You are on page 1of 15

Good afternoon everyone.

Im really excited and honored to be here with you

today and wanted to thank Dr. Mahar for inviting me to speak. As you might
be aware, Im going to talk about the financial crisis of 2007/2008, what
happened and - from a very high level why. Im also going to sprinkle in
some of my own memories of that time for good measure.
So the genesis for my talk today stemmed from a facebook post more like a
rant in my own estimation I wrote a few months ago after I previewed, the
Big Short, a movie about financial crisis during a screening in my hometown
just outside of NYC. The Big Short is a drama based on the best-selling book
by Michael Lewis about the mortgage debacle of the 2007/2008 era. Having
worked for Bear Stearns, one of the Wall Street firms that seemed to be a
focus of the movie, I was already well-familiar with the excesses and greed of
the mortgage business during that era, but the movie definitely brought me
back to what were very dark days indeed for the country and for me
personally. I was literally having flashbacks as I watched the movie.
During the 18 month period of time during the eye of the financial crisis
storm, I lost two jobs, my father to cancer, a significant portion of my net
worth and probably would have lost my home had it not been for the
inheritance I received from my father's estate. All of these events seemed to
converge on me just as liquidity was evaporating before my eyes (including
Chase Manhattan Bank suddenly cancelling the undrawn portion of my home
equity line of credit). With a family of four depending on me to pay the bills

and buy groceries, to say that I was feeling a little stress would be an
understatement. Talk about sleepless nights. The real eye of storm did not
last for many months, but it was terrifying to those of us in the middle of it
who knew how close we came to total and absolute economic Armageddon.
Now, let me take a step back to the spring of 2006, which is where this story
starts for me. I was down in Naples Florida visiting family and was at a local
barber getting a haircut. Once inside the shop I could overhear one particular
barber boasting in a somewhat loud voice, mind you - about his real estate
investing prowess. It seemed odd to me that a barber would have enough
cash to buy real estate in beautiful and affluent Naples Florida, so naturally
my ears perked up a bit and I listened intently. Over the next 20 minutes or
so, I heard this fellow brag to his fellow barbers and customers about how he
was able to purchase multiple homes, for purposes of flipping them which
is essentially buying real estate and quickly reselling in the hopes of a quick
profit after making a few minor improvements all using mortgage loans
that did not require putting any money down. In addition, these mortgages
did not require that he verify his stated income, which had been inflated for
purposes of qualifying for the loans. Can you say mortgage fraud? If this
wasnt a bubble, I dont know what would be. As a credit-trained corporate
lender, I knew that being able to verifying a borrowers ability to repay a loan
(by looking at looking at historical and projected cash flow) and relying on
some sort of equity cushion in the value of underlying collateral were two

extremely important pillars of any fundamental credit analysis, yet here in

Florida in 2006, that didnt seem to matter to anyone. Why was that?
Simply put, there were Wall Street underwriters who, for a fee, were willing
to package up these shaky loans, also known as subprime loans, and sell
tranches of debt securities backed by them to investors all over the world,
there were rating agencies willing to rate certain tranches of these securities
as investment grade and, as a result of these ratings, there were investors
willing to buy debt these shaky debt securities backed by pools of these
subprime mortgages. It wouldnt be until the spring of the following year
before the cracks started to appear in the faade of normalcy within the
mortgage market. The landslide, which would become an avalanche, started
in February 2007 with an announcement by Freddie Mac, one of the largest
public government-sponsored enterprise purchasers of mortgage backed
securities, that it would no longer buy the most risky subprime mortgages
and mortgage-related securities. Then, only two months later, New Century
Financial Corporation, a leading subprime mortgage originator/lender, filed
for Chapter 11 bankruptcy protection. By then, the crisis was in full-swing. It
had become obvious to every market participant that the housing market
was collapsing as overleveraged borrowers were defaulting on their
mortgages in record numbers driven by poor underwriting standards and
teaser rates on adjustable rates mortgages that made owning a home
affordable at first but not during the inevitable rate resets. One example of
the sort of loans being offered during those boom years was the so-called

NINJA Loan - a nickname for a very low quality subprime loan with NINJA
standing for No Income, No Job, (and) no Assets because the only thing an
applicant had to show was his/her credit rating, which was presumed to
reflect willingness and ability to pay. With the higher default rates, a
significant number of homeowners and real estate investors all rushed to sell
their homes at the same time, hoping to avoid a default. This flood of
inventory into the market triggered a significant decline in market prices,
and with that decline, the value of mortgage backed securities fell off a cliff
when it became clear that there were a significant number of homes that
were under water (meaning the value of the home was less than the value of
the mortgage balance).
During that same period, I was working in leveraged finance at Bear Stearns
where we financed leveraged buyouts of companies by a variety private
equity sponsors such as Blackstone, KKR and Bain Capital. Typically, in any
leveraged finance transaction, the private equity client would line up debt
financing (typically bank loans and/or bonds) for an LBO which might provide
75% of the purchase price of a company and they would use their funds
equity for the balance of the purchase price. Typically the financing would be
agreed-upon several months before the M&A transaction was ready to close
and the rate spreads on the debt would be decided upon months before the
debt financing was ready to be marketed to debt investors. This timing









underwriters would typically be taking market risk (basically the risk that

rates, or credit spreads on rates, would increase between the time the
commitment had been agreed-upon and the time the debt was sold). While
underwriters attempted to address this market risk by including so-called
market flex language in our debt commitments, the flex was typically
capped, so that there was still some degree of risk involved in syndicating
the debt commitments since wed be potentially be on the hook for a huge
unsold or hung debt commitment if spreads moved more than the flex.
During the spring of 2007, the leveraged finance market was on fire with
private equity firms buying up private and public companies alike and our
firm was definitely in the mix with a massive pipeline of forward
commitments. As spring turned into summer, it was clear that the troubles in
the mortgage market were beginning to spill over into the leveraged finance
market. Loans that might have cleared the market at LIBOR plus 350 bps in
March now required much higher spreads and with our market flex capped
out in many cases at 150 bps, we needed to start selling these loans at a
loss in order to move the risk off our books. Of course, we stopped booking
new credit commitments just another reflection of the credit crunch that
was unfolding - but spent the entire summer and early part of the fall
clearing our inventory of unclosed deals initially in the mid-90s (meaning 95
cents on the dollar) and by the fall of that year, the same sort of loans were
selling at 85 cents on the dollar. The market for corporate loans and bonds
was drying up as investors became more and more risk averse.

Meanwhile, as trouble brewed in our area of the firm, there were other areas
of Bear Stearns experiencing stress. In June of that year, our mortgage
department disclosed that two internal hedge funds that had used significant
amounts of borrowed money to leverage third-party capital to invest in
primarily mortgage-related debt that had declined significantly in value. By
the end of July, despite a $1.6 billion bail-out from the parent company, the
two funds filed for bankruptcy and were unwound, effectively wiping out all
of the $600 million of capital that investors had contributed. The two
managers of these funds were arrested and faced criminal charges of
misleading investors but were ultimately acquitted.
In December of that year, I along with about 20% of the firms employees at
the time, were let go. It was a tough blow, to be sure, but I collected my
severance and began searching for another job once the holidays were over.
Several months later, as my search process neared a conclusion, I happened
to be at an interview with a distressed debt fund out in Denver when I was
asked: Did you know your old firm (Bear Stearns) was having liquidity
problems? Turning on the television in the conference room, I saw Alan
Schwarz, Bears CEO, emphatically denying that the firm had any liquidity
problems. This assertion turned out to be the kiss of death for Bear, a firm
that significantly relied on overnight loans which could be withdrawn at any
time to fund its business. By the end of the following week in March of
2008, faced with the option of filing for bankruptcy or accepting a US
Treasury brokered bailout and sale to JPMorgan, Bear Stearns agreed to be

purchased for $2/share after having trading as high as $140/share less than
two years before. The deal, which had been put together in less than 48
hours, had only gone through after the NY Fed agreed to purchase up to $30
billion of Bear Stearns mortgage assets that JPMorgan found too risky to
assume. From the US Governments perspective, a Bear Stearns' bankruptcy
would have affected the real economy by causing a "chaotic unwinding" of
investments (forced selling) across the US markets. From a personal
standpoint, since a portion of my annual compensation each year had paid in
the form of restricted stock units which I could only sell after a three year
vesting period, the transaction effectively translated into a personal loss of
nearly $500 thousand dollars. On the other hand, I was one of the lucky ones
as I was able to find and start a new job only a few weeks later at Bank of
Of course, the last-minute acquisition of Bear Stearns did little to stem the
malaise in the markets- but the panic had not reached a crescendo yet. In
July, after a bank run reminiscent of Its a Wonderful Life, the Office of
Thrift Supervision closed California-based IndyMac Bank, the second largest
financial institution to close in the United Stated up until that point, after it
was forced to mark down a portfolio of mortgages that had been originated
with the intent to sell into the secondary market. By the end of the summer
of 2008, it was clear that a variety of financial institutions were under
pressure. Nearly every financial institution became unwilling to lend to other
financial institutions on an unsecured basis since an unsecured loan would

likely see a poor recovery in bankruptcy compared to a secured loan. Those

who were still willing to lend at all would only do so on a secured basis
(backed by collateral) and required more and more margin (decreasing the
loan to value), effectively reducing liquidity available in the market. The
upshot was - financial institutions did not have access to the dollars they
needed to grow, or even to sustain their businesses. Among the financial
institutions that appeared to be most at risk were the investment banks,
Lehman Brothers and Merrill Lynch, primarily due to the perception that they
were holding assets (including real estate and toxic mortgage backed
securities) on their balance sheets at values that were dramatically
overstated compared to their current market values. In addition, after being
forced to recognize untold billions of dollars of losses on its mortgage
portfolios which had apparently nearly depleted their respective capital
bases, the federal two Government-sponsored enterprises (or GSEs), Fannie
Mae and Freddie Mac, who were the two largest purchasers of conforming
home mortgage loans (not subprime) were placed into conservatorship of the
US government with additional backing being provided by the US Treasury of
up to $100 billion in each GSE.
Within a week of Fannie and Freddie being seized, Lehman Brothers was
attempting to sell itself to either Barclays Bank or Bank of America in the
days leading up to the weekend of September 13 th and 14th and got so far as
to reach a preliminary agreement for a transaction with the UK-based
Barclays. However, the U.K. regulators who govern Barclays, the Financial

Services Authority, declined to provide their approval of the deal on Sunday,

September 13th, which triggered the Lehman bankruptcy filing the largest
bankruptcy in US history as measured by assets - the following day on
September 14th. At the same time, in a transaction that probably averted a
similar bankruptcy, the investment bank Merrill Lynch agreed to sell itself to
Bank of America for $50 billion.
Nearly concurrent with the Lehman Brothers crisis, the NY Fed learned that
AIG, the largest insurer in the world, was teetering on collapse due to
margin-calls on its portfolio of credit default swaps (or CDS). Credit Default
Swaps are essentially contracts which permit the purchaser, in exchange for
an ongoing fee, to sell a set amount of a reference debt security to the seller
at par (face value) in the event of a credit event such as a bankruptcy filing.










exposure/investment in an enterprise in the event the enterprise would

declare bankruptcy. An AIG affiliate had sold billions of CDS on super-senior
tranches of mortgage backed bonds to a variety of third party financial
institutions including Societe Generale, Deutsche Bank, UBS, Goldman Sachs
and Merrill Lynch. As the financial crisis raged, despite the insurance being
on the super-senior tranches which were the safest, the credit spreads on
these tranches widened which required AIG to post additional collateral with
its trading counter-parties to cover the swing in the valuation of the
derivative contracts. In response to these collateral calls, S&P reduced AIGs
credit rating due to the combination of reduced financial flexibility caused

by meeting additional collateral needs and concerns over increasing

residential mortgage-related losses. This rating agency downgrade in and of
itself required AIG to post even more collateral, which ultimately became a
death spiral for the company. Faced with the prospect of letting AIG fall into
bankruptcy like Lehman brothers, and seeing the financial crisis accelerate
further and to prevent the domino effect of additional bankruptcies of other
financial institutions who had counterparty exposure to AIG , the Federal
Reserve stepped in on September 17, 2008, announcing the creation of a
secured credit facility of up to US $85 billion (a figure which was ultimately
increased to $182 billion) to prevent the company's collapse and enabling
AIG to deliver additional collateral to its CDS counterparties.
Now switching gears back to my own experience, at the time this was going
on, I was working at Bank of Tokyo, who was a lender to both Lehman and
AIG and its subsidiaries. As AIG neared insolvency, I was asked to create an
analysis over the weekend as to the likely recovery (or loss) on a significant
unsecured loan we had outstanding to ILFC, an investment grade aircraft
leasing company subsidiary of AIG. It wasnt pretty. If ILFC had been forced to
file for bankruptcy, which almost certainly would have happened if its parent,
AIG, had filed (since ILFC depended upon AIG for financial backing) the
forced sale of a portfolio of hundreds of aircraft may have led to a significant
loss for Bank of Tokyo. Needless to say, folks were pretty relieved when the
government stepped in when it did.

Less than ten days later, on September 25, 2008, following a 9 day bank run,
the United States Office of Thrift Supervision (OTS) seized Washington Mutual
Bank, the sixth largest bank in the United States at the time, and placed it
into receivership with the FDIC before being sold to JPMorgan for $1.9 billion
in a transaction that wiped out WAMUs shareholders and some bondholders
but didnt require any FDIC assistance to cover insured deposits.
Only days after that, Wachovia Bank, which was the fourth largest bank
holding company in the US and had been on the verge of collapse itself due
to a flight in its deposit base, was sold to Wells Fargo after being threatened
with seizure by the FDIC.
If the markets hadnt been in a state of turmoil already with the Lehman
brothers filing, the AIG near-collapse, the seizure of Washington Mutual and
forced sale of Wachovia turned up the panic several more notches.
Immediately following the Lehman bankruptcy filing, an already distressed
financial market began a period of extreme volatility, during which the Dow
experienced its largest one day point loss ever, largest intra-day range (more
than 1,000 points) and largest daily point gain. In addition, the moneymarkets witnessed the equivalent of an electronic bank run. Withdrawals
from money markets were $144.5 billion during the one week following the
Lehman filing, versus $7.1 billion the week prior. This interrupted the ability
of corporations to rollover (replace) their short-term debt. The U.S.
government responded by extending insurance for money market accounts

analogous to bank deposit insurance via a temporary guarantee and with

other Federal Reserve programs to purchase commercial paper which are
effectively overnight loans made to investment grade companies such as GE
- since investors were unwilling to buy the debt.
What followed was what many have called the "perfect storm" of economic
distress factors and eventually a $700bn bailout package (Troubled Asset
Relief Program often referred to as TARP) prepared by Henry Paulson,
Secretary of the Treasury, and approved by Congress and signed into law on
October 3, 2008.
Days afterwards, in an effort to get ahead of the series of bank runs which
had already caused several large bank failures, the Federal Deposit
Insurance Corporation (FDIC) established the Temporary Liquidity Guarantee
Program on October 14, 2008, to strengthen confidence and to encourage
liquidity in the banking system. The program had two parts: a Debt
Guarantee Program (DGP), which allowed banks to issue government
guaranteed debt, and a Transaction Account Guarantee (TAG) program,
which essentially extended deposit insurance to depositors in unlimited
amounts. In addition, on the same day, Secretary of the Treasury Henry
Paulson and President Bush separately announced revisions to the TARP
program. Through TARP, the Treasury announced their intention to buy $125
billion senior preferred stock and warrants from the nine largest American
banks and would also end up buying preferred stock and warrants from

hundreds of smaller banks, investing up to $250 billion (including the $125

billion invested in the largest firms).
While the October 2008 measures did not break the back of the financial
crisis altogether and there were certainly many more programs put in place
to try to unfreeze the credit markets, it was clear that the US Government
would use unprecedented and overwhelming measures to break the cycle of
panic which had spiraled out of control. Nonetheless, despite their efforts
clearly being seen as successful in retrospect, Federal Reserve Chairman Ben
Bernanke, U.S. Treasury Secretary Henry Paulson and former Federal Reserve
Bank of New York President Timothy Geithner faced incredible scrutiny,
criticism and were second-guessed for each decision at the time and for
years afterward. Saving Bear Stearns using government money was roundly
criticized at the time and letting Lehman fail was called a disaster and more
of a punishment for their polarizing CEO, Dick Fuld, than anything else
(Treasury Secretary Hank Paulson and Dick Fuld were long-time Wall Street
rivals and Fuld was known to have turned down opportunities to sell Lehman
only months before). In addition, while saving AIG was widely seen as a
necessary evil given the sheer size of the company, the fact that their
trading counterparties, which included Goldman Sachs, received 100 cents
on the dollar on amounts due to them under collateral calls as opposed to
taking some sort of a haircut since everyone else was losing moneydefinitely struck the wrong chord with many and was seen by some as the
elite taking care of their own.

We talked about the mechanics of the financial crisis, and how the deep
market penetration of MBSs exposed all the biggest financial institutions to
great risk.

We discussed the down-spiral effect of the dislocation of the

lending apparatus between financial institutions, and how lack of investor

confidence in the biggest financial firms expanded this crisis into pandemic

And- while most discourses on the financial crises from

financial professionals focus on Wall Street- we paused to consider how Main

Street contributed to the crisis as well, and why this made the scale of this
crisis was so great. Hopefully I was able to put a face on the financial crisis
and understood how it trickled down into becoming a personal crisis for so
many people, myself included. In the end, like any storm, the darkest of
thunderclouds seem to clear within a few months when it was obvious our
society wasn't collapsing into an abyss worse than the great depression
thanks to the quick action of folks like Bernanke, Paulson, Geithner and FDIC
Chairman Sheila Bair who prevented the mother-of-all bank runs (by
guaranteeing the money market funds in September of 2008 and by
orchestrating the various bailouts that were so controversial). While these
moves were widely condemned at the time and in retrospect, and many
criticize them for not taking action earlier to prevent the debacle, our
economy was literally on the precipice of total meltdown the likes of which
has not been seen before, so I am grateful they took the actions they did.

Have we all learned the lessons of that era? I don't know, but I have: Be
optimistic about the future because things always get better when things
seem darkest, but be ready for the worst case scenario. What does this
mean? It means that companies need to be prepared to deal with unforeseen
economic circumstances by not depending on short term funding to fund
illiquid assets and by having an ample amount of liquidity on hand to
manage through difficult circumstances such as market dislocations and
recessions. For individuals, it means having sufficient liquidity to manage
through potential periods of unemployment.
As for the lessons that ought to have been learned by the financial services
industry, I'm not so sure.