Part 4 (2/2)

These infusions helped give the illusion that things might be stabilizing. So did the actions of the Federal Reserve. In December the Fed along with other central banks started to provide long-term loans to banks. The Term Auction Facility (TAF), created in coordination with the European Central Bank and the Bank of England, was designed to unclog the interbank lending market by providing longer-term loans to banks. At the time of its creation, interbank loans lasting one, three, and six months had all but dried up, and the spread between LIBOR rates and central bank rates had risen to unprecedented highs.

At first the TAF was successful in reducing stress in the interbank market. One measure of stress-the LIBOR-OIS spread-fell from 110 basis points to below 50. The measure seemed to give the economy some breathing room, and there was hope that the worst had pa.s.sed. ”I'm optimistic about the economy,” said President George W. Bush to the press on January 8, 2008. ”I like the fundamentals, they look strong.” He acknowledged some clouds on the horizon but remained upbeat: ”We'll work through this period of time . . . the entrepreneurial spirit is strong.”

In fact, the U.S. economy had formally entered a recession the previous month, and the entire financial edifice was on the verge of crumbling. The crisis was about to enter its most dangerous and dramatic stage. Like Hoover's relief that there had been no ”significant” failure in the spring of 1930, Bush's conviction that things had stabilized was extraordinarily complacent. The levees were about to break.

The Reckoning.

Like the current crisis, the panic of 1825 was a speculative bubble gone horribly awry. That fall a single bank failure eventually triggered a ma.s.sive run on all the banks. At first the Bank of England did nothing, refusing to intervene. As the crisis spiraled out of control, pressure built for the government to do something-anything. In December 1825 the Bank of England reversed policy and began lending money in new and unconventional ways. The Bank became the lender of last resort to virtually every partic.i.p.ant in the financial system. The results, Bagehot recalled, were dramatic. ”After a day or two of this treatment, the entire panic subsided, and the 'City' was quite calm.”

This narrative-a central bank compelled to adopt extreme, unprecedented measures to arrest the panic-would play out numerous times in the succeeding decades, and 2008 was no exception. In the recent crisis, however, the Federal Reserve and other central banks could not-and did not-immediately bring the crisis under control. One reason was that central banks were in uncharted territory: the size and scope of the meltdown made many of the usual tools useless. Worse, many of the inst.i.tutions in the deepest trouble-investment banks and other members of the shadow banking system-lacked ready access to the lifelines that had served central bankers so well in previous crises. The central bankers caught in the midst of the crisis would have to improvise, much as their predecessors had done nearly two centuries ago.

In the spring of 2008 the pressure to do something quickly mounted. By then the securitization pipeline had all but shut down, not only for ordinary mortgages but for credit card loans, auto loans, and other consumer credit products. The securitization of corporate loans and leveraged loans into collateralized loan obligation froze up, a victim of plummeting demand and growing aversion to risk. When the credit markets shut down, banks and investment banks found themselves stuck with the loans, unable to turn them into securities and sell them off. They also found themselves stuck with $300 billion worth of bridge loans that gave temporary financing to private equity funds putting together leveraged buyouts. Banks and broker dealers trying to sell off these loans quickly realized that a.s.sets with a par value only a few months earlier were now selling into extremely illiquid markets at a steep discount.

All this was playing out against the backdrop of deterioration in a range of a.s.set cla.s.ses. The stock market continued to stumble downward, and banks continued to announce write-downs and losses as diverse structured financial products saw their ratings downgraded and their values plummet. Even AAA tranches of CDOs saw their ratings cut, and their prices fell by 10 percent or more. While banks and broker dealers could use accounting tricks to conceal some of the growing losses, structured financial products like CDOs had to be valued at the prevailing market price.

The net result of these declines-in a.s.sets both esoteric and conventional-was that banks had to announce write-downs on their a.s.set portfolios. By March 2008 banks around the world announced write-downs of over $260 billion. Citigroup alone took a $40 billion write-down, and other big banks would post comparable figures. Many of those that went public with their losses at this time may not have been insolvent yet, but their days were numbered. Two inst.i.tutions whose troubles would dominate the headlines in the coming months, AIG and Wachovia, posted write-downs of $30 billion and $47 billion, respectively.

Ordinary commercial banks were suffering, but the investment banks suffered first. Some of them, such as those attached to commercial banks-the units embedded in Citigroup, JPMorgan Chase, and Bank of America-could rely on the support of their parent companies. But the independents-Lehman Brothers, Merrill Lynch, Morgan Stanley, Goldman Sachs, and Bear Stearns-were on their own. Like ordinary banks, they borrowed short and lent long, but they did not have access to a lender of last resort, and their creditors could not rely on deposit insurance if things went awry. Worse, being less regulated, they tended to be much more leveraged. They were also highly dependent on short-term financing in the repo market.

None of the independent broker dealers would remain by the end of the year. The first to go was Bear Stearns in March 2008. Like its counterparts, it had been a big player in running CDO a.s.sembly lines, and it had kept plenty of now-toxic securities on its books. Losses mounted in the fall and winter of 2007 as the value of CDOs-particularly AAA tranches-eroded. There was a growing sense of clarity in the market: Bear Stearns was in trouble, and like the depositors who withdrew their money from Countrywide, Northern Rock, and other banks, the hedge funds borrowing from Bear Stearns and other firms lending funds to the ailing investment bank pulled their money. On March 13 the besieged bank reported that 88 percent of its liquid a.s.sets were gone, the result of creditors' refusing to roll over short-term financing. Bear Stearns was moribund, and over a frantic weekend the legendary firm was summarily sold off to JPMorgan Chase. The Federal Reserve intervened heavily, facilitating the sale and agreeing to a.s.sume most of the future losses tied to the former firm's toxic a.s.sets.

The Federal Reserve's move was not a full bailout; Bear Stearns's shareholders were effectively wiped out. But its creditors and counterparties were fully bailed out. Instead, the Fed made a cla.s.sic central bank move, as if following Bagehot's admonition to rescue the bank whose failure threatents otherwise solvent banks. In Bear Stearns's case, it deemed such intervention necessary: the firm had been a big player in selling credit default swaps against a variety of risky a.s.sets held by other banks and investors. Its collapse would have nullified those insurance contracts, potentially triggering ”derivative failures” throughout the global financial system.

But the Federal Reserve was not finished intervening. Much as the Bank of England had used swaps in 1825, the Federal Reserve began exchanging liquid, safe short-term Treasury bills for the more illiquid a.s.sets that were weighing down the balance sheets of the investment banks. This lending facility (which we will discuss in chapter 6) helped the banks contain the illiquidity trap that the panic created. So did the Federal Reserve's subsequent creation of another lending facility that gave investment banks like Goldman Sachs and Morgan Stanley access to lender-of-last-resort support. This was a radical break with past precedent: for the first time in decades, the government had opted to provide such support to key members of the shadow banking system.

The creation of the two new lending facilities reduced but did not eliminate the risk that the broker dealers would suffer a run. For starters, the broker dealers did not have access to deposit insurance, arguably the strongest shelter against a bank run. Moreover, their access to the lender-of-last-resort support of the Federal Reserve was conditional and limited. If a broker dealer was truly insolvent, the Federal Reserve would refuse to ride to the rescue. Or so prudent central banking practice would dictate. That almost guaranteed there would be some more high-profile failures.

At the same time, the bailout of Bear Stearns seemed to indicate that the Federal Reserve was unwilling to stand on the sidelines if the failure of a financial inst.i.tution would sow panic on a global scale. Bear Stearns was but the smallest of the independent broker dealers; surely, the reasoning went, the Federal Reserve would step in to save a bigger victim if doing so would stop the crisis from spreading further. Allowing such a failure would risk a meltdown of the entire global financial system.

Both views had merit. Unfortunately, both turned out to be correct. What happened in the succeeding months sent contradictory messages about whether the Federal Reserve would hold the line on moral hazard.

The Center Cannot Hold.

Whenever the narrative of a financial crisis is dominated by a high-profile failure, there's a temptation to see the entire crisis through the prism of that one event, as if all that came before and after can be reduced to a specific inflection point. In the recent crisis, the failure of Lehman Brothers played this role: many market watchers are convinced that it, more than anything else, was responsible for turning the American crisis into a worldwide conflagration.

This interpretation is understandable: reducing a crisis to one spectacular failure simplifies an extraordinarily complex chain of events. Unfortunately, it's misleading. The failure of Lehman Brothers was less a cause of the crisis than a symptom of its severity. After all, by the time Lehman announced it would file for bankruptcy on September 15, 2008, the United States had been in a severe recession for ten months, and other industrial economies were on the verge of entering one. The housing bust was entering its second year, and high oil prices were sending shock waves through the global economy. Some two hundred nonbank mortgage lenders had collapsed, and as securitization ground to a halt, SIVs and conduits had unraveled. Conventional banks were in trouble too: their balance sheets continued to deteriorate in 2008, and new write-downs inevitably followed. After showing some signs of improvement over the winter, interbank lending had seized up yet again in the spring and summer.

The inst.i.tutions charged with backing up the system-smaller insurers like Ambac and ACA, which specialized in guaranteeing bond payments (also known as monoline insurers), as well as sprawling insurance companies like AIG-were also deep in trouble long before Lehman collapsed. Using credit default swaps, they had insured several trillion dollars' worth of CDO tranches, effectively transferring their own AAA ratings onto a range of structured financial products. As the tide of losses rose, it looked increasingly likely that the insurers would be forced to pay out. Unfortunately, they didn't have the capital, thanks to being wildly overleveraged. The ratings agencies knew this and started to downgrade the monolines in the fall of 2007.

These real and looming downgrades threatened to rob companies like Ambac and AIG of their ability to confer AAA ratings on a range of securities. In the case of the smaller companies like Ambac, that meant not only CDOs but the munic.i.p.al bonds that had been their original bread and b.u.t.ter. In the spring of 2008 the deepening troubles of the monoline insurers plunged the usually boring (but rea.s.suringly stable) munic.i.p.al bond markets into turmoil. Many of the investment banks that had previously played a pivotal role in these markets abandoned the field, fearful of potential losses. Auctions of munic.i.p.al bonds started to fail, and panic spread throughout the market. Much of the more complex short-term financing used by these munic.i.p.alities-auction-rate securities and tender option bonds-also collapsed. In a matter of months, state and local governments that were otherwise solvent saw the costs of borrowing soar.

This facet of the crisis began as a matter of illiquidity, but here too the specter of insolvency loomed: many munic.i.p.alities that had profited from rising property values in the good times saw tax revenues fall off a cliff in the face of escalating delinquencies and foreclosures. The growing troubles of California, already evident in the summer of 2008, offered a glimpse of what lay in wait for other states and munic.i.p.alities. The problem was real; it wasn't merely a matter of investor psychology.

Fannie Mae and Freddie Mac started to falter too. These enterprises, sponsored by the federal government, had leveraged themselves at ratios of forty to one by issuing debt that enjoyed the implicit backing of the U.S. Treasury. They had used part of that supposedly risk-free debt to purchase risky mortgages and a.s.set-backed securities. By 2008 both inst.i.tutions were sustaining ma.s.sive losses that rapidly eroded their capital. Those losses came from two sources. For starters, the fee they received for guaranteeing the mortgages that they manufactured into mortgage-backed securities proved insufficient to cover their losses. In the worst housing crisis since the Great Depression, even safe ”prime” borrowers started to default, at rates far in excess of what Fannie Mae and Freddie Mac had antic.i.p.ated. The insurance premiums no longer covered the losses, which now surfaced on the two inst.i.tutions' balance sheets.

Far more significant was the fact that their investment portfolios were bursting with subprime mortgages and subprime securities. That summer the losses on these investments had become so large-and the two inst.i.tutions' capital had so dwindled-that investors panicked. Fears grew that the duo might no longer be able to cover the securities they had guaranteed. Even worse, investors who had purchased debt issued by the two giants now openly talked about the possibility of a default. The a.s.sumption that the U.S. government stood behind that debt had never been tested.

Here again the question of moral hazard came to the fore. Without a government takeover, the failure of Fannie Mae and Freddie Mac would clearly send financial markets and mortgage markets into a panic of unprecedented proportions, never mind spook the various foreign creditors that had purchased their debt. Here much more was at risk than the market for a bunch of subprime mortgages: the creditworthiness of the United States was at stake. Letting the two inst.i.tutions fail in the name of sending a message to the markets was not an option.

The result was another government takeover, formalized in September. Its terms protected those who had purchased the debt of Fannie Mae and Freddie Mac, but the common and preferred shareholders alike saw their investments wiped out. Unfortunately, many of the preferred shareholders included scores of regional banks, who overnight saw their ”risk-free” investments wiped out. These losses sent further shock waves reverberating through the collapsing financial system.

On the eve of Lehman's failure, much of the damage had already been done. Lehman and the other investment banks, most obviously Merrill Lynch, were floundering, awash in losses due to exposure to a range of toxic a.s.sets; their ability to remain liquid, much less solvent, was in serious doubt. All the financial system needed to plunge into a state of utter panic was a little push.

Mere Anarchy Is Loosed upon the World.

The panic of 1907 has a special place in the history of financial disasters. More than most, it has a hero, the banker J. P. Morgan, who occupied a singular place in the financial firmament as the biggest and most powerful banker of the day. In fact, in the days before the Federal Reserve, Morgan was the closest thing the United States had to a lender of last resort. The panic had begun in a series of lightly regulated, overleveraged financial inst.i.tutions that were the forerunners of today's shadow banking system. Like twenty-first-century investment banks, the ”investment trusts” of Morgan's day operated with little transparency.

The panic felled some secondary players, then detonated under the mighty Knickerbocker Trust Company. From there it spread swiftly, threatening to consume the other banks and trusts caught in the tangled web that bound together the financial community. Morgan was unable to save the Knickerbocker, but he decided to draw the line at another ailing inst.i.tution, the Trust Company of America. The crisis seesawed for days and eventually culminated in a private meeting at Morgan's enormous private library, where he gathered together the city's financial movers and shakers on a Sat.u.r.day.

Morgan asked them to pool their resources and rally behind the Trust Company of America. The bankers initially refused, and deliberations dragged into Sat.u.r.day night. At some point in the wee hours of the morning, the bankers realized that Morgan had locked them in the library and pocketed the key. He then issued an ultimatum: support the ailing Trust Company, or face the likelihood of complete annihilation in the ensuing panic. As he almost always did, Morgan got his way: the meeting broke up at 4:45 that morning after the bankers signed a mutual aid agreement. The panic was soon over.

On a very similar weekend 101 years later, Treasury Secretary Henry Paulson tried to pull off an equally audacious bit of brinksmans.h.i.+p. As Lehman Brothers and Merrill Lynch slid inexorably toward insolvency, he called the city's financial elite into the office of the Federal Reserve in Lower Manhattan on Sat.u.r.day, September 13, 2008. Summoning the spirit of Morgan, he told the a.s.sembled bankers that the duty of dealing with the panic would rest with all of them. ”Everybody is exposed,” he reportedly told the a.s.sembled bankers, hoping this would prod them to come up with some way of either buying Lehman or organizing its orderly liquidation.

The bankers came back the following morning but left later that day without a deal; Lehman would be allowed to go under. Paulson's attempt to channel J. P. Morgan had failed. By this time Merrill Lynch was rus.h.i.+ng into the arms of Bank of America, fearful of sharing Lehman's apparent fate. ”We've reestablished moral hazard,” claimed one person present at the meetings. ”Is that a good thing or a bad thing? We're about to find out.”

Much of what happened in the succeeding days and weeks was probably inevitable, even without the dramatic collapse of Lehman. But the speed with which it happened, and the drama that accompanied it, was a function of the shock waves that Lehman's failure sent through the financial markets.

Those shock waves. .h.i.t AIG first. On September 15, Lehman declared bankruptcy, and all the major ratings agencies downgraded AIG's credit rating. Its losses had been mounting for months, but the downgrade was the coup de grace: it effectively called into question the guarantees that the insurance giant had bestowed on a half trillion dollars' worth of AAA-rated CDO tranches. The day of the downgrade, the U.S. government threw the firm an $85 billion lifeline; additional funds would flow in the coming months. In exchange, AIG became a ward of the state: most of the firm's common stock now belonged to the government.

It was a bailout not so much of AIG as of all the banks that had purchased insurance from AIG. In the wake of the takeover, the U.S. government went to those banks and bought back the CDO tranches that AIG had insured. It could have demanded that the banks take a ”haircut”-a loss-on those tranches as a penalty for their foolishness in trusting AIG to make them whole. But it did not. Instead, the government paid one hundred cents on the dollar-the full value-even though the market value of the tranches had fallen far below that. By this time, any talk of holding the line against moral hazard had gone out the window.

The parts of the financial system that had so far escaped the crisis now descended into the abyss. Money market funds were one of the first to fall. The funds were supposed to operate reliably: they took cash from investors and sank it into safe, liquid short-term securities. Though a handful had stumbled the previous summer, in the wake of Lehman's bankruptcy things went completely awry. One of the most prominent funds, the Reserve Primary Fund, ”broke the buck,” meaning that a dollar invested with it was no longer worth a dollar. This was almost unprecedented, and it sparked a run on the fund.

Was the run even remotely rational? Yes. It turned out that the Reserve Primary Fund had surrept.i.tiously sunk some of its investors' money into toxic securities such as Lehman's debt. When this fact came out, suspicion fell on the entire $4 trillion money market industry, which became one big terra incognita, and the kind of dangerous uncertainty that Frank Knight had first described swept the field. In no time the federal government was forced to provide a blanket guarantee-the equivalent of deposit insurance-to all existing money market funds.

The panic in the money market funds quickly spilled over into other arenas, beginning with the market for commercial paper, the debt that ordinary corporations used as their main source of working capital. Money market funds had been primary purchasers of this kind of debt, and when their fortunes turned, the commercial paper market seized up too. Perfectly solvent corporations found themselves shut out of the market as borrowing rates went through the roof. For a few weeks during this liquidity crisis, corporate borrowing effectively collapsed, and blue-chip firms found themselves short of cash.

Emergency times call for emergency actions. The collapse of the commercial paper market, which handled some $1.2 trillion in loans, posed the risk that otherwise solid corporations would go insolvent because of a run on their short-term liabilities. In order to avoid any further runs, the Federal Reserve opted to extend lender-of-last-resort support to nonfinancial corporations. On October 7 it set up yet another lending facility that made loans to corporations issuing commercial paper, though only firms with an A rating or better could borrow from the Fed. This was a belated gesture at holding the line against moral hazard.

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