Episode 7: Bubbles, Bankruptcies and Burnt Bridges

Jim Grenn:  For most, 2008 serves as the reference point when discussing fear surrounding involving investment decisions. 

The average American household lost more than $100,000 during the Great Recession of 2008 / 2009 due to collapsing real estate prices and a plunging stock market… destroying $14 trillion of wealth in total.

8.8 million people lost their jobs according to the Bureau of Labor Statistics.

Some argue it could have been even worse if not for the trillions of dollars in government support.

On December 5, 2008 banks borrowed $1.2 trillion from the fed to stay afloat… Yeah… in a single day. 

Much has been said and movies have been made about the mortgage debacle that lead to the Great Recession.  Nevertheless, there is more to this story that we’d like to share with you.  Last week we discussed a small hedge fund in Connecticut and how their exotic investments brought the firm to its knees.  Well, a decade later similar factors that sunk Long Term Capital Management would cripple the entire financial system. 

This is Domino, an examination of a historical event that had a ripple effect on our global economy.

This is Jim Grenn, the host of Domino.  Today, we are examining what really happened behind the Great Recession of 2008.  But first, we need to go back to 1985.

Kent Oliver: Yeah, so here is the backstory to 2008… it begins in Greenwich Connecticut where a small company was quietly making a killing.

Jim Grenn: Greenwich Connecticut – the same city as Long Term Capital.

Kent Oliver: yeah… a sleepy little town of under 60,000. Just like last week, the story really starts the same – a smart guy leaves a bond department to start a new fund.  This guy’s name is Howard Sosin - At age 35 he was head of the ‘junk bond’ desk at the investment bank Drexel Burnham Lambert in 1987. Sosin and a couple select associates began planning their exit from Drexel with a plan to focus on the relatively untapped world of swaps.

Jim Grenn:  the same swaps that would eventually play a role in the demise of Long Term Capital Management?

Kent Oliver: Swaps can be used in a variety of ways to add risk or mitigate risk.  Initially though, they were created as a way to hedge investment risk and provide some form of insurance. 

Brady Raanes: up until the late 1980s most swap contracts were for a relatively short periods of time, like 90 days or maybe as far as twelve months.  Sosin and his colleagues envisioned their new firm creating complex deals with swaps that could last for decades.  It was a unique niche but potentially a lucrative one.

Kent Oliver:  It’s not overly important to understand the details of this strategy, what’s important is that Sosin was trying to disrupt a small corner of the investment industry by creating a way to provide longer term insurance on investments… investments that at the time looked pretty safe.

Brady Raanes: In order to make that dream a reality, Sosin would need to form a partnership with a larger institution, preferably one with deep pockets and a great credit rating.  This would allow Sosin to structure deals at a lower cost than rivals, a key to Sosin’s plan.  One name topped the list: American Insurance Group, or AIG.  AIG was massive, plus it boasted an AAA rating, and was considered one of the world’s strongest financial institutions.

Kent Oliver: AIG took the bait and agreed to form a new subsidiary known as AIG Financial Products, or AIGFP for short.  Ten co-workers followed Sosin to the new firm.  AIG’s AAA credit rating gave them a huge advantage over the competition by allowing them to structure deals at a lower cost for a longer term. 

Jim Grenn:  So – to clarify – the new firm - AIGFP’s – their main job was to help their clients mitigate risk with these swaps

Brady Raanes: Yes, the main thing they were offering is was risk management.  Internally, they carefully hedged their own risk as well.  Each transaction appeared to be virtually nearly risk-free for AIGFP. They were obsessed with understanding and mitigating risk.

Jim Grenn:  So, it’s not like AIGFP was doing the same stuff that Long Term Capital was.

Brady Raanes:  Yes, that’s correct – good point. 

Kent Oliver:  Shortly after opening their doors, AIGFP closed a $1 billion interest-rate swap deal with the Italian government.  The deal was monumental compared to the size of most swap contracts at the time.  For their efforts, AIGFP earned $3 million, or 0.03% (three one-hundredths of a percent) for their risk.  AIGFP quickly earned a reputation as the most creative firm on the street bringing in $60 million in revenue in the first six months.

Brady Raanes: That isn’t much money for such a large transaction, but in time AIGFP began attracting more and more clients with their exotic risk management strategies.  And soon they were making big money. 

Kent Oliver:  Sosin, the guy who started the firm had negotiated some pretty sweet deals for he and his employees to receive their bonus payments each year on the firm’s net income – which seems to make perfect sense until you realize that the income the firm received wasn’t really all theirs until the insurance, they offered expired which could be decades.

Brady Raanes:  Eventually, the compensation structure came to really bother management at AIG – and they pressured Sosin to renegotiate his deal – but Sosin refused. 

Kent Oliver: Eventually, after a lot of back and forth and bad blood, AIG, the parent company reaches a deal to buy out Sosin for more than $300 million. 

Jim Grenn: Good grief.

Kent Oliver: So, Sosin leaves and a new guy named Joe Cassano takes over.  Cassano even buys Sosin’s house and property in Westport, CT from him.

Jim Grenn:  Probably because he was the only one in the state that could afford it. 

Kent Oliver:  Maybe.  So – this move – the fact that Cassano takes over was actually a pretty important domino to fall, although, of course, no one realized it at the time. He’ll eventually be dubbed “the man who crashed the world” by Vanity Fair.  Others refer to him as “Patient Zero” of the financial crisis.

Jim Green:  Hmm… what year is this that he takes over?

Brady Raanes: 1993

Kent Oliver: Cassano was little more ‘rough around the edges’ than his predecessor.   He was this short, balding aggressive type… a self-proclaimed tough guy – a little louder, a little more demanding and a little less sensitive to risk management. 

Jim Grenn: Well that’s an interesting personality complex to be known for in the insurance world.

Brady Raanes: In time, the transactions grew more and more complex, and the deals grew larger.  Early in 1998, the firm stumbled upon an idea to creative a new product called a ‘credit default swap’. 

Jim Grenn:  Brady, can you come up with a creative analogy to help us understand credit default swaps?

Brady Raanes:  Imagine being able to buy life insurance on a stranger and profit from their death.  That’s what a credit default swap was like.

Jim Grenn:  Not your best analogy.  So, what were they really?

Brady Raanes: For a fee, AIGFP would agree to insure an investor against a default in another company’s debt.  Investors could speculate against the default on bonds regardless of whether they actually owned them.  It seemed simple enough but these credit-default swaps would come to define AIGFP over time. 

Kent Oliver: On the surface, these credit default swaps were simply another form of insurance, allowing a bond holder to reduce their risk for a fee by purchasing insurance against a bond default.

Jim Grenn:  Were these things regulated?  

Kent Oliver:  Officials in Washington were raising yellow flags, but no. These swaps were openly unregulated.    Which is kind of strange because of the Long Term Capital meltdown that we discussed last and accounting scandals involving derivatives at Enron, an energy company based in Texas, had been in the news due to the use of the complex investments. 

Brady Raanes: Fed Chair, Alan Greenspan felt that the contracts were helping to make the financial system more efficient; providing modern ways for companies to reduce risk.      In truth, few understood what a derivative contract actually was, and even fewer knew how to regulate them.  Congress offered no clarification either.

Jim Grenn: Shocking.

Brady Raanes: Free from oversight and regulation, swaps and others derivatives quickly became the wild-west of investing.

Kent Oliver: AIGFP, and more notably Cassano, embraced the freedom granted by Congress and began insuring more and more exotic debt instruments such as mortgage backed securities, eventually exposing AIGFP to hundreds of billions of dollars of risk if something went wrong.  Still, AIG remained confident that the credit defaults insurance was virtually risk free to the firm.

Jim Grenn: Let me take a second and try and summarize this for our listeners.  AIGFP is formed to provide a way for investors to hedge away certain risks.  In return for minimizing risk, AIGFP would charge a fee.  At first, they were really careful about what risks they took on and how they hedged them internally, but in time, they got a little sloppy and started taking on more risk.

One of the firms utilizing these credit default swaps was the investment bank Lehman Brothers.  You may have heard of them?

Stay with us.  Domino will be right back.


Jim Grenn:  We’ve brought in a special guest to help add a little perspective on the next part of our discussion around Lehman Brothers: Duane Raanes, Brady’s father and fellow co-worker. 

Brady Raanes:  Hey dad.

Duane Raanes: Hey son.

Jim Grenn: Touching.  Duane, tell us a little about Lehman Brothers.

Duane Raanes: Lehman was originally an old boring wall street firm specializing in mundane world of structuring bond deals; a fairly predictable and stable business with somewhat limited growth prospects.  But in the mid-1990s the firm hired a new CEO - Dick Fuld and Lehman Brothers expanded their services to include far more complex strategies.

Brady Raanes:  Dick Fuld gets major credit for transforming the company into a world class investment bank. In March of 2008, Fuld was named to Barron's list of the 30 best CEOs in the world.  The article even went so far as to dub Fuld “Mr. Wall Street.”

Duane Raanes:  Here is my favorite quote by Fuld from the article: "Smart risk management is never putting yourself in a position where you can't live to fight another day,"

Jim Grenn: Well that quote hasn’t aged well!

Duane Raanes: Shortly after Fuld’s arrival, Lehman Brothers purchased Aurora Loan Services, a company that made mortgage loans to borrowers with bad credit, known as subprime loans.

Jim Grenn:  And subprime loans are basically loans made to people with poor credit scores.  They are riskier than traditional loans  

Brady Raanes:  In 2000, Lehman purchased another low-quality lender, BNC Mortgage LLC.  Soon Lehman Brothers was a player in the subprime mortgage market.  In 2004, Lehman and its subsidiaries made more than $40 billion in subprime loans to borrowers.  By 2006, they were reportedly surpassing that total on a monthly basis. 

Duane Raanes: The beauty of the business was that Lehman Brothers didn’t actually hold the loans it made.  Instead, after making a loan Lehman pooled it with other loans and sold them to other investment banks, pension funds, and investors.

Jim Grenn: And did any of this concern the regulators? 

Duane Raanes:  No, not really, Alan Greenspan, the Chairman of the Federal Reserve, praised the “financial innovation” of the investment banks. 

Brady Raanes: The purchasers of the mortgage portfolio weren’t concerned either.  Interest rates were so low that banks and investors were starved for yield and happily gobbled up the mortgage investments just as quickly as Lehman and other Wall Street banks could package them.

Jim Grenn:  Interesting.    

Duane Raanes: The final factor that made Lehman’s plan so lucrative was the suspect support given by the rating agencies.  Thanks to hefty fees from the investment banks, the ratings on the subprime loans came back at, get this, AAA – the same credit quality given to the safest bonds on the planet. 

Jim Grenn:  But if the loans they were making were all cruddy subprime loans, how could they be AAA rated.

Duane Raanes:  Good question.  I suppose the rating agencies would argue that they viewed these loans as collection of mortgages – and people usually pay their mortgage.  Plus, real estate in general is thought of as a regional thing which add a level of diversification.

Jim: I see.

Duane Raanes:  In truth, these investment banks were the biggest customers for these rating agencies.  I think a strong case could be made that the rating agencies did what they did because they needed these top investment firms to keep paying fees.   

Brady Raanes:  That AAA rating was really important to keep investors buying the bonds.  The rating made it look like the risk of default on the mortgage pools was practically zero.   

Kent Oliver: Eventually, Lehman began to like what they were cooking.  As the market became saturated with the low-quality loans Lehman decided to begin holding some of the loans they originated. 

Jim Grenn: As opposed to selling them off to other investors.  Why would they do that?

Kent Oliver: I suppose they saw it as an opportunity to grow profits.

Duane Raanes: Especially if they could use leverage.

Jim Grenn: True.

Kent Oliver:  Which they did.  By early 2008, Lehman’s assets totaled $680 billion, backed by only $22.5 billion of actual firm capital.  Lehman’s leverage was closer to 30:1

Jim Grenn:  Which meant, like Long Term Capital Management a decade earlier, Lehman Brothers could be wiped out by a minor decline in assets values. 

Kent Oliver: So, they decided to enter into a series of credit default swaps with the strongest insurer on the street… I’ll let you guess who that was.

Jim Grenn: AIG? 

Kent Oliver: You got it.  And the insurance would be useless if AIG was also insolvent.  But that’s crazy talk.  Why even consider it?

Jim Grenn: but… (sighs…)

Duane Raanes:  In late 2007, the US economy began to slow.  Real estate prices weakened.  Unsold homes sat empty.  Unable to get their asking price, many borrowers found themselves unable to pay their mortgages.  The foreclosure rate began to increase. 

Jim Grenn: A common recession.

Duane Raanes: As real estate prices dipped, the value of the mortgages on the properties began to decline.  With 30:1 leverage, it didn’t take long for Lehman to feel the pinch.  In June of 2008, Lehman announced a quarterly loss of $2.8 billion.

Jim Grenn: So, the crisis is deepening… are people still buying these subprime mortgages?

Kent Oliver: The demand for the mortgage bonds had almost completely disappeared and the value of the loans were falling fast.  Without ready buyers, Lehman would be forced to restate the near-worthless value of the massive pool of mortgages they held.  

Kent Oliver:    As September approached, and Lehman faced even heavier losses, the conversations got more urgent.  Dick Fuld got in touch with the US Treasury and the Federal Reserve.

Duane Raanes: Treasury Secretary Hank Paulson reportedly contacted Bank of America with a specific request: “Buy Lehman.”  Bank of America sent a team to begin due diligence immediately and determine whether or not this was a rescue mission or a suicide mission. 

Jim Grenn:  Oh wow.

Duane Raanes: After one day of research, Bank of America came to the conclusion that they would need additional government assistance of $65 billion before they could agree to purchase the failing firm and take over Lehman’s massive leverage.  Government officials balked; no way where they sticking their neck that far out on the line.

Jim Grenn: So, it’s really hitting the fan for Lehman at this point

Kent Oliver:  Yeah, that same night, CEOs from twelve of the leading banks were summoned to the offices at the New York Federal Reserve for a special meeting to discuss a rescue of Lehman.  It was déjà vu for many of the attendees. 

Jim Grenn:  As you may recall from last episode, ten years earlier, in the fall of 1998, the same basic group had been seated around a similar table discussing the rescue of Long Term Capital Management.  The terms were different this time.  LTCM had been rescued with a measly $4 billion.  By all accounts, Lehman Brothers would need 15 times as much.

Kent Oliver: Furthermore, Treasury Secretary Paulson had made it clear that the government had no intention of providing money for the bailout.  The survival of Lehman Brothers rested squarely on the shoulders of its banking piers on Wall Street, the same group that Lehman had shunned a decade earlier.

Duane Raanes:  Lehman’s CEO, Dick Fuld, had burned too many bridges on Wall Street to muster the support he needed.  His Wall Street cohorts gave him and Lehman Brothers the same cold shoulder that Lehman gave to Long Term Capital Management in 1998.      

Jim Grenn: karma is a… bummer.

Duane Raanes:  Within twenty-four hours of learning the news that no package would be offered, Lehman Brothers filed for bankruptcy.  With over $600 billion in assets, Lehman Brothers was the largest company to file bankruptcy in American history; six times larger than the next closest.  All 26,000 employees were immediately jobless. 

Jim Grenn: I guess I didn’t realize they were the largest bankruptcy ever. 

Brady Raanes: On the same day as the Lehman bankruptcy, the investment firm Merrill Lynch announced that they were selling themselves to Bank of America for a fraction of their value just a few months earlier.  The credit rating agencies began downgrading virtually everyone on the street, including AIG. 

Jim Grenn: The firm with the AAA credit rating – and the home to AIGFP

Brady Raanes: Yeah… a day late and a few billion dollars short, don’t you think?  Investors suddenly questioned which other troubled firms may fall.  Shares of AIG stock fell 50% in a day.  The downgrade felt like a death sentence to the insurance giant.  AIG would need to come up with billions in extra collateral to cover potential claims; an impossible task in light of Wall Street’s collapse. 

Kent Oliver: AIG informed the Treasury and the Fed that they too needed assistance to stay afloat.  $30 billion should buy some time… maybe $40 billion.  JPMorgan’s research team reached a different conclusion.  AIG needed closer to $65 billion if they wanted to stay afloat.  One by one, the potential suitors bowed out.

Brady Raanes: Shortly thereafter, AIG posted the largest quarterly loss in American corporate history – some $61.7 billion.

Kent Oliver: Let’s see… a $61 billion dollar quarterly loss equates too… losing $27 million every hour… or $465,000 a minute… or roughly $7,750 a second.

Jim Grenn:  Kent the human calculator. 

Brady Raanes: He made a 38 on his ACT

Kent Oliver: Guys, I’m using an actual calculator.

Brady Raanes: AIG had 74 million policy holders in 130 countries, more than $1 trillion in total assets, and untold multiples of that in derivative contracts.  AIG was the domino that couldn’t afford to fall.  Ultimately the Fed and Treasury relented from their pledge not to use government money.  Later that day, AIG got an $85 billion bailout from the Federal Reserve in exchange for majority stake in the company.

Kent Oliver:  The decision to bailout AIG was an abrupt change in policy from just forty-eight hours earlier when the Fed opted to let Lehman fail, but many felt it was the only option. 

Duane Raanes: Over the course of the next three weeks, investment banks Goldman Sachs and Morgan Stanley required bailout funding.  Washington Mutual, the country’s largest savings and loan bank collapsed.  Wachovia Bank was taken over by Wells Fargo.  Plans for a massive government asset purchase plan known as TARP were released, celebrated, failed, reworked and ultimately approved by Congress.  

Jim Grenn: The Dow Jones Industrial Average plummeted more than 30% over the next three weeks.

Duane Raanes:  I’ve been in the business 34 years, and these are the most extraordinary events I’ve ever seen.  I mean, within a month, the “who’s who” of the financial world stepped forward, hands outstretched in search of similar bailouts.  The mixture of subprime debt, leverage and complex derivatives had wreaked havoc on the financial system. 

Jim Grenn: More than $2 Trillion dollars of government assistance was pledged over the next four months and bailouts abounded.

Jim Grenn:  In 2009, Joe Cassano was asked to tesify before congress about his role in the AIG debacle. Cassano invoked the Fifth Amendment more than 200 times, or—on average—once every 38 seconds, during while declining to answer questions from the Securities and Exchange Commission as part of its investigation into AIG’s near-collapse.

Cassano was paid more than $300 million to leave: but AIG retained his services as a consultant, for $1 million-a-month.

Dick Fuld received a measly $22 million retirement package at his departure. He owned 10.9 million shares of stock at the beginning of 2008.  Ouch!

Jim Grenn:  The government deficit reached over a trillion a year and the national debt grew to unseen levels, but the US wasn’t alone in their response.  Next week we will explore the impact and response of the Great Recession on Europe and how their policies are impacting the economic landscape today.pe today.