Forgotten Anniversary

No, I’m not talking about the second most expensive mistake a married man can make.

I’m talking about the real beginning of the government’s failed attempt to deal with the mortgage market meltdown (nice book title!) four years ago.

Chances are, you don’t remember it.

I do, in part because I sent out an alert to my colleagues at the time.  It was a major shift in policy that sent Treasury Secretary Hank Paulson to Wall Street and the Money Center banks to suggest that the Government wanted to help them unload their exposure to SIVs.  The stillborn bailout was called “Super SIV” and it was one of the first signs that Washington had noticed there was a financial Love Canal situation developing, and that they had to do something.  Just a few months earlier (April, 2007), Secretary Paulson was saying the subprime mortgage problem was both “contained” and at or near its bottom.

Before I explain why I’m marking this fourth anniversary, I should detour to correct a  popular misconception, and explain why Love Canal applies to the first serious stage of the attempt to contain the crisis.

The misconception is that the so-called Super SIV, or the rather more famous LTCM affair a decade earlier were government bailouts.  They weren’t.  They were joint actions strongly recommended to the pillars of Wall Street by Federal officials.  In that way, they were like financier JP Morgan’s famous dinner invitation a century earlier that ended with the heads of Wall Street’s banks locked into his dining room way up on Murray Hill until they could come out of the room with a solution for the Panic of 1907.

I guess the distinction I’m making is that the taxpayer wasn’t on the hook to cover losses, at least directly.  Paulson in 2007 (and before him Greenspan in 1998 and JP Morgan in 1907) were basically telling Wall Street’s leaders that they had better put up the dough to rectify a problem for their own collective good.  Forced socialism to save capitalism, in other words.

In 1998, the banks that had lent to LTCM all ended up investing hundreds of millions each into the LTCM hedge fund, rather than have it suddenly default on up to $100 billion of short term secured (margin) borrowing.  Needless to say, that $100 billion had been lent by those very same banks, so they could see what would happen if they all tried to sieze their collateral and liquidate at the same time.  It was roughly a choice of putting in a few billion new dollars to avoid the potential loss of tens of billions of already committed dollars.

The SIV (and Asset-Backed Commercial Paper) market had the same problem in 2007.  Here’s where Love Canal came in.  Hooker Chemical spilled an estimated 21,000 tons of dioxins and other ugly chemicals over the years.  The problem was like radioactivity, though.  Once those chemicals touched the local dirt, ALL of that dirt became toxic, milllions and millions of tons of it.

The subprime fiasco did the same to SIVs.  I wrote about it in a chapter of Mortgage Market Mayhem I called, appropriately enough, Contagion.

You see, I found it amazing when the Asset-Backed CP market (at the time nearly as big as the conventional CP market, amounting to well over half a trillion dollars) was now considered to be “toxic waste” because some of the programs held some AAA rated subprime MBS.  A Bloomberg article that summer even pointed out that the entire exposure was less than 7% of the holdings of the ABCP issuing vehicles.

Here’s how that math worked out:

Let’s say the houses were worth half of what they appraised for when those subprime mortgages were originated, and that the loans were pushing the upper limits of LTV’s for subprime first mortgages (80 LTV).  Assume also that foreclosing and selling would cost 25% of the value of the house for loans that defaulted.  Then assume that every single mortgage defaulted.  Except for some purely fraudulent alt-A deals consisting of 100% “investor” loans, I’m pretty sure no mortgage deal has had 100% defaults.  But let’s just assume it.

OK, the houses were really worth only 50 cents on the dollar, and after foreclosing (in that market) the recoveries were only going to be 40 cents.  Since the AAA bonds were the “top” 80% of the deals, that still gets a recovery of roughly half the money spent buying those AAA bonds.  Since the SIVs collectively owned only 7% subprime bonds, that amounts to 3.5% of potential losses at the time, when literally half the press and most non-mortgage analysts were calling the entire portfolios “worthless”.

You can see why Citi broke with the pack, and led the way to taking the SIV apart, and bringing that $49 billion of assets back onto their bank balance sheet.  Did it make the banks undercapitalized?  You bet.  Did it make more sense than swallowing tens of billions in losses by immediately selling?  Absolutely.

So now you know why the married man who forgets the anniversary makes reservations at the most expensive restaurant in town, and if he’s smart, he shows up for dinner with a full day spa treatment gift certificate.  The alternative, that of having his entire world turned upside down, is far, far more expensive.

In essence, that’s what happened over the course of 2007.  Every bank that might own some subprime exposure became Love Canal.  Every investor felt they were justified in avoiding those banks in every way possible.

And they didn’t even know that the worst was yet to come.  The worst, as it turned out, wasn’t the subprime mortgages, or the MBS.  It was the CDS that gave speculators the equivalent to credit bets against those those mortgage bonds and the companies that lent to those borrowers, all without anyone knowing.

The real reason the financial world stopped turning the weekend after Lehman collapsed was two-fold:

  • The largest AAA insurance company in the world collapsed into insolvency overnight because it wrote CDS on mortgage bonds.
  • The oldest and nearly the largest money market fund collapsed when its holding of $50 million of Lehman CP forced it to “break the buck.”

At that point (a Thursday evening and Friday business day), the CP and bank Letter of Credit businesses froze.  When they froze, so did corporate cash management and international commodity trade.  My libertarian brothers don’t believe me, but we were literally a few weeks away from having no bread on the grocery shelves, and no coal or iron ore at the steel mills, pretty much all over the planet.

Why do you think Hank Paulson and President Bush were so darned frightened by the time September 20, 2008 rolled around?  That’s the anniversary the rest of us remember.  Hank and GW saw that immediate future.  It turned them into a global socialist, central government economic planning practitioners overnight.





2 Responses to Forgotten Anniversary

  1. Bruce B says:


    Your Libertarian brothers might be mistaken about whether there was going to be a financial calamity without the massive intervention. They probably believe that government distortions and misplaced incentives caused the mess in the first place. Where we go from there and here is another question.

    • hhill51 says:

      Hey, Bruce…
      No doubt about it. Actually, (in case it isn’t obvious) my inclination is that direction, too. A dozen years ago my cyberbud and now co-author George Ure asked me where I landed on the political scale, and I decided it was “Libertarian, with a conscience”…. I recognize that “self made men” make their fortunes because they live in a world everybody else supports, with roads, courts, police, educated workers they can hire, etc. To think that they don’t owe something to society for making it possible and protecting their new wealth is to be just as unreasonable as the pure welfare idiots.
      I think the issue with our financial mess is whether you look at the obese patient and put them on a diet and exercise plan, or you lock them in a room with no food or water for the next two months.
      The outcomes will be wildly different, even though the problem is the same.

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