Editor’s Note: This is the third of Shah’s four-part series on what really happened to cause the Great Recession of 2008. You can access the first part of the series here, and the second part of the series here.
You know three major things that led to the financial crisis ten years ago:
- How Bear Stearns’s two credit hedge funds failed;
- That Bear itself was similarly leveraged and savagely attacked by its competitors, and;
- Who stood to profit from Bear’s demise.
Now, you’re ready to learn the frightening truth about what happened next.
This is the real story about how the entire investment banking, commercial banking, and shadow-banking interconnected sandcastle was leveraged by hundreds of trillions of dollars.
But before we get into it, let’s talk.
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Now, let’s dive in: who let the Great Recession happen, and why?
Very few people know how close the global financial system came to Armageddon, thanks to Wall Street “know-how.”
That is, knowing how to leverage capital to make as much money as you can by taking as much risk as you can.
But how huge was the risk pile?
Calling the amount of mortgage securities related leverage built up across U.S. investment banks (also called IBs), commercial banks, and the shadow-banking system “incomprehensively gigantic” is like calling the Grand Canyon a ditch.
The truth is no one has any idea how high the junk was piled.
Based on Congressional testimony, subsequent lawsuits, forensic accounting, and post-crisis regulatory reports, the amount of leverage (meaning at-risk capital multiplied by margin and other short-term borrowing facilities, then quadrupled by use of derivatives) of the sandcastle was somewhere between $150 and $350 trillion dollars.
Mortgage-Backed Securities Nirvana
The bottom layer of the leveraged pile of junk consisted of mortgages.
For decades, mortgages had been packaged into mortgage-backed securities (MBSs) and sold to investors who bought them for their pass-through yields.
Then, starting in 2000, in the artificially low-interest rate environment engineered by the Fed to deal with the stock market’s tech wreck and recession fears, and with prime borrowers having been granted all the mortgages they needed, Wall Street product pushers zeroed in on subprime borrowers.
Originating, packaging, selling, and trading subprime mortgage-backed securities was a no-brainer, because higher yielding securities were in demand.
Things really took off in 2001 when the Fed, the principal regulator of the giant “money-center” banks, steered its constituents into embracing the newly drafted Basel II rules.
The godsend in Basel II (incorporated by German regulators to encourage homebuying through easy mortgage money) was a reduction of capital reserves attached to mortgage holdings. New rules reduced the reserve (capital out of a loan set aside for safety) on mortgage bonds rated B or less, from 20% down to 2%, if they were AAA-rated securitized mortgages – which, of course, junk could be made into with government guarantees and by other structured finance techniques.
The idea that securities were more liquid than actual mortgages sitting on banks’ balance sheets made sense. And banks went to town on them, packaging all the mortgages they had to get them off their balance sheets and replacing them with MBS, with reserve requirements they could easily leverage up.
In 2003, their investment bank cousins starting quickly followed them. That’s when the SEC, the principal regulator of bank holding companies who controlled IBs along with their broker-dealer subsidiaries, let them use “highly-rated MBS” as collateral on securities borrowings.
Now, for the first time, broker-dealers and investment banks could not only get income from owning MBS, they could also use them as collateral. They could also use their customers’ holdings of MBS as collateral, to borrow against to feed their proprietary trading desks, to buy and trade more MBS.
Then in 2004, the SEC allowed IBs to measure their risk-weighted assets by adopting Basel II capital reserves for MBS. Meaning, capital reserve requirements to hold MBS became only 2%.
Fire up the factories, all of them.
To get subprime borrowers into mortgages, underwriting standards had to be lowered. And they were, thanks to the presumably government-backed mortgage factories Fannie Mae and Freddie Mac – which are another story altogether.
Not only were crappy loans to NINJA borrowers (no-income, no-job applicants) easy to make, they were easy to package into AAA-rated securities because they were guaranteed by a U.S. agency, by the presumption of government backing if they were able to be sold to Fannie and Freddie. Fannie and Freddie, at the height of the frenzy, bought 40% of all subprime mortgages to package, hold and sell, and could be wrapped, or warped, into structured finance products like CDOs (collateralized debt obligations) whose tranches could be labeled AAA by compliant rating agencies (oh boy, that’s another story altogether).
But creating hundreds of billions of dollars worth of subprime mortgage products wasn’t enough.
To make the most money out of holding them and trading them, everyone leveraged their capital – whatever they had or borrowed – to make more money on MBS products and their moving parts.
Of all the derivatives that were concocted out of subprime MBS, the two most insane and insidious were synthetic CDOs and CDS (credit default swaps).
Stay with me here.
An MBS CDO is a collateralized debt obligation based on mortgage-backed securities. The MBS are the collateral in a CDO. Bankers take the cash flows coming through the mortgages packaged into the MBS and rearrange them so that they flow like a waterfall (which is the term used in structured finance), from the top tranches down a cascade of lesser tranches.
Since the top tranches get assigned the best cash flows, they can get a AAA-rating (of course, the rating agencies were paid for those ratings, which is part of that other story). That’s an MBS CDO.
There was synthetic MBS. A synthetic MBS is a derivative contract that doesn’t have packaged real mortgages inside it. It has “reference” mortgages inside it. All a reference mortgage is is an identified mortgage, a reference to a real mortgage, but not a real mortgage. Synthetic MBS were real securities, derivatives, based on air. That’s how crazy things got.
A synthetic MBS isn’t the same thing as a synthetic CDO, not even close.
Before you start laughing when I tell you what a synthetic CDO is, you need to know what CDS are.
CDS are insurance-type derivatives. MBS are registered mortgage pools, meaning you can actually look into any MBS pool and see all the mortgages, where they were made, what interest they pay, etc.
A credit default swap can be written up as a contract to offer protection on any mortgage securities pool.
In other words, if you owned $100 million or $10 billion worth of MBS and wanted insurance that they wouldn’t default, you could buy CDS on all the individual MBS in your portfolio or buy CDS based on indexes of mortgages.
Plenty of “investors,” speculators, and banks sold CDS to collect the insurance premiums. And why wouldn’t they? It was free money in a low-interest rate environment where home prices and MBS prices kept rising.
CDS were another reason mortgage securities looked so safe, and why potential exposure to them and capital requirements could be cut back, because they could be insured.
But, CDS turned out to be time bombs.
The Pile Gets Bigger
About those synthetic CDOs. Are you sitting down?
Synthetic CDOs are CDOs (based on cash flow waterfalls) whose underlying collateral were CDS – yep, credit default swaps. Investors bought synthetic CDOs for the pass through of the cash flows from the insurance premiums buyers paid for CDS.
Of course, the small problem with synthetic CDOs is their investors own the CDS and are responsible for losses on the insurance contracts they were paid to takeover.
The pile gets bigger.
Not only was leverage build into MBS, CDOs, and all the other mortgage derivative products Wall Street manufactured, the ultimate deleveraging ploy-tool, credit default swaps, allowed holders of all these products, under the presumption that CDS insurance would cover losses, further leveraging based on the false premise everyone had absolutely defined risk.
Piles got so big that they had to be hidden in plain sight.
Banks, investment banks, and other players went as far as hiding piles of leveraged MBS products in offshore entities, off their balance sheets so they didn’t have to hold capital reserves against them.
SIVs, structured investment vehicles, were set up away from the prying eyes of regulators in offshore domains and capitalized by banks and investment groups.
They used their initial capital to buy AAA-rated MBS and CDOs. They then borrowed short-term money against those holdings in the commercial paper market, which was cheap for them because they were AAA-rated borrowers.
They used that borrowed money to buy more AAA-rated MBS and CDOs, and borrowed more money against new holdings to buy more MBS and CDOs.
The Fed and FDIC estimated the total of off-balance sheet holdings in SIVs to be $400 billion post-crisis.
That’s exactly what the Bear Stearns credit funds were doing. The ones that failed.
You see where this is going?
Back to Lehman
Lehman Brothers Inc. was deep into the game. Like Bear Stearns, the other investment banks, and big commercial banks – especially the ones that had investment banking and securities trading arms – Lehman had amassed huge leveraged positions.
In addition to what everyone else was doing to hide piles of leverage, Lehman employed what became known as 105 repos.
Borrowers use the repo market to borrow money from other banks and big companies that have extra cash to lend on a short-term basis.
In a repo, short for repurchase agreement, a bank “sells” some asset, typically Treasury bonds, corporate bonds, or mortgage securities to a lender. The bank knows the lender will purchase the collateral back in a few days. The borrowing bank buys back the bond at the end of the loan period, minus some small amount that the company gets to keep as interest.
During the boom, about $12 trillion in repos were outstanding on any given day.
Under accounting rules, the assets a bank uses in repo deals stays on the bank’s balance sheet.
When Lehman Brothers wanted to make it look like it wasn’t borrowing much, they did repo deals where Lehman borrowed less cash than the asset it hypothecated was worth.
For example, if Lehman owned a bond that was worth $105, it would “sell” it on the repo market for $100. (The “105” in Repo 105 refers to the fact that the assets were worth at least 105% of what Lehman was getting for them.)
The gap technically allowed Lehman to record the transaction as if it had been a true sale of the bond, even though they would repurchase the bond just a week or so after they had sold it.
Lehman would take the money it got from selling the bond and pay off some of its debts. Then, after it had issued its quarterly report, the company would borrow more money to repurchase the bonds.
The reason Lehman did 105 repos was to hide the truth about how leveraged and at risk they were from regulators and competitors, who wanted to crush Lehman.
It didn’t work.
Everyone knew how leveraged Lehman was and all the big trading shops went after it, shorting its stock, bidding up credit default swaps on it, doing to Lehman what Lehman itself and the others did to Bear Stearns.
Lehman was driven off a cliff and the Secretary of the Treasury, Hank Paulson, refused to let the Fed come to its aide, as it had done for Bear Stearns, guaranteeing almost $30 billion of toxic securities on Bear’s balance sheet so JPMorgan Chase & Co. (NYSE:JPM) could buy it cheaply.
But this time was different.
Lehman’s failure triggered a waterfall of MBS and CDO defaults and an explosion of risk beyond anyone’s comprehension. For one thing, everyone who bought CDS found out their counterparties would never be able to pay them off.
The whole soaring edifice built on subprime mortgages was built on sand, and it was shifting.
In the last piece in this series, I’ll tell you who aided and abetted all this happening in the first place, who controls them, and why the rescue of the system is nothing more than smoke and mirrors.