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November 17 - November 26, 2022
There is no way, in my opinion, that Washington is going to bail out an investment bank. Nor should they,”
In a period of less than eighteen months, Wall Street had gone from celebrating its most profitable age to finding itself on the brink of an epochal devastation.
Financial products—including a new array of securities so complex that even many CEOs and boards of directors didn’t understand them—were an ever greater driving force of the nation’s economy.
The mortgage industry was an especially important component of this system, providing loans that served as the raw material for Wall Street’s elaborate creations, repackaging and then reselling them around the globe.
Financial titans believed they were creating more than mere profits, however. They were confident that they had invented a new financial model that could be exported successfully around the globe.
the big brokerage firms had been bolstering their bets with enormous quantities of debt. Wall Street firms had debt to capital ratios of 32 to 1. When it worked, this strategy worked spectacularly well, validating the industry’s complex models and generating record earnings. When it failed, however, the result was catastrophic.
The crowning example of liquidity run amok was the subprime mortgage market.
With no documentation a prospective buyer could claim a six-figure salary and walk out of a bank with a $500,000 mortgage, topping it off a month later with a home equity line of credit.
As a result of the banks owning various slices of these newfangled financial instruments, every firm was now dependent on the others—and many didn’t even know it. If one fell, it could become a series of falling dominoes.
“In some cases intervention has and could result in a financial bailout paid for or guaranteed by taxpayers.”
the very complexity of mortgage-backed securities meant that almost no one was able to figure out how to price them in a declining market.
A bunch of “hedgies,” Wall Street’s disparaging nickname for hedge fund managers, had systematically taken down Bear Stearns by pulling their brokerage accounts, buying insurance against the bank—an instrument called a credit default swap, or CDS—and then shorting its stock.
You had to kill rumors. Let them live, and they became self-fulfilling prophecies.
The battle between bankers and traders is the closest thing to class warfare on Wall Street. Investment banking was esteemed as an art, while trading was more like a sport, something that required skill, but not necessarily brains or creativity.
At Lehman, senior executives were compensated based on the performances of their team.
Fuld eventually decided that Lehman was too conservative, too dependent on trading bonds and other debts; seeing the enormous profits that Goldman Sachs made by investing its own money, he wanted the firm to branch out.
Paulson had railed on a conference call with all the Wall Street CEOs about “moral hazard”—that woolly economic term that describes what happens when risk takers are shielded from the consequences of failure; they might take ever-greater risks.
Bear was insolvent without the government’s offer to backstop $29 billion of its debt, and Paulson did not want to be seen as a patsy, bailing out his friends on Wall Street.
The bank itself was the preferred choice as adviser on the biggest mergers and acquisitions and was a leading trader of commodities and bonds. It was paid handsomely by hedge funds using its services, and it was emerging as a power in its own right in private equity.
Traditional banks had the Federal Deposit Insurance Corporation, or FDIC, and the Federal Reserve effectively protecting them from going bankrupt; these agencies had a built-in transition plan that allowed them to take failing banks safely into receivership and auction them off.
But the FDIC had no authority over investment banks like Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearns, and Lehman Brothers, and unless Paulson was given comparable power over these institutions, he said during the meeting, there could be chaos in the market.
Wall Street’s broker-dealer model—in which banks could count on ever-dependable overnight financing by other investors—was by definition a tinderbox.
Treasury had to concentrate its efforts on two fronts: obtaining the authority to put an investment bank through an organized bankruptcy, one that wouldn’t spook the markets, and more immediately, urging the banks to raise more money.
Lehman had been swindled out of $355 million by two employees at Marubeni Bank in Japan, who had apparently used forged documents and imposters to carry out their crimes.
Bear Stearns—with its high leverage, virtually daily reliance on funding from others simply to stay in business, and interlocking trades with hundreds of other institutions—was a symptom of a much larger problem confronting the nation’s financial system.
The Federal Reserve had never before made such an enormous loan to the private sector. Why, exactly, had it been necessary to intervene in this case? After all, these weren’t innocent blue-collar workers on the line; they were highly paid bankers who had taken heedless risks.
the explosive growth in credit derivatives—various forms of insurance that investors could buy to protect themselves against the default of a trading partner—could actually make them ultimately more vulnerable, not less, because of the potential for a domino effect of defaults.
One of the first causalities of the credit crunch was two Bear Stearns hedge funds that had invested heavily in securities backed by subprime mortgages. It was those mortgages that were now undermining confidence in the housing market—a market that Fannie and Freddie dominated, underwriting more than 40 percent of all mortgages, most of which were quickly losing value.
The key idea he had to focus on was Paulson’s overall concern that, because taxpayer money was involved, shareholders should not be rewarded.
a provision in Bush’s economic stimulus package, introduced just days after the bailout, that raised the ceiling on the amount of mortgages that Fannie Mae and Freddie Mac could buy.
they questioned whether funding a takeover of Bear Stearns had created a dangerous precedent that would only encourage other firms to make risky bets, secure in the knowledge that the downside would be borne by the taxpayer.
defending the Bear bailout as a once-in-a-lifetime act of extreme desperation, not as the expression of a nascent policy.
It wasn’t his job to protect the interests of the U.S. taxpayer, only those of his shareholders. If anything, he was a little concerned that the Bear deal presented more problems for them than it was worth.
A more injurious slight came after the $83 billion merger with Citicorp, the deal that rewrote the rules of the U.S. financial system as the last Depression-era barriers between commercial and investment banking—passed as the Glass-Steagall Act of 1933—were removed by a bill introduced by Republican senator Phil Gramm of Texas and Republican congressman Jim Leach of Iowa.
the problems with Bear’s balance sheet ran so deep as to be practically unknowable.
“I am very troubled by the failure of Bear Stearns,” he said, “and I do not like the idea of the Fed getting involved in a bailout of that company. . . . That is socialism, at least that’s what I was taught.
mortgage- and real estate–related write-downs could total $945 billion in the next two years.
He said he was also anxious about the staggering amount of leverage—the amount of debt to equity—that investment banks were still using to juice their returns.
Lehman Brothers was leveraged 30.7 to 1; Merrill Lynch was only slightly better, at 26.9 to 1. Paulson knew intuitively that Wall Street’s leverage problem could not end well. He also knew that the firms would never rein themselves in; they were all blindly chasing one another.
credit markets were beginning to suffer as the air had begun gradually seeping out of the housing bubble. Cheap credit had been the economy’s rocket fuel, encouraging consumers to pile on debt—whether to pay for second homes, new cars, home renovations, or vacations. It had also sparked a deal-making frenzy the likes of which had never been seen: Leveraged buyouts got larger and larger as private-equity firms funded takeovers with mountains of loans; as a result, transactions became ever riskier.
Countrywide Financial, the nation’s biggest mortgage lender, warned that “unprecedented disruptions” in the markets threatened its financial condition. The rates that banks were charging to lend money to one another quickly spiked in response, far surpassing the central bank’s official rates.
“Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone.”
The housing problem, he had thought, was limited to the increase in subprime loans to borrowers with poor credit. Although the subprime market had mushroomed to $2 trillion, it was still just a fraction of the overall $14 trillion U.S. mortgage market. But that analysis did not take into account a number of other critical factors, such as the fact that the link between the housing market and the financial system was further complicated by the growing use of exotic derivatives. Securities whose income and value came from a pool of residential mortgages were being amalgamated, sliced up, and
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No longer would a bank simply make a loan and keep it on its books. Now lending was about origination—establishing the first link in a chain of securitization that spread risk of the loan among dozens if not hundreds and thousands of parties. Although securitization supposedly reduced risk and increased liquidity, what it meant in reality was that many institutions and investors were now interconnected, for better and for worse.
Government intervention on this scale hadn’t been contemplated in at least fifty years; the savings and loan rescue of the late 1980s was a minor blip by comparison.
Together they would solicit qualified investors in the private sector to manage the assets purchased by the government.
the people who made the reckless bets that initially caused the problems would be spared any financial pain.
“It means that the day before you go bankrupt is the most profitable day in the history of your company, because you’ll say all the debt was worthless. You get to call it revenue. And literally they pay bonuses off this, which drives me nuts.”
Lehman Brothers and made it clear that he felt the evidence suggested the firm was inflating the value of its real estate assets, that it was unwilling to recognize the true extent of its losses for fear of sending its stock plummeting.
Repo 105. What the public did not know—nor did some of Lehman’s top executives, including Fuld—was that Lehman had been artificially lowering its quarterly leverage ratio by using an accounting sleight of hand.
