a roller coaster. I I want to say that. I mean, I was affected in the first layoff. I was one that one of at the Windstream that was affected the first first round.

>> Wait a minute.

>> Yeah.

>> They laid off the mayor.

>> Yeah. Um

>> are you working now?

>> No. His town is shrinking this year. They closed an elementary school and they're slashing the city budget.

>> Have you already lost policemen?

>> Yes. Firemen?

>> Yes.

>> What about the hospital in town?

>> It's being reduced in size as well.

>> And that is the backdrop for Tuesday's election. In our national poll, we asked what's the most important issue in America. 54% said jobs. Healthcare came in second at 7%. Only 1% said the war. Newton's congressional district is bipartisan country. It voted for George Bush in 2004 and then for President Obama.

>> Hi, how you doing?

>> But now, Democratic Congressman Leonard Boswell is fighting for his job. He's been reelected here six times, but this week, his race against Republican Brad Zhan is too close to call.

>> My wife and I watched the news last night, and I I think every ad was a political ad. Who do you trust with your money, with your future? It's not Brad [music] Zon.

>> Leonard Boswell. Too wrong for too long.

>> But incredibly, Bruce Brayley [music] supports building a mosque at ground zero.

>> How much relevance does all of that have to you?

>> Nothing. Doesn't have a a bit of relevance to me.

>> We invited some of the folks in town to the Legion Hall. How many of you would say that you're angry about politics right now?

>> Yes. Oh, that got a big yes.

>> I'm sick and tired of people going to Congress in Washington DC and making a living out of it while we starve to death.

>> Does it matter much to anyone in here whether the Republicans or the Democrats control the House, for example?

>> No.

>> No.

>> Does it matter?

>> No.

>> If a Republican says it, the Democrats don't listen. If the Democrats say it, the Republicans don't care what they're saying. What gets done in Washington? What gets done at at the Iowa State House? very little gets done. I mean, everything comes down to either abortion issues, gay marriage issues there. It It needs to go above and beyond that. I don't have a job. That's all I care about. I don't care about the Republicans or the Democrats. I care about Newton, Iowa. The job situation, the financial situation.

>> We went to the foreclosure auction the other day. Nobody bid on anything.

>> Nobody has any money. help us um do something about the economy. It's um it's really hard out here.

>> The economy is not spurring jobs.

>> Todd Meyer was laid off from the same telecom company that laid off the mayor.

>> You served in the Gulf War.

>> I did.

>> You were in the Navy. Yep. In combat there.

>> Yep. USS George Washington.

>> And now you're unemployed.

>> Yes.

>> Meer and his wife Teresa are raising three kids. Their daughter Caitlyn is the first in the family to go to college.

>> I get emotional about it because it's just, you know, we never expected to be in this position, but [snorts] you know, I look at my daughter and I just think, how do I keep her in college?

>> It's every parent's dream to send their child to college, especially if that parent didn't have the same opportunity. I've had this dream since I was really little and my parents have done everything they can and it's just starting to get hard and I'm going to try and help out but it's hard to see that dream slip away.

>> How many of you think that your children will enjoy the same standard of living that you did?

>> This worry pessimism really weighs on families who had seen a different future. How many employees did you have at the peak?

>> 22.

>> How many do you have now?

>> I'm down to seven. Half pepperoni, half pineapple. All right. Fantastic.

>> Scott Creech bought his own pizza franchise in Newton 21 years ago.

>> How many hours are you working?

>> Last week it was 82.

>> 82 hours in a week.

>> Correct.

>> How long can you do that?

>> Uh until I die. Sales have slipped to a place that's sometimes dangerous for his family.

>> Once you get down around this area,

>> I may be able to file for food stamps.

>> His wife Julie is working at a school to take some of the pressure off.

>> He's 52 years old now and I worry about him every day. His brother um died of a heart attack when he was in his 40s and I worry about that all the time.

>> Hello everybody.

>> Hi. How are you?

>> His son Parker is 10. Creech comes home to put Parker in bed, but then he heads back to the shop. He washes up and closes up about 1:00 a.m. I wonder what the stress has been like for you. I've been blessed. You know, you have guilt. Guilt about what?

>> You'd like to have that 8 toive job, holidays off, but you can't do that now. No. Nationwide, the number of small businesses going bankrupt each year has tripled since the recession. There were 60,000 bankruptcies last year alone. When you're looking for the path out of this flat recovery, there are a couple of things that strike you. One, small businesses create most of the jobs in this country, 65% of all new jobs. But lending to small businesses is actually declining. In the second quarter of this year, lending to small businesses and farms dropped by $13 billion. That's nearly 2%. So, 3 years after the beginning of the Great Recession, with interest rates the lowest they've ever been in history, banks are lending less money to the engines that create jobs.

>> Have you gone to the bank?

>> Yeah. That that that's amazing cuz you know, you you you hear stories about how lending is going to be more friendly and and you know and and you know, even the president himself is is you know, going to tell banks that they need to they need to to understand what businesses are going through. There's no banks. The banks don't understand anything. They won't loan me a dime.

>> And you went you went to the bank and they said what?

>> Come back when you have a couple of good years behind you. Really? Cuz I won't need you then.

>> They'll offer money to you when you don't need it, but when you need it, you can't get it.

>> Perfect. Okay, we like to hear that. Here's your

>> Alan Yagi has been losing money at his jewelry store on the courthouse square for a year and a half. He makes a lot of his own jewelry and to try to match his customers falling income, he switched from gold to silver, diamonds to beads. His employees, Darlene Swank and Tina Kono even volunteered to cut their hours.

>> You're going to have to let Tina and Darlene go.

>> It's hard.

>> It's hard.

>> Do you remember when you had to sit down and explain it to them?

>> Yeah, I talked to Darlene first. I didn't have to say anything. She knew, you know, she does her books and she knew.

>> And what did the books tell you? Help me understand.

>> You just can't keep doing what you're doing. You um as hard as it is, we tried.

>> His store closed this weekend. More layoffs reduce demand, which creates more layoffs. Change may be coming again to Washington, but in Newton, many believe the struggle will stay the same as family businesses work to steal another day from the Great Recession.