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Kindle Notes & Highlights
by
Ray Dalio
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February 23 - September 1, 2019
While notable because it was a canary in the coal mine, Countrywide was not a systemically important financial institution.
At the time, Value at Risk (VAR), which is a measure of recent volatility in markets and portfolios, was commonly used by investment firms and commercial banks
That’s because low volatility and benign VAR estimates encourage increased leverage. At the time, some leverage ratios were nearing 100:1. To me, leverage is a much better indicator of future volatility than VAR.
Tim Geithner, who was the president of the New York Fed at the time, shared my thinking. He believed the moral hazard
framework was the wrong way to think about policy during a financial crisis because policy needs to be very aggressive in taking out catastrophic risk, and one can’t move slowly or precisely.13 That has proven true time and time again. Providing plenty of liquidity during a liquidity crisis leaves the government open to less risk and leaves the system healthier. In contrast, the moral hazard framework leads people to believe that if you let things burn, the government will assume less risk. In reality, if you let everything burn, the government will end up taking on all of the risk, as it will
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On September 18, 2007, the Fed cut rates by 0.5 percent, compared to the 0.25 percent expected by the market.
The banks’ (and investment banks’) balance sheet and liquidity problems were on both the asset side and the liability side. On the asset side, the problems stemmed from the banks’ ownership of subprime mortgages through securitizations. On the liability side, the banks had become dependent on risky sources of funding. Banks had always relied on short-term funding, but historically this had consisted largely of deposits, which could be controlled with guarantees. Savers can always pull their deposits, and widespread fears about bank solvency had led them to do just that in the Great Depression.
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On October 9, 2007, the S&P 500 closed at its all-time high. That high in stocks wouldn’t be reached again until 2013.
Meanwhile, despite optimism at home, the credit crunch spread from the US to Europe through two main mechanisms. The first was that some European banks (most notably the British bank Northern Rock) had come to rely on money markets for short-term wholesale funding. When that source of funding began to dry up in the summer of 2007, Northern Rock experienced a classic “run,” with depositors lining up to withdraw funds for three straight days in the middle of September.
US stock prices suffered a steep 2.6 percent decline on October 19, after JPMorgan posted a $2 billion write-down and Bank of America announced much weaker-than-expected earnings.
More specifically, in the three decades leading up to the crisis, a huge market in over-the-counter derivative contracts (i.e., those not traded on regulated exchanges) developed. In December 2000, Congress clarified that as long as these over the counter contracts (OTC) were between “sophisticated parties,” they did not have to be regulated as futures or securities—effectively shielding OTC derivatives from virtually all oversight.18 Over the next seven years, the OTC market grew quickly. By June 2008, the notional value of these contracts was $672.6 trillion.
A key derivative that would play a major role in the financial crisis was the credit default swap (CDS). A CDS plays a role that is similar to insurance. When an issuer sells a CDS, they promise to insure the buyer against potential defaults from a particular exposure (such as defaults creating losses from mortgage-backed securities) in exchange for a regular stream of payments.
I must say that they are much more reactive than proactive, which is understandable because, unlike investors, they are not in the business of having to bet against the consensus and be right, and they operate within political systems that don’t act until there is a broad consensus that there is an intolerable problem. As a result, policy makers generally don’t act decisively until a crisis is on top of them.
By January 20, the S&P 500 was down about 10 percent. Global equity markets were in even worse shape and fell even more, as shown in the chart below, left.
In our Bridgewater Daily Observations on January 31, we wrote:
Contrary to popular belief, a “D” is not simply a more severe version of an “R”—it is an entirely different process…An “R” is a contraction in real GDP, brought on by a tight central bank policy (usually to fight inflation) that ends when the central bank eases. It is relatively well managed via interest rate changes…A “D” is an economic contraction that results from a financial deleveraging that leads assets (e.g., stocks and real estate) to be sold, causing asset prices to decline, causing equity levels to decline, causing more forced selling of assets, causing a contraction in credit and a
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Bear Stearns was the most stressed of the major investment banks. Although Bear was the smallest of them, it still held $400 billion worth of securities that would be dumped onto the market if it failed.
Bear was big, but not that big compared to the largest commercial banks.” It was not “too big to fail,” it was “too interconnected to fail.”
Treasury Secretary Hank Paulson had more than thirty years of financial market experience at Goldman Sachs, including eight years as CEO, so he brought a good understanding of how financial institutions and markets worked and a forceful leadership style with experience in making tough decisions under pressure.
I saw up close how lucky we all were, because without such cooperation and cleverness, we would have had such a terrible disaster that it would have taken decades to recover from it.
Despite the announcement of the TSLF, the run on Bear continued. In just four days (March 10-March 14) Bear Stearns saw an $18 billion cash buffer disappear as its customers quickly began withdrawing funds.
JPMorgan, the third largest bank holding company in the country at the time, was the most natural candidate to buy Bear, because it was Bear’s clearing bank, served as an intermediary between Bear and its repo lenders, and was thus considerably more familiar with Bear’s holdings than any other potential suitor. Only JPMorgan could credibly review Bear’s assets and make a bid before Asian markets opened on Sunday, a process which importantly included guaranteeing Bear’s trading book. However, JPMorgan was not willing to proceed if it meant having to take over Bear’s $35 billion mortgage
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Of all the interventions, the guarantee to use public funds to support Fannie Mae and Freddie Mac was the most unprecedented. Fannie Mae and Freddie Mac were two government-sponsored enterprises (GSEs), created by Congress in 1938 and 1970 respectively, with the former being part of Roosevelt’s New Deal following the Great Depression. They were created to stabilize the US mortgage market and promote affordable housing. They did this primarily by buying mortgages from approved private lenders, packaging many together, guaranteeing timely payment on them, and then selling them back to investors.
Of course, all this was based on an implicit guarantee that the government would backstop Fannie and Freddie—it was only that guarantee that allowed the securities issued by GSEs to be seen as about as safe as treasuries, giving them very low borrowing rates. At times, the spread on their debt to treasuries essentially hit 0 percent.
Ironically the larger the GSEs grew, the more “systemically important” they became, which in turn all but guaranteed a government rescue if needed, making them safer and further fueling their growth.
The Treasury basically acquired a blank check, backstopped by the taxpayer, to do whatever it took to keep these institutions solvent.
Remember that when debts are denominated in a country’s own currency, the government has the power to eliminate the risks of default.
Paulson described the Fannie-Freddie situation to me as follows. In July 2008, when Fannie and Freddie were beginning to fail, the Treasury asked for very expansive emergency powers. As Freddie and Fannie combined were nine times larger than Lehman Brothers and the dominant sources of mortgage financing during the crisis, they could not be allowed to fail. However, Paulson’s political people had told him that if they put a big dollar number in front of Congress for approval, Congress would likely get spooked. As Paulson couldn’t ask for unlimited authority to inject capital into the two GSEs,
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In early August, falling oil prices and the Treasury’s unprecedented intervention helped usher in an interval of relief, with equities rallying modestly through August (about 2 percent), financials down only 1 percent, and the free fall of Freddie and Fannie stock halted.
This meant that some entity needed to invest in it or acquire it. Neither the Fed nor the Treasury had the authority to provide that. Hence, there was a need to find a private sector investor/buyer, like Bear Stearns had with JPMorgan. But finding an investor for Lehman was harder than it was for Bear. Lehman was bigger, with a bigger, more complicated, and murkier mess of losing positions.
Finding a buyer was made even harder by the fact that Lehman wasn’t the only investment bank needing a buyer to survive. Merrill Lynch, another iconic Wall Street investment bank, was in a similarly dire situation. As with Lehman, many believed that without an investor Merrill was no more than a week away from bankruptcy.
There were a couple of major channels of potential contagion. The most important (and least clear) was Lehman’s substantial presence in derivatives markets. At the time of its bankruptcy, Lehman was a party to between $4 and $6 trillion worth of exposure in CDS, accounting for about 8 percent of the total market.
Though many of these exposures were offsetting—Lehman did not actually owe huge sums on net—its failure sent clients scrambling to find new counterparties.
While Lehman’s bankruptcy was the largest in US history (and still is), with some $600 billion in reported assets, it was only about two-thirds the size of Goldman Sachs, and a quarter as large as JPMorgan. They were all connected and the losses and liquidity problems were spreading fast.
Privately, executives from blue-chip firms like GE admitted to regulators that even they were having trouble borrowing in the commercial paper market, which could put them in a cash-flow bind and force them to default.
AIG was one of the largest insurers, with around $1 trillion in assets at peak. Its problems centered around it having issued hundreds of billions of dollars of insurance contracts on bonds (called CDS and CDOs),
The deal, drafted in a rush on the afternoon of Tuesday, September 16,
Paulson, Bernanke, and congressional leaders (most importantly, Barney Frank) thought the best way to restore confidence was to buy troubled assets through what would become the Troubled Asset Relief Program. They could have pursued nationalizing the banks, but there was no precedent for it in the US, and when banks were nationalized in other countries, they were penalized with harsh terms. For that reason, banks were reluctant to accept capital and nationalization until just before or immediately after they failed. Paulson did not believe this was the way to go, because it would be more
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Prime money-market funds had been a crucial source of liquidity for all kinds of businesses, since they buy commercial paper, a type of short-term debt that businesses use to fund their operations. Because the commercial paper they hold is generally diversified and highly rated, these funds are usually considered almost riskless—like CDs or bank deposits. But a few prime funds took losses when Lehman failed, specifically the Reserve Primary Fund, which “broke the buck” on September 16. Fears that others might take losses caused many investors to pull their money.
But when the bill came up for a vote on Monday afternoon, it failed. Stocks fell 8.8 percent in the largest single-day drop since 1987.
The single largest push on the part of policy makers came over Columbus Day Weekend: October 11–13. On Saturday, October 11, President Bush met with members of the G7 in Washington to publicly commit himself to a coordinated international effort to contain what had become a global financial crisis. It was agreed that the members of the G7 would move together to inject capital into their banking institutions and increase deposit insurance guarantees.
For example, on Tuesday, October 28, the S&P gained more than 10 percent and the next day it fell by 1.1 percent when the Fed cut interest rates by another 50 basis points. Closing the month, the S&P was down 17 percent—the largest single-month drop since October 1987.
The market was also optimistic about the fiscal stimulus being pledged by president-elect Obama. The transition exemplified the very best of political behavior on the part of both transitioning presidents. Also, the continuity of Bernanke and Geithner on the economic leadership team helped.
It’s worth briefly recapping where the US economy was at this point. Virtually every economic indicator looked to be falling extremely quickly. As an illustration, in a single day in January, reports of employment cuts across companies totaled 62,000. In addition to weak economic growth, there were still at least five major financial institutions at risk of failure: Fannie Mae, Freddie Mac, AIG, Citigroup, and Bank of America; each of these was bigger than Lehman.
When President Obama took office on January 20, the markets began to focus on the administration’s economic policies.
The next week opened with more of the same. On Monday, March 9, the World Bank came out with a very pessimistic report and Warren Buffett said that the economy had “fallen off a cliff.” The stock market fell by 1 percent. Investor sentiment was extremely bearish and selling was exhausted. That was the day the bottom in the US stock market and the top in the dollar were made, though it was impossible to know that at the time.
the Fed announced that it was expanding its QE purchases of Agency MBS by $750 billion and agency debt by $100 billion, and that it would expand its purchases to US government bonds, making up to $300 billion in purchases over the next six months. In addition to increased QE, the Fed expanded the collateral that was eligible for TALF to a wider set of financial assets and stated its continuing expectations of “keeping rates exceptionally low for an extended period.”
By mid-April, stock and commodity markets around the world had rebounded sharply from their March lows. The S&P was up 25 percent, oil was up over 20 percent, and bank CDS spreads fell almost 30 percent, but in level terms they remained near their extremes. This appeared to be due more to a slower rate of selling than a pickup in buying.
The obvious question at the time was whether a bottom was being made or if we were just seeing another bear market rally. After all, there had been a number of classic bear market rallies along the way—e.g., the S&P had staged a 19 percent rally over a week at the end of October and a 24 percent rally over the last six weeks of 2008 before giving up the gains of each and hitting new lows.
As 2010 began, the financial markets were strong (up nearly 65 percent from their March 2009 lows) because they were flush with liquidity thanks to the Fed’s QE, and they were safer due to fiscal and regulatory changes.
