By Daniel Griffith, Carnegie Mellon University
This is part 3 of a 4 part series covering the recession, its causes, and potential future. This is the first in-depth description of the financial crisis Bulls & Bears has provided.
Following the first 2 articles in the series, this piece will outline the events which occurred from 2007-2009, the systematic failure of Wall Street firms, and how it affected the markets.
As early as January, 2007, major financial institutions were beginning to feel the effects of years of easy credit (as well as the other lucrative profit-increasing methods described in articles 1 and 2), and firms saw two ways out: bankruptcy or buyout. The first recorded company to fall due to the effects of the recession was Ownit Mortgage Solutions Inc. (owing $93 Million to Merrill Lynch at the time – Jan. 5, 2006). Ownit was known for providing 100% financing on new purchases (effectively offering subprime loans). However, this Chapter 11 filing was not seen as a red flag for the bursting of the housing bubble, rather a warning that lenders needed to start restricting credit. Later that year, Ameriquest (formerly the country’s largest subprime lender) declared in a press release that it would be closing all its retail offices, operating solely through mortgage brokers (which were not held to the same restrictions as Ameriquest’s retail offices). At this point in time, economic forecasters began taking the housing bubble seriously, some calling for increased savings before a recession set in.
The situation escalated rapidly, in March of 2007, Ben Bernanke (then Chairman of the Fed) warned that the GSEs Fannie Mae and Freddie Mac could be sources of systemic risk, and that the federal government needed to enact legislative fail safes should the corporations need support. Also, at this time, the Federal Reserve estimated the total value of all subprime loans to be $1.3 Trillion (a number not to be ignored). As more financial institutions (such as Accredited Home Lenders Holding, New Century Financial, and homebuilder, DR Horton) began to fail as a result of subprime loan defaults, different areas on Wall St. begin to see the contagion effect. By August-September 2007, hedge funds around the country begin posting large losses as they liquidate assets in an assumption that a liquidity crisis will soon hit. This serves as an example of how contagion affects areas completely unrelated to where problems begin. Many hedge fund managers saw an impending liquidity crisis, as people would eventually make a run on mutual and money market funds, and in an effort to stay afloat, the funds liquidated assets early, but risked posting losses. As a result- in late 2007, Merrill Lynch seized and liquidated two Bear Stearns hedge funds trading in primarily mortgage backed securities with the liquidation resulting in large losses.
By early 2008, larger companies were experiencing significant and crippling losses as a result of subprime lending alone. On March 16, 2008 Bear Stearns received emergency funding from the U.S. Fed as Bear Stearns’ shares plummeted- and just 2 days later, the firm is bought by JPMorgan Chase for $2 a share in an effort to avoid bankruptcy. On June 19, 2008 several Ex-Bear Stearns fund managers were arrested by the FBI for misleading investors as to what the values of mortgage backed securities truly were. One month later, on July 11th, Indymac Bank (the largest credit union in the LA area) closed its doors, at the time it was the 4th largest bank failure in U.S. history. 19 days later, President Bush signed the Housing and Economic Recovery Act of 2008 (extending a credit line of $300 Billion to residential subprime borrowers for 30 year mortgages).
Problems grew exponentially worse on September 7, 2008, when the government was forced to take over Fannie Mae and Freddie Mac (who at the time held half of the U.S. $12 Billion in domestic mortgages). Then just 7 days later, as Lehman Brothers searches frantically for a government bailout or assisted buyout, Merrill Lynch is sold to Bank of America (amidst fears of a liquidity crisis). After two days over the weekend spent in closed-doors meetings between Wall St. executives and the Fed, determining ways to potentially save Lehman, Lehman Brothers files for bankruptcy protection on Monday September 15th. The firm’s failure was the largest bankruptcy filing in U.S. history with Lehman assets totaling $635 Billion in assets) .
The Lehman collapse is a story of its own, clarified by a recent release of a 2,200 page report by government appointed auditor Anton Valukas. The report described an accounting trick referred to as “Repo 105”, which allowed Lehman over a period of eight years to hide impaired assets.. This accounting process consisted of selling debt to counterparties, days before financial reports were to be released. This process removed bad assets from Lehman’s balance sheet and misleads investors as to how the company was doing. By 2008 this process helped Lehman hide roughly $50 Billion in worthless investments.-. Partly as a result, Lehman failed, and pieces of the firm were bought at fire sale prices by Barclays, operating under the British organization’s name.
Following the Lehman failure, AIG began to post significant losses, in part because of trading in credit default swaps with large Wall Street firms, –which prompted an $85 Billion bailout in September 2008 in an effort to avoid bankruptcy. Some controversy which arose from the bailout was that a large percentage of the $85 Billion essentially went straight to Goldman Sachs (through CDS). As the credit and liquidity crisis rolled on, by the end of September 2008, Wachovia had been sold to Citigroup Inc, and Washington Mutual had been purchased by JPMorgan Chase.
During the first week of October 2008, the government had imposed its first bailout (HR 1424) of $700 Billion, and President Bush signed the Emergency Economic Stabilization Act- creating TARP (a $700 Billion program to help consolidate and eliminate debt accumulated through easy credit). Through the year end 2008, the Fed established four special purpose vehicles (similar to the entities recently created by Goldman Sachs to facilitate Liquidity Swaps for the Greek Government) to purchase troubled assets on the market.
These early attempts to curb the market effects of years of loosely regulated economic policy and lax financial oversight were somewhat effective, but contributed to the creation of larger more consolidated firms.
Part 4 of this series will cover how the collapses changed the recession outlook, and potential long term government responses.
