Of all the decisions made by Hank Paulson and Ben Bernanke, the one to let Lehman go under stands as the most pivotal. And the most controversial. The Federal Reserve and Treasury decided to let Lehman fail and set a "moral hazard" example: from now on, you can't rely on Uncle Sam to bail you out. Make a deal, raise some capital or call your bankruptcy lawyers. Funny how that didn't apply to Bear Stearns, which the Feds at least sold for a couple of bucks to JP Morgan. Instead of stopping the financial meltdown, letting Lehman go down amplified it. Any confidence in the market was undermined, and financial stocks began to head south in a hurry. Not only was the U.S. forced to step up to save AIG, it was soon on the hook for $700 billion in bailout money to faltering financial institutions.
What's a mild-mannered insurance company doing selling exotic derivatives to everyone in sight? Merely setting the stage for a $100 billion bailout by the U.S. government and becoming the poster child of the meltdown. From its London branch office, AIG's CDS chief Joseph Cassano minted money for the company for a couple of years, and garnered huge payouts for himself, by basically selling everyone in the world insurance that the Titanic wouldn't sink. What were the odds of that happening? Instead of Titanic, insert CDOs, short for collateralized debt obligations. You get the picture. As the value of those contracts plummeted, AIG found itself facing insolvency. And taxpayers found themselves paying the bill.
After 30 years of incompetence, the American auto companies and their obstreperous union finally closed the quality gap with foreign competitors and narrowed the manufacturing cost differential to within inches. Nice try. The credit market freeze ensured that average Joes who love Fords and Chevys couldn't possibly get the loans they need to buy them. So sales were off more than 30% in October and November, pushing GM and Chrysler close to insolvency. When the auto bosses pleaded their case to Congress for $34 billion in loans to tide them over, they got treated as if they manufacture smallpox.
Too big to fail but one big failure nonetheless. When it was assembled by Sandy Weill 10 years ago, Citi was positioned to be the world's biggest financial services supermarket, with everything from stocks to insurance and a little banking in between. Today Citi is a one-bank depression. This year it has announced 75,000 job cuts, sold off divisions, and blew the acquisition of equally troubled Wachovia, which was whisked away by Wells Fargo. It's been forced to take a $20 billion handout from the U.S. government to shore up its capital base, which took a huge hit because of its exposure to CDOs and other toxic assets. The government also agreed to back more than $300 billion of those assets to keep it from collapsing. Citi stored much of that garbage in off-the-books Structured Investment Vehicles (SIVs). But now that the mortgage game is over, Citi has been forced to take the SIVs back, writing down billions in the process. Its share price is less than $10, at one point falling 90% from its peak. No wonder, as its slogan says, the Citi never sleeps.
The quasi-government backed mortgage buyers had the perfect structure to ride out any financial storm: the two entities were sponsored by the U.S. government, and loaded with former pols pulling down fat salaries and stock options. But Fannie and Freddie got caught in the downdraft. By being among the last outfits to jump into the business of crap mortgages, Fannie and Freddie basically loaded their balance sheets with more dry brush than California in August. When the market match struck, they went up in a hurry. And while Washington wasn't about to let the twin enterprises go under, no one in the Bush Administration was prepared to prevent the equity holders from being wiped out.
Auction-rate securities, the Reserve Fund, CDOs. Auction rate notes gave municipalities, universities, museums and other issuers a vehicle to borrow long, but pay a shorter term interest rate. The mechanism was an auction, and investors looking to get a better short return on their money ate these auctions up. Until their money wasn't returned. Money market funds were supposed to be ultra safe, always maintaining an asset value of $1 per share and always investing in rock solid government bonds to maintain liquidity. The Reserve Fund didn't just follow that principal, its founder, Henry B. R. Brown, created the whole business, with Reserve started in 1970. Money market funds, which unlike bank accounts are not guaranteed by the FDIC, had a practically unassailable record for safety, until Reserve decided to invest in Lehman's highly rated bonds. Investors running for the exits will be lucky to get 98 cents on the dollar. The same kind of security was supposed to have been attached to Collateralized Debt Obligations, those ultimately toxic assemblages of different mortgages that helped sink Wall Street. After all, many were given the AAA seal of approval by the ratings agencies, and we know how reliable they are.
Moody's, Standard & Poors and Fitch stood by their AAA top ratings for Collateralized Debt Obligations (CDOs), which are based in part on pools of subprime mortgages. Some of that stuff was indeed top drawer, but the bottom tranches were filled with junk. So how do you make the call? The agencies, looking backward at the accumulated data, continued to give their top rating to securities that were piling up risk as each week went by and the real estate markets started to wobble. And did we mention that the agencies get paid by the issuers of the CDOs to make their supposedly objective rating? When it all went south — propelled in part by the same folks, who suddenly started slapping bad grades on already fragile firms like AIG — the agencies said their ratings were merely opinions. In our opinion, they're useless.
Don't feel so bad if you find the stock market perplexing. Hedge fund managers, who are supposed to be geniuses about these things, demonstrated a spectacular penchant for making vast amounts of money disappear this year. There was Citadel's Ken Griffin, arguably the smartest guy in the business, puking up 47% of its main fund through November and professing to being completely flummoxed by the market's behavior. At least Citadel is still in business. Others, such as Ospraie Fund and Centaurus Capital, chose to close funds after a bad performance sent investors scampering for redemptions. Rich people have no patience for people who fail to make them richer. Tudor Investment and Fortress Investment Group, on the other hand, have barred the door by preventing investors from leaving, hoping to buy some time to fashion a rebound. There will be no such thing at what is arguably the biggest hedge fund bust, if not the biggest financial fraud ever — the $50 billion collapse of the semi-exclusive fund run by legendary investor Bernie Madoff, who it turns out, had done so well all those years because he had created his double digit returns out of thin air. Only a select few funds, such as Paulson & Co, made a bundle by shorting banks stocks and securities tied to the mortgage industry.
The Ayn Rand enthusiast was nearly branded the God of Money. As Fed Chairman, his easy money policy after the dotcom collapse in 2000 seemed like the perfect policy prescription for what ailed us. And it was. Until the chairman refused to do what Fed Chairmen are supposed to: take away the punch bowl just when the party's getting good. By not raising rates quickly enough in a real estate bubble, Easy Al helped let the money flow to every high-risk, no document loan applicant extant. The former Fed Chairman was forced to admit that he was completely wrong about the risks in the system from subprime mortgages and the bonds sold against them. The man famous for his expository obfuscation was forced to admit: I screwed up.
Three major banks, 300,000 people and zero liquidity. It's not often that the wealth of an entire country is wiped out. But Iceland almost managed that when its currency, the kroner, got caught in a freefall created when investors bailed. Its billions of dollars of Euro-denominated foreign debts became unpayable. Caught in the middle: depositors in Great Britain and Germany, who were lured by rich rates being offered by Kaupthing Bank hf, Landsbanki and Glitnir Bank hf. The IMF is providing a $2.1 billion loan while Finland, Sweden, Norway and Denmark will provide a further $2.5 billion. German also coughed up a couple hundred million, which will be used to make German depositors whole. Iceland is even talking to the Russians for help. Iceland is broke, but it's got geothermal heating, so at least no one will freeze to death.
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