ONE
BACKGROUND
On September 11, 2008, seven years to the day since the terrorist attacks on the World Trade Center and the Pentagon, America found herself under attack again. This attack was nonviolent, and went undetected by the vast majority of the country, but was no less audacious in its execution and promised immeasurable devastation. No terrorist organization was behind this attack. It was brought on by market panic.
The market had been shaky and volatile all year to that point, suffering the combined uncertainties of a handful of high-profile corporate failures and the looming presidential election. Americans were peripherally aware of the overall malaise at that point, but they had no sense of what was about to come. Under the surface, a vast cauldron of toxic assets was boiling, and the noxious brew was coming to a head.
According to Congressional testimony, market watchers at the Federal Reserve noticed an unusual spike in the outflow of money market funds on the morning of September 11. As they stared at their screens, the spike quickly mushroomed into a mass exodus. In just over an hour, $550 billion disappeared from money market accounts. They realized something was very, very wrong.
The protocols in place at the time demanded Treasury involvement, so the call went out from the Fed to the Treasury. The Treasury response was to flood the market with more money. They injected $105 billion into the market, thinking such a massive sum would ease the strain. The money was gone in minutes.
The Treasury realized too late that it was an electronic run on the banks, and was forced to exercise their nuclear option and shut down all money market accounts for the day. To ease further panic, they agreed to guarantee all money market accounts up to $250,000. Left unchecked, the run would have drawn five and a half trillion dollars out of the money market by two o'clock, according to Treasury estimates.
“It would have been the end of our economic system and our political system as we know it,” said Rep. Paul Kanjorski (D-PA), chairman of the Capital Markets Subcommittee. “If you don't have a banking system, you don't have an economy.”
Early the following week, Treasury Secretary Hank Paulson appeared before Congress to propose the framework of the Troubled Asset Relief Program (TARP) and to ask for $700 billion to fund the program.
In its earliest incarnation, TARP was meant to purchase the toxic assets underlying the collapse in the world markets. I make the point of saying world markets because the actual authorization also allows for the purchase of foreign troubled assets at the Treasury Secretary's discretion.
Within weeks, however, it was determined that $700 billion was inadequate to buy enough troubled assets to make a difference. The program was then redesigned to provide Tier 1 capital to banks (the core capital which represents a bank's equity and reserves) in the hope of making the aid more effective.
“It was much cheaper to put more money in banks as equity investments than to start buying their bad assets,” Kanjorski continued. “Because it became early determined that we'd probably have to spend three or four trillion dollars of taxpayers' money to buy these bad assets. And we didn't have it. We only had $700 billion.”
The legislation provided broad latitude to the Treasury department vis-a-vis the execution of TARP, and enabled the Secretary to make the changes deemed necessary with a minimum of Congressional wrangling. For this reason, TARP oversight has been a political hot potato since the beginning.
By December 31, 2008, the Treasury doled out $247 billion of the original $350 billion authorized. This included $178 billion in capital purchases exclusive of AIG ($40 billion), Citigroup ($20 billion), and GMAC ($5 billion), according to the Congressional Budget Office report in January 2009.
At the time of this writing (May 2009), all but $37 billion of the $700 billion authorized has been committed. The largest individual recipients have been AIG ($70 billion), Citigroup ($50 billion), Bank of America ($45 billion), and the U.S. automakers ($48 billion). Additionally, $149 billion has been distributed to various financial firms.
$100 billion has also been set aside to fund TALF (Term Asset-Backed Securities Loan Facility), an Obama administration mandate to ease consumer lending. This number is expected to swell to as much as $1 trillion (by the administration's own admission) and will most likely become a separate program altogether. Another $100 billion has been used as seed capital for the Public-Private Investment Program (PPIP), and an additional $50 billion is earmarked for relief to struggling homeowners.
HOUSING BUBBLE
In simplest terms, the underlying cause of the global financial crisis was the various real estate bubbles in the U.S., Europe and, to some extent, Asia. Exacerbated by rising commodities prices driven by the cost of crude oil, consumer spending dropped and demand for housing waned.
In the United States, the crisis was more acute due to the proliferation of sub-prime mortgages. In the 1990's, Congress issued a mandate under the Community Reinvestment Act that required banks to lower their lending standards to make home ownership possible for buyers who wouldn't traditionally qualify for a home mortgage. This opened the real estate market to millions of buyers that would have otherwise not qualified to participate, creating an explosion in the demand for housing.
In the early years of the 21st century, the housing market reached a fever pitch. Spurred by historic lows in interest rates and lax lending standards, property values rose across the country, and skyrocketed in high demand markets. In some markets, homeowners were re-financing their properties annually to cash out the accumulated equity. Defaults and foreclosures weren't much of a concern, as the defaulted property was generally worth more than the loan amount.
Eager to capitalize on the booming housing market, investment banks and traders created securities out of bundled mortgages and sold these securities to investors. This was the birth of the modern derivatives market. These securities were known as Collateralized Debt Obligations (CDOs) because the mortgages were debt instruments that were backed up by the underlying property as collateral.
Bundles of mortgages contain many different terms and rates of interest, as well as a variance in the value of the collateral and the creditworthiness of the borrowers. Hence, a given CDO was broken into different tranches, or levels of quantifiable risk.
The top tranche represented the best of the bundle. Comprised of the most credit worthy borrowers and the most conservative collateral, this tranche was considered AAA rated investment grade paper. It represented the least risk and paid the lowest rate of return. The primary market for the top tranche of a CDO were risk-averse investors and institutions such as pension plans.
Incidentally, investment banks made the top tranche of many CDOs even more attractive to investors by insuring them against loss. This insurance is known as a Credit Default Swap, and works in much the same way as municipal bond insurance. The single largest provider of Credit Default Swaps to investment banks was insurance giant American International Group (AIG).
The lower tranches of a CDO included less credit worthy borrowers and less reliable collateral. As an investor went from the top tranche to the middle tranche to the bottom tranche, his rate of return increased along with the risk of default.
All was well as long as housing prices continued to appreciate. Defaults were infrequent and negligible in cost. The steady stream of home buyers continued as banks lowered their lending standards. Banks had little to risk because they bundled the loans and sold them to Government Sponsored Enterprises such as Fannie Mae and Freddie Mac almost immediately.
Lending standards became so lax that terms such as “No-Doc” loan (a loan given to someone with no documentation to prove income, debt ratio, or ability to repay) became common parlance. Mortgage brokers even had an industry term for these loans. They called them NINJA loans (No Income, No Job, no Assets).
The loans themselves morphed to meet market demand as well. Traditionally, a home owner would choose between a 15 or 30-year fixed rate mortgage. At the height of the housing boom, adjustable rate mortgages were all the rage. Low “teaser” rates were offered to buyers to keep payments affordable until the rate adjusted higher at some point in the future.
When even adjustable rate mortgages couldn't keep up with rising home prices, interest-only loans were made available (where the home owner paid no principal, only the interest on the loan), negative amortization loans hit the scene (where the principal amount due on the mortgage actually increased each month), and finally, extended term loans like 40-year negative amortization adjustable rate mortgages.
CDOs fueled a large part of the speculative bubble that manifested itself in real estate prices. In 2006 alone, CDOs accounted for almost $1 trillion in mortgage issuance, by that time mostly sub-prime. $200 billion of the CDOs issued in 2006 were comprised of an average of 70% sub-prime mortgages.
Housing prices began to drop, and the adjustable rate mortgages generated three to five years earlier began to adjust higher. Unable to make the higher payments or re-finance their mortgage in a declining market, home owners began to default on their loans. The increasing number of foreclosed properties on the market forced home prices lower still.
The increasing default rate and significant downgrades by the ratings agencies caused the lower tranches of the CDOs to implode. Investors who sustained heavy losses no longer had an appetite for mortgage-backed securities. To add to the problem, sub-prime mortgages crept into the AAA rated top tranche of many CDOs, causing a fallout in investor confidence across the board.
It can be argued that this quality creep was caused by the ratings agencies' complicity or the fact that CDOs are traded over the counter (as opposed to exchange-traded securities) where they cannot be regulated. To be sure, there will be much greater government oversight of the derivatives market in the future. But the damage was done.
With effectively no market for CDOs, investment banks found themselves saddled with billions in what are now known as “toxic assets”. With default rates climbing and the value of the underlying collateral collapsing, these toxic assets were blowing huge holes in the banks' balance sheets.
This is where counter-party risk enters the market. After years of trading over the counter CDOs among themselves, packaging and re-packaging the underlying mortgages, and selling and re-selling the same mortgages to investors, the banks became hopelessly intertwined and dependent upon one another.
Sensing the impending disaster, banks endeavored to discover what it was exactly that they owned, and what their overall exposure was to default by counter-party banks. Many discovered that they were in bad shape, and if one of their counter-parties defaulted they were doomed.
The market seemed to sense this as well, and bank shares began to plummet. In March 2008, 85-year old Bear Stearns collapsed under the weight of their leveraged derivatives and had to be acquired by JPMorgan Chase with government assistance. Their stock had been as high as $133 per share in the previous year. Bear was sold to JPMorgan Chase for approximately $10 per share, despite Treasury Secretary Paulson's insistence on a punitive $2 per share sale price designed to send a message to Wall Street that there would be no more government bailouts.
The market staggered around the ring for several months as one body blow after another rained down on it in the form of liquidity concerns, lack of credit, and declining share prices. The knockout punch came in September 2008 when 158-year old Lehman Brothers was forced into bankruptcy.
The cat was out of the bag, and the government knew there was no hiding the fact that financial Armageddon was upon the U.S. The day after Lehman's bankruptcy filing, the government stepped in to save AIG, at the time the 18th largest public company in the world.
When it came to counter-party risk, AIG was king. The majority of the credit default swaps that insured the AAA rated tranches in the CDO market were underwritten by AIG. The government knew that if AIG failed, so would all the major banks.
In exchange for 79.9% of the company, the government provided AIG with an $85 billion loan. This figure proved woefully inadequate, as the total government investment in AIG now stands at $170 billion.
By the end of September 2008, the credit markets were effectively frozen. No banks were willing to lend to any other banks, because major banks were defaulting and going under in the space of 72 hours. Even an overnight loan might never be heard from again.
The stock market, already down 20% for the year, was on the verge of total collapse...
