How Ben Bernanke saved the world

Today was Ben Bernanke’s last press conference as FOMC chairman (he has one meeting yet to go). He spent quite a lot of time musing over what the global financial crisis was, what it meant and how it was addressed.

He rightly couches the event in the long tradition of banking crises, the primary difference being that this ‘bank run’ was from intermediation markets by investors, not from banks by depositors.

He confessed to be slow to recognise the crisis but rightly claimed that his actions prevented something far worse.

In the end, despite the questions over QE, I suspect history will smile on Ben Bernanke as the man that saved Western civilisation from total financial collapse. The ultimate rationale for a central bank is to be the lender of last resort and on this score Bernanke was fast enough, very innovative and sufficiently bold to rescue the world from a depression that would have made the 1930s look like a doddle.

To mark this occasion, find below one chapter from my book, the Great Crash of 2008 (co-authored with Ross Garnaut), that recounts the GFC and gives you a measure of what Bernanke had to confront.

Chapter 6: Things Fall Apart
THE US FEDERAL RESERVE records the first salient date of the Great Crash as 7 February 2007: the day that the government-sponsored enterprise (GSE) Freddie Mac declared it would no longer buy subprime mortgages from mortgage originators.1 But Freddie Mac’s actions were clearly responding to something, and digging a little deeper pushes the time line back.

Nine months earlier, a US mortgage originator called Merit Financial had gone bankrupt. It had done so as the refinancing boom brought about by low interest rates in the post-2001 period came to an end. A subsequent investigation revealed the unorthodox lending practices that would come to characterise the Crash.

Merit was founded in 2001 by former Washington Huskies football star Scott Greenlaw, then aged twentynine. It specialised in lending to clients with a bad credit history (subprime borrowers). Within five years it had written more than $2 billion of mortgages and employed 400 people.

According to the Seattle Times, Greenlaw employed loan officers in his own image. Many were ex-footballers, one an ex-Hooters girl. The loan officers went through a 19-step training program lasting one hour. After the bankruptcy, one employee confessed that many officers ‘didn’t even know how to read a credit report’.

Many former employees described Merit’s working environment as a raucous, sometimes lewd ‘frat party’. Merit provided kegs of beer for staff meetings, and employees were free to bring in six-packs on Fridays.

Several loan officers boasted online that doing drugs was a favourite pastime. ‘Let’s get hopped up and make some bad decisions’, wrote one beside a photo of himself grinning broadly.

The end of Merit Financial is an appropriate inflection point for the beginning of the Great Crash.

Any of the four parts of the Great Crash elephant might have precipitated the crisis. China’s boom and its imbalances may have been undone by a change of macro-economic strategy in either a deficit or a surplus country, perhaps in response to some bump in the road of economic growth. Western consumers may have reached some tipping point in their capacity to service debt. The animal spirits that had driven the boom may have turned around in panic. The greed of corporate and government figures may have crushed political support for the new financial system.

In the end, higher interest rates in response to inflation concerns triggered asset deflation and the circulatory system of the boom failed. The shadow banking system that transferred capital across the world, supported the imbalances, fed the booms and rewarded the greed, went into cardiac arrest.

Between the collapse of Merit Financial and the Freddie Mac announcement, another twenty-nine mortgage originators declared bankruptcy. These included the eleventh largest in the country, Merrill Lynch’s OwnIT.

As the mortgage originators went bust, declines in house prices began to register on the Case-Shiller Home Price Index in July 2006. Seven months later, as Freddie Mac made its declaration, the index was down 3 per cent to 201 points. Ben Bernanke, Chairman of the Federal Reserve Bank, and Secretary of the Treasury Hank Paulson both responded with reassuring comments about how mortgage problems were ‘contained’ in the subprime market.

These comments were echoed by the investment banks Bear Stearns and Lehman Brothers. The US stock market took comfort and, as measured by the Standard & Poor’s 500 (S&P 500), blithely rallied towards its peak in October 2007.

But beneath the bullish rhetoric and bourse, the number of mortgage originator failures had continued, reaching fifty-one in March 2007. Sentiment took a heavy blow on 2 April when New Century Financial, the second largest originator of subprime mortgages for 2006, was liquidated. Two months later, the toll of mortgage originator bankruptcies had reached eighty-one and the Home Price Index had fallen steadily to 199, now down 4 per cent from its peak. On 1 June, the rating agencies Moody’s and Standard & Poor’s broke from the closed loop of securitisation and downgraded the AAA ratings on a range of outstanding mortgage-backed securities (MBS) and collateralised debt obligations. This was immediately followed by the suspension of redemptions at two highly geared Bear Stearns hedge funds that traded the securities.

By late July, Bear Stearns was liquidating the two hedge funds. Standard & Poor’s placed another 612 securities backed by subprime mortgages on credit watch, and mortgage originator implosions reached 106. Bernanke and Paulson repeated their assertion that the problem was contained, and interest rates remained on hold.

In early August, the collapse of the market for asset backed securities (ABS) crossed the Atlantic when French banking giant BNP Paribas halted redemptions at three specialist ABS investment funds. In a press release, the company explained: ‘The complete evaporation of liquidity in certain market segments of the US securitisation market has made it impossible to value certain assets fairly regardless of their quality or credit rating’. In short, conditions were deteriorating so fast that they couldn’t attribute any particular value to the assets.5 This was the turning point. Henceforth, the shadow banking system ceased lending to and investing in ABS.

It didn’t take long for the supply of capital to dry up.

By mid September the Bank of England had announced plans to provide extraordinary loans to support Northern Rock, the United Kingdom’s fifth largest mortgage lender and its most aggressive securitising bank.6 It borrowed heavily from short-term money-market funds so it could write more mortgages than its deposit base would have allowed, then securitised the mortgages. The money market funds refused to roll over Northern Rock’s loans.

Various players in the shadow banking system were now turning on one another. The securitisation chain on which all had relied was decoupling at every link. Northern Rock’s predicament sent shock waves through UK consumer markets. There was an old-fashioned run on the bank and it was nationalised within five months.

In Australia, the first casualties were the non-bank lenders. With the investment world in outright panic about exotic securities, the market for Australia’s plain vanilla residential mortgage-backed securities evaporated.

This plunged the listed non-bank lender RAMS into immediate crisis as it was unable to refinance more than A$6 billion of debt in short-term corporate paper markets. By October 2007 the company was being dismembered. Westpac bought the brand and its branches for A$140 million. Numerous other non-bank lenders either wound down operations or disappeared over subsequent months.

By September 2007, US mortgage originator deaths had hit 149. The government authorities continued their rhetoric about the fallout from the collapses being contained, but their actions suggested otherwise. The Federal Reserve cut the federal funds target rate by a larger amount than had become usual—50 basis points— on 18 September. A month later, another twenty-two mortgage originators failed and the Home Price Index slide had dropped to 191, down about 8 per cent. Finally, even the US stock market’s rose-coloured glasses began to fog. The S&P 500, the main broadly based index of stocks on the New York Stock Exchange, reached an intraday peak of 1565 on 19 October. By year-end it was down nearly 7 per cent.

The US stock market continued its fall through January and February of 2008. The Federal Reserve’s interest rates also kept coming down, by 25 points in November 2007 and again in December, followed by emergency cuts of 125 points in January. Any pretence that the shadow banking system was in a controlled shake-out was now abandoned.

Another shadow banking domino fell in January as the rating agencies Fitch and Standard & Poor’s threatened to downgrade one of the main monoline insurers: AMBAC Financial. Then in March, the growing strife reached the centre of the securitisation machine. In the middle of that month, Bear Stearns, the number one US investment bank dealer in MBS, suddenly found itself insolvent.

Bear Stearns had begun the year with $11 billion of equity supporting $395 billion in assets, which meant a leverage of more than 35 to 1. Such a highly leveraged balance sheet, consisting of many illiquid and potentially worthless assets, could be sustained only with investor and lender confidence. That confidence was now falling apart.

Nouriel Roubini, professor of economics at the Stern School of Business, New York University, described what was happening as a ‘generalised run on the shadow financial system’.

Bear Stearns was sold to JPMorgan for $1.2 billion, with help from the New York Federal Reserve. The melt down sent a huge shock through the US housing market, shadow banking system and stock market.

When March arrived, mortgage originator deaths had soared to 241 and the Home Price Index had entered free-fall, plummeting to 172. The S&P 500 hit a new low of 1276, down 18.5 per cent from the previous October. Wall Street was joined in its bear market by the UK Stock Exchange index, the FTSE, which had also sunk 16 per cent from its October peak. Most international stock markets now followed suit.

However, there was continued buoyancy in commodity markets. Demand growth remained strong and was expected to continue on the back of expansion in China and the other large developing countries. A number of specific supply and demand factors helped to boost most food prices to record levels. And since the prices for most commodities, including oil, other energies and metals, are mostly set in US dollars, they were boosted by the fall in the US dollar that accompanied the Federal Reserve’s aggressive reductions in interest rates. The prices of oil, natural gas, coal, copper and grains all reached historic peaks in or around the middle of 2008. And so the stock markets of countries in which resource stocks were of major importance held up better than others, at least for a while.

With its high concentration of resources stocks, the Australian stock market was one of these. Although down from its October 2007 peak, the main Australian stock price index, the All Ordinaries, continued to hold up reasonably well through the northern hemisphere troubles, right up until mid May 2008. However, the relative sectoral strengths were revealing. The Financials Index had steadily slid from the October 2007 peak of around 7500 to a March 2009 low of around 2700.

This represented a loss of value of almost two-thirds in Australian dollar terms. The fall was much greater in international currency, as the Australian dollar—along with the currencies of other resource exporting countries—fell by more than 30 per cent against the US dollar in a short period after commodity prices began to slide in July. The Materials Index for resources stocks continued to rally through to a May 2008 peak above 17 000 points.

While April, May and June of 2008 seemed relatively uneventful, with stock markets tracking sideways or declining slowly, beneath the calm surface the carnage in the US housing market continued to build. By the end of June, the Home Price Index had slid to 167, now down more than 20 per cent from its peak, and mortgage originator failures had climbed to 262. And in July, history resumed its relentless course across the whole spectrum of financial activity.

The equity prices of the pioneers of securitisation, Fannie Mae and Freddie Mac, had been sliding well ahead of the general stock market for over a year. Now, both stocks entered a death spiral. Making matters worse, the drying up of capital supply to securitisation meant that international investors had abandoned GSE debt and MBS. Foreign purchases of both collapsed. The Chinese Government, a major creditor to the American GSEs, sent a sharp message that there would be major consequences for Chinese capital flows to the United States if there were capital losses on debt that had been presumed to have government backing.10

The problem dogging the GSEs was the same as that dragging down the other players in the shadow banking system. Owing to the complexity at the heart of shadow banking risk management, investors were simply unable to clarify which companies’ earnings were going to be hit by the losses arising from the housing crash. Sensibly enough, investors therefore abandoned all of the players at risk. Such is the vulnerability of a system based purely upon confidence, as had been clearly demonstrated in many previous bank runs, including in the Great Depression.

Soon there was nowhere to hide the weakening realities and sentiment. In July, the prices of oil and a range of other commodities reached their peaks. In August, global nervousness about the ongoing housing and shadow banking crash pushed commodity markets down sharply, and by the end of the month, oil was down almost 30 per cent from the July peak.

Then came September. Entering the month, the Home Price Index registered 161, mortgage originator fatalities stood at 275 and the S&P 500 was steady at 1282 points. On 7 September, Fannie Mae and Freddie Mac succumbed to investor revulsion and were placed into ‘conservatorship’ by the US Federal Reserve. This was in reality a nationalisation—a socialisation of immense losses. The management and boards of the two firms were dismissed, and the US Treasury was issued with 79.9 per cent of preferred shares and warrants, effectively wiping out shareholders.

Before anyone could draw breath, on 15 September the core of global shadow banking leapt over the flailing GSEs and into oblivion. On that day, two of the remaining four investment banks responsible for building and running the securitisation machine ceased to exist. The first was Merrill Lynch, whose symbol of the charging bull was familiar in markets all over the world. Merrill Lynch mustered a half-crazed stampede of its businesses into a waiting corral at the Bank of America, where the mob was rebranded for $50 billion.

The thundering herd at Lehman Brothers hurtled straight off a cliff. The Federal Reserve had found no institution large, bold and uninformed enough to take any risk at all on it. Lehman Brothers filed for Chapter 11 bankruptcy, which rapidly developed into outright liquidation.

This was the largest bankruptcy in US history. It left $613 billion in ordinary debts, $155 billion in bond debt, and assets worth $639 billion. Lehman’s was counterparty to more than 8000 firms through its derivatives book.11

The following day the knacker called upon the American Insurance Group, shadow banking’s most audacious insurance firm. The Federal Reserve stepped in and announced an $85 billion extraordinary loan to the stricken enterprise. It would be bailed out another three times over the subsequent four months to the tune of $170 billion and ultimately be nationalised as well. Its ribald financial products arm was wound down precipitously.

The carnage in the shadow banking system wrought over September now sliced through the major arteries of equity markets, company and mainstream bank lending. Lehman Brothers had lines of credit open to more than 100 hedge funds, many of which were highly leveraged players in the equity markets. Its sudden bankruptcy meant that all of these lines of credit were called in at once. Desperate to raise cash, the funds sold equities and pushed prices lower. Risk aversion surged across the spectrum of other banks.

It was a gargantuan margin call on global equities.

By the end of September, the S&P 500 was down to 1106 points; by 20 November, it had been cut in half from its peak to 752 points. All of the world’s bourses followed closely behind. Other markets tended to fall further than New York, the ‘risky’ emerging markets most of all.

The scepticism that had gripped investors for eighteen months now took hold of the banks themselves. They demanded huge premiums on business loans or refused to lend at all, either to one another or to other corporations. LIBOR, the interest rate at which banks in London lend to other banks, shot to levels that howled an unwillingness to pass capital to even the safest banks. The short-term corporate debt market shut down completely. Known as the commercial paper market, it is the key source of cash flow for the day-to-day operations of the world’s largest businesses. Trade finance also collapsed, with no bank keen to accept letters of credit to support importers and exporters. After all, the risk with the foreign counterparty was unknown.

The collapse in trust that was consuming shadow banking had now swallowed the basic financial operations of the entire global economy.

In the United States, traditional deposit-taking banks now joined the mass slaughter of mortgage originators.

The first to the knife was Washington Mutual, the sixth largest bank in the country. Depositors withdrew $16.7 billion, 9 per cent of the total, in the week following the Lehman Brothers collapse. The company was seized by the Federal Deposit Insurance Corporation (FDIC) and sold to JPMorgan Chase for just $2 billion at the end of September.

Next in line was Wachovia, the fourth largest national bank by assets. On the heels of the Washington Mutual seizure, Wachovia also suffered a run by depositors, including $5 billion in just one day.14 After some controversy, it was taken over by Wells Fargo in early October for $15 billion.

After having seen no bank failures in 2005 or 2006, and only four in 2007, the FDIC was deluged with thirty seven bank collapses from September 2008 to March 2009.

Contagion was now also rife among highly leveraged banks in Europe. The Benelux giant Fortis was partially nationalised on 28 September. By the end of October, the giant British bank HBOS had been sold to Lloyds TSB of London and the combined group was partially nationalised, with the UK Treasury holding a 43 per cent shareholding. Icelandic banks Glitnir, Landsbanki and Kaupthing were all under government or regulator control.

In Australia, there was a huge outflow of deposits from mid-tier banks to the big four. Cash logistics companies were overstretched in responding to requests to transfer physical currency. A spectacle unfolded in which two of the major banks anxiously pushed takeovers for shaky mid-tier banks even as their own problems in refinancing wholesale debt intensified. More heavily dependent on overseas wholesale funding than banks in any other country, their ability to fund their business dried up suddenly. The Commonwealth Bank acquired BankWest from the flailing HBOS on 8 October. Westpac pushed for competition regulator approval of its buyout of St George Bank. The major banks advised the government that their capacity to absorb shaky secondtier banks and to continue in business depended on a government guarantee.

With refinancing no longer possible, and as short term debt repayments came due, a desperate rush to sell assets at distressed prices took hold of Australian-listed asset managers. By 2009 the two investment banks, Allco Finance and Babcock & Brown, were in receivership.

Overall, the listed property and infrastructure managers’ market capitalisation was down 64 per cent to $83 billion.

These shifts in value were accompanied by massive dislocations in currency markets. Entire countries were now having their asset stock devalued at astonishing speed. Generalised risk aversion dramatically lifted the value of the US dollar as investors worldwide dashed to buy dollars to repay US dollar-denominated loans.

Between July and November, the US dollar appreciated 17 per cent against a basket of currencies.

The same risk aversion also reversed the yen carry trade. Hedge funds, banks, other corporations and Japanese investors who had borrowed money in Japan and then reinvested it in much higher yielding emerging market assets scrambled to dump the assets and return the money to its source. The yen soared. Emerging market and commodity currencies, including the Australian dollar, fell 30 per cent and more against the US dollar.

What began in May 2006 with the collapse of a US mortgage lender escalated over twnety-nine months into worldwide debt revulsion. After the long boom, the system was now in complete reverse. The asset bubbles that underpinned Western prosperity had burst. The wondrous machine of shadow banking that supported the global imbalances was still.

A testament to the underlying strength of Platinum Age growth was that no major economy was conscious of being in recession prior to the September 2008 quarter. Unemployment had crept higher but had remained a fringe issue. The shock of September changed all of that. The Great Crash elephant had turned rogue and trampled debt-sopped consumers.

They lay flat and did not move.