Editor’s Note: This is the second of Shah’s four-part series on what really happened to cause the Great Recession ten years ago, in 2008. You can access the first part of the series here. You can also access a special presentation from Shah by clicking here, in which he’ll tell you how you can learn to profit from the worst companies on Wall Street.
Now that you know who had the power to let Lehman Brothers Inc. fail and why, you need to understand how Lehman and the other banks got so bloated on mortgage-backed securities and derivatives in the first place.
Because, when you learn who aided and abetted the leveraging of both Main Street and Wall Street, who really gambled America’s future by letting the financial crisis and the Great Recession happen, and what was gained by it, you’ll understand who really runs this country.
This is the story you were always afraid was true.
Make no mistake about it; while not everyone on Main Street who bought homes and flipped houses knew they were playing a dangerous game, almost everyone on Wall Street playing the mortgage game knew it was a calculated gamble.
A Game Played on Shifting Sands
Before Lehman Brothers was forced into bankruptcy in September of 2008, Bear Stearns, a scrappy, successful Wall Street investment bank and trading shop, had to be rescued in March of that same year.
Like Lehman, Bear had gotten too big.
Both investment banking trading shops (because investment banking generates tradable securities) had gotten fat on mortgage-backed securities (MBS) packaging, trading, and by leveraging their greedy bets on every iteration of MBS products using unregulated derivatives.
The two shops had also become too big as competitors and were taking market share from the likes of The Goldman Sachs Group Inc. (NYSE:GS), Morgan Stanley (NYSE:MS), Deutsche Bank Aktiengesellschaft (NYSE:DB), and other big players in the shell game.
Bear’s demise began with the insolvency of two “credit” hedge funds run internally at the firm.
Understanding how dangerous these supposedly safe credit funds were will explain how the whole game was played on shifting sands.
Both credit funds – Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund – were essentially high-yielding investments based on collateralized debt obligations (CDOs).
CDOs can be made from pools of receivables, loans, lines of credit, corporate bonds, mortgage-backed securities, almost any pool of instruments that produces cash flow.
Basic MBS pools are bundled mortgages where cash from homeowner mortgage payments flows through the packaged products to investors who buy the securities for their yield.
Bankers then take bundles of MBS pools and “structure” them as collateralized debt obligations, with the collateral being the underlying MBS.
By dividing up the sum of all the MBS’s cash flows into “tranches” that have different credit quality features, based on how the tranches are structured to receive cash flows, tranches can be rated AAA, down to high-yielding junk, that’s first to default if the CDO or its MBS collateral faces pricing and or credit stresses.
To generate the high-yield investment opportunity the Bear funds boasted, including AAA ratings, the funds bought AAA-rated subprime MBS CDOs with their investors’ capital.
Those CDOs yielded more than the cost of what the funds paid to borrow money in the open market. They then borrowed more money using the excess yield on the CDOs they owned and bought more CDOs, and so on, and so on, leveraging up their yield to make themselves attractive to investors.
In addition, they used some of the yield they were generating to buy credit default swaps (CDS), derivative-based insurance-type securities on pools of mortgages, specifically, on the MBS collateral underlying the CDOs they bought.
With “insurance” the funds looked even more secure, and certainly worthy of their AAA ratings.
Then the unforeseen happened.
Bear Stearns Was Under Attack
Starting in 2007, home prices stopped rising and homebuyers and “flippers” started to miss mortgage payments.
By June 2007, both hedge funds were quickly losing money.
The High-Grade Structured Credit Fund needed a $1.6 billion bailout out from Bear to help meet margin calls while it liquidated its positions.
But there was no stopping the carnage.
In a July 2007 investor letter, Bear Stearns Asset Management reported its $1 billion Bear Stearns High-Grade Structured Credit Fund had lost more than 90% of its value, and its less than one-year-old $600 million High-Grade Structured Credit Enhanced Leveraged Fund had lost virtually all of its investor capital.
On July 31, 2007, the two funds filed for Chapter 15 bankruptcy. Bear Stearns wound down the funds and liquidated all their holdings.
What the outside world didn’t see or know was Bear’s funds and Bear itself were under attack.
In the trading game, especially a highly competitive game where the stakes are untold billions of dollars, sharks prey on whomever they can make money on or from.
In the case of Bear, once word got out its hedge funds were in trouble, the sharks circled and tore at the funds.
While the funds owned some CDS insurance, they didn’t have near enough to make any difference to their bottom lines if their portfolio holdings went south.
The CDOs they owned, and the MBS underlying those CDOs, were all quickly earmarked by other traders – marked for shorting, that is.
To make money off what they could force the funds to do, other trading shops, including Lehman, shorted the underlying MBS pools and CDOs that supported the funds.
At the same time, they bought and bid up the credit default swaps (insurance derivatives) that would pay off if the MBS and CDOs they were shorting went down (increasing the value of their CDS securities positions) or triggered default events causing the insurance to be paid out.
Everyone knew the Funds were going down because they knew how leveraged the Bear funds were, and that they’d have to liquidate their CDOs and any MBS they were holding that happened to be collateral in those CDOs because they had margined them to the hilt.
It was a feeding frenzy at Bear’s expense.
But it wasn’t just about the funds.
Some sharks wanted to kill Bear entirely, to eliminate a major competitor from the playing field once and for all.
Since Bear’s principal business had become mortgage-backed securities packaging and trading, it would be an easy target as a firm, having leveraged its own balance sheet to a lesser degree, but not unlike how its insolvent funds were structured.
That’s what happened to Bear Stearns.
It was overleveraged and when other traders started shorting Bear’s stock – in the process, knocking down its equity capital, and biding up credit default swaps on Bear Stearns itself, to pressure other investors into believing Bear was headed for oblivion – it spiraled into insolvency.
It was a concerted attack, and Lehman was in on it.
Wall Street Plays Dirty
On March 16, 2008, JPMorgan Chase & Co. (NYSE:JPM) announced that it would acquire Bear Stearns in a stock-for-stock exchange that valued Bear Stearns at $2 per share. JPMorgan later raised its price to $10, to avoid shareholder lawsuits.
The irony of Bear’s essential bailout was that the Federal Reserve, who refused to later bailout Lehman or help anyone buy it, guaranteed $29 billion of Bear’s toxic securities to entice JPMorgan to buy the firm it wanted to absorb or eliminate as a competitor.
Wall Street’s a dirty, bruising back alley at times.
What Lehman didn’t know, at the time, was that it was next.
In the third part of this four-part series, I’ll explain how all the players in the mortgage game had gotten so bloated, how they hid hundreds of billions of dollars of MBS, who knew where they were, and how the sharks going after Lehman backfired on all of them in a spectacular fashion.