Too big to jail

Sept. 15 is the 10th anniversary of Lehman Brothers declaring bankruptcy. It was a day after the global money markets seized up, turning a worldwide daisy chain of financial institutions into a ticking bomb. In the wake of the bankruptcy, it seemed likely that the United States financial system as a whole would cease to operate, a financial blackout that would render paychecks, credit cards, and ATMs useless.

Lenders, including large companies, financial institutions, and money market funds, suddenly hoarded cash in the face of growing losses and threats to their own sources of credit. They no longer knew which borrower was a good risk, so they treated all of them as bad risks.

The world experienced the worst financial crisis since the Great Depression of the 1930s and the economy plunged into deep recession. The Federal Reserve and Treasury Department misjudged the scale of the fallout from Lehman’s bankruptcy.

The failure of Lehman Brothers started a chain reaction in financial markets, as it was the first true test of the “too big to fail” hypothesis. Whereas Bear Stearns was sold to JP Morgan in March 2008, Lehman failed to find a buyer in time. The federal government refused to provide financial assistance and the company was forced into bankruptcy. Lehman was the fourth largest investment bank, and its failure sent huge waves across global financial markets. Market volatility peaked, and for some time it seemed that no bank was safe.

Merrill Lynch, the third-largest investment bank, rushed to sell itself to Bank of America that same weekend. Even Goldman Sachs and Morgan Stanley felt the shock and quickly tried to raise capital. The Federal Reserve allowed those two banks to change their charters and become bank holding companies which facilitated their funding via the discount window at the Federal Reserve.

On September 16, the federal government rushed forward with an initial $85 billion in taxpayer cash to bail out AIG, the nation’s largest insurance company. The very next day the nation’s largest money market fund was forced to “break the buck”, that is, report a share value of less than a dollar. The firm’s stake in debt securities issued by Lehman Brothers, with a face value of $785, million was essentially worthless. As a result, the share value fell to 97 cents. (Gasp.)

In the biggest bank failure in United States history, federal regulators seized the assets of Washington Mutual, the sixth largest U.S. bank, on September 27. JP Morgan acquired Washington Mutual’s bank deposits, assets, and their troubled mortgage portfolio from the Federal Deposit Insurance Corporation for $1.9 billion, making it the largest U.S. depository institution.

The crash brought together many forces: stagnant wages, widening inequality, anger about immigration and, above all, a deep distrust of elites and government. The road to recovery has been long for ordinary workers since those white-knuckle days of September 2008, resulting in a wave of nationalism, protectionism, and populism.

The ordinary American scraped by in the aftermath of the crisis, while Wall Street bankers soon returned to wealth and profitability, continuing their well-upholstered lives. The bankers were able to avoid accountability for the financial institutions they ran crashing the economy by trading trillions in fraudulent securities tied to risky or even certain-to-fail mortgages. No senior executive ever had to plea to criminal charges.

Policymakers and prosecutors took the view that prosecuting senior bank executives would cause too much collateral damage to employees, customers, other banks, and the economy. In 2013, then-Attorney General Eric Holder told the Senate Judiciary Committee that he was “concerned that the size of some of these (financial institutions) becomes so large that it… become[s] difficult… to prosecute them when we are hit with indications that… if you do bring a criminal charge, it will have a negative impact on the national economy, perhaps even the world economy.”

In short, they were too big to jail.

Originally Published: September 8, 2018

AIG’s $180 billion bailout still stings


Eight years ago this month the global financial system seemed on the verge of collapse, and its rescue led to the greatest depredation on the public purse in American history. There were many crucial events during the month of the long knives, but no corporation was more central to the mess than AIG.

On Sept. 7, 2008, the federal government took control of Freddie Mac and Fannie Mae and injected $100 billion to ensure the troubled mortgage lenders could pay their debts. On September 15, Lehman Brothers announced it would file for Chapter 11 bankruptcy and Bank of America acquired Merrill Lynch for $50 billion.

Then, in the biggest bank failure in U.S. history, the Federal Deposit Insurance Corporation (FDIC) seized the assets of Washington Mutual, the sixth largest U.S. bank, and JPMorgan acquired the bank’s deposits, assets, and troubled mortgage portfolio from the FDIC. On Sept. 21, the Federal Reserve approved Morgan Stanley and Goldman Sachs transition to commercial banks.

While many blamed the investment banks for high leverage, bad risk management and overreliance on faulty internal models, not to be overlooked is the role AIG, the nation’s largest insurance company, played in the crisis. AIG was once one of the largest and most profitable companies in corporate America, with a gold-plated “AAA” credit rating.

But on September 16, the federal government provided an initial $85 billion in taxpayer cash to bail out the firm. In return, AIG became a ward of Uncle Sam, which acquired 79.9 percent ownership of the company. This was only the first of four bailouts for AIG, totaling an estimated $180 billion.

AIG was in worse shape than Lehman Brothers had been. Yet unlike Lehman, the feds chose to save it. The explanation: AIG was regarded as too big, too global, and too interconnected to fail.

After the 1999 repeal of Glass-Steagall, the law that had regulated financial markets for over six decades, President Clinton signed the Commodity Futures Modernization Act (CFMA) in 2000, which effectively removed derivatives such as Credit Default Swaps (CDS) from federal and state regulation, proving once again that regulators exist to protect the interests of the regulated.

CDS are essentially a bet on whether a company will default on its bonds and loans. AIG was a huge player in the CDS business, which allowed the firm to insure asset-based securities containing sub-prime mortgages against default.

Although swaps behave similarly to insurance policies, they were not covered by the same regulations as insurance after passage of the CFMA. When an insurance company sells a policy, it is required to set aside a reserve in case of a loss on the insured object. But since credit default swaps were not classified as insurance contracts, there was no such requirement.

AIG’s CDS business caused it serious financial difficulties in 2007, when the housing bubble burst, home values dropped and holders of sub-prime mortgages defaulted on their loans. By selling these contracts without reserves, the firm left itself unprotected if the assets insured by the swaps defaulted. AIG had insured bonds whose repayments were dependent on sub-prime mortgage payments. Yet it never bothered to put money aside to pay claims, leaving the company without sufficient resources to make good on the insurance.

Taxpayers stepped in to pay in full the dozens of banks whose financial products were insured with AIG swaps. Unlike in corporate bankruptcies, none of these counterparties were forced to take a haircut, requiring the government to pump more public money into the banks.

To add insult to injury, two weeks after the government provided its fourth bailout to AIG in 2009, it was revealed that the firm was paying $165 million in bonuses to retain key employees to unwind the toxic financial waste. Most people understand that if you go to government for a handout, executives should forgo bonuses. Then again, so much of what happened eight years ago this month defied common sense.

Originally Published: Sep 16, 2016.

The day Wall St. failed Main St.

Six years ago this weekend, Wall Street was rocked by the collapse of Lehman Brothers. What began as a banking crisis morphed into something that shook the U.S. economy to its core. Only federal intervention prevented an even more catastrophic result.

How the world’s biggest economy came to the brink of depression is a question that will be debated for a long time, but one could argue that the predicament stemmed from a financial system that was “too interconnected to fail.”

On Sunday, Sept. 14, 2008, Lehman CEO Dick Fuld had run out of options to save one of Wall Street’s grandest institutions. In the early hours of Sept. 15, the company issued a press release announcing that it was seeking bankruptcy protection.

On the day of Lehman’s filing, the Dow Jones Industrial Average plummeted 500 points, its largest decline since Sept. 11, 2001. Adding to the anxiety was the Sept. 14 announcement that America’s best known securities firm, Merrill Lynch, had decided to sell itself to Bank of America for $50 billion amid fears for its own survival.

All hell broke loose within hours of the Lehman bankruptcy. Credit markets froze and banks stopped lending to one another. Lenders no longer knew which borrower was a good risk, so they treated all of them as bad risks.

The Feds made an emergency $85 billion loan to the American International Group because of AIG’s enormous exposure to sub-prime mortgages through the underwriting of credit default insurance. Unlike for Lehman, here the feds opened the checkbook because they determined that the company had to be rescued to protect the financial system and the broader economy. They then allowed Morgan Stanley and Goldman Sachs to become bank holding companies and authorized the Federal Reserve Bank of New York to extend credit to both firms.

Lehman’s downfall created widespread panic in financial markets, as investors scrambled to withdraw their money. On Sept. 16, the nation’s largest money market fund was forced to cut its per-share value below the sacred $1 level because a major portion of its portfolio, invested in short-term debt issued by Lehman, was frozen in bankruptcy court.

The announcement brought Wall Street’s problems home to Main Street by undermining the confidence of millions of small investors in money market funds as a safe place to park their savings. That prompted the Treasury to announce a temporary program to guarantee investments in participating funds.

Much has been written about the causes of the crisis and different witnesses provided conflicting accounts. But it may be that being too interconnected to fail counted even more than size.

That’s why the feds decided so many financial institutions had to be bailed out; sold off to others with government guarantees to sweeten the deal, loaned enormous sums of taxpayer money or recapitalized with government equity.

The elaborately interconnected nature of the financial industry greatly increased the speed and efficiency with which money could move through society. But all the sophisticated technology in the world ultimately depends on one sacred principle: A person keeps his or her word. Suddenly people in the financial industry stopped trusting what their counterparts said about the .value of the portfolio being offered as collateral on a loan and a whole host of other avowals.

How can you do business with a person you can’t trust? As a result, the entire financial world melted down. And the feds had to rush in with open checkbooks to stave off the apocalypse.

originally published: September 2014