Professional Documents
Culture Documents
and buy groceries, to say that I was feeling a little stress would be an
understatement. Talk about sleepless nights. The real eye of storm did not
last for many months, but it was terrifying to those of us in the middle of it
who knew how close we came to total and absolute economic Armageddon.
Now, let me take a step back to the spring of 2006, which is where this story
starts for me. I was down in Naples Florida visiting family and was at a local
barber getting a haircut. Once inside the shop I could overhear one particular
barber boasting in a somewhat loud voice, mind you - about his real estate
investing prowess. It seemed odd to me that a barber would have enough
cash to buy real estate in beautiful and affluent Naples Florida, so naturally
my ears perked up a bit and I listened intently. Over the next 20 minutes or
so, I heard this fellow brag to his fellow barbers and customers about how he
was able to purchase multiple homes, for purposes of flipping them which
is essentially buying real estate and quickly reselling in the hopes of a quick
profit after making a few minor improvements all using mortgage loans
that did not require putting any money down. In addition, these mortgages
did not require that he verify his stated income, which had been inflated for
purposes of qualifying for the loans. Can you say mortgage fraud? If this
wasnt a bubble, I dont know what would be. As a credit-trained corporate
lender, I knew that being able to verifying a borrowers ability to repay a loan
(by looking at looking at historical and projected cash flow) and relying on
some sort of equity cushion in the value of underlying collateral were two
NINJA Loan - a nickname for a very low quality subprime loan with NINJA
standing for No Income, No Job, (and) no Assets because the only thing an
applicant had to show was his/her credit rating, which was presumed to
reflect willingness and ability to pay. With the higher default rates, a
significant number of homeowners and real estate investors all rushed to sell
their homes at the same time, hoping to avoid a default. This flood of
inventory into the market triggered a significant decline in market prices,
and with that decline, the value of mortgage backed securities fell off a cliff
when it became clear that there were a significant number of homes that
were under water (meaning the value of the home was less than the value of
the mortgage balance).
During that same period, I was working in leveraged finance at Bear Stearns
where we financed leveraged buyouts of companies by a variety private
equity sponsors such as Blackstone, KKR and Bain Capital. Typically, in any
leveraged finance transaction, the private equity client would line up debt
financing (typically bank loans and/or bonds) for an LBO which might provide
75% of the purchase price of a company and they would use their funds
equity for the balance of the purchase price. Typically the financing would be
agreed-upon several months before the M&A transaction was ready to close
and the rate spreads on the debt would be decided upon months before the
debt financing was ready to be marketed to debt investors. This timing
mismatch
created
somewhat
of
conundrum
since
we
and
other
underwriters would typically be taking market risk (basically the risk that
rates, or credit spreads on rates, would increase between the time the
commitment had been agreed-upon and the time the debt was sold). While
underwriters attempted to address this market risk by including so-called
market flex language in our debt commitments, the flex was typically
capped, so that there was still some degree of risk involved in syndicating
the debt commitments since wed be potentially be on the hook for a huge
unsold or hung debt commitment if spreads moved more than the flex.
During the spring of 2007, the leveraged finance market was on fire with
private equity firms buying up private and public companies alike and our
firm was definitely in the mix with a massive pipeline of forward
commitments. As spring turned into summer, it was clear that the troubles in
the mortgage market were beginning to spill over into the leveraged finance
market. Loans that might have cleared the market at LIBOR plus 350 bps in
March now required much higher spreads and with our market flex capped
out in many cases at 150 bps, we needed to start selling these loans at a
loss in order to move the risk off our books. Of course, we stopped booking
new credit commitments just another reflection of the credit crunch that
was unfolding - but spent the entire summer and early part of the fall
clearing our inventory of unclosed deals initially in the mid-90s (meaning 95
cents on the dollar) and by the fall of that year, the same sort of loans were
selling at 85 cents on the dollar. The market for corporate loans and bonds
was drying up as investors became more and more risk averse.
Meanwhile, as trouble brewed in our area of the firm, there were other areas
of Bear Stearns experiencing stress. In June of that year, our mortgage
department disclosed that two internal hedge funds that had used significant
amounts of borrowed money to leverage third-party capital to invest in
primarily mortgage-related debt that had declined significantly in value. By
the end of July, despite a $1.6 billion bail-out from the parent company, the
two funds filed for bankruptcy and were unwound, effectively wiping out all
of the $600 million of capital that investors had contributed. The two
managers of these funds were arrested and faced criminal charges of
misleading investors but were ultimately acquitted.
In December of that year, I along with about 20% of the firms employees at
the time, were let go. It was a tough blow, to be sure, but I collected my
severance and began searching for another job once the holidays were over.
Several months later, as my search process neared a conclusion, I happened
to be at an interview with a distressed debt fund out in Denver when I was
asked: Did you know your old firm (Bear Stearns) was having liquidity
problems? Turning on the television in the conference room, I saw Alan
Schwarz, Bears CEO, emphatically denying that the firm had any liquidity
problems. This assertion turned out to be the kiss of death for Bear, a firm
that significantly relied on overnight loans which could be withdrawn at any
time to fund its business. By the end of the following week in March of
2008, faced with the option of filing for bankruptcy or accepting a US
Treasury brokered bailout and sale to JPMorgan, Bear Stearns agreed to be
purchased for $2/share after having trading as high as $140/share less than
two years before. The deal, which had been put together in less than 48
hours, had only gone through after the NY Fed agreed to purchase up to $30
billion of Bear Stearns mortgage assets that JPMorgan found too risky to
assume. From the US Governments perspective, a Bear Stearns' bankruptcy
would have affected the real economy by causing a "chaotic unwinding" of
investments (forced selling) across the US markets. From a personal
standpoint, since a portion of my annual compensation each year had paid in
the form of restricted stock units which I could only sell after a three year
vesting period, the transaction effectively translated into a personal loss of
nearly $500 thousand dollars. On the other hand, I was one of the lucky ones
as I was able to find and start a new job only a few weeks later at Bank of
Tokyo.
Of course, the last-minute acquisition of Bear Stearns did little to stem the
malaise in the markets- but the panic had not reached a crescendo yet. In
July, after a bank run reminiscent of Its a Wonderful Life, the Office of
Thrift Supervision closed California-based IndyMac Bank, the second largest
financial institution to close in the United Stated up until that point, after it
was forced to mark down a portfolio of mortgages that had been originated
with the intent to sell into the secondary market. By the end of the summer
of 2008, it was clear that a variety of financial institutions were under
pressure. Nearly every financial institution became unwilling to lend to other
financial institutions on an unsecured basis since an unsecured loan would
this
protects
the
owner
of
the
CDS
against
their
Less than ten days later, on September 25, 2008, following a 9 day bank run,
the United States Office of Thrift Supervision (OTS) seized Washington Mutual
Bank, the sixth largest bank in the United States at the time, and placed it
into receivership with the FDIC before being sold to JPMorgan for $1.9 billion
in a transaction that wiped out WAMUs shareholders and some bondholders
but didnt require any FDIC assistance to cover insured deposits.
Only days after that, Wachovia Bank, which was the fourth largest bank
holding company in the US and had been on the verge of collapse itself due
to a flight in its deposit base, was sold to Wells Fargo after being threatened
with seizure by the FDIC.
If the markets hadnt been in a state of turmoil already with the Lehman
brothers filing, the AIG near-collapse, the seizure of Washington Mutual and
forced sale of Wachovia turned up the panic several more notches.
Immediately following the Lehman bankruptcy filing, an already distressed
financial market began a period of extreme volatility, during which the Dow
experienced its largest one day point loss ever, largest intra-day range (more
than 1,000 points) and largest daily point gain. In addition, the moneymarkets witnessed the equivalent of an electronic bank run. Withdrawals
from money markets were $144.5 billion during the one week following the
Lehman filing, versus $7.1 billion the week prior. This interrupted the ability
of corporations to rollover (replace) their short-term debt. The U.S.
government responded by extending insurance for money market accounts
We talked about the mechanics of the financial crisis, and how the deep
market penetration of MBSs exposed all the biggest financial institutions to
great risk.
Have we all learned the lessons of that era? I don't know, but I have: Be
optimistic about the future because things always get better when things
seem darkest, but be ready for the worst case scenario. What does this
mean? It means that companies need to be prepared to deal with unforeseen
economic circumstances by not depending on short term funding to fund
illiquid assets and by having an ample amount of liquidity on hand to
manage through difficult circumstances such as market dislocations and
recessions. For individuals, it means having sufficient liquidity to manage
through potential periods of unemployment.
As for the lessons that ought to have been learned by the financial services
industry, I'm not so sure.