Diary of a Very Bad Year Chapter 3 - Right Before Everything Broke

This is part of my series retelling Diary of a Very Bad Year. Today we’re covering Chapter III.

It’s September 4, 2008. The Dow is at 11,188. Unemployment just hit 6.2 percent. Over 300,000 foreclosures this month. And HFM is back in his midtown office, looking out the window at the same city. But things are worse now.

He describes it as “a rainstorm of shoes.” Not just one shoe dropping. Shoes keep falling from the sky, and the clouds aren’t clearing.

The losses keep growing

Last time, HFM was cautiously hopeful that banks were starting to admit their losses. They were. But the problem got bigger. The losses started in subprime mortgages. Then they spread to Alt-A mortgages. Now people are worried about prime mortgages, commercial property, development loans. Every week it’s a new category.

Over the summer of 2008, the numbers came in. Merrill Lynch lost $4.6 billion in Q2. Lehman lost $2.87 billion. Citigroup lost $2.5 billion. And in July, the FDIC shut down IndyMac Bank because of all the bad mortgage loans on its books.

But here’s the thing. The real economy hadn’t crashed yet. Technically, there wasn’t even a recession. No negative GDP growth. That’s what confused everyone. The financial world was on fire, but regular people were still going to work and buying stuff. U.S. exports were strong because the dollar was weak and countries like China, Brazil, Russia, India were growing fast.

That was about to change.

The dollar paradox

This is one of the most interesting parts of the chapter. Remember how everyone was saying the dollar was dead? “The dollar is going to get killed.” HFM had warned against this kind of thinking before. Currency markets are forward-looking. They don’t just reflect what already happened.

So what actually happened? The dollar went on a tear.

Here’s why. For years, investors had been selling dollars and buying every other currency they could find. First because they were excited about emerging markets. Then because they were scared of American banks. The whole world was short the dollar.

But then the global slowdown started hitting everyone. Europe started going down. Emerging markets started cooling off. The Russian ruble, Brazilian real, and Mexican peso all hit their peaks and started falling.

And suddenly all those investors who were short the dollar just wanted out. They didn’t want to make money anymore. They wanted to reduce risk. As HFM put it, they wanted to “curl up into a ball.” So they bought dollars back. And the dollar surged.

The world was scared, and when the world gets scared, it runs to dollars. Even when America is the source of the problem. Think about that for a second.

Fannie and Freddie are dead, but nobody will say it

Here’s where HFM gets blunt. Fannie Mae and Freddie Mac, the two giant semi-government mortgage companies, are insolvent. Done. If you took all their assets, marked them to market, and compared them to their liabilities, the assets were worth less. The equity was wiped out. Negative equity.

If they were normal companies, they’d go bankrupt. But they’re not normal companies. They play a huge role in the mortgage market. They’re politically powerful. And everyone is terrified that admitting they’re dead would cause a panic.

HFM had a great analogy. Imagine there’s a dead body in the room. And someone keeps saying, “That person’s not dead, they’re just resting.” But sooner or later the smell becomes overpowering and everyone has to run from the room.

That’s Fannie and Freddie in September 2008. Zombie companies. Everyone knows, but nobody wants to say it out loud.

The factory problem

HFM breaks down the big policy debate into a simple picture.

Imagine you have a factory that’s having problems. One approach: you shuffle the claims. You tell the equity holders their stake is worth nothing, and the debt holders now own it. The factory itself is fine. People still show up to work. The machines still run. You just changed who owns it.

The other approach: you go in and smash all the equipment. Now the factory is actually broken.

So the question is: if you force banks to recognize all their losses right now, is that just shuffling claims? Or does it destroy the bank itself?

For a regular company, bankruptcy is just claim shuffling. The factory keeps working. But for a bank, bankruptcy can actually smash the equipment. Because a bank’s entire business model is built on trust. The moment people stop trusting a bank, it stops functioning. Deposits leave. Lending stops. The intellectual capital walks out the door.

That’s why banks fight harder than anyone to avoid admitting they’re bust. And that’s why regulators have to be the ones to step in and say, “You’re done.”

The scary math

HFM does some back-of-the-envelope math. Look at how much profit the financial industry made relative to GDP over a long period. It was pretty stable for decades. But in the five years before the crisis, it shot up way beyond the historical trend. All that excess profit was probably fake. CDOs, subprime securitization, all of it.

How much needs to be reversed? Between $1.25 trillion and $1.5 trillion.

How much had been written down so far? About $500 billion.

Banks had raised about $350 to $400 billion in new capital to cover those losses. But the gap was still enormous. There was clearly more pain coming.

And here’s the frustrating part. The real losses happened a long time ago. When someone built a house nobody needed. When someone got a $400,000 mortgage on a house that was really worth $150,000. When someone bought an iPod on a credit card they couldn’t pay off. Those losses were already real. The financial system just hadn’t admitted it yet.

$600 billion under the mattress

Everyone kept saying “there’s no money.” But HFM pointed out that hedge funds alone were sitting on $600 billion in cash. The problem wasn’t lack of money. It was lack of courage. Nobody wanted to take risks because every single day brought more bad news. Credit spreads wider. Gas prices higher. Another bank admitting losses.

Why would you invest when you know tomorrow is going to be worse?

The existential question

The chapter ends with something unexpected. The interviewer from n+1 asks HFM a personal question. Basically: you have a beautiful mind, you can explain all of this so clearly. And we’re living through a historic crisis of capitalism. Do you feel like your brain is being used in the best possible way?

HFM’s answer is short. “Where do you think it would be used better? If there’s a problem here, this is the place. This is where the problem is.”

It’s a quiet moment. No drama. Just a smart person asking himself if any of this matters. And deciding that yes, if the system is breaking, the people who understand it should be the ones trying to fix it.

Even if nobody is listening yet.

Previous: Chapter II - The Death of Bear Stearns

Next up: Chapter IV - How Bad Is It?, where the collapse actually happens.