In the last two blog posts, the July 1998 hearings on derivatives were reviewed. A generous interpretation of Lawrence Summers testimony could - with a straight face - claim that Summers was merely advancing a limited legal argument. (1) Namely, the CFTC had no legal right to regulate derivatives and he was not against regulating derivatives per se. Indeed, in his testimony Summers gave two reasons for being skeptical of regulating derivatives (2);
- The parties to derivative contracts were largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies.
- Given the nature of the underlying assets involved...there would seem to be very little scope for market manipulation of the kind seen in traditional agricultural commodities.
However, LTCM's failure in September 1998 showed these two reasons were completely invalid. When faced with such a situation, any fair-minded person would have been forced to revisit any conclusion based on these now obviously incorrect reasons. Of course, Summers didn't revisit his conclusion regarding regulating derivatives, and the November 1999 report prepared by the President's Working Group on Financial Markets is proof of this. This report - which was also signed by the Fed's Alan Greenspan and the SEC's Arthur Levitt - was a total whitewash, and completely ignored the obvious lessons provided by LTCM's spectacular failure.
So, while it can be said that Summers played mid-wife to the subsequent derivative dominated failure of AIG in November 2008, the failure was nurtured by the colossal ignorance of Tim Geithner, President of the Federal Reserve Bank of New York, and Henry Paulson, Treasury Secretary of the United States. The brief timeline below will show numerous alarms going off regarding mortgage bonds generally as well as AIG's specific problems. In the face of all these alarms, the ignorance of Geithner and Paulson to the enormous problems that eventually swallowed AIG is inexcusable.
A brief timeline;
October 2003: Tim Geithner is named President of the Federal Reserve Bank of New York. The AIG fiasco will metastasize into an enormous crisis right under Geithner's nose. Later Geithner will testify that he was never a regulator. However, the NY Fed's website states; "The Supervision Group of the Federal Reserve Bank of New York supervises the financial institutions that are subject to the Board's supervision and are located in the Second Federal Reserve District....the objectives of supervision are to evaluate, and to promote the overall safety and soundness of the supervised institutions, the stability of the financial system of the United States and compliance with relevant laws and regulations."
October 2005: Investment manager Michael Burry writes to his investors and tells them he has established a major 'short' position in mortgage bonds. Burry thinks there is an enormous housing bubble and the mortgage bonds will collapse in value. "Selectively shorting the most problematic mortgage-backed securities in history today amounts to just such an opportunity." (3) (In the movie "The Big Short," Burry was played by Christian Bale)
November 2005: Deutsche Bank's Greg Lippman wants to be short the mortgage market by owning credit default swaps (CDS). AIG is the main seller of mortgage CDS. By purchasing CDS from AIG, Lippman is betting mortgage bonds will suffer large losses. This is the same trade that Michael Burry is making. (4) (In the movie, "The Big Short," Lippman is played by Ryan Gosling)
End of 2005: Lippman travels to London to meet with AIG Financial Products (AIG FP), the biggest insurer of sub-prime mortgages. AIG FP is the long side of Lippman's bet against mortgages he owns via the credit default swaps. Lippman tries to convince AIG FP the mortgage market is ripe for an enormous collapse, and they should stop selling mortgage credit default swaps. (5)
Early 2006: Gene Park of AIG FP, convinces Joe Cassano, the head of AIG FP, to stop insuring mortgage bonds via credit default swaps. However, AIG FP doesn't attempt to reduce their exposure via the CDS products they have already sold. This decision will produce at least $60-billion in losses. (6)
July 10, 2006 - Henry Paulson is appointed Treasury Secretary. Paulson had been CEO of Goldman Sachs and had spent most of his working life on Wall Street. His ignorance of the mortgage market was total.
August 17, 2006 - In a meeting with President Bush, Treasury Secretary Paulson describes the economy as "strong" but admits to little knowledge of the specifics of the market for derivatives; 'no one knew how much insurance (derivatives) was written on any credit in this private, over-the-counter market. Settling trades had become a worrying mess; in some cases backlogs ran to months.' (7)
September 08, 2006 - Grant's Interest Rate Observer fires a shot across the bow of the mortgage derivative market, and openly discusses the merits of being short mortgage bonds. "Overvalued, we, in fact, judge trillions of dollars of asset-backed securities and collateralized debt obligations to be, and we are bearish on them... housing related debt is cheap by no standard of value. For institutional investors equipped to deal in credit default swaps, there's an opportunity to lay down a low-cost bearish bet."
In the same issue, Grant's then goes on to describe in perfect detail exactly how someone who wants to short mortgage bonds can identify the bonds most likely to default; He (a CDS buyer) looks for "high Florida exposure, high California exposure, high second-lien exposure. You look for equity take out loans because those appraisals tend to be overstated, a high-percentage of stated income loans (aka liar loans) and you build yourself a portfolio of credits from weak underwriters that are ultimately likely to be impaired." (8)
THIS WAS TWO YEARS BEFORE THE FAILURE OF LEHMAN BROTHERS!
September 22, 2006 - Grant's Interest Rate Observer fires another shot across the bow; "the issuance of complex mortgage structures is booming when house prices are not and the visible and looming difficulties in residential real estate have not yet depressed the prices of such instruments as....CDOs...Everyone is playing the same game, which is: As long as the problems don't occur too soon, we are all okay." (9)
September 28, 2006 - Merrill Lynch in its Review of ABS ( asset backed securities) predicts that with as little as a 5% depreciation in home prices, losses in mortgage backed bonds will be enormous. (10)
October 06, 2006 - Grant's Interest Rate Observer fires another salvo against the mortgage bond market, "At last report 44% (of sub-prime mortgages) where characterized by limited documentation, 31% by piggyback loans and 22% by interest only." The article goes on to describe, like Merrill's report from 28 SEP 2006, that even small drops in home prices will produce enormous losses in mortgage bonds. (11)
Fall 2006 - Deutsche Bank's Greg Lippman has now made presentations to hundreds of Wall Street investors. These presentations completely document why mortgage bonds are ripe for an epic collapse, and owning mortgage CDS is an easy way to capitalize on this collapse. (12)
November 13, 2006 - Investor and author, Peter Schiff, addresses the Western Regional Mortgage Bankers Conference and warns of impending collapse. He states, "The way this sub-prime works...65% of the sub-prime mortgage market, 65% of those bonds, of those mortgages - where a guy - stated income, no-doc, negative am, risky loans - 65% of those things are repackaged by Wall Street and rated triple-A. Triple-A!...That particular piece of paper should be rated F and it will go to zero as will several tranches above it...The bottom is going to drop out of the sub-prime market." (13)
December 01 and December 05, 2006 - Two sub-prime mortgage originators, Sebring Capital Partners and Ownit Mortgage Solutions go bankrupt.
December 15, 2006 - Grant's predicts large losses on even investment grade mortgages. "Grant's has much to say about mortgage credit this year...we find that under some not very adverse assumptions - even higher rated mortgage structures are vulnerable to infestation by credit termites. A few - a minority - believe that troubles now unfolding at the margins of sub-prime are the leading edge of a much deeper problem. We are in that camp." (14)
April 02, 2007 - New Century Financial, the second biggest sub-prime lender declares bankruptcy.
Late April 2007 - Henry Paulson tells the Group of 100, sub-prime problems are largely contained." (15)
July 17, 2007 - A hedge fund manager, Greg Eisman, says on a conference call, "Just throw your model in the garbage can. The models are all backward looking. The models don't have any idea of what the world has become....We are in the midst of one of the greatest social experiments this country has ever seen. (to increase homeownership, PCS) Losses in excess of $300-billion should be expected from the (derivative) portion of the market." (16) (In the movie, "The Big Short," Eisman is played by Steve Carrell.)
July 17, 2007 - Investors in Bear Stearns mortgage products learn their money has been invested with hedge funds exposed to mortgage credit default swaps - the same investment AIG is exposed to - and has been completely lost.
August 06, 2007 - American Home Mortgage Investment Corporation goes bankrupt.
August 15, 2007 - Countrywide Financial - the largest private issuer of sub-prime mortgages - is forced to draw on back-up lines of credit because it is unable to borrow from its traditional sources.
October 16, 2007 - Paulson states, "I've seen turbulence in the market a number of times and I can't think of any situation where the backdrop of the global economy is as healthy as it is today."
October 30, 2007 - Merrill Lynch CEO resigns after enormous losses in mortgages.
November 04, 2007 - Citi annnouces enormous losses in mortgages.
December 2007 - AIG executives and a Wharton finance professor hold a press conference to explain their investments in mortgage bond 'insurance' via credit default swaps are not exposed to large losses. The computer models they use to make their investments are "simple, they're specific and they're highly conservative." (17) The Wharton finance professor is Gary Gorton, Dunce #27.
February 28, 2008 - AIG announces an $11.5-billion loss on its mortgage CDS investments and they have posted $5-billion as collateral against other losses.
February 29, 2008 - Joseph Cassano, head of AIG FP, leaves the company.
May 08, 2008 - AIG admits to another $9-billion in unrealized losses on its credit default swap investments. The total losses are now a staggering $20-billion.
September 13, 2008 - During meetings associated with the attempt to 'save' Lehman Brothers, Chris Flowers of Bank of America asks Treasury Secretary Paulson if he knows how bad things are at AIG. Flowers tells Paulson that AIG will be out of cash in just ten days. Paulson admits to being ignorant of the scale of AIG's problems. (18)
September 14, 2008 - AIG tells Paulson it will need a $40-billion 'loan.'
September 16, 2008 - Acting on its own authority - without any input from Congress or the President - the Federal Reserve initiates an $85-billion bailout of AIG.
Defenders of Geithner and Paulson - and the system that spawned them - argue the financial crisis developed quickly and without warning. I hope this brief timeline shows, the financial crisis - at least the mortgage derivative component of it - developed over enormous lengths of time. This aspect of the crisis goes back to Summer's fully fraudulent report on derivatives from November 1999. The crisis was then nurtured by both Tim Geithner and Henry Paulson who ignored one warning after another, particularly those in 2006. After the crisis, Geithner and Paulson defended the AIG bailout by claiming AIG was so interlinked with other financial services firms, that its failure would have a domino effect up and down Wall Street. If this is the case, then what is the explanation for what was their complete ignorance of what was occurring at AIG even when so much public and contemporaneous information was available?
Peter C. Schmidt
Sugar Land, TX
August 18, 2019
PS - As always, if you like what you read, please register with the site. It just takes an e-mail address and I don't share this e-mail address with anyone. The more people who register with the site, the better case I can make to a publisher to press on with publishing my book. Registering with the site will give you access to the entire Confederacy of Dunces list as well as the financial crisis timeline.
Help spread the word to anyone you know who might be interested in the site or my Twitter account. I can be found on Twitter @The92ers
(3) Michael Lewis, The Big Short, Penguin Books, New York, 2010, p. 55
(4) The Big Short, p. 80
(5) The Big Short p. 83
(6) The Big Short, p. 89
(7) Henry Paulson, On the Brink, Business Plus, New York, 2010, pp. 43-46
(8) James Grant, Mr. Market Miscalculates - The Bubble Years and Beyod, Axios Press, Mount Jackson, VA 2008, pp. 169-170 and 173-176
(9) Mr. Market Miscalculates, pp. 179-180
(10) Mr. Market Miscalculates, p. 180
(11) Mr. Market Miscalculates, p.181-182
(12) The Big Short, p. 104
(13) Start at the 7:40 mark; https://www.youtube.com/watch?v=xNKs8lBnd2U
(14) Mr. Market Miscalculates, p. 184
(15) On the Brink, p. 66
(16) The Big Short, pp. 175-176
(17) Behind AIG's Fall, Risk Models Failed to Pass Real World Test," Wall Street Journal, October 31, 2008 https://www.wsj.com/articles/SB122538449722784635
(18) On the Brink, p. 200
(19) On the Brink, pp. 217-218