Ten years ago, things were mostly quiet. The crisis was staring us in the face, with a little more than a year before the effects of growing leverage and sloppy credit underwriting would hit in full. But when there is a boom, almost no one wants to spoil the party. Yes a few bears and financial writers may do so, but they get ignored by the broader media, the politicians, the regulators, the bulls, etc.
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It’s not as if there weren’t some hints before this. There were losses from subprime mortgages at HSBC. New Century was bankrupt. Two hedge funds at Bear Stearns, filled with some of the worst exposures to CDOs and subprime lending were wiped out.
And, for those watching the subprime lending markets the losses had been rising since late 2006. I was following it for a firm that was considering doing the “big short” but could not figure out an effective way to do it in a way consistent with the culture and personnel of the firm. We had discussions with a number of investment banks, and it seemed obvious that those on the short side of the trade would eventually win. I even wrote an article on it at RealMoney in November 2006, but it is lost in the bowels of theStreet.com’s file system.
Some of the building blocks of the crisis were evident then:
- European banks in search of any AAA-rated structured product bonds that had spreads over LIBOR. They were even engaged in a variety of leverage schemes including leveraged AAA CMBS, and CPDOs. When you don’t have to put up any capital against AAA assets, it is astounding the lengths that market players will go through to create and swallow such assets. The European bank yield hogs were a main facilitator of the crisis that was to come, followed by the investment banks, and bullish mortgage hedge funds. As Gary Gorton would later point out, real disasters happen when safe assets fail.
- Speculation was rampant almost everywhere. (not just subprime)
- Regulators were unwilling to clamp down on bad underwriting, and they had the power to do so, but were unwilling, as banks could choose their regulators, and the Fed didn’t care, and may have actively inhibited scrutiny.
- Not only were subprime loans low in credit quality, but they had a second embedded risk in them, as they had a reset date where the interest rate would rise dramatically, that made the loans far shorter than the houses that they financed, meaning that the loans would disproportionately default near their reset dates.
- The illiquidity of the securitized Subprime Residential Mortgage ABS highlighted the slowness of pricing signals, as matrix pricing was slow to pick up the decay in value, given the sparseness of trades.
- By August 2007, it was obvious that residential real estate prices were falling across the US. (I flagged the peak at RealMoney in October 2005, but this also is lost…)
- Amid all of this, the “big short” was not a sure thing as those that entered into it had to feed the trade before it succeeded. For many, if the crisis had delayed one more year, many taking on the “big short” would have lost.
- A variety of levered market-neutral equity hedge funds were running into trouble in August 2007 as they all pursued similar Value plus Momentum strategies, and as some fund liquidated, a self reinforcing panic ensued.
- Fannie and Freddie were too levered, and could not survive a continued fall in housing prices. Same for AIG, and most investment banks.
- Jumbo lending, Alt-A lending and traditional mortgage lending had the same problems as subprime, just in a smaller way — but there was so much more of them.
- Oh, and don’t forget hidden leverage at the banks through ABCP conduits that were off balance sheet.
- Dare we mention the Fed inverting the yield curve?
So by the time that BNP Paribas announced that three of their funds that bought Subprime Residential Mortgage ABS had pricing issues, and briefly closed off redemptions, and Countrywide announced that it had to “shore up its funding,” there were many things in play that would eventually lead to the crisis that happened.
Some of us saw it in part, and hoped that things would be better. Fewer of us saw a lot of it, and took modest actions for protection. I was in that bucket; I never thought it would be as large as it turned out. Almost no one saw the whole thing coming, and those that did could not dream of the response of the central banks that would take much of the losses out of the pockets of savers, leaving bad lending institutions intact.
All in all, the crisis had a lot of red lights flashing in advance of its occurrence. Though many things have been repaired, there are a lot of people whose lives were practically ruined by their own greed, and the greed of others. It’s a sad story, but one that will hopefully make us more careful in the future when private leverage rises, creating an asset bubble.
But if I know mankind, the lesson will not be learned.
PS — this is what I wrote one decade ago. You can see what I knew at the time — a lot of the above, but could not see how bad it would be.
Article by David J. Merkel, CFA, FSA - The Aleph Blog