The Financial Crisis

This is the BONUS fourth post. Just wanted to wrap up the long and complex story. So the last time we left off, it was March 24, 2008 and Bear Sterns was just bought by JP Morgan for $10 a share. To set the stage, Tibetan Protests were just getting violent with the Olympics months ahead, Barack Obama is still three months away from clinching the primary, and Pennsylvania is still weeks away. Fast forward a few months to mid July. If you recall, for the past several years there was an active and premeditated effort on the part of Wall Street lenders to cut into the market share of the government mortgage lenders, the Federal Home Loan Mortgage Corporation (“Freddie Mac”) and Federal National Mortgage Association (Fannie Mae). By 2008, these two organizations either owned or had acquired the risk of 6 trillion dollars worth of American mortgages, around half of the entire market. As you might imagine, this made them very exposed to the housing market, and when the value of the American home started decreasing for the first time in several generations, FMAC and FMNA felt it more then investment banks who had other investments.

And around mid July 2008 Henry Paulson saw that there was another crisis of confidence on the horizon and, recognizing that if anything were to happen to either Fannie Mae or Freddie Mac, Half of American homeowners still paying back their mortgages would be in hot water very quickly. All of a sudden both stocks go down around 60%. So Paulson requests congress that, if it gets bad enough, He and the Treasury have the ability to place FMAC and FMNA under Government Conservatorship. So right then, FMAC and FMNA’s problem goes from “How do we get our Stocks Up?” to “How can we stop Hemorrhaging money?” And the answer to that is to go to investors.

The investors, however, are in a quandary. Many of the people who invested in Bear when they were in a similar position lost their shirts when they received cents on the dollar after the sale to JP Morgan. This was still very, very fresh in the mind of investors. So Investors told Dan Mudd, the head of Fannie Mae, that when the government says they’re not going to take you over we’ll give you our money, but until we get assurances of that, its too risky for us to give you anything. So there’s no inflow of capital into either company. And the treasury has stalled and is unwilling to give any indication either way. So the two companies are in limbo.

So then, having scared away potential investors and now forced to resort to his last ditch option, Paulson informs the Boards of FMAC and FMNA that the Treasury has bought 80% of their stock, that the CEO and Boards are out, and that Treasury selected Boards and CEO are in. There are two ways of looking at this. One end suggests that it was completely necessary for the survival of the American economy, which has some heavy validity to it; The 6 trillion under control of the two companies is essentially the bedrock of mortgages in this country, and theyre seen almost as secure as US Treasury Bonds. Capital markets would have seized up and the Global economy would have basically suffered a stroke if anything happened to Freddie and Fannie. The other viewpoint is that, had FMAC and FMNA not gone under conservatorship, Lehmen would have been able to get enough capital to say afloat, but that acknowledging the bad debt just torpedoed that. But that comes next anyway. I personally think that the first analysis is most prudent and least speculative.

The thing to take away from this is that what Paulson saw as a necessary action for the preservation of American capitalism, traders saw as waving a white flag. Consumer confidence wasn’t just low, it was as if Henry Paulson had personally beaten it mercilessly and took its lunch money. So when Lehmen got in trouble, there was no way anyone was going to take a risk, and take any sort of action that wasn’t a B- line for a life boat off of the USS Lehmen.

Understanding what happened to Lehmen Brothers requires understand what exactly Lehmen Brothers specialized in. A major source of income for them was the Prime Broker, where they would handle all of the little, backroom transactions for major hedge funds. It alleviated much of the work for hedge fund managers and was a very, very profitable service Lehmen provided. The issue is, when investors call their hedge fund manager and alert them that they are uncomfortable with Lehmen handling their money, it was a one simple phone call and that’s all it took to have, for instance, Goldman Sachs be your prime broker. And if enough people go scared and called their hedge fund manager, this could lead to a massive hemorrhaging of cash.

On September 5, JP Morgan asked Lehmen for 5 Billion dollars in cash to cover collateral. JP Morgan handled most of Lehmen’s trades, so this put Lehmen in an awkward position. However, Lehmen has larger problems. They needed financing very, very quickly or else they would not be able to stay in business. They had discreetly attempted to secure financing from a laundry list of financial services, including Barclays, Bank of America, HSBC, Morgan Stanley, various kings and royalty in the Middle East, and even Warren Buffet. When their last attempt at courting a Korean Bank to fund them went south, word got out they could not get the cash and their stock dropped 45% in a day on September 9. Lehmen couldn’t secure funding mostly because they would not accept that the mortgage based securities had decreased in value as much as they had in reality, so they asked far too much for something that other companies had settled for a quarter on the dollar. CEO Rick Fuld refused to settle and would not acknowledge the problem, only wasting valuable time that could have been spent negotiating for the salvation of their company.

Within Lehmen Brothers, people are absolutely freaking out. They announce restructuring plans, beg and plead people to stay with them, march on CNBC and announce that everything will be OK, and avoid mentioning the fact they now need 3-5 Billion dollars to stay in business. The Fed wanted absolutely nothing to do with Lehmen, which they saw as a firm actually evaporating in front of them. JP Morgan asks for a additional % Billion dollars in order to finance more collateral in the even of defaulture on the part of Lehmen Brothers. In a twist, it is this very act that causes the defaulture of Lehmen Brothers.

On September 12, the Fed contacts the heads of the major banks on Wall Street and makes it abundantly clear that, because of moral hazard, the Fed will not be bailing out Lehmen Brothers. The fed believe a bailout n this case would send out the message that capitalism does not have consequences. Still hurting from Bear Sterns, the Fed would not open itself up to this big of a risk. Some lawmakers, such as Chair of the House Financial Services Committee Barney Frank, believe that in retrospect saving Lehmen Brothers, while still a moral hazard, would have prevented the domino effect we saw in the upcoming weeks of banks being knocked over left and right. There isn’t a way to tell, but I believe that argument has validity. The Fed simply miscalculated risk.

The next few days, specifically September 16 and 17, are confusing, frenzied, and catastrophic to global economic continuity. AIG was very, very bad. AIG was first and foremost an insurance company. They were turning profits. They are still turning profits. On September 16 their stocks fell 61% and by the afternoon Bernake, after meeting with Paulson, takes 85 Billion out of the 800 Billion dollar Federal Reserve rainy day stash and buys up 80% of AIG to stop the calamitous fall. AIG had simply miscalculated risk. They had issued insurance to people against the failure of Lehmen Brothers, and who could blame them? Lehmen brothers was a secure, storied, and profitable financial institution, and the risk of Lehmen evaporating was similar to the likelihood of a single hurricane leveling Washington DC, New York City, and Boston. It was blindsided. AIG also did not fall under the jurisdiction of the SEC, since decades of ‘deregulation’ had made it so the SEC could not adapt to a changing financial climate, instead stuck in the 1980s. The SEC could not oversee the credit default swaps, the financial insurance, to prevent the failure of AIG.

If all a sudden, out of nowhere, AIG was unable to make good on all of the credit default swaps for Lehmen and every other company who would go down, it would actually lead to the global markets having a stroke. It would mean the failure of the economy on a scale never seen before, not even the depression. Bernake and Paulson know this. On September 17, Bernake tells Paulson that they need a bailout. On September 18, they go to congress and inform them- very, very correctly- if they do not get the money they need the United States of American will not have an economy on Monday. If the banks go down and credit dries up, then this hits every American in the sense that all non cash transactions will not be able to electronically happen.

So at 1:30 in the morning on September 20, Paulson submits a three page bill that asks for $700 Billion, no strings attached, no agency can oversee anything, and no court can do anything. Right now the government is, in simple terms, giving the banks money to compensate for the gaping distance between what a financial service was actually worth in reality and what the Gaussian copula Function implied it was worth. On Septemeber 21 an era ends and the last two surviving investment banks, Goldman Sachs and Morgan Stanly, become bank holding companies and submit themselves to the jurisdiction of the federal reserve. On September 25, the day when WaMu become the largest bank failure in history, President Bush meets with McCain and Obama and Senate and Congressional leaders for a debriefing on the response to the event.

The house, underinformed and having a kneejerk reaction to this plan so close to election season, turns down the plan causing the Dow Jones industrial average to drop seven hundred points on September 29, the largest drop in history. On October 3, the house passes a slightly revised bill which gives the treasury broad authority. Finally, on October 13, Bernake, Geithner, and Paulson meet with the heads of the largest surviving banks informing them that, whether they like it or not, they will all be accepting capital to ensure that markets stabilize. Of the 250 Billion dollars, half is loaned to JPMorgan, Bank of New York Mellon, Merrill Lynch, State Street, Morgan Stanley, Goldman Sachs, Bank of America, Citigroup, and Wells Fargo, and the other half is loaned to a multitude of smaller banks.