Ten years ago this week August 7, 2007, the world financial system began to fail. Ten years ago Banco National de Paris and BNP Paribas announced they were closing down three of their subprime investment funds because of a lack of liquidity. They closed down because there were so many late-paying mortgages. No one wanted to trade in these securities in those funds. All redemptions were put on hold. This was not ordinary for a Global bank not to “make a market in a fund they had sponsored. This was the begging of the world financial meltdown.
No redemptions for the funds meant you couldn’t pull the money you invested out of the funds. It was the beginning of mistrust that would infect the giant financial institutions of the world. Few people knew at the time that this would begin the greatest financial crisis since the great depression of the 1930s. Months earlier the Federal Reserve Chairman commented there were some bumps in the road but the system would withstand them. He had seen some of these mortgage funds start having delinquencies in people paying their monthly mortgage fees. But so what. The Banks were rock solid other than the bad mortgage situation. But no one knew that because of incestuous trading. The Crisis would unfold rapidly. The Crisis this time was about short-term money underwriting long-term money. Trust and faith in a fair deal are the bedrock of modern banking and capitalism. Banks were borrowing short-term money like 6 months and then using that short-term money to invest in long-term Mortgage-Backed Securities. These mortgage-backed securities were just that. Withing the Mortgage Bonds there are mortgages. Each month thousands of people pay their mortgages. If people start to not pay. The Financial Instrument starts to slowly disintegrate. It produces less and less money because fewer and fewer people are paying their mortgages. When the larger banks stopped redeeming the Bonds in the Funds. They were telling investors the Bonds were nonperforming and could not garner enough cash flow to pay the additional interest or redeem the principal amount invested.
This meant Faith and Trust in the market started to wane. No one wanted to trade these securities because they didn’t trust their backing or the value of the underlying instruments (mortgages). The funds contained mortgages. The banks borrowed short-term money to then buy these assets. Now it started that parts of the bond market froze up and this was a shock to bankers and it would lead to the Great Liquidity Crisis. The bonds and parts of the market froze up. No Liquidity. It started to spread. Like domino’s falling.
At that time what very few understood is that the large financial institution in New York, London, and around the world have become so yield-hungry in their investment portfolios. Risky investments bring higher returns. They had started to invest for higher returns. Mortgage back Securities. Backed only by the Institutions. Not by the US Government. Banks had started backing the full faith and interest in these Bonds. The Banks were supposed to have enough excess Capital to pay full principle back to the investors.
Unknown to the rest of Main Street, Federal Reserve, leaders on the street, and other Large Capital Funds. No one knew that the Banks all started buying each other high-yielding risky instruments. This exacerbated the situation because it was incestuous. They were borrowing short-term money from the over-the-counter money market then using that to buy Mortgages backed Securities underwritten by high-yielding securities. (Mortgage Backed Securities).
Before deregulation banks were never allowed to risk their money capital or credit rating on high-yielding instruments. But after deregulated trading rooms had become huge profit centers within the biggest Banks in the large money centers.
This was one of the negative aspects of deregulation. It put deposits at risk because it was a contingent liability for the Bank and ultimately it put the bank’s entire Credit Rating at risk.
To make market liquidity even looser they were buying each other’s funds. Lending to each other short term. Then use that money to underwrite the (Mortgage Backed Securities) So in the money market banks do this all the time. But nobody knew that amongst themselves they were spreading the bad Paper. This provided for redi-markets. It was the type of Bank incestuous behavior. This model did not spread the risk wide enough. So if one bank failed. Because the other bank-owned their Risky investment it would lead to that new bank now being infected by the bad financial instruments of the sick bank. So once one bank got sick. They could no longer buy from the other bank. their credit rating had dropped. So visa Versa now the other bank had bought the bad financial instrument from the recent sick bank. All of these investments were contingent liabilities set up by the banks but underwritten on their good Credit. Their Credit rating had changed because their Mortgage was becoming worth far less than what they have bought them for.
Their good credit rating helped create the problem. Each trusted each other and never looked into contingent structures (special purpose vehicles) and the make-up of the contingent liabilities and effect on liquidity for the greater market. They took on more and more of each other’s investments.
Then more and invested in risky investments to leverage each other and make even more money they lent each other more money and used the risky instruments as collateral to buy even more high-yielding security’s. This is why it was incestuous behavior because by doing this there was no diversification. If one failed or had their credit rating drop. It would affect the others who used the securities as collateral with them. So they all made lots of money but if one started to fail they were the collateral at the other banks so the banks would have to find other collateral when that one bank failed. It created a domino effect that would rock the world financial system.
Wow, how things change. It was so different. Many years earlier I had worked in the Bond Markets. In the late 1980’s it was still a highly regulated business. My experience was with Harry Shaefer and Bear Stearns. Back then. All products Bonds and Finacial instruments that we sold to the Banks, Insurance Companies, and large money funds and securities were government guaranteed.
So if the mortgages went bad or failed they would be back by the Federal Government. If the Bond went bad. Who would pay the bondholder the full amount? So for the Banks, there was very little Risk. for the financial institutions that held them. Today I remember good friends mentors Harry Shaffer, Chuck Ramsey, and Greg Spivack. These are the guys who helped create and sell the first mortgage-backed Securities. These three men worked at Bear Sterns and taught me so much in my life. Bear Stearns was one of the Great Innovators in the Wall Street area which helped innovate and spread many of these money Bonds into other Areas instead of the tightly regulated market. Harry was considered one of the Best Bond Salesmen in the United States. He was the best Salesman I ever worked with. Harry was from Tennessee and had the same grit and mentality that many early Texans had who had moved to the Lone Star State. Before he worked with his own Harry worked with Marcus Stowell and Beye and He taught me so much about Bonds, Sales, and respect for customers. Never a better Salesman.
Chuck Ramsey had worked as a Policeman in Beaumont and came to Houston during the boom as so many small-town guys did. He worked with Harry and was so good Bear Stearns wanted him in New York where he lead and headed up the main trading desk. While at Bear Chuck created the first computer programs on Wall Street that would measure and then predict the duration, early payback risk, interest rate risk, and more. Mortgage-Backed Security could prepay and what their rate of payment would be over time do to yield to maturity of that risk.
He was an innovator and he instilled in me the power of information and its impact on value by measuring and tracking key metrics. Using what I learned I found a new home in Argus Analytics. Chuck’s innovations were very useful when used in a highly regulated market to help generate very high revenues and value for Bear Stears. His program was able to segment different mortgages and pool the results for the investors and the Bankers. He helped expand the business and as a result, millions of dollars in Mortgages were made that put millions of people into homes that they might not have ever had.
So ten years after the Banking Meltdown and the Liquidity Crisis the balance sheet of the Federal Reserve is at 12 trillion dollars. Before the crisis, it was less than a Trillion. So thanks to President Obama, Timothy Geithner, and Paul Bernanke they all brought faith and trust back to our financial system. Instead of the Federal Reserve Printing money, they are slowly lowering the 12 Trillion and getting back to normal. Interest Rates have gone back up and money is being priced more as it should.
Financial rules were put back into place to prevent this Liquidity Crisis from happening again. Many rules including the “Volcker Rule.” This prevented the large institutions from investing in high-yield Risky investments. Hopefully, the medicine works.
Ten years later looking back it was a thrill to be in this business. It is so important to understand that President Obama with his strong leadership and Timothy Geithner and Paul Bernanke saved the Banking System and Capitalism as we have known it since the Great Crash of 1929. Hopefully all we learned we will not forget.