Strategy

Markets: The great deleveraging

How the nightmare on Wall Street got started.

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.

For a while, it was the future of finance. And there were real benefits. As securitization grew, companies began to specialize. Some concentrated on writing mortgages. Others specialized in packaging them into bundles. The investment banks concentrated on sales. In Canada, companies like Coventree popped up, and products like asset-backed commercial paper came into being. The competition between firms kept margins razor-thin, and that brought down the cost of a mortgage for the average person. There were likely billions in savings for homebuyers as a result of securitization.

But according to The Trillion Dollar Meltdown, a book on the current crisis written by lawyer and former banker Charles R. Morris, there was one limiting factor on the market: the toxic waste. How do you get rid of it? You could always find buyers for the higher-rated tranches — that was the cream of the crop — but who wanted the trash? No one, really. So in some cases, the toxic waste was simply left on the books of the investment banks manufacturing the securities. Some of it was sloughed off on unsophisticated investors. Some of it went to cowboy hedge funds, which could make a big boatload of money off the high coupons, or an even bigger boatload if they leveraged up.

For one thing, the regulations around lending steadily decreased over the last 20 years. (According to Morris, in the early ’80s about 80% of lending happened in regulated institutions; by the mid-’90s, the proportion of lending in regulated areas of the market had fallen to 26%.) But what really sent the whole kit and caboodle into bubble territory was the decision by the U.S. central bank to turn on the taps after 9/11. Rates went to 1.5% for almost three years, and money flooded Wall Street. In fact, with real interest rates effectively negative (inflation was just under 2% in 2002), the system was paying people to borrow money. With so much lending, the U.S. housing frenzy went into overdrive. Homes were bought as speculative investments, and the majority of new job creation in the U.S. was coming from the housing-related market.

By 2003, the U.S. mortgage industry had gone through all the good credits, so to keep the party going it began lending money to the bad ones. In normal times in the United States, subprime mortgages represent maybe 15% of the total. By the middle of this decade, they made up almost 50% of new mortgages in some areas. The most unscrupulous mortgage brokers, more interested in their fees than the viability of the loan (which in any event would end up held by some pension fund in Japan or wherever), began advancing mortgages to people who had no hope of repaying. Home prices rose faster than they otherwise would have because of the new demand in the market.

It all began to turn in the summer of 2007, when mortgage payments on all the securitized mortgages didn’t show up as expected. Highly leveraged hedge funds were unable to make margin calls. The banks stepped in to seize their assets. Then, when the banks found no one wanted to buy the assets, they got stuck holding tons of paper.

The toxic waste began to leak out of the basement. And some of the biggest houses on Wall Street began to crumble.

Who knows what comes next? It seems an unregulated banking system that relies on leverage of 30 times assets is dead. Savvy politicians have already taken note of the change in the political winds; even the Republicans are shouting “more regulation.” Kevin Phillips, a former speech writer for Richard Nixon and one of the first to write a book predicting the post-1970s rise of the conservative movement in the U.S., suggested in a recent interview that Big Finance is going to become a target of political and popular anger in the years ahead, as the effects of this debt bubble settle in.

The other big question is where the bottom will be. What needs to happen first is for home prices to stop falling, so that banks can figure out what the mortgage securities are worth. Only then will the fear that has gripped the market — and prevented banks from lending — really lift and allow a recovery to get underway. The Bush administration’s end-of-the-week pledge about a “comprehensive” plan to scoop up all the banks’ distressed securities could be key to a recovery.

But even if a recovery gets underway, there are others who argue that the medium to long term still looks gloomy. There are dark forces still gathering over the world’s largest economy (and Canada’s largest trading partner): oil-supply uncertainty, consumer debt, demographic issues, the trade deficit. They suggest that the global economy might be heading into a new part of a larger historical cycle, one that will see the United States move through an extended period of volatility — not unlike the ’30s, say some.

By the end of the week, the hurricane was pulling in money market funds, massive pools of cash that are not FDIC-insured, but the Dow had rallied strongly. Whether this is the end of postwar America’s golden years is yet to be seen. But at least Fannie Mae is now safely back in the arms of the American government, ready to pick up from where it all started 70 years ago.