Wall Street's Meltdown: An Executive Summary

So what happened? What caused the Wall Street melt down this past week? My friends asked me to point them to a cogent explanation, but I couldn't find one. So this is my stab at it, in a very simplified format.

Writing Down AAA Mortgage Exposure

This year, banks, insurance companies and investment houses lost several hundred billion dollars against their equity because they were forced to write down, or mark to market, bonds that two years ago were rated AAA. Until recently, the historic loss experience on AAA bonds was nominal. Today, those bonds, which represent securitized subprime mortgages, are valued at something like 50 cents on the dollar.

The writedowns are done according to an industry benchmark that is, by most accounts, highly unreliable. But nobody has a better way for measuring these bonds' fair value, because nobody knows how the mortgage defaults will play out. Why the uncertainty? First, a lot of the underlying residential mortgages involved fraud. Second, the securitization, which sliced and diced ownership of the mortgages, has turned into a legal straightjacket that prevents anyone from taking charge and renegotiating the mortgages effectively. Third, this real estate bubble was so much bigger than any other in recent U.S. history, so no one really knows how long it will take to work off the excess supply of homes.

As investors shunned subprime mortgage securities, they also avoided mortgage securities for commercial properties where the underlying economic fundamentals, and likelihood of full recovery, are much better.

No One Knows What Surprises Lurk Within the $600 Trillion (Notional Amount) Derivatives Market

Financial institutions assumed "AAA risk" in other ways as well. They obtained credit risk insurance, sometimes known as credit default swaps, from other financial institutions, such as AIG. Lehman Brothers also had credit default swaps, along with hundreds of billions of dollars in other liabilities, both on and off its balance sheet, owed to financial counterparties. When Lehman collapsed on Monday, other banks and investment houses were forced to recognize losses on their Lehman exposure. Given the complications and uncertainties of bankruptcy law, it would be very hard for anyone to get a quick handle on the magnitude of the loss.

Uncertainty Leads to a Crisis In Confidence

The uncertainty surrounding the losses from Lehman, and potential losses from AIG, on top of the losses from mortgage backed securities, made everyone anxious about whether banks and brokerage houses would have sufficient equity capital by September 30, the end of the fiscal quarter. To preserve their capital, banks cut back on extensions of uncommitted credit, including inter-bank loans.

As a result, financial institutions suffered a crisis in confidence from which they could not easily recover. If you were a corporate treasurer, you might reconsider keeping your company's payroll account with Washington Mutual. Goldman Sachs might cut back on trading securities with Morgan Stanley. Citibank might stop trading foreign currencies with Bank of America.

The specter of everything grinding to a halt was what prompted Paulson to seek extraordinary powers to provide a credit backstop for the financial system.

Lehman Failed Because It Ran Out of Time

Lehman's demise was driven by timing. Its fiscal quarter ended on August 31, so it was compelled to report $7 billion in losses on mortgage backed securities on September 10, sooner than other banks. And Lehman's negotiations to sell itself to Barclays extended into the eleventh hour.

My hunch is that Lehman was the victim of hardball bait-and-switch tactics. On Friday afternoon September 12, Hank Paulson told Wall Street that the government would not step in to save Lehman. (If Paulson doesn't regret that statement, many others certainly do.)

By the time Barclays walked away from the negotiating table on September 13th or 14th, there was physically not enough time, before the opening of the markets on Monday September 15th, for Lehman to negotiate anything with anyone else. Lehman was forced to file for Chapter 11 on Monday September 15th, and a few days later Barclays was able to cherry pick Lehman's best assets and business units and buy them for a reduced price. Barclays had a competitive advantage over other bidders because of its earlier due diligence. Again, it's just a hunch. I wasn't in the negotiating room. But the tactic -- run up the clock to the last minute so the other side must decide when his back is against the wall -- is well known in the financial services industry. It's also a well known tactic on Capitol Hill, where it's being used right now.

Comments

[OutsideLookingIn]

"The writedowns are done according to an industry benchmark that is, by most accounts, highly unreliable."

Herein is the underlying problem of the whole crisis - a relatively new accounting rule that requires funds to regularly "mark to market".

Mark-to-market regulations require banks, fund managers and their accountants to value assets daily or regularly. It has been rigidly enforced by accountants trying to avoid the sort of criticism they received during the dotcom bubble and crash of 2000

The US financial crisis is essentially an accounting problem caused by rules requiring banks to write down assets to market prices even when trading in these securities is so illiquid that no reliable market prices exist.

Following the forced sale of US bank Bear Sterns some analysts expressed concern that the credit crisis could spiral out of control because when a bank revalues its mortgage-backed securities at fire-sale prices it can lead to further sales and even more write downs, which is what appears to have happened.

As soon as one set of bonds is revalued, it becomes the benchmark and all other bonds must be revalued.

Without the writedowns the banks would actually have enough capital to lend and help homeowners being caught by the crisis. The shortfall is all on paper.

[noneIn2008]

Senate Committee on Banking, Housing and Urban Affairs
http://banking.senate.gov/public/index.cfm?FuseAction=Information.Membership

Chairman Christopher J. Dodd, Richard Shelby, Tim Johnson, Robert F. Bennett, Jack Reed, Wayne Allard, Charles E. Schumer, Michael B. Enzi, Evan Bayh, Chuck Hagel, Tom Carper, Jim Bunning, Robert Menendez, Mike Crapo, Daniel K. Akaka, Elizabeth Dole, Sherrod Brown, Mel Martinez, Robert P. Casey, Bob Corker, Jon Tester

[ModerateDon]

It sounds like a tactic to resist.

[Bboyshoes42]

I think that I may be confused, but wouldn't a value on a bad mortgage still probably be far better than .50 on the dollar. Is there a way that average people could put money up to buy a failing mortgage? The way I would see it, there is property behind this mortgage, which, in and of itself would most likely be valued beyond 50% of the mortgage value. If someone is willing to sell me a property for 50% of its value, that would make sense to pick it up?

[Henry]

I have friends who work at a remote mortgage processing of one of the Invstmnt banks just recently merged out. They process mortgage payments for loans that in sum total amount to billions and their rule of thumb is that for each (of the 12000 per month clip) foreclosure valuation processed, the market value is 50% of the original appraised value that accompanied the loan they process. So... it is the complicated issue of identifying the "defaluts" amongst the various indentures that are assets that cannot find a "market" will to purchase them at their original "AAA" rating. And these indentures are scattered accross the globe. If you could distinguish the bonds that are only subprime mortgage loans, you'd have a leg up. But there is the problem of distilling the problems from the vasst array of securities. This consolidation (which added to initial value) now turn out to be a considerable problem when it comes to cleaning the mess.

[iambusto]

of all the banks Barclays CEO is a genius. sheer genius.

why pay a couple of billions with the risk of toxic debt, when you can let LEH go bankrupt and just pick the assets you want. :)

[schatsie]

It was Barclay's that had to close shop in the US because of a rogue trader....How did that happen?

I am so sick of these financial wizards who are just picking our pockets... We need Stiglitz and Kevin Phillips involved... There is no rush on this, it is already a mess and frankly, these institutions were the EXPERTS and they took this industry down...

We need jobs in this country!

[Findley]

ACT NOW...call Sen. Reid and Rep. Pelosi's office in DC : message -- NO BLANK CHECK for Paulson and this adminstration. NO trust in these people under any, dire or not, circumstances.

CALL them NOW-- show your support! Don't just sit there. Reid: 202.224.3542 Pelosi: 202.225.4965 Schumer:202.224.6542 Google for others.

Congress must HEAR from us and know we want Oversight & transparency, mortgage help for homeowners, no golden parachute/executive pay, & to include a stimulus package for average citizens. The assistant I spoke to said they pay attention to phone calls!! Send to all Dems...MAKE THE CALLS.

[OzDanJoaquin]

David, you're the man. This is the most concise, cogent and accurate synopsis I've read ANYWHERE on the meltdown, and I happen to have some, admittedly amateur, insight in this area. (I accurately predicted the collapse of Lehman & Merrill Lynch back in April) Your links are superb and comprehensively substantiate the points you're making. Well done! This should be essential reading for every would-be-pundit on the current , and ongoing, crisis. You were already one of my favourite writers on politics/media. Your mastery of this issue moves you into another category entirely. I'm forwarding your article to everyone I know, and geninely look forward to your next posting

[jms2qc]

I competely agree. Your articles lack the biased, opinion based commentary that so many are inclined to produce. Thanks for providing links to where you found your information and for posting this in an effort to educate those who seek the truth in what is going on these days. While I am not the most informed on this topic, it greatly interests me so keep up the posts!

[CitizenE]

So is this like a domino theory? If Lehman had had longer...what? Am I correct in understanding that what this poster avers is that Paulson backed Lehman up against the wall, and then did the old Pontius Pilate with them? Which leads again to not one but three questions. So AIG falling down right after that and everything else out there that we taxpayers will be covering was a created panic that led Paulson to lead the nation to this buyout? And if so, to what purpose? And finally, isn't a house made of cards sooner or later just a house made of cards? I mean at a certain point where's the house money?

[tcagle]

The music stopped.