1994 – Clinton used an executive order to create the National Homeownership Strategy, with the very good intention that everyone should be able to afford a home. This began reducing borrowing standards so more people could get loans.
1995 – Presidential executive orders forced banks to establish a lending quota of up to $6 trillion to people who were not able to afford a home. Again, very good intentions. I don’t blame Clinton. Owning a home was considered a source of pride. But good intentions often lead to very BAD outcomes.
Seemingly unrelated… 1998 – The hedge fund Long-Term Capital Management (LTCM), set up by top investor John Merriweather and two Nobel Prize winners, was hit by disaster. It was so leveraged that it almost tanked the world, until all of the major banks joined together to bail out LTCM and save the financial system. Well… all of the banks except two: Lehman Brothers and Bear Stearns (this is relevant later).
1999 – The Glass-Steagall Act was passed, deregulating banks, and also allowing banks to form hedge funds that could invest more aggressively than the bank normally would. This also allowed banks to lend more. Good intentions again…
2000–2001 – The internet bust and recession. 9/11. The market collapsed. Interest rates were deeply cut to restimulate the economy, allowing more subprime borrowers to take out no-money-down, interest-only loans. Again, good intentions. Until…
2002–2006 – Low interest rates + more lending + more investors allowed banks to lend to make interest-only, no-money-down loans to subprime borrowers. Many subprime borrowers bought homes. Anyone who wanted to could own a home. Good intentions…
1999–2006 – The government promised to backstop the loans (reduce risk for the banks so they could lend more): Fannie Mae would “buy” the loans as soon as they were made and the banks were simply paid to collect the money (exactly like PPP loans today, with the Federal Reserve buying the loans).
2000–2006 – As a result of the above, banks had zero risk in lending. So they lent as much as possible, would resell loans to the government, service the loans, take a fee. EXACTLY how the PPP loans today will work. But then derivatives…
2000–2005 – Hedge funds (often run by the banks) started buying the loans, since the mathematical models showed that risk of default in a diversified portfolio of mortgages had never failed. Then mortgages were bundled together to create “mortgage-backed securities.”
Note: The mathematical models hedge funds and banks were using never considered subprime borrowers. Hedge funds were borrowing at 1% and buying as many mortgage-backed securities as they could at 4%. Banks, funds, brokers… making money. People buying homes, homes going up in value…
As a result, the economy heated up. So the Fed started raising interest rates, from 1% to 5%. Now people who borrowed “interest-only” loans at 1% had to pay 5x more per month in payments. Subprimes started to default…
2006–2007 – Housing actually bottomed. It would’ve come back quickly — but nobody counted on the disaster of mortgage-backed securities, and a small unnoticed change in the banking laws…
2006–2007 – Hedge funds started to crack. The mortgage-backed securities started to default. If a hedge fund were leveraged 100:1 (as some bank hedge funds were), then a 1% drop in MBS meant the hedge fund had a 100% (!) loss (because of the 100:1 leverage). But it gets worse…
2005–2007 – Credit default swaps were created. If a lender was nervous that a borrower would default, a credit default swap acted as “insurance” that the lender would get paid in full. The lender would have to BUY the credit default swap from someone.
Hedge funds got involved… They would SELL the credit default swaps). It was free money for the hedge funds since, up until then were, defaults basically zero if you sold a basket of diversified credit default swaps. This was a ton of free money for the hedge funds. But HUGE, HUGE leverage…
2006 – A few hedge funds (John Paulson, Michael Burry) got smart and started buying tons of credit default swaps from hedge funds. The sellers (the hedge funds acting like insurance companies on subprime loans) were laughing all the way to the bank until…
The hedge funds that were buying the insurance (John Paulson, Michael Burry) were losing money every month. Their long-term bet was that the system would collapse. John Paulson pitched me on his fund and I left his office thinking, “Holy fuck, we are screwed.”
Paulson only had one worry… He told me in 2006 (way before the top of the market) that he was afraid the banks would go out of business before he could get his money out. Two years later, this almost came true.
2007–2008 – Higher interest rates, plus more defaults from subprime borrowers, caused credit default swaps to trigger. The hedge funds that sold these had to start paying up. The system was cracking. But the banks were able to hold on UNTIL the worst happened.
2007 (critical moment) – FASB 157 was passed. This was a new rule that required banks to “mark to market” their assets in order for regulators and customers to determine the financial health of a bank. Again, good intentions. BUT this is what it meant…
For 70 YEARS, banks had “marked to value.”
Example: Your house is worth $200,000. You know this because of the history of house sales in your area. You paid $170,000 a few years ago, etc. Normal house appreciation.
But what if your neighbors are getting divorced and fire-sell their house? They live next door to you and their house is exactly like yours. They sell for $125,000 but you think, “No big deal. That was a weird situation.” That’s “mark to value.”
“Mark to market” turns it upside down… It forces you to use the last comparable house sale and NOW that’s what your house is worth: $125,000. Not $200,000. You don’t care because you know it will bounce back. And banks are now more transparent. Good intentions again…
But a bank that switches from “mark to value” to “mark to market” — RIGHT IN THE MIDDLE OF SUBPRIME DEFAULTS — it suddenly has to mark down its entire portfolio. Still, not quite a disaster yet. BUT… what if the banks borrowed too much?
If a bank or fund used 100:1 leverage, then even if 1% down (caused by the defaults ,plus some manipulation) will wipe out an entire trillion-dollar bank (Lehman Brothers) or insurance company (AIG) or dozens of hedge funds and basically every bank on Wall Street.
Lehman Brothers collapsed. Lehman was one of the only banks that didn’t help in the bailout of the highly leveraged Long-Term Capital Management hedge fund (LTCM) in 1998. The decision-maker, Treas Secy Hank Paulson, former CEO of Goldman Sachs, had a 10-year grudge.
One day later… Paulson saved Merrill Lynch by arranging a sweetheart deal with Bank of America.
Because of FASB 157, nobody could lend to the banks anymore (they had to mark their assets to less than zero)… which meant banks couldn’t loan to companies to make payroll….
The American system collapsed. The Great Recession began. Nobody could get cash into the system. Paulson arranged TARP (semi-nationalizing the banks) and the bailout (same as now — exact same playbook). But some important notes…
November 2007, when FASB 157 passed, was the top of the stock market. Mark to market was the law in the early 20th century but outlawed by FDR in 1938, which probably led to the end of the Great Depression as banks were able to lend more. So how did Recession end?
In early 2009, FASB 157 was a huge debate. On March 12, Congress met to discuss, and eventually new rules were passed to allow “mark to value” again. On March 9, the market started going straight up, until February 2020 (coronavirus)… similar to the Great Depression.
From 1938–2007, because of “mark to value,” there was no depression. Without TARP, and then the bank bailout in early 2009, then the repeat of FASB 157, we would’ve had a depression.
BUT “mark to value” is often called “mark to myth.” Who benefited? And who is benefiting now?
John Paulson turned $100 million into $6 BILLION (I wish I had invested when he asked me to).
Bill Ackman turned a $27 million investment last month into $2.6 BILLION. He went on CNBC saying the world was going to hell. He sold his investment right after. BUT…
The point is: We have to be careful of good intentions. Nobody is to blame. Should we blame Clinton for loosening borrowing requirements? Blame FASB 157? Blame hedge funds for speculating? Blame Glass-Steagall for deregulating banks?
Blame mortgage brokers for convincing subprime borrowers to buy houses? Blame banks for lending the money? Blame hedge funds for manipulating the market of MBS? Blame Bush for not seeing this coming? Blame Paulson for the bailouts?
The point is….
Government, leaders, voters often have the best intentions but don’t realize consequences that could come years later. Watch out for student loans and watch out for future bubbles in this bailout. There WILL be a crisis two to five years down the road created by current good intentions.
I’m not sure why I did this. I wanted to show how, when you connect the dots, something complicated can be presented in a simple fashion. I also wanted to underline future unknowns in what is happening now by looking at the past. AND see if Twitter is a good place to “teach.” THANKS!