Collapse of the Shadow Banking System

Senator Gramm left Congress to join UBS as a senior investment banker and head of the company’s lobbying operation. A November 2008 New York Times profile, highlighted how Gramm, “who declined to discuss his compensation at UBS, picked an opportune moment to move to Wall Street.

Major financial institutions, including UBS, were growing, partly as a result of the Gramm-Leach-Bliley Act. Increasingly, institutions were trading the derivatives instruments that Mr. Gramm had helped escape the scrutiny of regulators. UBS was collecting hundreds of millions of dollars from credit-default swaps. (Mr. Gramm said he was not involved in that activity at the bank.) In 2001, a year after passage of the commodities law, the derivatives market insured about $900 billion worth of credit; by [2007], the number had swelled to $62 trillion.

But as housing prices began to fall last year, foreclosure rates began to rise, particularly in regions where there had been heavy use of subprime loans. That set off a calamitous chain of events. The weak housing markets would create strains that eventually would have financial institutions around the world on the edge of collapse. UBS was among them. The bank has declared nearly $50 billion in credit losses and write-downs since the start of last year, prompting a bailout of up to $60 billion by the Swiss government.”

For his part, Gramm “blamed others for the crisis:

Democrats who dropped barriers to borrowing in order to promote homeownership; what he once termed “predatory borrowers” who took out mortgages they could not afford; banks that took on too much risk; and large financial institutions that did not set aside enough capital to cover their bad bets….Mr. Gramm says that, given what has happened, there are modest regulatory changes he would favor, including requiring issuers of credit-default swaps to demonstrate that they have enough capital to back up their pledges. But his belief that government should intervene only minimally in markets is unshaken.

“They are saying there was 15 years of massive deregulation and that’s what caused the problem,” Mr. Gramm said of his critics. “I just don’t see any evidence of it.”

Edward Gramlich, Federal Board of Governors and chair of the Fed’s community and consumer affairs committee, repetitively for years, warned that deregulatory subprime mortgage markets were the “giant hole in the supervisory safety net.” In spite of his word of warning, Federal Reserve Board Chairman Greenspan and a majority of Board members continued to champion a deregulatory philosophy. According to Greenspan, “for the Fed to go in and audit how they act on their mortgage applications would have been a huge effort, and it’s not clear to me we would have found anything that would have been worthwhile without undermining the desired availability of subprime credit.”

Subprime risk models and investment strategies appeared, at least in the early stages of subprime securitization, to be a robust predictor of investment risks. However, subprime math-driven risk analysis estimates and forecasting models developed by the so-called “Quants of Wall Street” related on overly optimistic predictions on increases in housing values.

Beginning in 2006, for the first time, an over half century pattern of home prices going up had reversed. As the subprime mortgage speculative frenzy ended, the lightly regulated sector found itself caught in a destructive web. In retrospect, heavy investments in subprime mortgage products with short resets, little documentation, and homeowners with “little skin in the game” in the form of home equity formed the core of the housing crisis.

In a “60 Minutes” interview Michael Lewis, best-selling author of “The Big Short” and former Wall Street bond trader explains how Wall Street’s “finest minds” managed to destroy $1.75 trillion of wealth in the subprime mortgages market. According to Lewis:

“All of the incentives in Wall Street’s largely unregulated bond market were geared toward keeping the subprime money machine humming… Wall Street’s most influential investment bank convinced the financial products division of insurance giant AIG insurance to join the party, a decision that would destroy the company…”They insured tens of billions of dollars of subprime mortgage loans without even knowing…Goldman Sachs persuaded them to insure these piles of loans without them ever investigating what was in the pile. So, there’s an additional level of incompetence. They didn’t even know the mistake they were making.” Asked what role the rating agencies played in this, Lewis said, “They were handmaidens to Wall Street. The ratings agencies get paid by Wall Street, by Merrill Lynch, by Citigroup, by Morgan Stanley, by Goldman Sachs, to rate the bonds that Wall Street creates. This creates a certain moral hazard.”

The rise in subprime mortgage defaults and foreclosures caused a liquidity drought forcing subprime mortgage companies to close their doors and file for bankruptcy. On April 2, 2007, New Century Financial a major supplier of subprime mortgage products files for bankruptcy. In the same year, several additional subprime companied filed for bankruptcy. The bailout of the Germany financial giant IKB by a group of government-back Germany banks was one of the earliest indicators of the global ramification of the subprime crisis.

In swift succession, the subprime crisis “ricocheted from the United States to Europe.” Overexposure in holding of subprime mortgage credit securities and derivatives caused HSBC Holdings PLC, Europe’s biggest bank, to report billions of dollars in “impairment charge” related to subprime investments. The large French bank, BNP Paribas, announced that the bank was freezing $2.2 billion in “redemptions” at three Hedge Funds that had invested in subprime mortgage securities because the U. S. subprime securitization sector has seen a “complete evaporation of liquidity.”

The large U.K. bank, Barclays wrote down $2.7 billion worth of assets directly linked to the U.S. subprime mortgage collapse and announced danger exposures in subprime collateralized debt obligations totaling an estimated 13 billion pounds. The Swiss bank giant UBS, the largest wealth manager in the world, took similar steps shutting down its internal hedge fund and announcing billion of dollars in subprime related losses. Japan’s biggest bank, Mitsubishi UFJ Financial Group, reported that it had 300 billion yen ($2.6 billion) exposure in subprime mortgages. The Bank of China reported major losses from their $10 billion portfolio of subprime mortgage backed-securities. China’s largest bank, Industrial and Commercial Bank of China, held $1.2 billion of subprime-related securities. By the end of 2007, the collapse of the subprime sector eradicated an estimated $5.5 trillion off the value of equities worldwide.

As the subprime market imploded, a number of systemically important financial institutions remained significantly exposed. Global financial institutions like Bear Sterns, Citibank, Goldman Sachs, and Morgan Stanley were bankrupt, bailed out, or struggling as losses in the subprime sector cascade across the globe. Then on September 15, 2008, the large Wall Street investment firm Lehman Brother filed for Chapter 11 bankruptcy. The bond market for subprime derivatives collapsed with bankruptcy of Lehman Brothers triggering a liquidity crisis and near collapse of American International Group (AIG).

On September 16, 2008, a day after the collapse of Lehman, surmising that AIG “was too big to fail”, the Federal Reserve Board used it authority under section 13 (3) of the Federal Reserve Act  to authorized the New York Fed to provide AIG with a line of credit of $85 billion.

The Federal Reserve Board concluded that AIG was so interconnected to other actors in the financial sector that its potential failure created systemic risk. According to the Board of Governors Press Release:

“The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.”

The New York Fed established two new lending facilities with the authority to lend up to $22.5 billion to purchase residential mortgage-backed securities and $30 billion to purchase subprime-related credit derivatives on which AIG has written credit default swaps contracts.  AIG counterparties who purchased “protection” included Goldman Sachs, Merrill Lynch, Bank of American and a number of other top tier global investment banks.

The New York Fed agreed to reimburse AIG counterparties contracts at par value. This meant that investment firms received billions from their subprime related investment losses without taking a deduction in market value or “haircut.” In a January 27, 2010 testimony, before the U.S. House of representatives Committee on Government Oversight and Reform, Federal Reserve Bank of New York Executive Vice President and General Counsel Thomas C. Baxter, explains the New York Fed decision:

In the months leading up to early November 2008, AIG had been actively engaged in efforts to negotiate tear-ups of its CDS contracts with its counterparties. AIG was completely unsuccessful… In the limited time available, agreement had to be obtained from at least the eight largest counterparties…With bankruptcy not an option, it was necessary to find a solution that stemmed the liquidity drain arising from the continuing collateral calls on the CDS contracts, stabilized AIG and protected the taxpayer interests.   [Allowing the purchase of AIG counterpart credit default swaps] was the solution…In this context, the Board of Governors authorized the New York Fed to lend Maiden Lane III up to $30 billion, and to secure that loan with the multi-sector CDOs that were insured by the AIG CDS contracts.

Pursuant to this authorization, the New York Fed lent $24.3 billion to Maiden Lane III that it used, in combination with a $5 billion equity investment from AIG, to purchase CDOs from 16 of AIG’s counterparties. At the time, the CDOs had a fair market value of about $29.6 billion and a par value of approximately $62 billion. In exchange for agreeing to terminate AIG’s CDS contracts and turning over the underlying CDOs to Maiden Lane III, the counterparties would also be allowed to retain approximately $35 billion in collateral previously posted by AIG. The result was that counterparties essentially received “par…”

On why the New York Federal Reserve did not insisted on AIG counterparties taking a “haircut” on the credit default swaps. The New York Federal Reserve General Counsel testified:

“The Federal Reserve has been criticized by some for not using its regulatory power to force the counterparties to accept less money for the CDOs. The critics overlook a number of key factors…First, there was little time, and substantial execution risk and attendant harm of not getting the deal done by the deadline… When the Federal Reserve reached out to AIG’s counterparties, we believed, based on AIG’s own experience, that our probability of success of getting them timely to agree to concessions was slim. Even in a best-case scenario, we did not expect that the counterparties would offer anything more than a modest discount to par…

Some have said that, in the absence of other bargaining power, the Federal Reserve should have used its regulatory power—threatening an adverse use of that power, or suggesting some kind of a benefit flowing from it—to make regulated counterparties give up or compromise their contractual rights. We see that as an abuse of regulatory power. The idea that the Federal Reserve would threaten a financial institution with supervisory action when no grounds for such action exist, or give a financial institution special treatment simply to gain an advantage in a commercial transaction is, in our view, an abuse of our authority. Such conduct by the Federal Reserve might have generated bargaining power over the counterparties, but it is simply inconsistent with the rule of law.”

In a Vanity Fair article, Michael Lewis vigorously and compellingly denounced the New York Fed for reimbursing AIG counterparties contracts at par value:

Here is an amazing fact: nearly a year after perhaps the most sensational corporate collapse in the history of finance, a collapse that, without the intervention of the government, would have led to the bankruptcy of every major American financial institution, plus a lot of foreign ones, too, AIG’s losses and the trade that led to them still haven’t been properly explained. How did they happen? Unlike say, Bernie Madoff’s pyramid scheme, they don’t seem to have been raw theft. The may have been an outrageous departure from financial norms, but if so, why hasn’t anyone in the place been charged with a crime? How did an insurance company become so entangled in the sophisticated end of Wall Street and wind up the fool at the poker table? How could the U.S. government simply hand over $54 billion in taxpayer dollars to Goldman Sachs and Merrill Lynch and all the rest to make good on the subprime insurance A.I.G. F.P. had sold to them—especially after Goldman Sachs was coming out and saying that it had hedged itself by betting against AIG?

In his 2007 memoir, The Age of Turbulence, former Federal Reserve Chairman Alan Greenspan, one of the lending architects of financial deregulation, said “the unwinding of the housing boom has hurt some groups” however “it did not create great difficulties for the great mass of homeowners who have built up substantial equity in their houses as prices rose.” He continued that he knew “the loosening of mortgage credit terms” increased financial risk.” Yet he believed “that the benefits of broadened home ownership are worth the risk.”

After observing the global impact of the subprime financial crisis, he told Congress that he had been “partially wrong” and that the subprime crisis had left him in a “state of shocked disbelief.” In his 2008 testimony before the House Committee of Government Oversight, Greenspan stated:

“I discovered a flaw in the model that I perceived is a critical functioning structure that defines how the world works. I have been going for 40 years with considerable evidence that it was working exceptionally well….I was wrong to think that free markets could regulate themselves without government oversight. I made a mistake in pursuing that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholder and their equity in the firms.” The fact that warning signs were disregarded or overlooked debunk the notion that the subprime crisis was an unavoidable “once-in-a-thousand-year storm.”

Columbia University economist and Nobel laureate, Joseph E. Stiglitz in his book “Freefall” and retelling of events, with his characteristic left-of-center dissent, described the subprime mortgage collapse more bluntly:

“Ultimately, the financial instruments that banks and lenders used to exploit the poor were also their undoing. The fancy instruments were design to extract as much money as possible from the borrower. The securitization process supported never-ending fees, the never-ending fees supported unprecedented profits, and the profits generated unheard-of bonuses, and all of this blinded the bankers. They may have suspected it was too good to be true—and it was.”