So, What Happened?
To Fannie Mae, Freddie Mac, Lehman, and A.I.G.? Freakonomics' Steven D. Levitt hit up to his finance professor colleagues Doug Diamond and Anil Kashyap, and here's an excerpt from The New York Times from what they wrote:
The common denominator in all three cases was the ability of the firms to secure financing. The reasons, though, differed in each case.The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the "conforming" mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.
Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.
But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.
Lehman's demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. When it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.
This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.
Why did the financing dry up? For months, short-sellers were convinced that Lehman's real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.
Lehman's costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman's credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.
A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.'s), were hemorrhaging.
Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.'s debt on Monday. With its lower credit ratings, A.I.G.'s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.
A second problem A.I.G. faced is that if it failed to post the collateral, it would be considered to have defaulted on the C.D.S.'s. Were A.I.G. to default on C.D.S.'s, some other A.I.G. contracts (tied to losses on other financial securities) contain clauses saying that its other contractual partners could insist on prepayment of their claims. These cross-default clauses are present so that resources from one part of the business do not get diverted to plug a hole in another part. A.I.G. had another $380 billion of these other insurance contracts outstanding. No private investors were willing to step into this situation and loan A.I.G. the money it needed to post the collateral.
In the scramble to make good on the C.D.S.'s, A.I.G.'s ability to service its own debt would come into question. A.I.G. had $160 billion in bonds that were held all over the world: nowhere near as widely as the Fannie and Freddie bonds, but still dispersed widely.
In addition, other large financial firms -- including Pacific Investment Management Company (Pimco), the largest bond-investment fund in the world -- had guaranteed A.I.G.'s bonds by writing C.D.S. contracts.
Given the huge size of the contracts and the number of parties intertwined, the Federal Reserve decided that a default by A.I.G. would wreak havoc on the financial system and cause contagious failures. There was an immediate need to get A.I.G. the collateral to honor its contracts, so the Fed loaned A.I.G. $85 billion.
Much more at the link, including why Bear Stearns was rescued and why Lehman was not, what it means for the Fed and Treasury, and what it means for markets in the future.
These guys gambled like they were in Vegas...and lost. I wish I had a rich uncle.
The Mad Hungarian at September 19, 2008 6:20 AM
There was a funny bit on 'The Daily Mash', very British humour about the US government now being the largest welfare housing holder in the world, since they assumed all the mortgage debt. Everyone should immediately start peeing in the stairwells!
Seriously, how can the US consider itself a capitalist society with all this government intervention in the free market? Sound bloody socialist to me.
Maybe if there were actual regulations and controls on the banking industry so that any greedy bastard couldn't do whatever he wanted...
Chrissy at September 19, 2008 6:36 AM
Amy Alkon
http://www.advicegoddess.com/archives/2008/09/19/so_what_happene.html#comment-1591627">comment from The Mad HungarianI wish I had a rich uncle.
You do. His name's Uncle Sam, and unless you're really rich and gambled piles and piles of money, he isn't leaving you shit.
Amy Alkon
at September 19, 2008 6:42 AM
Chrissy,
There is currenty plenty of regulation in the banking industry. The reality is that bankers lent to these people because Fannie and Freddie were willing to guarantee the loans. The solution is not more control on the banking system but less gov't interference. Bankers are essentially conservative, but everyone can become a gambler if the federal gov't is willing to back you up. Politicians need to stop trying to boost homeownership. As usual, unintended consequences ...
Another thing is being overlooked here. Alan and Ben have more blame in this than most people seem to realize. They kept short term interest rates at 1% for how many years? This lead to an excess of liquidity. Investors wound up with too much cash on their hands and began buying ever riskier investments. Again, gov't interference in the free markets. Remind me again why we need these people?
Charles at September 19, 2008 7:20 AM
I think I recommended it here a while back, but here goes again: anyone interested in this kind of stuff but isn't really famillar with it should rent or buy The Commanding Heights. It is a GREAT BBC documentary about how the views of two differing economic schools of thought changed the 20th century. As boring as that may sound, it is presented in an easy to understand format.
Meanwhile, comrades, welcome to the United States Socialist Republic!
Eric at September 19, 2008 7:29 AM
PS- AMy, this one's for you~
Bank of America is now too big to fail!
Eric at September 19, 2008 8:08 AM
Chrissy - There were attempts to regulate Fannie and Freddie.
They were blocked by Democrats (specifically Chris Dodd and Barney Frank)
Franklin Raines (and a shitload of others) walked away from Fannie with millions in bonuses that were later found to be based upon fraudulent income statements. Nobody's in jail.
If you want to find fault, keep looking in Congress.
brian at September 19, 2008 8:27 AM
Rumor has it the takeovers of Fannie and Freddie were the largest nationalizations ever conducted in a non-communist country.
Unfortunately I don't know how to verify or debunk that, so I'll just say I'm now a proud part-owner in two gigantically f'ed-up companies. Woo hoo!
Gog_Magog_Carpet_Reclaimers at September 19, 2008 9:01 AM
I keep hearing from some corners that all of this signals that the end of capitalism is near. Really?! If anything, it tells me that the grand socialist experiment to put every American in a home of their home - EVEN IF THEY COULDN'T AFFORD TO PAY FOR IT - is proof positive of which system is the sure loser.
Robert W. at September 19, 2008 9:35 AM
P.S. More here on one of the big reasons that this all started.
Robert W. at September 19, 2008 9:38 AM
Gog -
They are only nationalizations in that the "private" half of the "public-private partnership" has failed utterly and there is no way that the economy could handle a collapse of these fetid and festering boils on the economy.
Congress' takeover of Fannie and Freddie is simply one more way that the corrupt on Capitol Hill are trying to hide their tracks.
brian at September 19, 2008 9:40 AM
We have a real mess on our hands. I’m sure it too will pass, but I think there are some CEOs, board members, etc. who should go to jail.
It was only a few months ago that I watched the Senate hearings on Fannie and Freddie. The company officers were cooking the books to increase their compensation packages to the tune of millions of dollars. What was done? Nothing.
Roger at September 19, 2008 9:47 AM
I’m sure it too will pass, but I think there are some CEOs, board members, etc. who should go to jail.
Frankly, I don't want to see them go to jail. Then we're paying the room and board. I do support requiring them to pay back every penny they earned in the position, and then put a 75% surcharge on that amount.
Hopefully it will leave them broke.
I also say do not loan the car companies money. I can support giving them tax breaks, and having the states give tax breaks on hybrids/alternative fuel vehicles. But they made their mess. They had thirty years to read the writing on the wall. Screw 'em.
Jim P. at September 19, 2008 9:55 AM
I'd like to know where the government thinks it's going to get this money. We already can't afford the Iraq war and all the entitlements that have been promised.
Pirate Jo at September 19, 2008 10:45 AM
Robert W.,
The problem right now is you have a bunch of economically challenged do-gooders saying that the crisis is due to a failure in free markets and further compounding their idiocy by informing us that we need more gov't intervention.
As for nationalizing Fannie and Freddie. They weren't really private to begin with. They may have had the profit motive, but they were still essentially run by the gov't (with the gov't's implicit backing). To make matters worse, they pretty much had a cost of capital of 0%. So in the end, what you had were institutions that wanted to maximize their profits, fulfill an unattainable social goal (every American owning a home), had the backing of the US gov't, and had unlimited access to capital. Is it any wonder that there's a financial crisis?
Charles at September 19, 2008 10:51 AM
I agree, I think all those who made a killing should pay the money back.
And I've read a bit about it and agree that the government shouldn't have been there to backup mortages because then there was no incentive to make wise business decisions, plus then the greedy crooks could take advantage of it.
Chrissy at September 19, 2008 11:04 AM
"I agree, I think all those who made a killing should pay the money back."
I disagree. You cannot change the rules in the middle of the game. They made the killing legally. You should blame the law makers not the law abiding killers.
The problem is you cannot be elected in Congress unless you promise the voters house for everybody, tax cut for everybody, boob job for everybody....
The Democracy is at the cross road. We really should question if this is the good system for us to practice for the future. At least, we should stop telling other nations to practice Democracy.
Chang at September 19, 2008 11:27 AM
>> You cannot change the rules in the middle of the game.
But that is exactly what is happening. Look at the short sellers- they correctly bet that these institution values would fall, and the government is today handing them billions of dollars in losses (they are forced to purchase those shares back and now highly inflated prices) while rewarding the shareholders of the institution that got themselves into this mess.
The taxpayers are going to take this in the teeth via increased inflation and long term tax increases.
eric at September 19, 2008 11:39 AM
Chang - wrong again.
Raines, Gorelick, and countless others profited wildly from the fraud and deception at Fannie and Freddie.
There's no legal support for intentionally overstating earnings by over $10B and then using those earnings statements as a justification for paying millions in executive bonuses.
brian at September 19, 2008 12:22 PM
> At least, we should stop telling
> other nations to practice
> Democracy.
Your seventeenth birthday's coming up, isn't it?
Crid [cridcridatgmail] at September 19, 2008 12:39 PM
"Raines, Gorelick, and countless others profited wildly from the fraud and deception at Fannie and Freddie."
Then, why none of them are in jail like their friends in Enron? Did any accounting firm go under for issuing fraudulent financial statement?
Their financial statement followed the Generally Accepted Accounting Principle (GAAP)legally. Yes, what they did was to find a loop hole to pay off large bonuses to senior executives but it was totally legal.
I am pretty sure their accountants pointed out the loop hole and they OKed it to take advantage of it.
Chang at September 19, 2008 12:48 PM
"Your seventeenth birthday's coming up, isn't it?"
Crid, my 17th birthday wish is that when I grow up, I just want to be as smart as you.
Chang at September 19, 2008 12:55 PM
Charles: Well said!
Chang: It's amazing that you have time to pull yourself away from the DailyKos to be a troll on here. Yes, yes, the great nation of Totalitarian China would be a much better model for us over here, wouldn't it?!?
Robert W. at September 19, 2008 2:10 PM
>>Yes, yes, the great nation of Totalitarian China would be a much better model for us over here, wouldn't it?!?
Best to just hold your nose when thinking about foreign owners of US Treasury Securities, eh Robert W.?
Jody Tresidder at September 19, 2008 3:12 PM
Jody -
I am not Robert, but I can say that no, I don't hold my nose - I get downright pissy about the notion. I'm not xenophobic, nor am I racist, just very adamantly against toto.
DuWayne at September 19, 2008 3:51 PM
"Yes, yes, the great nation of Totalitarian China would be a much better model for us over here, wouldn't it?!?"
So, do you think that China should practice democracy like India?
Democracy has worked for the U.S. so far. as we have all the ingredients to make it happen. However, it will fail as soon as the public vote to rob the public fund to build their own houses or buy SUV. And I am afraid it is happening right now.
Robert W., you remind me of the people, who believe that your shit does not stink as you live in democratic society. But it stinks just as much as people who live in totalitarian society.
If you don't believe me, just make sure the U.S. flag is flying high when you are in line for free cheese being handed out by Chinese.
Chang at September 19, 2008 5:09 PM
The beginning of this mess started in the Clinton administration when he tried to increase home ownership among the poorer class. It was the classic a “A chicken in every pot, a house for every deadbeat.” When it became easier to get a home, prices started to rise (supply and demand).
The newly “house rich” decided to cash in on their good fortune and refinance over and over. The politicians were buying votes with housing loans. No one in government wanted to be the one to make it harder for the poor to own a house. It’s a game of musical chairs and the music has stopped.
David H at September 19, 2008 5:35 PM
Chang, the fact that you so easily dismiss democracy and free enterprise speaks volumes of your ignorance.
Have a great weekend, comrade!!!
Robert W. at September 19, 2008 7:41 PM
Pssst RobertW: He's very young.
Crid [cridcridatgmail] at September 19, 2008 10:51 PM
Ain't that the truth? Fuck.
Jeff at September 19, 2008 11:58 PM
I still don't believe the will of the majority (the weakness of democracy) HAS been done in this case.
Pirate Jo at September 20, 2008 8:45 AM
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