By Pam Martens: January 6, 2014
The conventional wisdom is that the crash on Wall Street that continues to devastate the U.S. economy and job growth began in earnest in 2008. That’s likely because marquee Wall Street firms, in business for 75 to more than 100 years, did not blow up until 2008. Bear Stearns imploded in March of 2008 and was taken over by JPMorgan. On the same day, September 15, 2008, that Lehman Brothers filed bankruptcy, Merrill Lynch was taken over by Bank of America. Other major Wall Street firms were propped up with the largest taxpayer bailout in the history of U.S. financial markets.
A careful review of the report from the Financial Crisis Inquiry Commission (FCIC), Federal Reserve documents, Fed appointment calendars, and news archives indicate clearly that the financial system began “unraveling,” (as the FCIC phrased it) in 2007. More importantly, a number of events in 2007 had the clear, indisputable earmark of a financial panic but were glossed over by the Federal Reserve, which did not begin to cut interest rates until the third quarter of the year, and then only after serious market convulsions in the U.S. and Europe.
At its January, March, May, June and August meetings of the Federal Open Market Committee (FOMC), the Fed repeated the same words: “The Federal Open Market Committee decided today to keep its target for the federal funds rate at 5-1/4 percent.”
The only possible explanation for the Fed’s resistance to cutting interest rates sooner is that it was in the dark about how Wall Street had tied a noose around its neck, anchored it to the U.S. housing market, then infused that risk into the overall economy through hybrid securities and derivatives sold here and around the globe.
The warning signs began as early as January 2007 when Mortgage Lenders Network said it was ceasing to fund mortgages or accept applications. In February, HSBC, one of the largest subprime lenders in the U.S. at the time, announced a $1.8 billion increase in its provision for potential losses. In March, New Century, which ran a close second to HSBC in subprime loans, said in an SEC filing that federal investigators were “conducting a criminal inquiry under the federal securities laws in connection with trading in the company’s securities, as well as accounting errors regarding the company’s allowance for repurchase losses.” In April, New Century filed bankruptcy.
Against this backdrop, Congress heard the following from Fed Chairman Ben Bernanke and U.S. Treasury Secretary Hank Paulson in March 2007. “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,” Bernanke told the Joint Economic Committee of Congress. Paulson testified to a House Appropriations subcommittee: “From the standpoint of the overall economy, my bottom line is we’re watching it closely but it appears to be contained.”
Were they watching closely?
By June 2007, two of Bear Stearns’ multi-billion dollar hedge funds were in deep trouble. Bear told major Wall Street firms that it lacked the cash to meet the margin calls on the funds and asked for a reprieve. None came. On July 31, 2007, both funds filed for bankruptcy.
The Fed knew that major Wall Street firms had serious loan exposure to Bear Stearns. But this was the statement in the Fed’s FOMC meeting of June 27-28, 2007 as it voted to leave interest rates unchanged:
“…a number of participants pointed to rising mortgage delinquency rates and related difficulties in the subprime mortgage market as factors that could crimp the availability of mortgage credit and the demand for housing. Spillovers from the strains in the housing market to consumption spending had apparently been quite limited to date.”
From July 10 to 12, the delusional ratings agencies that had given structured products from subprime debt a AAA-rating, began to downgrade billions of dollars in mortgage-backed securities. The market understood that this was only the beginning and the credit markets tightened further.
According to the FCIC, on August 14, the Federal Reserve sent a confidential memo to the Fed’s Board of Governors concerning Countrywide, another major subprime lender. The memo said: “…The ability of the company to use [mortgage] securities as collateral in [repo transactions] is consequently uncertain in the current market environment. . . . As a result, it could face severe liquidity pressures. Those liquidity pressures conceivably could lead eventually to possible insolvency.”
By August 17, the insured depository bank owned by Countrywide was experiencing a full blown customer panic and bank run. The Los Angeles Times reported: “Anxious customers jammed the phone lines and website of Countrywide Bank and crowded its branch offices to pull out their savings because of concerns about the financial problems of the mortgage lender that owns the bank.”
The same day, August 17, the Federal Reserve finally cut its discount rate by 50 basis points, beginning a long path of rate cuts to try to restore stability to the markets. Europe had now joined the turmoil with the European Central Bank playing catch up by infusing tens of billions of dollars of liquidity into the system.
By early November, Citigroup was forced to announce its massive exposure to subprime assets, issuing a press release on November 4 that said it had experienced “declines since September 30, 2007 in the fair value of the approximately $55 billion in U.S. sub-prime related direct exposures in its Securities and Banking (S&B) business.” It added that it estimated that “the reduction in revenues attributable to these declines ranges from approximately $8 billion to $11 billion (representing a decline of approximately $5 billion to $7 billion in net income on an after-tax basis.)”
The Federal Reserve had presided over the inscrutable behemoth called Citigroup, allowing its creation through the repeal of the Glass-Steagall Act; then allowing it to grow into an unwieldy global conglomerate with 2,000 operating subsidiaries, a $2 trillion balance sheet and $1.2 trillion off its balance sheet.
On a November 5, 2007 conference call with analysts, Gary Crittenden, the CFO of Citigroup, was asked by an analyst why the firm didn’t hedge its risk. Crittenden responded:
“I mean I think it is a very fair question…we are the largest player in this [collateralized debt obligation; CDO] business and given that we are the largest player in the business, reducing the book by half and then putting on what at the time was three times more hedges than we had ever had at least in our recent history, seemed to be very aggressive actions given that we were a major manufacturer of this product…once this [decline in values] process started…the size was simply not there. The market is simply not there to do it in size in any way and it would have been uneconomic to do it.”
The “size” to hedge was not there because these derivatives were not trading on exchanges, thanks in no small part to pressure to deregulate derivatives by former Fed Chairman Alan Greenspan and members of the Clinton administration. In 2008, Citigroup would require a taxpayer bailout of $45 billion in equity, over $300 billion in asset guarantees, and low-cost loans from the Fed of over $2 trillion.
J. Kyle Bass, a managing partner at Hayman Advisors, had outlined the problem to the House subcommittee on Capital Markets in testimony on September 27, 2007: “I will tell you why and how regulators completely missed the epic size and depth of the problem in the credit markets today. An important concept to appreciate is that each securitization is essentially an off balance sheet bank…However, the securitization market has no Federal and State banking regulators to monitor its behavior. The only bodies that provide oversight or implicit regulation are the NRSROs [rating agencies] — bodies that are inherently biased towards their paymasters, the securitization [Wall Street] firms. Without sufficient oversight, this highly levered, unregulated, off balance sheet securitization market and its problems will continue to have severe ramifications on global financial markets.”
Nothing that the Federal Reserve or Congress has done thus far has removed the risk that Wall Street could collapse the U.S. economy again. Until the Glass-Steagall Act is restored, separating Wall Street speculators from insured banks holding the life savings of millions of Americans, 2007 and 2008 must be viewed as Wall Street’s warm-up act.