September 14, 2018
By Paul Bubny
The March 2008 collapse of Bear Stearns sent shudders of disbelief through the financial services sector and commercial real estate investment. How could a major Wall Street shop fall so far and so fast? But it was only a warning shot across the bow for what would occur six months later.
Over the weekend of Sept. 15, 2008, two more giants of investment banking fell. One, the venerable Merrill Lynch, was sold to Bank of America for a third of its 2007 peak value. Another, Lehman Brothers, filed for what is still the largest corporate bankruptcy in American history, with liabilities of about $613 billion. The bank’s Chapter 11 filing triggered the biggest single-day decline in the Dow Jones Industrial Average since 9/11.
That same weekend also saw the largest savings bank failure in U.S. history as the assets of Washington Mutual were sold to J.P. Morgan Chase. Insurance conglomerate AIG needed an $85-billion life preserver from the federal government to stay afloat, although American taxpayers made a profit on the government’s exit from its AIG stake four years later.
What led to this cataclysmic series of events? In an article on the Seeking Alpha website, contributor Jeremy Blum identifies two primary causes. The primary cause, and the one given the biggest share of the spotlight in the aftermath of the Lehman collapse, was subprime residential mortgages. Less widely discussed or publicized was the same factor that triggered the S&L crisis of the early 1990s: bad commercial real estate debt.
Although some observers blamed the proliferation of poorly underwritten, high-risk home mortgages on aggressive lending by Fannie Mae and Freddie Mac, Blum puts the GSEs at the bottom of the list of culprits. Topping the list is the borrowers themselves, who took on debt they could never afford to repay.
However, if mortgagees bore at least half the blame, according to Blum, then the ratings agencies were “the Number One enabler.” The agencies “slapped investment grades” on securitizations that included high-risk tranches of problematic loans, he writes. Their stamps of approval created demand among institutions, and encouraged lenders to make more such loans.
After the ratings agencies, Wall Street comes in third on Blum’s list of bad actors. Among the most prolific packagers and sellers of subprime loans, Wall Street firms exacerbated the level of risk with credit default swaps, essentially insurance policies on losses from the subprime mortgage-backed securities.
“All of the Wall Street firms were overleveraged, which magnified the effect of the losses they took,” writes Blum.
Lenders, including non-bank companies, also bore a share of the responsibility. Non-bank lenders in particular commonly encouraged borrowers to take on debt that was beyond their means to repay, writes Blum. The Federal Reserve under Alan Greenspan also contributed to the crisis by lowering interest rates in the early 2000s, thereby making it easier to borrow.
At the bottom of the roster, but certainly not immune from culpability, were the GSEs. They may not have precipitated the subprime crisis, yet Fannie and Freddie “exacerbated the situation by taking on increasingly more subprime loans,” due in part to encouragement by the federal government.
Ten years later, it appears that many of these actors learned their lessons from the Great Recession. Borrowers and lenders alike are more conservative on both the residential and commercial sides, banks are far better capitalized, and the ratings agencies appear unlikely to repeat their past mistakes.
However, Blum sees storm clouds on the horizon. He notes that with the federal funds rate held below 1% for nearly a decade following Lehman’s collapse, corporate non-financial debt has climbed to 45% of GDP, the same level as in 2008. Student debt, meanwhile, is more than twice what it was 10 years ago.
The biggest culprit, though, is the federal government. “There are no fiscal conservatives in Washington anymore,” Blum writes. “We are expected to have a trillion-dollar deficit shortly, during a time of a strong economy. That is as large as we had during the last recession.” If a recession occurs in the next year or so, “the Fed may not have sufficient ammunition to fight it.”
For comments, questions or concerns, please contact Paul Bubny