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For a while, it looked nothing less than epochal. The financial hurricane ripping up Wall Street left a trail of devastation. Lehman Brothers bankrupt. Merrill Lynch independent no more. AIG on the rocks. The two big government-sponsored mortgage entities, Fannie Mae and Freddie Mac, nationalized. Titans of American capitalism, al l— blown away like so many bits of securitized paper.
On the markets, the action suggested the apocalypse was nigh. By Sept. 17, the Dow had plunged more than 800 points, the TSX even more, and the U.S. Federal Reserve’s liquidity window — a device set up earlier in this crisis — was opened even wider. The Russian market cratered, while millions of Chinese got an unwonted taste of the dark side of capitalism. On Wall and Bay streets, traders could only mumble and mutter that they’d never seen anything like it.
Late in the week, U.S. treasury secretary Henry Paulson announced that the government would massively intervene in the economy, taking distressed assets off the hands of failing financial companies in a move that will cost taxpayers hundreds of billions of dollars. Then, U.S. and British regulators banned short-selling of stock in certain financial companies. That helped to restore confidence on stock markets around the world — so much so that on Sept. 19 the TSX and the Dow ended the week up.
But such heroic measures only point to the severity of the crisis. How did it all turn so bad so fast?
What really seemed to put the Street on edge was the downgrade to AIG Inc.’s credit rating. One of the world’s largest insurance outfits, AIG also happens to be a big player in the credit derivatives market — providing insurance against defaults on the hundreds of billions in debt issued over the past decade. The credit derivatives that “insure” all that debt tie the Street’s firms together in a bundle of counter-party obligations and financial contracts. The cascade that would have followed an AIG bankruptcy and the unbundling of credit insurance would have been — well, let’s just not go there.
Recognizing the dangers, the Federal Reserve in midweek forked over $85 billion to keep AIG afloat. But the amount only seemed to spook the Street. At the height of the panic, the level of confusion among the pros was alarming. In a note to investors, one veteran investment strategist called it “the most confusing environment of our careers”; the Wall Street Journal compared markets to a patient in “intensive care.” Everyone was wondering where to put their money.
So what happens now? Gerard Cassidy, a banking analyst with RBC, suggests that a round of meltdowns among U.S. regional banks might be next. “The eye of the hurricane has just passed,” he says. “But we’ve still got the back wall to go through.” At least before Paulson’s intervention, traders were nervously eyeing Morgan Stanley and Goldman Sachs, the last of the big independent Wall Street brokerages still standing. The speculation was that they might have to merge with one of the big commercial banks, as Merrill did with Bank of America in the US$50-billion buyout of Sept. 15 — or that they too could go under.
If they do, it would mark a complete washout of Wall Street, a cleaning so thorough that it might well represent a shift in the essential form of western capitalism. Comparisons have been made over the past year to previous market meltdowns. Was this like the Asian Crisis of 1997? The recession of the early ’90s? The one back in the mid-’70s? Before it’s over, this one might turn out to rank nearer the top of the hit list — say, up around the Big One back in the ’30s.
But before we speculate about what the new map of North American financial services might look like, it’s worth a look back at how we got here. There are a lot of entry points to this story. Thousands. But let’s start in the ’30s, when President Franklin Delano Roosevelt busied himself repairing the damage of the Great Depression through a Keynesian basket of government programs known as the New Deal. Part of that effort was the 1938 creation of the institution now known as Fannie Mae, whose mandate was to help Americans buy homes by borrowing on their behalf from banks. The guarantee of the U.S. government convinced the shattered, scared banks of the time to lend, and that helped the economy out of the Depression.
Fast-forward 30 years. Lyndon Johnson is in the White House. In a bid to free up space in the budget for the Vietnam War, he kicked Fannie Mae and its corporate sidekick, Freddie Mac (created to provide competition for Fannie), off the government’s books. As private-sector companies (with an assumed government backstop), they became linchpins of the residential mortgage market. And from that market in the 1970s emerged the financial technique known as securitization.
With securitization, individual mortgages are packaged into bundles and turned into a security that pays income and can be sold as a “bond-like” investment. The issuer gets value from the mortgages up front; the buyer gets the supposedly predictable payback of the mortgages. Simple in its bare bones, but it lies at the complex heart of everything we see now. “I think securitization is going to be seen as one of the most important features of our times,” says David Rothkopf, a visiting scholar at the Carnegie Endowment for International Peace, a think-tank in Washington.
Yet the first generation of securitized assets didn’t deliver enough yield for risky investors, and weren’t safe enough for conservative investors. What to do? The answer was to take that bundle of mortgages and slice it into parts. The top slice, or tranche, would get the initial payments from the mortgage pool, the next tranche would be next in line, and so on down the line to the final tranche — which came to be known as “toxic waste.” The moniker stems from the dismal investment value of the bottom tranches, where the holder, basically, assumes all of the risk of the rest of the mortgage pool.
The market for securitized assets grew rapidly over the last two decades, and before long just about any receivable you could think of was getting securitized. Auto loans, credit-card receivables, commercial mortgages — wherever you had loans that could be bundled together, there was a banker there ready to offer you money so that he could package it up and sell it.
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