Monday, October 19, 2009

Eight Days: A First-Hand Account of the 2008 Financial Panic

LJT did two excellent posts on the Bear, Lehman and AIG components of the financial collapse a while back. But he was writing those as the events developed, and with no benefit of hindsight. And, also, LJT is just some gie, not a reporter, so he didn't get to interview lots of people about what happened.

We are now more than a year removed from that week in September when the final unraveling began. This dude from the New Yorker decided that while LJT's work was good, he wanted to build on it. So he went and interviewed pretty much everyone who was involved in the financial crisis that exploded in September of 2008. Since there are six people who read this blog, I am comfortable that the New Yorker will not come after me for copyright infringement, so if you want a copy I will send you the PDF. I would put the link here, but you have to register for the site in order to access it. Assuming you don't want to do that, he basically explains the financial crisis this way:

1). Lehman Brothers had a leverage ratio of 30 to 1 (i.e., for every dollar of assets, it had thirty dollars of debt). So in the face of significant losses by Lehman on sub-prime mortgages (which had been packaged together and sold as investment products to pension funds, insurance companies, and other institutional investors) investors start to worry that Lehman's assets were insufficient to cover its liabilities, which begat a run on Lehman;

2). Politics, poor communication, and artificial line-in-the-sand-drawing, resulting in no government bailout for Lehman, begat the Lehman bankruptcy;

3). The Lehman bankruptcy begat the "breaking of the buck" at the Primary Fund (i.e., a money market account whose value fell under $1.00 per share - a previously theoretical (but now not so much) scenario in which a money-market fund (basically a savings account, but not FDIC-insured) has insufficient assets to cover all deposits);

4). The breaking of the buck at the Primary Fund begat a run on all money-market funds with investors pulling $4 trillion out of the private sector and putting it on deposit with the government (in the form of T-bills);

5). The run on money-market funds effectively suspended the purchase of "commercial paper" - short term debt issued by companies like GE, FedEx, etc. to fund daily operations, payroll, and the like.

6). The inability of companies to access the credit markets and obtain liquidity to operate threatened to create a run on the bank and become a widespread and irreversible panic.

And while all of this was going on, AIG was on the verge of collapse because one division of the company - the Financial Products division - was facing staggering losses on credit-default swaps (CDSs). Through CDSs, AIG basically provided insurance to investors that if a security (a bond, a pool of securitized assets, a stock, etc.) defaulted, they would pay the investor's losses. And as the risk of default increased, AIG would post additional collateral to prove that they could cover in the event of an actual default. So as subprime mortgage crisis ballooned, and more and more borrowers started defaulting on their home loans, which led to more and more defaults of the now-infamous "mortgage-backed securities," this division of AIG had to post more and more collateral. So even before an actual default, the mere increased risk of default was proving unmanageable for AIG.

But if AIG failed, everyone who had insurance (and therefore valued their investment by accounting for both the investment itself and the value of the insurance on top of it) would be sitting on uninsured investments that were tanking by the hour. It would be (sort of) like if everyone driving in Manhattan found out at the exact same time that they were uninsured, and there just happened to be a blizzard going on at that very moment (sort of). There would be a mass exodus from the roads, and the fear of lots of car accidents would become a self-fulfilling prophecy. The sudden instability that thousands of institutions would have faced from the change in their investment portfolio would have had catastrophic consequences.

So the government bailed out AIG, because as LJT noted even a year ago, they really were too big to fail. But one of the author's points is that, in light of the dominoes that came down after Lehman failed, maybe it was too big to fail, too. Because once it did, the only way for the government to stabilize the markets and prevent another Lehman-type failure was to inject $700 billion directly into the financial system.

In the end, he is sort of critical of the decision to let Lehman fail, but acknowledges that these guys were making impossible decisions with no time for any real study, and they had to balance political, financial and other unknown factors in making their decisions. There was no playbook for this, so even if they should have stepped in to shore up Lehman, it is tough to fault them for that now. Particularly because (a) if they had, they might have only been delaying, and not avoiding, the total collapse that followed the Lehman bankruptcy, and (b) every other decision they made both before and after the Lehman bankruptcy - to get the TARP funds in sufficient magnitude to prove that the government was on top of the problem, to back-stop money-market funds, to restrict short-selling in financial stocks, to bail out AIG, etc., etc., - has proven to have had a stabilizing effect on the markets and mitigated the problem considerably.

Or, to put this post more succinctly: this is, without a doubt, the best and most comprehensive description of the financial collapse that I have seen. You should read it.


ChuckJerry said...

Send it to me, please.

Is the Bear Sterns thing not related at all?

Open Bar said...

Hm. I'll check it out.

Best thing I've read in a while on the whole financial collapse, though obviously quite different from the New Yorker piece: