Understanding a Financial Crisis - Part II

This is Part II of a three-part series on understanding a financial crisis. Click here for Part I.

Systemic Risk:

By early 2008, investors and the rest of the world were starting to lose confidence in the world's largest banks. News was starting to roll out about banks' heavy investments in sub-prime mortgages and risky derivatives and people were beginning to see just how interconnected all these banks had become. In March of 2008, rumors began to swirl about risky investments and a looming failure of Bear Stearns, one of the largest banks in the world. The stock began to drop, people were calling the bank asking to withdraw their money, and the bank was scrambling to meet all the demands and stop the pandemonium.

As Washington had gotten word of this, the president of the Federal Reserve, Tim Geithner, was called to assemble a team of investigators to determine how bad the books looked at Bear Stearns. In their investigation they discovered what central bankers fear more than anything: systemic risk. Systemic risk is easy to understand. Since all these banks owed each other money, if even one bank were to go bankrupt who would pay all the banks they owed money to? Then, if the banks who were owed money were not getting paid, how would they pay off the banks that they owed money to? Systemic risk is feared because it puts you in a situation where if one piece of the system fails the entire system goes down. In this case, the system was the global economy.

A Way Out:

Upon the completion of the investigation Geithner's team conducted at Bear Stearns, Geithner called Ben Bernanke, then Chairman of the Federal Reserve, and informed him that he believed Bear Stearns was "too big to fail" (in other words they were too interconnected with the rest of the world in order to be allowed to go bankrupt). Bernanke knew that if Bear failed it would bring down the entire financial system, so he suggested to Henry Paulson (then Treasury Secretary) that they "bail out" Bear Stearns by allowing another bank to buy their assets. In this way, Bear would be able to pay its creditors and avoid bankruptcy. Henry Paulson was very free-market in his way of thinking and called this a ridiculous idea, telling Bernanke that the market rewards and the market punishes. Paulson originally believed that Bear should be allowed to fail because they were in trouble due to their own greed, but changed his mind after he realized how bad the situation was. The Federal Reserve agreed to give JP Morgan $30 billion if JP Morgan would agree to buy Bear Stearns, and they did. Bear was sold for a mere $10 a share, only 7.5% of their 52-week high stock price before the crisis.

Average, hard-working investors who owned Bear Stearns stock lost more than 90% of their investment.

Paulson warned America of moral hazard. Moral hazard basically asks "if you bail someone out of a problem that they created themselves, what incentive do they have to not do the same thing again?" Paulson warned the major banks that the $30 billion Bear Stearns bailout was a one-time deal and that they were on their own and needed to manage their risks accordingly.

The Summer of Assurances:

After the Bear Stearns bailout, President George Bush gave control of the management of the spreading financial crisis to Henry Paulson. Paulson realized that in order for the system to continue to function and avoid failure, they had to keep money flowing into the banks. Since the main source of the banks' money was people, the Bush administration spent the summer of 2008 trying to reassure Americans and the rest of the world that everything was fine in the financial system and that they should trust the banks. They should continue to keep their money in the banks and trust that the situation would work itself out as long as confidence stayed high.

This reassurance campaign became known to some as the summer of assurances. Unfortunately no matter how much Paulson and the Bush administration reassured the world, a disaster was already inevitable. In the fall of 2008, it became obvious that Lehman Brothers, one of the United States largest investment banks, had become so riddled with toxic debt in sub-prime mortgages and risky derivatives that they would need to file for bankruptcy since they simply couldn't pay their bills to other banks and their investors.

The Aptly-named Dick Fuld:

Dick Fuld was the CEO of Lehman Brothers. While his bank made billions of dollars trading derivatives and collecting interest on loans, he took massive bonuses, lavish vacations and bought excessive material things. This was the kind of guy who would buy a yacht just because he could. Dick Fuld truly is, well, a dick. Anyway, Dick Fuld remembered that Paulson had bailed out Bear Stearns, and he knew that Lehman Brothers was in a similar if not worse situation. He tried to call Paulson's bluff and believed that the government would bail them out. He did nothing to mitigate the risk posed to the global economy and showed zero remorse for his lavish spending and ignorance of clear issues on Lehman's books. Paulson would stand firm though (as he rightfully should have). In early September on a Monday morning, Lehman Brothers announced that it had filed for bankruptcy and the Dow Jones Industrial Average plunged over 600 points.

Paulson was sitting on an incredibly difficult situation. He knew that since Lehman Brothers had failed, AIG would be right behind it since AIG had credit default swap agreements totaling over $400 billion with banks that Lehman Brothers owed money to. The financial crisis was starting to become uncontrollable. Paulson again switched teams in an effort to save the economy and the Federal Reserve reached an agreement to bail out AIG for over $180 billion. These inconsistent signals Paulson was sending (while somewhat understandable) had investors unsure of what to expect from the banks and from the Fed. People knew the problem was bad, but they didn't know how bad and they didn't know how long it would go on or what the government and the banks were doing to fix the problem. While Paulson and other members of the Bush administration tried to reassure Americans and the rest of the world that the crisis was under control, they all knew it really wasn't.

TARP:

As Lehman Brothers filed for bankruptcy and AIG was bailed out, shockwaves of financial panic began to rip through the market. There was no end in sight and no one knew how deep the roots of the problem went. Because of this uncertainty, Ben Bernanke recommended that Paulson go to Congress and establish a bailout "fund" which would allow them to relieve the pressure on the markets by setting money aside that the banks could use if they needed it to pay each other off. The idea was to restore confidence to the financial system so that banks could lend each other money again in a healthy way. Of course Congress was split down the middle on this, with some people believing that a bailout was the only way to resolve the problems and others believing that a bailout just sent a signal to the banks that they could do whatever they wanted, make billions, and taxpayers would pick up the pieces.

After much debate a program was finally created called TARP - or the Troubled Asset Relief Program. This was a $700 billion bailout "fund" that would be divided up amongst the banks that had the biggest financial problems. While it seems like this would take months to resolve, you should understand that the speed at which this whole situation happened was such that Paulson was only able to get the bill passed by telling congress that if they didn't pass it, the financial system of the world would melt down in a matter of days.

And it would have. The entire process happened in a matter of weeks.

After TARP was established, Paulson called the leaders of the largest investment banks together in New York and told them that they needed to take the money or they would face severe ramifications.   While one CEO tried to deny receipt of the money because he believed it was wrong (Dick Kovacevich of Wells Fargo), they were all ultimately forced to sign the agreement that day and over $125 billion of the TARP fund was divided up between them. The money came with no stipulations. No regulatory changes, no limitations on bonuses or salaries, nothing. The banks were paid billions of dollars and received no punishment for their terribly risky and greedy behavior.