When an organization is too powerful or interconnected with other organizations, in case of its fail whole financial system can be affected or even collapse, such organizations are regarded as Too Big To Fail (TBFT). This term is intially populated in Federal Deposit Insurance Corporation's intervention with Continental Illinois and usually used for the large banks which are prevented from failure with the help of government bailouts to ensure financial systems' stability. This action of governments leads 2 opposing view: one is that bailouts are making banks or other TBFT organizations more willing to take risks because they believe that prince charming,usually government, will rescue them from the bankruptcy castle and the opponent view is that banks should have enough power and support to be creative and come up with the new financial solutions or concepts which can improve our lives like credit cards but also can lead to economic distresses like collateralized debt obligations (CDOs) so its a mixed picture. From banks' perspective being creative means taking risks for improving whole system and they expect very generous payoffs for this.
Originated from Andrew Ross Sorkin's book, "Too Big Too Fail chronicles the 2008 financial meltdown, focusing on the actions of U.S. Treasury Secretary Henry Paulson" and this post will be about my understanding of the situations in the film so there will be too much spoilers of course.
Eventhough film starts with the breaking news about housing bubble, I suppose years 2007-08, I think we should look back to see how we came here in the very first place. I think 1980's deregulations of banks can be good starting point to discover what has really happened. Of course one should note that proponents of deregulations were against U.S. Banking Act of 1933 which was part of the regulations after 1929 stock crisis and it prevented commercial banks from investment banking activities. "Proponents of deregulation argue that overbearing legislation reduces investment opportunity and stymies economic growth, causing more harm than it helps." Later, in 1999, the Financial Services Modernization Act, was passed which is overturning the Glass-Steagall Act(U.S. Banking Act of 1933) completely. In 2000 the Commodity Futures Modernization Act prohibited the Commodity Futures Trading Committee from regulating credit default swaps and other over-the-counter derivative contracts. In 2004 the SEC made changes that reduced the proportion of capital that investment banks have to hold in reserves which can be interpreted as support for leverages. Hence, we are seeing a flow of events starting with 1929 crisis, after crisis we observe regulations were formed but when crisis' after effects started to disappear we see deregulation movements rise. Of course these deregulation movements are halted by 2007 crisis and now its impossible not to see the pattern of crisis came after deregulation and regulations which came after crisis etc.
We can say that with the dregulations in financial system banks' playing ground is enlarged. From customers' perspective, accessing to credit become easier since banks become more flexible in terms of loans and interest they can charge. This is followed by increasing housing prices and overall indebtness level. Of course booming housing prices was also meaning increase in the value of collateral and this supported people towards increasing their borrowings and purchasing more houses which all contributed to the end leading increaed house prices again. Of course banks was also increasing their borrowings to to extend more loans for housing or cars or to buy more financial assets based on bundles of home loans. Leverage ratio of investment banks peaked at 43 before financial crisis because of deregulations of course and maybe because CDOs were making being highly leveraged more profitable as they are seen "less risky" relative to other financial instruments.
CDO is a structured financial instrument consisting of a bond backed by a pool of fixed-income assets, it is a derivative as it can be understood from the fact that their price depends on or derived from the underlying asset. In our case the CDO's which are backed by subprime mortgages were one of the main causes of crisis because they were highly overvalued According to the Financial Crisis Inquiry Report, "the CDO became the engine that powered the mortgage supply chain" promoting an increase in demand for mortgage-backed securities without which lenders would have "had less reason to push so hard to make" non-prime loans. By the way when you hear subprime it means borrower has high risk of default, so you need to run away but that wasn't the case between 2003 and 2007 since Wall Street issued almost $700 billion in CDOs that included mortgage-backed securities as collateral. Of course it was known that subprime loans have default risk, but credit rating agencies like Fitch Ratings, Moody’s and Standard & Poor’s were giving high ratings to assets created by subprime mortgages because they believe risk is diminished by diversification and also housing market is rock solid after many years in great moderation so they did not anticipated a downturn or hundreds of mortgages default.
Who wouldn't pay his/her mortgage loan?
The main reason i think why instutitions were late to interfere housing bubble is the idea that even if some defaults occur in subprime mortgages still many people would pay on time so that mixed portfolio will still bring some return but probably the problem of the inflated supply and low credit rating standards were underestimated. With such risk taking approach of organizations like banks insurance companies, credit reating agencies, I think before "too big to fail" we had "too profitable to reveal" or maybe "too optimistic to be real". I believe risks was apparent right at the beginning but the idea of eliminating risk through diversification is abused by the profitibleness of the MBS's and CDO's so that this become the fact that it fall on deaf ears.
The truth is that banks were making good profit by bundling home loans together as mortgage backed securities.To maintain making profit what they needed was more lenders so that they can issue more of these mortage backed securities. How can you find more lenders? Lower the credit scoring standards, lower the down payment requirement. Actually the movie called the Big Short shows this hype really well in which we see many people having 2-3 houses but not enough money to repay.
"Real estate is gonna come back. "-Dick Fuld/CEO of Lehman Brothers
Guess what, it didn't. I was constantly thinking about why Lehman did not get help as Bear Stearns did, then I watched the film and Dick Fuld's attitude towards movie provided me a good answer. This "Real estate is gonna come back" statement is suffering from clear psychological phenomena called confirmation bias and belief perseverance. let me discuss confirmation bias. Confirmation bias refers to the fact that when we have some thought or belief we tend to encounter with the ideas supporting ours but neglect opposing ones. Clearly Dick Fuld has initial idea that housing market will come back to where it was, however the only proof he has is that in the past it always did. He knew how highly they were leveraged as a bank and also saw the case of Bear Stearns but he insisted with his initial idea. Other psychological concept refers to the fact that even if we are aware of confirmation bias and we still have tendency to stick with our initial ideas eventhough we encounter clear opposing evidences. This is called belief perseverance, many people had very good record of housing market in their minds before meltdown so they sticked with this idea no matter what.
There were other red flags in Lehman case which I believe contributed to their failure. In the film we first saw Henry Paulson, Treasury Secretary, warning Fuld about the situation and conivnce him to ask for help from Warren Buffet but Fuld rejects Buffet's offer by believing that "storm always passes". By the way offer was preferred shares at 40, with a dividend of nine percent. What Dick Fuld taught me through the movie is that never say "never" or "always" if you are one of the players in the market. Another unpleasant situation was when Koreans came for deal with Lehman Brothers. Koreans were aware of the situation as I understand from the behaviors of the head of their team. They worked on a deal which does not include mortgage backed securities or any related assets. Eventhough Dick Fuld is told to play "missing man" he interrupted the meeting by praİsing housing market which was disrespectful and insincere as I infer from Koreans reactions. I think here important point was cultural differences in values because when Dick Fuld questioned whether they came from Korea just for giving up that easily he wasn't considering how important is dignity and respect for Koreans. So our priorities are determined by our values and if we want to persuade someone we should emphasize the things that conform to their values not ours.
Hence after all of these Lehman couldn't find the 30 billion dollars support which government did when Bear Stearns, which was 5th largest investment bank at that time, is sold to JPMorgan $2 per share( this was %94 discount). So there were no "very large purchase assistance package" for Lehman. Another glimmer of jope for Lehman was Barclays, eventhough I realized racist comments as "British people never close deal", scenes were realistic and one quote make me get goose bumps that "I don't want to import your cancer". By the way they have been already imported this cancer but anyway. Last chance of Lehman, Bank of America, was also lost when John Tain, CEO of Merril Lyinch precede before Lehman in terms of closing the deal.
I think the main Too big to fail instutition was AIG because it was including leased planes, life insurances, pension funds either invested in or insured by AIG. AIG was the key important player because it insured CDOs against default through a financial product known as a credit default swap. When people started to default on their mortgages, AIG had to pay out on what it had promised to cover. "The AIGFP division ended up incurring about $25 billion in losses. Accounting issues within the division worsened the losses. This, in turn, lowered AIG's credit rating, forcing the firm to post collateral for its bondholders. That made the company's financial situation even worse." In such situation firms expose risk of insolvency meaning that they require cash to remain liquid. I want to quote from the film here
" To control their downside, the banks started buying a kind of insurance. If mortgages default, insurance company pays. Default swap. The banks insure their potential losses to move the risk off their books, so they can invest more, make more money."
"And while a lot of companies insured their stuff, one was dumb enough to take on an almost unbelievable amount of risk. AIG."
Mortgage-backed securities tank. AIG has to pay off the swaps. All of them. All over the world. At the same time. AIG can't pay. AIG goes under. Every bank they insure books massive losses on the same day. And then they all go under. It all comes down.The whole financial system? And what do I say when they ask me why it wasn't regulated?"
"No one wanted to. We were making too much money."
How other banks survived? Well, Goldman Sachs and Morgan Stanley changed their structure. Lloyd Blankfein, CEO of Goldman Sachs utilized from low interest rate from Fed during crisis.Personally my favorite bank through the film was JPMorgan with Jamie Dimon as CEO. Eventhough JPMorgan bought Bear Stearn and what has left from Washington Mutual it still kept its position better than its rivals i think. But what is really important is that through the end of the movie we see Hank Paulson trying to stabilize the country’s financial system. How? One proposed option was nationalizing the banks and other was buying the toxic assets as a result The Troubled Asset Relief Program (TARP) created. "TARP's original purpose was to increase the liquidity of the money markets and secondary mortgage markets by purchasing the mortgage-backed securities (MBS), and through that, reduce the potential losses of the institutions that owned them."
The U.S. government bought preferred stock in eight banks: Bank of America/Merrill Lynch, Bank of New York Mellon, Citigroup, Goldman Sachs, J.P. Morgan, Morgan Stanley, State Street, and Wells Fargo.
Distribution of the money under TARP
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