Diary of a Very Bad Year Chapter 4 - How Bad Is It Really
This is part of my series retelling Diary of a Very Bad Year. Today we’re covering Chapter IV - the start of Part 2: The Collapse.
This chapter is dated December 11, 2008. The Dow is at 8,565. Unemployment is at 7.2 percent. Foreclosures hit 259,085. Since the last interview in early September, the entire financial system went through something that HFM compares to a heart attack.
Let’s break down what happened.
Lehman goes down
Three days after the previous interview, Fannie Mae and Freddie Mac went into conservatorship. Then Lehman Brothers started falling apart. Its stock was collapsing. Its leadership was scrambling for a rescue.
The New York Fed gathered the big banks to discuss a private bailout. Lehman was also trying to sell parts of itself to Barclays or Bank of America. But Bank of America chose Merrill Lynch instead. Barclays needed permission from the British government and didn’t get it. At 1:45 a.m. on September 15, Lehman filed for bankruptcy.
HFM had some exposure to Lehman. Not a lot, but enough that he had to go through bankruptcy procedures he’d never done before. And he admits he got it wrong. He thought letting Lehman fail was the right call. Moral hazard and all that. For the first day or two, things seemed okay. People were closing out their Lehman positions, rehedging. It looked manageable.
Then it wasn’t.
The Reserve Primary Fund breaks the buck
Here’s the thing. The real damage from Lehman wasn’t direct. It was what came after.
Lehman had issued a ton of commercial paper. Short-term debt that money market funds buy. And the Reserve Primary Fund, one of the oldest money market funds in the country, had about 2 percent of its holdings in Lehman paper. When Lehman went bust, that paper became worthless.
The fund “broke the buck.” That means the value of one share dropped below $1. Money market funds are supposed to always be worth $1. People treat them like cash. And suddenly the cash wasn’t cash anymore.
HFM’s exact words: people “lost their shit.”
Investors rushed to pull money out of every money market fund. That meant the entire commercial paper market started seizing up. Commercial paper is how big companies handle their short-term cash needs. They borrow for 30 or 60 days, roll it over, keep operating. If nobody is buying commercial paper because nobody is putting money into money market funds, then perfectly healthy companies can’t make payroll.
And it gets worse. If a Chinese exporter thinks the American company on the other end can’t pay, they’re not putting goods on a boat. If a bank is worried about its own balance sheet, it’s not issuing letters of credit. Trade stops. The whole system locks up.
The irony is that the Reserve Primary Fund’s manager had spent years bragging about being the most conservative fund out there. He criticized competitors for taking too many risks. But then, a few years before the crisis, his fund started buying riskier commercial paper to boost returns. Including Lehman’s. Nobody thought 30-day Lehman paper was risky. Until it was.
Central banks respond
The authorities went all in. The Fed started buying commercial paper directly. The FDIC raised deposit insurance limits. TARP, the $700 billion bailout package, was pushed through Congress. Other countries did similar things. The idea was to inject capital into banks so they could keep functioning.
But here’s what happened with the money. The Fed expanded its balance sheet from $800 billion to over $2 trillion. Of the $1.2 trillion in new money, about $600 billion went straight back to the Fed as excess reserves. Banks were hoarding cash. People were hoarding cash. T-bills were trading at zero yield because everyone just wanted the safest possible thing to hold.
The Fed could create all the liquidity in the world, but it wasn’t reaching the real economy. It just sat there as precautionary balances.
The AIG bailout
AIG was the one that really scared HFM. Not because of AIG’s insurance business, which was solid. The problem was AIG Financial Products, which was basically a one-way hedge fund inside an insurance company. They wrote massive amounts of credit default swaps, insuring other banks against losses on mortgage-backed securities. And because AIG had a high credit rating, they didn’t have to post any collateral.
Goldman Sachs and others treated AIG’s promises like cash. Why worry? AIG is triple-A rated.
But AIG had written so much of this insurance, on risks that turned out to be heavily correlated, that when the extreme scenario actually happened, the losses were enormous. When AIG’s credit rating fell, suddenly all its counterparties demanded collateral. AIG didn’t have the cash.
HFM thought bailing out AIG was actually a decent trade for the government. AIG had valuable businesses like life insurance that could be sold over time. The government had the luxury of waiting. It was investing, not just spending. Same with TARP. The $700 billion wasn’t being thrown away. It was equity injections, loans, investments. The government might not make a great return, but it probably wouldn’t lose the whole thing either.
The real economy starts breaking
By December 2008, the financial plumbing was sort of working again. But the damage was spreading to real people and real businesses.
The country saw its largest one-month drop in payrolls in 25 years. Car sales fell 40 percent year over year. The Big Three automakers came to Congress begging for $25 billion. A huge percentage of bulk cargo ships went idle because trade just stopped.
HFM puts it this way: this wasn’t a crisis caused by a drought or a war or a meteor hitting London. The factories were still standing. The capacity to make things was still there. But people’s attitudes about risk changed so drastically that the machinery stopped. A few neurotransmitter imbalances in the brains of financial decision-makers, and the whole economy grinds to a halt. He says that after years in the business, this still blows his mind.
And the supply chain problems were creating future problems too. Farmers couldn’t get fertilizer because of credit issues. Grain silos couldn’t get propane to dry the grain. Less food was being planted. The effects might not show up for months, but the price of bread was going to feel this eventually.
Trading with Martians
One of the best moments in this chapter is when HFM talks about buying credit protection on the U.S. government. At that point, insuring against a U.S. default cost more than insuring against Campbell’s Soup defaulting. But the whole concept is absurd. If the U.S. government actually defaults, what bank is going to be around to pay you on that insurance?
His answer: you’d have to buy it from the Martians. “LGM Capital Management. Little Green Men Capital Management. A perfectly good counterparty.” Because they’d be the only ones not correlated to the U.S. economy.
The terrifying moments
HFM describes two moments that truly scared him.
The first was watching Congress vote down TARP on live TV. Markets had started recovering because everyone thought it would pass. When it didn’t, the S&P dropped 9 percent in a single day. HFM felt like the politicians didn’t understand the gravity of the situation. And even when TARP eventually passed, the messy way it happened took away much of its confidence-restoring power. As the old Latin saying goes, “he gives twice who gives quickly.” A reluctant gift doesn’t calm people down.
The second was when Citibank’s stock dropped to around $3.50. HFM ran into a colleague who had just gone to Citibank to withdraw his deposits. This was a professional investor. And his deposits were within the government-insured limit. It was pure blind fear. When even the calm, rational finance people are running to the bank to pull their cash out, you know things are bad.
By the end of the chapter, HFM says the financial markets have stopped falling every single day. But the real economy damage is just getting started. He compares it to a depth charge hitting a submarine. You hear the explosion, but you don’t know what happened down there. You just wait for the bodies to bob up.
No holiday party that year. Just “holiday drinks.”
Previous: Chapter III - On the Eve
Next up: Chapter V - Year-End Closing