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.

When The Shit Hit The Fan

Back in March, Bear Sterns sold themselves to JP Morgan while on the brink of almost certain bankruptcy as we so brilliantly chronicled here at Wheeeeeeeeeeeeeeeere's Luke. It was a financial failure that shocked many and the first failure of a major financial institution since Long Term Capital failed back in the 1990s.

Ah, the good old days.

Over the course of the last few months, and especially the last week the shit has truly hit the fan.

The US Government had to make explicit what was once implicit: they backed up Fanni Mae and Freddie Mac, two private but yet public corporations that had a piece of 70% of all American mortgages and in whom most of the world's nations held significant amounts of bonds.

Their downfall would have brought the world economy to a screeching halt.

And, so, to avoid this we bailed them out at $200 billion apiece.

Then, last week Lehman brothers, bailout-less, went into bankruptcy and Merril Lynch sold themselves to Bank of America to avoid a similary fate.

But the real kicker seemed to be my former employer, American International Group. As they teetered on the brink of failure The Fed initially threatened to let them fall while trying to push Goldman Sachs and JP Morgan to bail them out for what was $40 billion, then $50 billion and then $75 billion dollars.

No dice, said the I-bankers.

The government didn't want to have to guarantee their investments and Goldman and JP Morgan weren't going to take that risk.

AIG is an enormous company that does many things: insurance, aircraft leasing, money management, port owners just name a few and I think no one felt they could have possible done an even remotely reasonable amount of due diligence in a day or two.

And, so, The Fed blinked and bailed out AIG.

Why Bear and AIG and not Lehman?

Well, I think it's because while Bear Sterns and Lehman were both the same thing, Investment Banks, essentially what the difference was no one saw Bear about to fall whereas everyone was sitting around sort of watching Lehman fall apart for six months - lessening the investor panic when the eventually fell whereas a Bear fall would have been much more jarring to the markets.

Now, with AIG, I think the problem was, of course, the 'no-one seriously saw this coming' factor but they were also really just too big to let fail.

At the heart of this whole things are CDOs, or credit default swaps, and if you don't know how they work you can check it out here.

AIG was so big and had so much money in these CDOs, basically, insuring banks against potential defaults that if they were to go under it would have meant that those banks that they insured would then have to account for that increased liability on their balance sheets - showing a lot more debt.

To offset all that debt, they would have had to raise more cash but AIG had something in the neighborhood of $500 billion in of these CDOs - that's a lot of pesos.

To put that much debt back into the market overnight would have been catastrophic because none of these banks are liquid enough to come up with cash that quickly which could have resulted in many more banks going under.

And so, The Fed bailed out AIG.

Basically, the financial sector has turned into a giant Jenga game and everyone was too afraid that to pull out the AIG pegs would make the whole fucking thing fall.



It was not, however, a game saver and while the market continued to dive the undertakers sized and sold short on WaMu, Goldman and the like forcing them to consider selling themselves or face dire consequences.

No one knew where it would stop and that is why The Fed has proposed throwing $700 billion dollars at this problem.

Now, I don't profess to really know how to solve this problem, but first we have to identify the problem and what I think is that there are two problems.

First, with these CDOs, basically what happened was that people writing mortgages were able to sell them off and not 'live' with them so they made their money not on getting paid back but on the up front fees and costs which made it beneficial for them to relax their criteria for giving out mortgages. The companies buying these CDOs were making pretty good coin on them for a long time as well. And of course, Americans wanted bigger and bigger houses.

The thing is, everyone lost touch with reality which is that they housing boom had to end eventually. And it did, in a big way.

So, there's that.

But here's the thing that we don't really want to admit.

The problem really is bigger than AIG and Fannie and Freddie and whoever else may have invested unwisely.

The problem.....(drumroll, please)...is Americans.

(I said it, I said it!)

It's me and most of you.

We live our lives buying shit we can't afford. Wanna go to Vegas? Charge it! That house? Charge it! That car? Those shoes? That expensive dinner? That war in Iraq? Those tax cuts? Charge it! Charge it! Charge it! Charge it! Charge it!

We are a Veruca Salt Nation.

"I want it noooowwww!"

At some point that is going to have to change: we can start following a budget or we're going to go broke.

Now, I'm all for getting out of this serious emergency but along with plugging a hole, we have to go on a fiscal diet.

That maybe means no tax cuts and maybe some raises.

That means losing benefits.

That means driving that toyota for another five years instead of getting that Benz you've beeing dying for.

That means figuring out what the fuck we are, in fact, going to do with Medicare once and for all.

So yes, let's step back from the brink and bail ourselves out but let's not kid ourselves: we are bailing ourselves out on a giant credit card courtesy of the U.S. of A. and we're going to have to pay it back, along with our kids and grandkids and, so, we need to wakeup and realize we don't just need to get our I-Banks in order.

We need to put an end to The Credit Card Culture.

Whoa No Shoot

I don't know if anyone else is interested, but I'm kind of fascinated by Bear Sterns - they had been the # 5 Investment Bank on Wall Street until quite recently - going under.

Their stock had peaked at, like, $170 a share in 2007 and yesterday, it was sold for $2 per share. Having been going, very part time, to business school for four months I can tell you that that's a lot less.

So what happened?

I don't profess to have a deep understanding of the financial markets, by any means but I'm going to take a shot at what happened, as I understand it - albeit in overly simplified terms - and anyone that understands it, please jump in.

Bear Sterns is an Investment Bank and basically what that means is they have a shitload of other people's money (billions) and they take that money, invest it and try to make more.

One of their investments was in the the subprime mortgage market. When Fannie Mae or Countrywide or whoever, sell all those mortgages, they are owed billions of dollars by home owners/mortgagees (collectively). They're taking a risk people can't pay them back - the higher the risk you won't pay them back, the higher the interest you pay because it's more of a risk. And when you're a pretty high risk, they call you subprime and charge you a very high rate.

All of this debt is amassed by the mortgage companies and because they don't want to take all the risk themselves, they sell it off to investors and pay them a percentage in order to take the risk from them (if people start defaulting, they lose the money too.)

With all this debt, they essentially made towers of debt and I-Banks bought the debt at some level on the tower, accepting the risk of the people defaulting on the loans, picture this:


If you have the blue layer, you may get paid, say 10% interest on your level and there is a 3% risk of people in your section defaulting, you reflect that on your balance sheet as a 7% profit margin (as long as people don't default); if you're red it may be 8% and and 2% for 6% profit, etc.

Basically what happens is even if these banks weren't in the blue, where losses due to defaulted mortgages were actually paid out, they still took a balance sheet loss because they were getting paid as if there risk was the red level but the risk was actually in the blue level now because after part of the blue level was eroded the red had to drop down - closer to the actual risk of mortgage defaults - which is less of a profit than they said they were making, and now they have to write that down on their balance sheet as a loss.

Multiply that by four kajillion, and that's a big loss and because Bear Sterns had put too many of their proverbial eggs in the proverbial subprime basket, when people started defaulting due to the slumping housing market, BS had to write down like a trillion dollars (it may be in the billions but I'm not going back to look it up and, anyway, the point is it was a lot of money).

Investors started freaking out and were no longer trying to invest with Bear Sterns as well as pulling money out and, with their funds in jeopardy, their stock price plummeted.

All this led to the choice of going bankrupt or being bought out.

They went with terrible option B, which is how JP Morgan was able to purchase the decades-old former Wall Street giant for 1.2% of it's peak value in 2007.