Wednesday, October 10, 2018

Trump’s Poison Pills for China

A week ago I wrote about “China’s Syndromes.” I noted that aging demographic forces, which were significantly exacerbated by the Chinese government’s one-child policy, are already depressing the growth rate of real retail sales in China (Fig. 1 and Fig. 2). As a result, the government is scrambling to expand its overseas military and economic power to counter the structural weakness at home.

I argued that President Donald Trump is implementing policies aimed at either slowing or halting China’s drive to become a superpower. He wants to reduce America’s huge trade deficit with China by forcing US and other manufacturers to move out of that country. In the process, the US would no longer be financing China’s ascent with our trade deficit and providing technological know how that has been either stolen or extorted.

I didn’t have to wait long to get confirmation of my working hypothesis. Consider the following fast-paced developments:

(1) The President’s speech. In his 9/25 speech before the United Nations General Assembly, Trump said only the following about China, focusing on trade: “The United States lost over 3 million manufacturing jobs, nearly a quarter of all steel jobs, and 60,000 factories after China joined the WTO. And we have racked up $13 trillion in trade deficits over the last two decades. But those days are over. We will no longer tolerate such abuse. We will not allow our workers to be victimized, our companies to be cheated, and our wealth to be plundered and transferred. America will never apologize for protecting its citizens. … China’s market distortions and the way they deal cannot be tolerated.”

(2) The Vice President’s speech. In a 10/4 speech at the Hudson Institute, Vice President Mike Pence discussed the administration’s policy toward China in far greater detail. He started out by warning: “Beijing is employing a whole-of-government approach, using political, economic, and military tools, as well as propaganda, to advance its influence and benefit its interests in the United States.”

He accused the Chinese Communist Party of using “an arsenal of policies inconsistent with free and fair trade, including tariffs, quotas, currency manipulation, forced technology transfer, intellectual property theft, and industrial subsidies that are handed out like candy to foreign investment. These policies have built Beijing’s manufacturing base, at the expense of its competitors—especially the United States of America.”

He specifically berated the party’s “Made in China 2025” plan for aiming to control 90% of the “world’s most advanced industries including robotics, biotechnology, and artificial intelligence. To win the commanding heights of the 21st century economy, Beijing has directed its bureaucrats and businesses to obtain American intellectual property—the foundation of our economic leadership—by any means necessary.” He accused the Chinese of stealing US technology including cutting-edge military blueprints. “And using that stolen technology, the Chinese Communist Party is turning plowshares into swords on a massive scale,” he said.

He point-blank accused China of economic and military aggression abroad: “[W]hile China’s leader stood in the Rose Garden at the White House in 2015 and said that his country had, and I quote, ‘no intention to militarize’ the South China Sea, today, Beijing has deployed advanced anti-ship and anti-air missiles atop an archipelago of military bases constructed on artificial islands.” The result has been provocative and dangerous near misses between our two navies in the South China Sea.

Pence also documented instances of China using so-called “debt diplomacy” to expand its influence: “Today, that country is offering hundreds of billions of dollars in infrastructure loans to governments from Asia to Africa to Europe and even Latin America. Yet the terms of those loans are opaque at best, and the benefits invariably flow overwhelmingly to Beijing.”

The US has responded by boosting defense spending and slapping tariffs on China. These “exercises in American strength” explain why China’s largest stock exchange fell by 25% in the first nine months of this year. Got that? The US is targeting China’s stock market!

Pence accused the Chinese government of oppressing its own people at home. He railed about the Great Firewall of China “restricting the free flow of information to the Chinese people.” Even more frightening, he said, is the “Social Credit Score,” which, according to the official blueprint, will “allow the trustworthy to roam everywhere under heaven, while making it hard for the discredited to take a single step.” It will be implemented in 2020.

Pence also attacked the Chinese government for meddling in US politics in an effort to weaken America. He claimed that in June, “Beijing itself circulated a sensitive document, entitled ‘Propaganda and Censorship Notice.’ It laid out its strategy. It stated that China must, in their words, ‘strike accurately and carefully, splitting apart different domestic groups’ in the United States of America.”

There are lots more complaints about China in Pence’s speech. Clearly, the Trump administration’s policy toward China isn’t just about trade. A 10/5 NYT article critically stated that Pence in effect had declared a “New Cold War” with China. An alternative spin is that Pence was simply recognizing that China has launched an ever-expanding war against American interests.

(3) The poison pill placed in USMCA. A 10/5 CNBC article noted that there is a provision in the newly passed North American trade agreement, the United States-Mexico-Canada Agreement (USMCA, a.k.a. “the new NAFTA”), “which effectively gives Washington a veto over Canada and Mexico’s other free trade partners to ensure that they are governed by market principles and lack the state dominance.” In effect, that’s a “poison pill” aimed at China.

When Trump was elected, I observed that after eight years of government by community organizers, we were about to have a major regime change with government by dealmakers. US Commerce Secretary Wilbur Ross, a consummate wheeler-dealer when he was in the private sector, signaled on Friday that Washington may insist on including this poison-pill provision in future bilateral trade deals. “People can come to understand that this is one of your prerequisites to make a deal,” he said.

(4) JP Morgan’s bearish call. Last Wednesday, JPMorgan strategists wrote in a note that “[a] full-blown trade war becomes our new base case scenario for 2019” with 25% US tariffs imposed on all Chinese goods. They added, “There is no clear sign of mitigating confrontation between China and the U.S. in the near term.” In his 10/5 Barron’s column, Randy Forsyth noted that the bank’s strategists “estimate that 25% levies on all Chinese imports to the U.S. would trim earnings for the S&P 500 by $8 a share, from their original projection of $179 for 2019. ‘Such a downgrade would mark the first of the Trump era and potentially end the U.S. stock market rally, even assuming a forward [price/earnings] multiple of 17, unless some other offset materializes,’ they conclude.”

I agree that Trump will probably slap Chinese goods with an across-the-board 25% tariff. I think that the US economy will be strong enough to boost S&P 500 earnings by 6.8% to $173 per share, which has been our number for next year for a while. I don’t think that the escalating trade war with China will be the event that ends the bull market in the US (Fig. 3). However, it may already be marking the beginning of a severe and prolonged bear market in China (Fig. 4).

While financial markets were closed all last week in China for the Golden Week vacation, Hong Kong stocks fell for four consecutive days as investors grew increasingly concerned that the impact of the trade war is starting to show.

On Sunday, the People’s Bank of China slashed the reserve requirement ratio for large banks (currently 15.5%) and small banks (13.5%) by 100 basis points effective October 15 (Fig. 5). This is the fourth such cut this year. The prime rate is also likely to be cut soon (Fig. 6). Beijing has pledged to expedite plans to invest heavily in infrastructure projects as the economy shows signs of cooling further, with investment growth recently slowing to a record low.

CNBC reported yesterday, “On the back of the central bank’s announcement, China’s mainland markets traded in negative territory for much of their first trading day following the Golden Week holiday. Both the Shanghai composite and the Shenzhen composite fell more than 3.7% by the end of the trading day.” The two indexes peaked this year on January 24 and are down 23.7% and 25.0%, respectively (Fig. 7). China’s MSCI is down 26.0% from its peak on January 26. Hong Kong’s Hang Seng is down 21.0% from its peak also on that day (Fig. 8).

(5) Cyber war. The 10/4 Bloomberg Businessweek included a cover story titled “The Big Hack: How China Used a Tiny Chip to Infiltrate U.S. Companies.” The story is based on information from multiple intelligence and business sources who confirmed that Chinese spies attacked almost 30 US companies, including Amazon and Apple, “by compromising America’s technology supply chain, according to extensive interviews with government and corporate sources.” Operatives of the People’s Liberation Army inserted tiny microchips designed for spying in motherboards made in China and sold to American companies.

Both Amazon and Apple denied they had been hacked. Whether accurate or fake news, the story certainly could convince many companies to cut China out of their supply chains. That would fit in nicely with the Trump administration’s campaign to move production out of China back to the US.

(6) Bottom line. Trump’s fiscal, trade, and sanctions policies have boosted the dollar, oil prices, and interest rates. The risk, of course, is that these developments could punish not only China but lots of other emerging market economies as well. In the US, higher oil prices along with higher interest rates could also weigh on the US economy. Those are the major foreseeable risks. For now, I don’t see this all leading to a financial crisis or a recession. But I’m on alert: There sure are lots of poison pills out there!

Monday, October 1, 2018

China’s Syndromes

China I: Getting Trumped. I’m coming around to a new working hypotheses on the outlook for China’s economy. I think it could be much weaker much sooner than widely recognized. A significant slowing in the growth rate of inflation-adjusted retail sales over the past couple of years suggests that the aging demographic factor—attributable to the government’s previous population control measure—may be hitting consumer spending significantly already. As a result, Trump’s escalating trade war with China may very well hurt China’s economy much harder than widely realized.

Furthermore, what if Trump’s trade war with China isn’t just about trade? Yes, we all know it is also about intellectual property rights. But what if at heart it’s about China’s superpower ambitions—as evidenced by its moves to control the South China Sea, to build the “Silk Road” linking China to Europe by way of Central Asia, and to exploit the resources of Africa? The Chinese government, under President-for-life Xi Jinping, is intent on challenging America’s status as the world’s sole superpower. So why should the US continue to enable Xi’s geopolitical masterplan by allowing the Chinese to run a huge trade surplus with the US and to steal US technology?

The Trump administration’s overarching policy goal vis-à-vis China, therefore, may be first and foremost to use America’s economic power to slow, or even halt, the ascent of China into a superpower, which will challenge America’s interests around the world. If so, then any concessions that the Chinese make on trade and technology are likely to be rejected by the Trump administration. In other words, they have nothing to offer that would satisfy Trump other than an unconditional retreat from their geopolitical expansion plans, which they will never do voluntarily.

So Trump may very well raise the ante soon by slapping a permanent 25% tariff on all goods that the US imports from China. The goal isn’t to force concessions out of China but rather to get manufacturers out of China and into either the US (ideally) or to countries such as Mexico that do agree to the terms of bilateral trade deals with the US!

Of course, manufacturers who stay in China won’t be paying the 25% tariff: US consumers who buy China-made goods will be hit with that price hike. However, to remain competitive in the US, manufacturers are likely to scramble to other countries that can export to the US without having the US dollar price of their goods marked up by 25%.

I have one piece of anecdotal evidence that companies may be starting to move out of China already. A good friend of mine has a small business in Manhattan designing and selling high-end raincoats in the US. He has been manufacturing them in Vietnam. He stopped making them in China a few years ago because labor costs have been rising there, while they remain low in Vietnam. He told me he was shocked recently when his Vietnamese vendor had to lengthen delivery schedules from four months to six months because it was swamped with orders that used to be filled in China prior to Trump’s trade war.

Now consider the following recent developments before we review China’s depressing demographic outlook:

(1) Peter Navarro’s view. A Monday 9/24 CNBC article reported that Peter Navarro, director of the National Trade Council at the White House, said getting a trade deal with China will be tough: “The challenge is, they've engaged in so many egregious practices that it's far more difficult to make a deal with China than it would be with Mexico.” Navarro is a former economics professor and author of The Coming China Wars: Where They Will Be Fought, How They Can Be Won (2006).

A 6/24 Axios article quoted Navarro saying: “Since China joined the WTO [i.e., the World Trade Organization] in 2001, the U.S. has lost over 70,000 factories, more than five million manufacturing jobs, and suffered from substantially lower real GDP growth rates. As America’s manufacturing and defense industrial base has weakened, China’s has strengthened and we now face a strategic rival in places like the South China Sea whose military forces have been largely financed by the massive trade deficits the U.S. runs with China.”

Navarro had more to say on this subject in a 6/20 WSJ article titled “Trump’s Tariffs Are a Defense Against China’s Aggression: Beijing seeks economic and military domination by taking U.S. technology and intellectual property.” His opening paragraph said it all: “The Chinese government’s Made in China 2025 blueprint reveals Beijing’s audacious plans to dominate emerging technology industries. Many of these targeted sectors, such as artificial intelligence and robotics, have clear implications for defense. China seeks to achieve its goal of economic and military domination in part by acquiring the best American technology and intellectual property. President Trump’s new tariffs will provide a critical shield against this aggression.”

(2) Higher tariffs. Also on Monday 9/24, Washington slapped tariffs of 10% on $200 billion of Chinese products that include furniture and appliances, and the rate will increase to 25% by the end of the year. President Xi Jinping's government retaliated by imposing taxes on 5,207 US imports, worth about $60 billion. Products such as liquefied natural gas, coffee, and various types of edible oil will see a 10% levy, while a 5% tax will be imposed on items such as frozen vegetables, cocoa powder, and chemical products.

The US and China already had applied tariffs to $50 billion of each other's goods. Trump has warned that any retaliation by China would prompt Washington to “immediately pursue phase three, which is tariffs on approximately $267 billion of additional imports.”

Trump has overtly expressed his desire to narrow the US trade deficit with China significantly and to bring back manufacturing capacity to the US, so he may not declare victory in his trade war with China until Apple is making most of its iPhones in the US. It’s also conceivable that Trump may be mollified if Chinese leaders relinquish at least some of the country’s unfair trade practices, especially those related to foreign technology investment. But even if Trump’s negotiations with China and other countries don’t succeed in getting what he wants, they may succeed in providing more opportunities for the US to shop around for fairer trading partners.

Interestingly, cell phones and other household items is the largest category of imports to the US from China, according to the World Economic Forum. China isn’t the only place in the world to make cell phones, though. South Korean electronics giant Samsung is “now looking to fend off Chinese companies trying to dominate the market for inexpensive phones” by expanding manufacturing into India, according to an article in the 9/4 WSJ. The company’s new facility in a New Delhi suburb, to be completed in 2020, will eventually make 120 million handsets a year, or roughly one of every 13 phones in the world. Around 30% of those will be exported.

(3) Arms race. On Thursday 9/20, Washington imposed sanctions on a Chinese military unit for purchasing Russian weapons, claiming the transaction violated a US sanctions law known as “Countering America's Adversaries Through Sanctions Act,” which was signed by President Trump on August 2, 2017. The act imposed sanctions on Iran, North Korea, and Russia. The Chinese government summoned the US ambassador in Beijing over the matter and said Beijing would recall its navy chief from a visit to the US.

On 9/25, the US approved a $330 million arms sale to Taiwan in another sign of Washington’s support for the government in Taipei amid rising Chinese pressure on the country. In the latter years of George W. Bush’s presidency, Washington dropped annual weapons sales to Taiwan in favor of bundling sales every few years, a move that was seen as acquiescence to pressure from China. Under Trump, there may be a return to the routine sale of weapons to Taiwan, despite protests from China.

Meanwhile, China has sought to strengthen its claim to the South China Sea by building seven islands on reefs and equipping them with military facilities such as airstrips, radar domes, and missile systems. Five other governments claim territory in the oil- and gas-rich area, through which an estimated $5 trillion in global trade passes annually. Last Thursday, China called a recent mission by nuclear-capable US B-52 bombers over the disputed South China Sea “provocative.”

China II: Why Trump Won. Trump won on November 8, 2016 because he appealed to voters who lost manufacturing jobs after China entered the WTO and manufacturers left the US. Previously, I’ve shown a chart that clearly shows this development. It tracks US manufacturing production and capacity since January 1948 (Fig. 1). The two were on similar and solid uptrends—tracking at about 4% per year on average—until China joined the WTO during December 2001. Both have been flat ever since. I estimate that if the trend prior to December 2001 had persisted, US manufacturing capacity would be 77% higher than it was during August of this year (Fig. 2)!

We can also guesstimate China’s impact on jobs. Factory payrolls dropped 4.3 million from December 2001 (when China joined the WTO) through March 2010 to the lowest level since March 1941 (Fig. 3). They were still down 3.4 million through Election Day 2016 and 3.0 million through August of this year.

The ratio of US factory jobs to capacity has declined 24% since the end of 2001 through August of this year, presumably reflecting productivity gains (Fig. 4). If capacity had remained on its uptrend prior to China joining the WTO, factory employment arguably would be 53%, or 6.7 million jobs, higher than August’s level of 12.7 million. (We derived the percentage increase by subtracting 77% from 24%.)

So Trump’s victory on Election Day 2016 may largely reflect the hostile reaction of America’s manufacturing Heartland to China’s ascent, presumably at US factory workers’ expense.

China III: The Most Important Indicator. While manufacturing employment may be the key indicator explaining why Trump beat Clinton, inflation-adjusted retail sales in China may be the most important variable for tracking the impact of China’s increasingly dismal demographic profile on its economy. Consider the following:

(1) Real retail sales. Every month, the Chinese report retail sales and the consumer price index (CPI). We’ve been monitoring the yearly percent changes in both for many years (Fig. 5). The difference between the two is the growth rate in real retail sales. It has been on a downtrend since 2008-2010 when it typically exceeded 15%. During August of this year, it was down to 6.7%, one of the lowest readings since China joined the WTO at the end of 2001. It is down from 9.3% two years ago.

(2) Industrial production. Real retail sales has actually been growing faster than industrial production since early 2012 (Fig. 6). The latter has been growing around 6.0% y/y since 2015. It is likely to fall sooner rather than later if the downtrend in real retail sales persists (as suggested by the demographic trends discussed below) and Trump’s trade war weighs on exports.

(3) Credit. All of the above suggests that the Chinese government may have no choice but to continue propping up economic growth with debt-financed infrastructure spending. Bank loans (in yuan) have quadrupled in China since February 2009 (Fig. 7). Yet the Chinese are getting less and less bang per yuan. The ratio of Chinese industrial production to bank loans has dropped by roughly 50% since late 2008 (Fig. 8).

It’s possible that my analysis so far is too negative. Missing is the growing importance of services industries in China. Nevertheless, demography is destiny, and the Chinese government made an increasingly dismal global outlook on this front much worse in China.

China IV: Depressing Demographic Destiny. In Chapter 16 of my book, Predicting the Markets, I discuss China’s depressing demographic destiny. That discussion is especially relevant to today’s commentary:

“The fertility rate in China plunged from 6.1 in the mid-1950s to below 2.0 during 1996 (Fig. 9). Still below 2.0, it’s projected to remain so through the end of the century. Initially, the drop was exacerbated by the government’s response to the country’s population explosion, which was to introduce the one-child policy in 1979. While that slowed China’s population growth—to a 10-year growth rate of 0.5% at an annual rate in 2016 from a 3.0% pace in 1972—it also led to a shortage of young adult workers and a rapidly aging population.

“So the government reversed course, with a two-child policy effective January 1, 2016. Births soared by 7.9% that year with the deliveries of about 18 million newborns. But that was still short of the government estimates and might not be sustainable. At least 45% of the babies born during 2016 were to families that already had one child. [For more, see link.]

“Meanwhile, urbanization has proceeded apace, with the urban population rising from about 12% in 1950 to 49% during 2010; it was an estimated 57% in 2016 (Fig. 10). The urban population has been increasing consistently by around 20 million in most years since 1996 (Fig. 11). To urbanize that many people requires the equivalent of building one Houston, Texas per month, as I discuss in Chapter 2. I first made that point in a 2004 study.

“The move to a two-child policy is coming too late, in my opinion. China’s primary working-age population peaked at a record high of just over 1.0 billion during 2014 and is projected to fall to 815 million by 2050 (Fig. 12). By then, the primary working-age population in China will represent 60% of the total population, below the peak of 74% during 2010 (Fig. 13). The elderly dependency ratio will drop from 7.5 workers per senior in 2015 to 2.3 by 2050 (Fig. 14).

“In any event, despite the initial mini baby boom, the fertility rate is unlikely to rise much in response to the government’s new policy. Many young married couples living in China’s cities are hard-pressed to afford having just one child. An October 30, 2015 blog post on the Washington Post website, titled “Why Many Families in China Won’t Want More than One Kid Even if They Can Have Them,” made that point, observing that education is particularly expensive, as parents feel compelled to prepare their child to compete for the best colleges and jobs. Another problem is that most couples are the only offspring of their aging parents, who require caregiving resources that rule out having a second child. As it says in the Bible, ‘As you sow, so shall you reap.’”

Wednesday, September 26, 2018

Bear Traps for Stocks?

In the past, the worst time to buy stocks typically has been when the unemployment rate was making a cyclical low (Fig. 1). Needless to say, initial unemployment claims was doing the same at the same time—and screaming “Get out! Get out!” (Fig. 2). Buying stocks when the yield curve was flat and on the verge on inverting has also been a bad idea (Fig. 3). Buying stocks when the Fed is raising interest rates can work okay for a while, until higher rates trigger a financial crisis, which often turns into a credit crunch and a recession (Fig. 4 and Fig. 5). Rising bond yields aren’t always bad for stocks, until they are (Fig. 6). Those times late in an expansion when the profit margin exceeds its mean tend to set it up for a bruising reversion to the mean and even below, which is bad for profits and bad for stocks (Fig. 7). As for buying stocks when valuations are extremely high, anyone could tell you “fuhgeddaboudit!” (Fig. 8).

All of the above bear traps may be set to snare the current bull market. A 9/10 Bloomberg article was titled “Goldman Bear-Market Risk Indicator at Highest Since 1969: Chart.” The Goldman indicator neatly converts all of the major bear traps into one series:

“A Goldman Sachs Group Inc. indicator designed to provide a ‘reasonable signal for future bear-market risk’ has risen to the highest in almost 50 years. The firm’s Bull/Bear Index, which is based on measures of equity valuation, growth momentum, unemployment, inflation and the yield curve, is now at levels last seen in 1969. While the gauge is at levels that have historically preceded a bear market …”

So why does the stock market bull continue to charge ahead? Last Friday, the S&P 500 closed a whisker below its record high of 2930.75, hit on Thursday—rapidly approaching my 3100 target for this year (Fig. 9). It is up 9.6% ytd. It has recovered smartly from the nasty 13-day correction earlier this year with a gain of 13.5% since the year’s low on February 8 (Fig. 10). During the current bull market, I count five corrections (exceeding 10%), one near correction (that rounds up to 10%), and a total of 61 “panic attacks” that were followed by relief rallies.

The latest relief rally reflects mounting confidence that Trump’s trade war won’t escalate into one that depresses the economy and corporate earnings, which continue to soar. In addition, there is less fear lately that the Fed’s policy normalization will trip up the bull market. Earlier this year, there was fear that a 10-year US Treasury bond yield above 3.00% would be bearish for stocks. It recently rose back slightly above that level, yet it was widely deemed to be bullish for financial stocks. Go figure!

So what will it take to snare the bull in the bear traps? It will take a recession. That’s all there is to it. While Goldman and everyone else is on the lookout for this event, both the Index of Leading Economic Indicators (LEI) and the Index of Coincident Economic Indicators (CEI) rose to new record highs during August (Fig. 11). The LEI did so even though the yield curve spread, which is only one of this index’s 10 components, has been narrowing fairly steadily since 2013, but remains positive. It only subtracts from the LEI when it is negative. So it is still contributing positively to the LEI, though to a lesser extent. History shows that the CEI, which is a good monthly proxy for quarterly real GDP, falls when a financial crisis occurs, triggering a credit crunch and a recession. There’s no sign that scenario is about to play out again anytime soon.

I have argued that there was a growth recession during 2015 caused by the collapse in commodity prices. Credit quality yield spreads widened dramatically, especially in the junk bond market. Yet here we are at a record high in the S&P 500. Arguably, there has been an emerging markets crisis this year, yet here we are at a record high in the S&P 500.

Sunday, September 16, 2018

Financial Crisis of 2008 Part VII: FEDDIE

This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

WITH THE FINANCIAL crisis rapidly spreading during September 2008, US Treasury Secretary Henry Paulson proposed a plan under which the Treasury would acquire up to $700 billion worth of MBSs to relieve banks of these toxic assets. Only three pages long, the plan was called the “Troubled Asset Relief Program” (TARP). A longer version became the formal legislation enacted on October 3.

Just 10 days later, at a meeting with nine major US banks on October 13, TARP was changed. It became a program in which the Treasury would purchase individual banks’ preferred shares to inject capital into the banking system. Some of the bankers initially balked at the switch, but Paulson made them an offer they weren’t allowed to refuse.[1]

By the way, Paulson was the CEO of Goldman Sachs from 1999 until he became Treasury Secretary in 2006. He testified to the FCIC that by the time he became secretary, many bad loans already had been issued—“most of the toothpaste was out of the tube”—and that “there really wasn’t the proper regulatory apparatus to deal with it.” Paulson was on Time’s list and was blamed by the FCIC as follows: “Under Paulson’s leadership, Goldman Sachs had played a central role in the creation and sale of mortgage securities. From 2004 through 2006, the company provided billions of dollars in loans to mortgage lenders; most went to the subprime lenders Ameriquest, Long Beach, Fremont, New Century, and Countrywide through warehouse lines of credit, often in the form of repos.”[2]

More reassuring than TARP, which was poorly planned and executed, was the FDIC’s Temporary Liquidity Guarantee Program, implemented on October 14. It fully guaranteed all noninterest-bearing transaction deposits at participating banks and thrifts through December 31, 2009. The deadline was extended twice and expired on December 31, 2010. In addition, the FDIC guaranteed certain newly issued senior unsecured debt of the banks.[3] At its peak, the guarantee covered $345.8 billion of outstanding debt through the end of 2012. Sheila Bair, FDIC chair at the time, deserves credit for her role in ending the crisis.

The Fed lowered the federal funds rate from 5.25% in mid-2006 to nearly zero near the end of 2008, the so-called “zero lower bound.” Fed Chairman Ben Bernanke also responded to the crisis by flooding the financial system with liquidity. Under his leadership, the Fed was remarkably effective at creating numerous emergency credit facilities that helped to contain the crisis so that it wouldn’t turn into a full-blown contagion and collapse of the financial system. As the crisis popped up in various parts of the financial system, Bernanke masterfully played “whack-a-mole” using three sets of tools:

• Liquidity facilities for financial institutions. The first set was closely tied to the central bank’s traditional role as the lender of last resort for financial institutions. In addition to the Fed’s discount window, the traditional facility for distressed banks, these facilities included the Term Auction Facility, Primary Dealer Credit Facility, and Term Securities Lending Facility. Credit swap agreements were approved on a bilateral basis with several foreign central banks to relieve liquidity problems arising in global bank funding markets.

Liquidity facilities for borrowers and investors. A second set of tools targeted distressed borrowers and investors in key credit markets, including the Commercial Paper Funding Facility, the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Money Market Investor Funding Facility, and the Term Asset-Backed Securities Loan Facility.[4] Collectively, the Fed’s emergency loans rose from $391 billion during the first week of September 2008 to peak at $1.7 trillion during the week of December 10.

Quantitative easing programs. In addition to these targeted facilities, the Fed expanded its traditional tools related to open-market operations. On November 25, 2008, the Fed announced the first round of a program of quantitative easing (QE). There were three rounds all told:

QE1 from November 25, 2008 to March 31, 2010. The first round entailed the purchase of the direct obligations of housing-related GSEs—Fannie Mae, Freddie Mac, and the Federal Home Loan Banks—and MBSs backed by Fannie Mae, Freddie Mac, and Ginnie Mae. Over the next several quarters, the Fed would purchase up to $100 billion in GSE direct obligations and up to $500 billion in MBSs. The program was expanded on March 16, 2009 to include purchases of $300 billion in US Treasuries. Under QE1, the Fed purchased $1.5 trillion in bonds, including $1.2 trillion in US Agency debt and MBSs and $300 billion in US Treasuries.

QE2 from November 3, 2010 to June 30, 2011. The second round entailed the purchase of $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. Under the program, the Fed purchased $826 billion in US Treasuries, while its holdings of US Agency debt and MBSs declined $246 billion as securities matured.

QE3 from September 13, 2012 to October 29, 2014. The third round was open-ended, with the FOMC committing to purchase $40 billion per month in Agency MBSs. No total was announced, nor was a termination date. On December 12, 2012, the program was expanded to include $45 billion per month in “longer-term” Treasuries. On December 18, 2013, QE3 was tapered to $35 billion per month in MBSs and $40 billion per month in Treasuries. It was terminated on October 29, 2014 after the Fed had purchased $832 billion in MBSs and $808 billion in Treasuries.[5]

Ben Bernanke had transformed the Fed into “Feddie,” supplementing and shoring up Fannie and Freddie. Because of the three rounds of QE from November 25, 2008 through October 29, 2014, the Fed’s holdings of MBSs increased from zero to $1.8 trillion, and the Fed’s holdings of Treasuries increased from $476 billion to $2.5 trillion.

Not widely recognized is that the Fed stepped in to buy Agency- and GSE-backed MBSs because overseas investors were bailing out of these securities. Their holdings soared from $264 billion during the first quarter of 2000 to a record high of $1.6 trillion during the first half of 2008. By the end of the fourth quarter of 2014, when the QE program was terminated, they had dumped $734 billion of their holdings. Some of the foreign holders were central banks parking their international dollar reserves in these securities because they yielded more than US Treasury securities and were deemed to be just as safe.

There wasn’t much the Fed could do for the ABS issuers directly. However, the Fed’s purchases of Agency- and GSE-backed MBSs certainly propped up these financial institutions and the underlying mortgages they held. Feddie had saved the day.

It was also a new day for central banks following the financial crisis. The Fed and the other major central banks evolved into central monetary planners, essentially grabbing more power to manage the economy via monetary policy—with tremendous consequences for the major capital markets around the world.


[1] “How the Bailout Bashed the Banks,” Fortune, June 22, 2009.

[2] The Financial Crisis Inquiry Report, p. 142.

[3] “Temporary Liquidity Guarantee Program,” FDIC factsheet.

[4] “Credit and Liquidity Programs and the Balance Sheet,” Federal Reserve Board webpage.

[5] “Chronology of Fed’s Quantitative Easing,” YRI webpage.

The Financial Crisis of 2018 Part VI: FLAW IN THE MODEL

This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

IN THE MOVIE Casablanca (1942), police Captain Louis Renault walks into the back room of Rick’s Café and asserts, “I’m shocked, shocked to find that gambling is going on in here!” As he shuts the place down, the casino manager hands him his recent winnings. Likewise, Alan Greenspan repeatedly professed his shock at what had gone on in the credit casino under his watch, and he certainly lost some of his public admiration when he did so—though Greenspan’s shock was a good deal more genuine than Renault’s.

In the prepared remarks for his October 23, 2008 testimony before the House Committee on Oversight and Government Reform, at a hearing on the role of federal regulators in the financial crisis, the former Fed chairman noted that subprime mortgages were the root of the problem but indicated that the real crisis stemmed from the uncontrolled securitization of those mortgages: “The evidence strongly suggests that without the excess demand from securitizers, subprime mortgage originations (undeniably the original source of crisis) would have been far smaller and defaults accordingly far fewer.” He went on: “[S]ubprime mortgages pooled and sold as securities became subject to explosive demand from investors around the world.” Greenspan noted that there had been a surge in global demand for US subprime securities by banks, hedge funds, and pension funds that were supported by “unrealistically positive rating designations by credit agencies.”[1]

Greenspan continued, “As I wrote last March: those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief. Such counterparty surveillance is a central pillar of our financial markets’ state of balance. If it fails, as occurred this year, market stability is undermined.” During his Q&A exchange, he said:

“I made a mistake in presuming that the self-interest of organizations, specifically banks and others, [was] such [that] they were best capable of protecting their own shareholders and their equity in the firms. . . . So the problem here is something which looked to be a very solid edifice and, indeed, a critical pillar to market competition and free markets did break down. And I think that, as I said, shocked me. I still do not fully understand why it happened and, obviously, to the extent that I figure out where it happened and why, I will change my views. And if the facts change, I will change.”

Then he admitted, “I found a flaw in the model that I perceived is the critical functioning structure that defines how the world works, so to speak.” He added, “That’s precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.”[2]

In his prepared remarks, Mr. Greenspan said that the models used by Wall Street’s financial engineers were also flawed:

“In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivatives markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.”

Apparently, he was in so much shock that he offered the committee only one specific recommendation: “As much as I would prefer it otherwise, in this financial environment I see no choice but to require that all securitizers retain a meaningful part of the securities they issue. This will offset in part market deficiencies stemming from the failures of counterparty surveillance.” Greenspan’s reluctance to force securitizers to have skin in their own game is just plain odd.

Committee Chairman Henry Waxman (D, CA) blamed regulators and Congress alike. “Congress is not exempt from responsibility,” he acknowledged. “We passed legislation in 2000 that exempted financial derivatives from regulation. And we took too long—until earlier this year—to pass legislation strengthening oversight of Fannie Mae and Freddie Mac. Over and over again, ideology trumped governance.” Politics, greed, and outright corruption trumped governance as well.

Many lay blame for the subprime crisis on the GSEs’ embrace of the low-end lending market—or, rather, their forced embrace. Former Senator Phil Gramm, the same fellow who had pushed for the law that outlawed regulating credit derivatives, drew such a linkage in a Wall Street Journal editorial on February 20, 2009. He observed that when the housing market collapsed, Fannie Mae and Freddie Mac had to deal with three quotas: 56% of their mortgage holdings had to be loans to people with below-average incomes, 27% had to be loans to families with incomes at or below 60% of the area median income, and 35% had to target underserved geographic areas. Consequently, the subprime portion of the mortgage market shot up from 5% (with 31% of that securitized) in 1994 to 20% (81% securitized) in 2006.[3]

Needless to say, Gramm was doing his best to absolve himself and his two signature pieces of legislation in 1999 and 2000 from any responsibility for the financial disaster that seemed to ensue from them. Instead, he blamed it all on the “politicization of the mortgage market.” He quoted from Greenspan’s October 23, 2008 testimony that “the subprime market . . . essentially emerged out of CRA.” In other words, the government made the lenders take on these riskier mortgages.

The GSEs initially resisted purchasing these risky mortgages. But they ended up going along for the ride. It was a win-win for everyone. Poor communities and their community organizers benefited from the surge in homeownership. Wall Street profited from increased sales of Fannie Mae, Freddie Mac, and guaranteed MBSs and derivatives. And the GSE heads were very richly rewarded, so they showered their political friends in Washington with campaign contributions.

In 2009, the renowned economist Henry Kaufman put the financial crisis into perspective in a book titled The Road to Financial Reformation: Warnings, Consequences, Reforms. A review of it in The Economist was titled “He Told Us So.”[4] The reviewer wrote that he felt “shortchanged” because Kaufman didn’t mention his role at Lehman and didn’t “shed light on the failings of corporate governance that contributed to the humbling of high finance.” Martin Feldstein, who had chaired the Council of Economic Advisers in the Reagan administration and was another paragon of financial conservatism, sat on AIG’s board when it collapsed.

On April 18, 2010, former President Bill Clinton squarely blamed two of Time’s “Three Marketeers,” Rubin and Summers, for their bad advice on the credit derivatives market, in an interview on ABC’s This Week program: “On derivatives, yeah I think they were wrong and I think I was wrong to take [their advice] because the argument on derivatives was that these things are expensive and sophisticated and only a handful of investors will buy them and they don’t need any extra protection, and any extra transparency. The money they’re putting up guarantees them transparency,” Clinton said. “And the flaw in that argument,” he added, “was that first of all sometimes people with a lot of money make stupid decisions and make [them] without transparency.”[5]

In response to the financial crisis of 2008, Congress passed the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010. Ironically, the sponsors were none other than US Senator Chris Dodd and US Representative Barney Frank, whom some believed should have been included in the list of people to blame for the crisis. The Act increases the amount of liquid assets and capital that banks must have to back up their activities. Large banks must pass an annual stress test administered by the Fed. The Act’s so-called “Volcker Rule” bans the big banks’ trading desks from proprietary trading, limiting them to making markets for their clients. The Trump administration is committed to easing some of the regulatory constraints imposed by the Act.


[1] See “Testimony of Dr. Alan Greenspan,” October 23, 2008, before the US House of Representatives’ Committee of Government Oversight and Reform. The Q&A portion is available in an October 24, 2008 Washington Times article titled “He Found the Flaw?

[2] Again, see Greenspan’s October 23, 2008 testimony and the October 24, 2008 Washington Times article for the Q&A.

[3] “Deregulation and the Financial Panic,” Gramm’s op-ed in The Wall Street Journal, February 20, 2009.

[4] “Henry Kaufman on Financial Reform: He Told Us So,” The Economist, August 27, 2009. Kaufman did have more to say about Lehman in Tectonic Shifts in Financial Markets (2016). However, rather than recounting his experiences at Lehman as board director, he blamed US Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke for letting the firm fail. See Appendix 3, Bernanke’s Fed and the Lehman Bankruptcy.

[5] “Clinton: I Was Wrong to Listen to Wrong Advice Against Regulating Derivatives,”, April 18, 2010.

The Financial Crisis of 2008 Part V: FAULTY INSURANCE POLICIES

This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

LLOYD BLANKFEIN, CEO of Goldman Sachs, wrote an article in the February 8, 2009 Financial Times titled “Do Not Destroy the Essential Catalyst of Risk.”[1] He observed that it should have been obvious something wasn’t right about CDOs: “In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A.” It was a belated warning, to say the least! “It is easy and appropriate to blame the rating agencies for lapses in their credit judgments,” Blankfein continued. “But the blame for the result is not theirs alone. Every financial institution that participated in the process has to accept its share of the responsibility.” It’s easier to spout mea culpas after all the profit opportunity has dried up. What good do they do then, besides silencing critics with the same incriminating points to make?

As Blankfein admitted, the most obvious perpetrator of the 2008 financial crisis was the credit insurance industry. This industry emerged following the first of the three Basel Accords. In Basel I, the banking regulators of the major industrial nations agreed to impose uniform capital requirements on banks. Risky assets required more capital. The credit insurance industry employed an army of financial engineers whose innovations magically transformed subprime mortgages, junk bonds, liars’ loans, and other trashy debts into AAA-rated credits. Many of these products were defective. This financial engineering was a great business while it lasted. But it represented huge fraud at worst or negligent malpractice at best.

Among the major contributors to the debacle were the credit-rating agencies that had awarded AAA ratings to thousands of CDO tranches, as Goldman’s Blankfein belatedly observed. The FCIC’s January 2011 report was correct to call the rating agencies “essential cogs in the wheel of financial destruction” and “key enablers of the financial meltdown.” There were only three big rating agencies—Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings.

The FCIC concluded: “The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.”[2]

The securitization business brought the agencies huge fees. The raters were paid by the issuers to rate the CDOs that included bunches of tranched ABS. The more complex the security, the greater the fee generated. By the time Moody’s became a public company, structured finance was its top source of revenue. Gretchen Morgenson of The New York Times reported on December 6, 2008 that Moody’s fees for rating mortgage pools were four to five times more than fees for rating similarly sized municipal bonds.[3]

The rating agencies were operating as a government-sanctioned oligopoly without any government regulation—no federal agency was charged with oversight. Washington finally recognized that the rating agencies were running amok and needed to be reined in, so Congress passed the Credit Rating Agency Reform Act, and President George W. Bush signed it into law in late 2006.

Under the Act, the SEC filled the void and became the agencies’ regulator. While the new law gave the Commission new powers to inspect and punish the agencies, it also prevented the SEC from regulating how ratings were determined. The SEC had no authority to make rules governing the agencies’ business or to subject them to examinations as nationally recognized statistical rating organizations (NRSROs).

The Commission established its formal regulatory program for NRSROs in June 2007; seven firms applied to be registered, and all were approved. As SEC Chairman Christopher Cox testified on April 22, 2008, before the US Senate Committee on Banking, Housing and Urban Affairs, “as of the end of September 2007, seven credit rating agencies—including those that were most active in rating subprime RMBS [residential mortgage-backed securities] and CDOs—became subject to the Commission’s new oversight authority, and subject as well to our newly adopted rules.”[4]

But September 2007 was too late. When the delinquency rates of mortgages started escalating in early 2007, calling into question the AAA ratings on many CDOs with subprime loan exposure, the rating agencies didn’t fail to notice. The rating agencies lowered their credit ratings on $1.9 trillion in MBSs from the third quarter of 2007 through the second quarter of 2008, with dire implications for the credit quality of the CDOs composed of the downgraded MBSs. In other words, CDOs began to hit the fan.

Why hadn’t Moody’s noticed the rising delinquencies in early 2007? Moody’s did have a US residential mortgage bond team in place to track troublesome developments, according to the October 17, 2008 issue of the Financial Times.[5] But the rising delinquencies seen in January 2007 didn’t compel Moody’s to take action. That’s because rising delinquencies alone was only the first of three cautionary signals in Moody’s alarm system—which was still flashing a “green light.” True, the speed of delinquency escalation shocked analysts, but their system told them to sit tight. The Financial Times noted: “According to a report in March 2007, the risks of the defaults in subprime mortgage bond pools climbing further up the structured finance chain were ‘mild to moderate.’” Soon after, the amber light flashed when the number of delinquencies exceeding 90 days shot through the roof. Still, “[o]utwardly, the agencies were sanguine,” reported the Financial Times.

As US mortgages continued to sour at a breakneck pace, Moody’s analysts, upon inputting the new data, were stunned by the severity of the mortgage crisis. In the final few months of 2007, the rating agency downgraded more bonds than it had over the previous 19 years combined, reported the Financial Times. Similar revelations must have occurred in the offices of Standard & Poor’s and Fitch, which also began downgrading like mad.

Moody’s abundant AAA ratings on pools tainted with subprime allowed for little possibility that the housing boom might go bust—even though Moody’s very own in-house chief economist, Mark Zandi, had been warning of a US housing downturn since May 2006! According to the Financial Times, Zandi wrote in May 2006 that the housing market “feels increasingly ripe for some type of financial event.”

We now know that the 800-pound gorilla in the credit insurance industry was AIG. In the Mayfair neighborhood of London dubbed “hedge fund alley” were the offices of AIG Financial Products—the business unit from which AIG issued its credit default swaps. It had been run for 21 years by American Joseph Cassano.[6] Most of those years were great ones financially, for both the high-performing subsidiary and its highly compensated leader. That all changed at the end of 2007. Cassano had built the credit default swap business so successfully that AIG Financial Products provided guarantees on more than $500 billion of assets by that point, including $61.4 billion in securities tied to subprime mortgages.[7]

An accounting shift that affected how the Financial Products unit valued collateral resulted in the markdown of these credit default swaps—and poof went $34 billion. In contrast to standard practice, AIG Financial Products did not hedge its exposure to a possible fall in the CDS market. When AIG’s accountants asked the insurer to change the way it valued CDSs, the comparatively small base of capital on which AIG Financial Products had built a mountain of business became visible. This began the unravelling that led to AIG’s central role in sparking the globalization of the US financial crisis, because many European banks had purchased AIG credit derivatives to insure their loan portfolios and bonds.[8]

On September 16, 2008, AIG suffered a liquidity crisis when its credit rating was downgraded. To avoid a financial meltdown, the US Treasury Department extended an $85 billion credit line in exchange for just under 80% of its equity. On March 2, 2009, AIG announced fourth-quarter 2008 results representing “the biggest quarterly corporate loss in US history,” according to a March 4 Washington Post article: a loss of $61.7 billion.[9] The US government at about the same time re-restructured the terms of AIG’s total bailout package, which by then had swelled to $152 billion—providing another $30 billion in taxpayer funds, eliminating dividend payments, and granting the government stakes in two of AIG’s big insurance subsidiaries.

On Tuesday, March 3, 2009, testifying at a Senate hearing on the federal budget, Fed Chairman Ben Bernanke was really mad: “[I can’t think of] a single episode in this entire 18 months that has made me more angry . . . than AIG.” That was the first time the characteristically reserved central banker had publicly displayed any emotion about the financial crisis. What most got his goat reportedly was the way AIG had strayed from its core insurance business to take unmonitored and unnecessary risks; writing billions of dollars in exotic derivative contracts had nearly destroyed the company. “AIG exploited a huge gap in the regulatory system,” Bernanke said. “There was no oversight of the Financial Products division. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets—took huge losses. There was no regulatory oversight because there was a gap in the system.”

On the same day that the Fed chairman was castigating AIG before the Senate, Treasury Secretary Timothy Geithner was over in the House trying to defend the government’s ever-growing rescue of AIG to fuming lawmakers. The March 4, 2009 Washington Post quoted some of his testimony before the House Ways and Means Committee: “AIG is a huge, complex, global insurance company, attached to a very complicated investment bank hedge fund that built—that was allowed to build up without any adult supervision, with inadequate capital against the risks they were taking, putting your government in a terribly difficult position. . . . And your government made the judgment back in the fall that there was no way that you could allow default to happen without catastrophic damage to the American people.”

In his mea culpa article on behalf of the financial industry, Blankfein admitted that it was all about making lots of money: “We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us—especially when exuberance is at its peak.”

Blankfein didn’t mention that his firm had been dangerously exposed to AIG. In 2007, Goldman began marking down the value of CDOs on its books that had been insured by AIG against the possibility of default. When Goldman requested that AIG put up more collateral to cover those losses, the insurance company sometimes posted half or less of the amount demanded, disputing Goldman’s valuations. When the government took over AIG, its creditors, including Goldman, were made nearly whole. An April 15, 2009 editorial in The Wall Street Journal argued that the government’s takeover of AIG amounted to a bailout of Goldman, though the firm claimed it had “no material economic exposure to AIG” when the insurer collapsed.[10]


[1] “Do Not Destroy the Essential Catalyst of Risk,” Blankfein’s Financial Times op-ed of February 8, 2009.

[2] The Financial Crisis Inquiry Report, p. xxv.

[3] “Debt Watchdogs: Tamed or Caught Napping?” Morgenson’s article in The New York Times, December 6, 2008.

[4] “Testimony Concerning Oversight of Nationally Recognized Statistical Rating Organizations,” Cox’s April 22, 2008 congressional testimony.

[5] “How Moody’s Faltered,” Financial Times, October 17, 2008.

[6] “AIG Trail Leads to London ‘Casino’,” The Telegraph, October 18, 2008.

[7] “AIG Said to Pay $450 Million to Retain Swaps Staff (Update1),” Bloomberg News, January 27, 2009.

[8] Again, see “AIG Trail Leads to London ‘Casino’.”

[9] “Bernanke Blasts AIG for ‘Irresponsible Bets’ that Led to Bailouts,” The Washington Post, March 4, 2009.

[10] “The Goldman Two-Step,” The Wall Street Journal, April 15, 2009.

The Financial Crisis of 2008 Part IV: THE GREAT RECESSION

This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

THE DAY CAME when the house of cards collapsed upon itself. The rapidity of destruction was astonishing:

First half of 2007. The financial system started to come unglued during the fourth quarter of 2006 as delinquency rates on subprime mortgages rose, leading to a wave of bankruptcies among subprime lenders. On February 8, 2007, HSBC Holdings, the multinational bank headquartered in London, said it would have to add to loan loss reserves to cover bad debts in the subprime lending portfolio. On June 20, a couple of hedge funds at Bear Stearns announced major losses resulting from bad bets on securities backed by subprime loans.

Second half of 2007. On July 30, German bank IKB announced losses linked to US subprime securities. On October 24, Merrill Lynch reported huge losses in its credit derivatives portfolio. The firm’s CEO, Stanley O’Neal, left at the end of the month. MBIA announced a significant exposure to credit derivatives, which threatened its AAA rating as well as the value of its insurance on many municipal bonds.

First half of 2008. On March 16, JP Morgan agreed to buy Bear Stearns, with the Fed agreeing to acquire up to $30 billion of Bear’s distressed assets. On March 19, the government lowered capital requirements on Fannie Mae and Freddie Mac to provide liquidity to the mortgage market.

Second half of 2008. On July 11, the FDIC assumed control of IndyMac, a California bank that had been one of the leading lenders making home loans to borrowers without proof of income. On July 13, the Fed authorized the GSEs to borrow from the discount window for emergency funding. On September 7, Fannie Mae and Freddie Mac were placed in conservatorship, with life support provided by the US Treasury.[1] On Monday, September 15, Bank of America agreed to acquire Merrill Lynch. The very same day, Lehman Brothers filed for bankruptcy due to losses resulting from holding onto large positions in subprime and other lower-rated tranches of securitized mortgages.

On Thursday, September 16, AIG imploded following the failure of its Financial Products unit. This division was overseen by OTS, the thrift regulator, which The New York Times in a May 20, 2009 article called “arguably . . . the weakest of all the federal bank regulators.”[2] Thanks to the Financial Services Modernization Act of 1999, AIG had been allowed to choose OTS as its noninsurance overseer in 1999, the article explained, after buying a small S&L. The FCIC concluded in January 2011 that “AIG failed and was rescued by the government primarily because its enormous sales of credit default swaps were made without putting up the initial collateral, setting aside capital reserves, or hedging its exposure.”

On Sunday, September 21, the Fed announced that Goldman Sachs and Morgan Stanley, the last two independent investment banks, would become bank holding companies, subjecting them to new regulation and supervision. The move also signaled that the Fed wouldn’t let them fail, because it gave them access to the Fed’s borrowing window. Why the same courtesy wasn’t extended to Bear Stearns, Merrill Lynch, and Lehman Brothers remains a mystery. (See Appendix 8.3 in my book, Bernanke’s Fed and the Lehman Bankruptcy.)

Here in brief is the credit history of the housing crisis:

Home prices, owners’ equity, and mortgage debt. On a 12-month average basis, the median existing single-family home price doubled from the fall of 1994 to peak at $224,283 during July 2006. Not surprisingly, this series is highly correlated with the value of real estate held by households—a data series, compiled quarterly in the Fed’s Financial Accounts of the United States, that doubled from the second quarter of 2000 to peak at $22.7 trillion during the second quarter of 2006.

The Fed also tabulates quarterly data on “owners’ equity in household real estate.” That doubled from the second quarter of 2000 to peak at $13.4 trillion during the first quarter of 2006. Over the same period, home mortgage debt also doubled.

Home prices proceeded to drop 27% from July 2006 through February 2012. That doesn’t seem like a big correction given the steep ascent of home prices since the early 1980s. However, mortgage leverage converted that into a 56% drop in owners’ equity from the first quarter of 2006 through the first quarter of 2009. The aggregate value of owners’ equity fell below the amount of mortgage debt outstanding, which was reflected in lots of “underwater” homeowners who owed more than their houses were worth.

Ratios of owners’ equity to income. The ratio of aggregate home values to disposable personal income soared from 1.4 at the start of 1998 to peak at a record high of 2.3 during the final quarter of 2005. The comparable ratio for owners’ equity in their homes rose from 0.8 to 1.4 over this same period. That was a heady time to own a home. Almost no one seemed to recognize the bubble, inflated by the flood of mortgage credit, for what it was. The ratio of home mortgage debt to disposable income rose from 0.6 at the start of 1998 to a record high of 1.0 during the last half of 2007.

Owners’ equity as a percentage of the value of household real estate was 84% when the data started in 1945. It fell to a range of 60%–70% from the mid-1960s through the mid-2000s. It then fell from 60% during the last quarter of 2005 to a record low of 36% during the first quarter of 2009. The flip side of that story, of course, is that the amount of leverage—i.e., the percentage of mortgage debt on the underlying value of residential real estate—rose to a record high of 64% during the first quarter of 2009.

Borrowing binge. During the 1990s, the annual pace of home mortgage borrowing was fairly steady around $200 billion. It then went parabolic during the first six years of the 2000s, peaking at $1.3 trillion over the four quarters through the second quarter of 2006. Home equity loans also became a popular way to extract some of the real estate gains on home sweet home. The outstanding amount of such loans soared from $334 billion at the end of 1999 to peak at a record high of $1.1 trillion during the last quarter of 2007.

Mortgage borrowing collapsed during the financial crisis and remained weak for years, with loan repayments exceeding loan extensions from 2010 through 2013 before recovering from 2014 through 2016. Home equity loans dropped back down to $585 billion by mid-2017, the lowest since the third quarter of 2003.

ABS issuers. In the private sector, the issuers of asset-backed securities (ABS) mimicked the GSEs and created credit derivatives but with mortgages that didn’t conform to the lending standards of the GSEs. From the first quarter of 2000, the debt of ABS issuers soared 391% from $815 billion to a record high of $4.0 trillion during the first quarter of 2008. It then plunged, returning to $1.2 trillion by the end of 2016, while the amount of home mortgages held by the ABS issuers fell from a peak of $2.4 trillion during the second quarter of 2007 to $521 billion by the end of 2016.

Commercial paper. The commercial paper of ABS issuers turned toxic, peaking at a record $1.2 trillion during the week of August 8, 2007. It sank to $708 billion during the week of October 8, 2008, when the Fed set up an emergency facility to provide liquidity to the commercial paper market.

Depository institutions. Among FDIC-insured depository institutions, provisions for loan losses soared along with delinquency rates. It didn’t take long for spiraling delinquencies to turn into foreclosures, resulting in net charge-offs for bad loans. Cumulative net charge-offs soared $693 billion from the fourth quarter of 2007 through the fourth quarter of 2012. The Fed’s Financial Accounts of the United States shows that financial institutions were forced to shore up their badly depleted capital by issuing $720 billion in equities from the fourth quarter of 2007 through the fourth quarter of 2009.

The global economy sank into a severe synchronized recession as business activity fell off a cliff everywhere. Global industrial production dropped 12.8% from February 2008 through February 2009. The volume of world exports plunged 20.0% from January 2008 through January 2009. In the United States, real GDP declined by 4.2% from the last quarter of 2007 through mid-2009. It was the deepest recession since the Great Depression. However, it lasted only 18 months. So why has it been dubbed the “Great Recession,” even by Fed officials who had touted the Great Moderation only a few years earlier? The answer is that the recovery was the weakest on record.

Contributing to the weak recovery was housing starts, which plummeted from a high of 2.27 million units during January 2006, at a seasonally adjusted annual rate, to 478,000 units during April 2009, a record low since the start of the data in 1959. By the end of 2016, housing starts had recovered to 1.27 million units, a pace comparable to previous cyclical lows rather than cyclical highs.

This is in line with the history of bubbles: when a bubble in an asset or an industry bursts, it can take a painfully long time for the ensuing recovery in related prices and activity to unfold. That’s because the flood of capital that had poured into the asset or industry dries up while investors, lenders, and speculators lick their wounds.

With the benefit of hindsight, there was plenty of anecdotal evidence showing that mortgage originators had lowered lending standards significantly before the crisis. They were offering loans with all sorts of gimmicks, including no down payments, home equity loans equivalent to the down payment, below-market teaser rates for a year on variable-rate loans, balloon loans that were interest-only for several years before any principal was due, and heavily discounted closing costs. NINJA loans proliferated—i.e., mortgages extended to a borrower with “no income, no job, and no assets.”

Nouriel Roubini, a professor at New York University’s Stern School of Business and chairman of Roubini Global Economics, had been vocally pessimistic since 2005. Roubini was right. The financial press dubbed him “Dr. Doom.” David Rosenberg also correctly predicted the severity of the financial calamity. He was the chief North American economist at Bank of America Merrill Lynch in New York for seven years, prior to joining Gluskin Sheff in the spring of 2009. Ironically, while he was issuing his dire warnings, his firm was one of the leading manufacturers of CDOs.

A handful of investors who did their homework and positioned for the calamity made fortunes, as chronicled by Michael Lewis in The Big Short: Inside the Doomsday Machine (2010). Prior to the crisis, Fed Chairman Ben Bernanke offered a relatively sanguine assessment, which he presented in a May 17, 2007 speech in Chicago titled “The Subprime Mortgage Market.”[3] He certainly must regret coming to the following conclusion:

“The rise in subprime mortgage lending likely boosted home sales somewhat, and curbs on this lending are expected to be a source of some restraint on home purchases and residential investment in coming quarters. Moreover, we are likely to see further increases in delinquencies and foreclosures this year and next as many adjustable-rate loans face interest-rate resets. All that said, given the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system. The vast majority of mortgages, including even subprime mortgages, continue to perform well. Past gains in house prices have left most homeowners with significant amounts of home equity, and growth in jobs and incomes should help keep the financial obligations of most households manageable.”

Following the financial crisis, the most prominent bears were joined by lots of other tardy doomsayers who warned that financial calamity might soon return. Then years later, US real GDP and the Dow Jones Industrial Average climbed well into record-high territory.


[1] For more on the housing GSEs’ conservatorship, see the Federal Housing Finance Agency’s “FHFA as Conservator of Fannie Mae and Freddie Mac.”

[2] “Regulator Shopping,” editorial in The New York Times, May 20, 2009.

[3] “The Subprime Mortgage Market,” Bernanke’s May 17, 2007 speech.

The Financial Crisis of 2008 Part III: FINANCIAL WMDs

This seven-part series is excerpted from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

CREDIT DERIVATIVES TURNED out to be weapons of mass financial destruction. They took off after the passage of the Commodity Futures Modernization Act of 2000. Once again, a key architect of the Act was Phil Gramm. His accomplices included Fed Chairman Alan Greenspan, Treasury Secretary Robert Rubin, Deputy Secretary Lawrence Summers, and SEC Chairman Arthur Levitt.[1] All four adamantly opposed what they viewed as a power grab by Brooksley Born, the head of the Commodity Futures Trading Commission (CFTC). In retrospect, her actions suggest she was guided not by power as much as by prescience and a strong moral code.

Born insisted that her agency should regulate the over-the-counter (OTC) credit derivatives market, which she wanted to see become an open exchange with strict rules, similar to the ones for commodities and financial futures. On May 7, 1998, the same day that the CFTC issued a concept release advocating her position, Rubin, Greenspan, and Levitt issued a joint statement denouncing her move: “We have grave concerns about this action and its possible consequences. . . . We are very concerned about reports that the CFTC’s action may increase the legal uncertainty concerning certain types of OTC derivatives.”[2] They proposed a moratorium on the CFTC’s ability to regulate OTC derivatives.

A few months later, during September 1998, Long-Term Capital Management (LTCM) blew up. The huge hedge fund had accumulated on a notional basis more than $1 trillion in OTC derivatives and $125 billion in securities on $4.8 billion of capital. The Federal Reserve Bank of New York orchestrated a bailout of the firm by its 14 OTC dealers, who had been clueless about LTCM’s enormous bets. This incident was a powerful indictment of the Rubin/Greenspan/Levitt position opposing tighter regulation of OTC derivatives and spoke volumes about the wisdom of Born’s initiative. Incredibly, in October 1998, Congress passed the requested moratorium on her proposal.

LTCM’s collapse should have been a victory for the CFTC’s view. Born said on November 13, 1998 that the LTCM debacle raised important issues about hedge funds and their increasing use of OTC derivatives—including “lack of transparency, excessive leverage, insufficient prudential controls, and the need for coordination and cooperation among international regulators.” She continued, “I welcome the heightened awareness of these issues that the LTCM matter has engendered and believe it is critically important for all financial regulators to work together closely and cooperatively on them.”[3]

That turned out to be Born’s swan song. Along with Greenspan, Rubin, and Levitt, Born sat on the President’s Working Group on Financial Markets, which was charged with recommending reforms in response to the LTCM debacle. But she resigned as CFTC chair in January 1999, leaving the group before its report was released amid what The New York Times called infighting that had deteriorated into a “fray.”[4]

The group’s report came out in April 1999, calling for new risk-reporting rules for hedge funds and others.[5] But its message was not long remembered. The working group’s next report, released in November 1999, did not recommend the regulation of derivatives that Born fought for—far from it. This later report suggested that Congress expressly exempt derivatives from oversight. Notably, it was produced after Larry Summers replaced Robert Rubin both as Treasury Secretary and on the working group, and after William J. Rainer had taken Born’s former job and place in the group.[6] Without Born’s advocacy, the notion of regulating derivatives died. The CFTC quietly withdrew its proposal.

The 2000 Act essentially prevented the regulation of credit derivatives. Derivatives products were deemed to be neither “futures,” requiring regulation under the Commodity Exchange Act of 1936, nor “securities,” subject to the federal securities laws. The Act’s rationale in exempting them from any specific regulation beyond the general “safety and soundness” standards to which the vendors of these products—banks and securities firms—normally were held by their federal overseers was that OTC derivatives transactions occurred between “sophisticated parties,” who presumably knew the risks they were undertaking. Therefore, the parties had no need for government protection; they watched out for themselves and kept each other honest.

The Gramm–Leach–Bliley Act of 1999 introduced the concept of functional regulation, a clever way of disempowering the regulators. This Act upended the system of regulatory checks and balances on the various special interest groups within the financial industry, replacing it with a divide-and-conquer system with respect to the regulators.[7] The 2000 Act simply barred financial industry regulators from any jurisdiction over credit derivatives. In effect, Phil Gramm’s invisible hand gave Wall Street carte blanche. The 2000 legislation introduced the concept of self-regulation by Wall Street, which was presumed at the time to be the next logical extension of functional regulation.

No one back then seemed very troubled by the fact that shortly after these two deregulation acts were passed in 1999 and 2000, Enron Corporation—a Houston-based energy, commodities, and services company—blew up. Gramm–Leach–Bliley had exempted from government regulation trades on electronic energy commodity markets, in a provision that later came to be known as the “Enron Loophole.” Exploiting this loophole, Enron had created the global market for energy-based derivatives. These customized risk-swapping contracts enabled parties to hedge their exposure to changing energy prices and supply fluctuations. Enron declared bankruptcy on December 2, 2001.

Wall Street’s investment bankers proceeded to ramp up the assembly lines in their credit derivatives departments that transformed trash into gold. The alchemy was enabled with collateralized debt obligations and credit default swaps (CDOs and CDSs). Here are some of the basics of these credit derivatives:

Slice and dice. “The CDO Machine” is the eighth chapter of The Financial Crisis Inquiry Report—released in January 2011 by the US government’s Financial Crisis Inquiry Commission (FCIC) and updated in February of that year. It is devoted to understanding the huge role that CDOs played in the financial crisis of 2008.[8] This chapter explains that CDOs are “structured financial instruments that purchase and pool financial assets such as the riskier tranches of various mortgage-backed securities.”

The tranches into which many MBSs are structured divide pools of mortgage debt into higher and lower credit ratings. Whatever losses result from defaults on the underlying mortgages (or other credit events) are absorbed by lower-rated (typically termed “equity” or “mezzanine”) tranches first, while the highest-rated (dubbed “senior”) tranches are the most sheltered from credit risks.

Wall Street piled the harder-to-sell lower-rated MBS tranches into CDOs, which were vouched to be sufficiently diversified that they were safer than their underlying MBS tranches. The credit rating agencies signed off on this sales pitch by giving AAA ratings to the vast majority of CDOs even though they consisted mostly of lower-rated MBS tranches. After all, the thinking went, these instruments were secured by a diversified pool of underlying assets that were very unlikely to go belly up at the same time. The problems began when this is exactly what did happen: the underlying securities’ performance started to correlate and, as the FCIC investigators wrote, “stopped performing at roughly the same time.”

Full menu. CDO products became more and more complicated. Some CDOs even had 80% to 100% of their assets in other CDOs, an instrument called “CDOs squared.” Compounding the complexity, financial services companies, including American International Group (AIG)—an American multinational insurance corporation—offered CDSs to CDO investors. CDSs, the FCIC explained, “promis[ed] to reimburse [investors] for any losses on the tranches in exchange for a stream of premium-like payments. This credit default swap protection made the CDOs much more attractive to potential investors because they appeared to be virtually risk free, but it created huge exposures for the credit default swap issuers if significant losses did occur.” There were also “synthetic” CDOs, which were “complex paper transactions involving credit default swaps.” The inquiry report concluded that CDOs, especially synthetic ones, worked to magnify the risk built up in the structured finance markets, multiplying the effects of the crisis. (See Appendix 8.2 in my book, Credit Derivatives: Basic Definitions.)

With so much easy credit available in the mortgage market, lending standards deteriorated rapidly and significantly. The FCIC reported, “Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities.” Executives at Countrywide Financial Corporation, headed by Angelo Mozilo (on Time’s list of suspects) and the nation’s biggest mortgage lender at the time, realized as early as September 2004 that the loans they were making could result in “catastrophic consequences.” But they kept making more of them.[9]

Unregulated lenders jumped into the market. Many lenders no longer required down payments. Income verification was lax or nonexistent. Subprime mortgages jumped from 8% of mortgage originations in 2003 to 20% in 2005. The menu of mortgages expanded to include adjustable-rate mortgages (ARMs), interest-only mortgages, and payment-option ARMs. Lots of borrowers chose ARMs known as “2/28s” or “3/27s,” with low “teaser rates” for the first two or three years of their 30-year mortgages. Most of them turned delinquent as soon as they were reset at the market rate after the teaser period. (Again, see Appendix 8.2 in my book, Credit Derivatives: Basic Definitions.)

Orange County, California saw more than its share of unregulated lending companies sprouting up to meet Wall Street’s heady demand for mortgages to securitize, according to CNBC’s excellent special report on the financial crisis, House of Cards (first aired on February 12, 2009). People inexperienced and uneducated in banking were creating lending companies to get in on the action. Pizza boys were plucked from delivery trucks to become loan officers. Their only training was on the job—they learned to write mortgages by writing mortgages, according to the former head of such a company spotlighted in the documentary.

It was like the California Gold Rush all over again. For mortgage suppliers, the race was on to create more mortgages than the next guy. For their investment bank customers, the race was on to buy up more mortgage assets than the next guy and create more CDOs. Wall Street had discovered what seemed like a foolproof way to sell fool’s gold as real gold.

After the fact, all the lenders claimed that the loans had made sense at the time because everyone expected home prices to keep rising; almost nobody expected them to fall. For a short while, home prices didn’t just rise, they soared—along with home sales, financed by an orgy of mortgage lending that was facilitated by the securitization of mortgages.

Sometimes, cover stories in major magazines can be contrary indicators. This is the so-called “front-cover curse.” In 1997 and 1998, Rubin, Summers, and Greenspan worked with the International Monetary Fund and others to combat and contain financial crises in Russian, Asian, and Latin American financial markets; Time’s February 15, 1999 cover blared: “The Committee to Save the World: The inside story of how the Three Marketeers have prevented a global economic meltdown—so far.”[10] Ironically, their opposition to any regulation of the credit derivatives market and their support for the 2000 Act certainly helped to set the stage for the 2008 meltdown.

By the way, Brooksley Born got to have the last word on the subject, as one of the members of the FCIC. Not surprisingly, the commission’s report noted the irony of Time’s cover coming less than five months after LTCM hit the fan and three months after Congress buried the Glass–Steagall Act. The report took numerous direct swipes at Greenspan, Rubin, and Summers, not only for failing to stop the excesses that led to the financial crisis but also for helping to set the stage for it.


[1] See the US Commodity Futures Trading Commission Handbook.

[2] “Joint Statement” by Rubin, Greenspan, and Levitt, US Treasury, May 7, 1998.

[3] “Regulatory Responses to Risks in the OTC Derivatives Market,” Born’s November 13, 1998 speech.

[4] “Who’s in Charge? Agency Infighting and Regulatory Uncertainty,” The New York Times, December 15, 1998.

[5] Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, President’s Working Group on Financial Markets report, April 28, 1999.

[6] Over-the-Counter Derivatives Markets and the Commodity Exchange Act, President’s Working Group on Financial Markets report, November 9, 1999.

[7] “Securities Regulation After Glass–Steagall Reform,” SEC Commissioner Norman S. Johnson’s March 3, 2000 speech.

[8] The Financial Crisis Inquiry Report, specifically Figure 7.2 on p. 116, Figure 8.1 on p. 128, and Figure 8.2 on p. 144.

[9] The Financial Crisis Inquiry Report, p. xxii.

[10] Check out the cover of the February 15, 1999 issue of Time, featuring Robert Rubin, Alan Greenspan, and Larry Summers, and the corresponding article, “The Three Marketeers.”