The Interest of Time
Description
The Interest of Time is a book about your Money.
As we approach the 10-year anniversary of the events that led to the Global
Financial Crisis, the economies around the world have yet to regain pre-crisis
growth levels. After unprecedented levels of stimulus, the US has embarked
on a process of normalization of interest rates. Will the central banks of
the world raise rates before the private sector has repaired their balance sheets?
Or will another recession put us on a collision course with 0% interest rates and
the Zero Lower Bound?
There are two ways to build wealth. Make more money. Or spend less. Traditional
economic theory relies on households and corporations who are always
trying to "maximize profits" (make more money). However, once every 50-100
years, a special type of debt-driven recession damages balance sheets so drastically it changes people's thinking. They go into balance sheet repair mode. They spend less, instead of trying to make more.
The Great Depression was a Balance Sheet Recession that lasted over 12
years and caused a global depression that fueled the start of World War II.
Japan's Lost Decade is a Balance Sheet Recession and has been raging for
almost 2 decades now.
And finally, the Global Financial Crisis, or The Great Recession, is a Balance
Sheet Recession. And it is not over.
Everybody knows that there was a financial crisis that occurred in 2008. This
is the true story about how the 30 million families that found themselves in underwater balance sheets recovered from the greatest financial crisis since The
Great Depression. Many more are still struggling under the weight of backbreaking
debt and stagnant wages in the US, and around the world.
This book is about the Great Balance Sheet Recession, why it happened, how
the governments, households and corporations of the world can deal with it,
and steps you can take to strengthen your family's balance sheet for the future.
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Content
Chapter 1
Days of Thunder
On Monday September 15th, 2008, shortly after 1 am, Lehman Brothers filed for Chapter 11 Bankruptcy protection in a New York court. It was the largest bankruptcy in US history at the time, and it remains so to this day.
The 164-year old investment bank was out of business. The Wall Street titan's demise began the chain reaction of events that led to the largest economic crisis since the Great Depression.
The original firm was founded in 1844 by Henry Lehman. It was originally named H. Lehman. However, when his brothers Emanuel and Mayer joined the firm in 1850, it took on the Lehman Brothers moniker.
The firm would dominate the residential mortgage backed security market until all the dominoes came crashing down that crisp September Monday morning.
Their leader, Dick Fuld Jr., had risen to the level of Chairman and CEO after 40 years of climbing the ranks. From fixed income trader, all the way up to the C-Suite. The Chairman and CEO had led the firm since 1994.
Lehman Brothers was the fourth largest Wall Street bank at the time of their bankruptcy filing, with a total of $639 billion in assets, and $619 billion in debt. The firm's foray into the private label mortgage backed security market would eventually lead to their collapse. Lehman Brothers employed over 25,000 people around the world and had offices in every major financial center in the world.
The bankruptcy judge would approve the filing, simply stating that: "I have to approve this transaction because it is the only available transaction. Lehman Brothers became a victim, in effect the only true icon to fall in a tsunami that has befallen the credit markets."
The aftermath of what occurred in the following days and weeks would become the raw material for what I will call The Great Balance Sheet Recession.
The story begins well before Lehman Weekend, as it will forever be known. We can trace the beginning of the end for Lehman and all the top players in the space back to Bear Stearns.
In late 2007, Bear Stearns, the scrappy investment bank had risen to the number five largest Wall Street bank. They had over 15,000 employees specializing in Capital Markets, Investment Banking and Wealth Management.
The firm had been an institutional trading powerhouse, clearing trades for many of the top hedge funds on Wall Street at the time.
The Bear Stearns High Grade Credit Fund
Jimmy Cayne was a Wall Street boss. The Chairman and CEO of Bear Stearns had held the title since 2001, although he had been the CEO since 1993, one year before Dick Fuld took the reigns over at Lehman.
Cayne was born on Valentine's Day in 1934, during the Great Depression.
He was known to hire people who were "poor, smart and had a deep desire to be rich." The bank's culture was a bit different from the other Wall Street banks who had their pick of top college talent. Bear Stearns had to find the diamonds in the rough, the undervalued future stars.
Ace Greenberg, the CEO before Cayne would comment: "If somebody with an MBA degree applies for a job, we will certainly not hold it against them, but we are really looking for people with PSD degrees." Poor, Smart, and a Deep desire to be rich.
The culture at Bear Stearns was one of risk taking. It was encouraged from top down and embedded in the minds of the employees.
Mr. Cayne, or "Jimmy" as some of the desk bosses would call him, had a penchant for playing Bridge. He would routinely be playing at tournaments, and happened to be playing in one in Nashville, Tennessee at the time of the first spark that lit the fire for the Great Balance Sheet Recession.
The Bear Stearns High-Grade Structured Credit Strategies Fund had been knee-deep investing in synthetic securities. Their 2006 financial statement had this to say about their exposure to Collateralized Debt Obligations:
"The Master Fund enters into investment grade bonds backed by a pool of variously rated bonds, including junk bonds. CDOs, CBOs and CLOs are similar in concept to Collateralized Mortgage Obligations ("CMOs"), but differ in that CDOs, CBOs and CLOs represent different degrees of credit quality rather than different maturities. Underwriters of CDOs, CBOs and CLOs package a large and diversified pool of bonds, including high risk high yield junk bonds, which is then separated into "tiers". Typically, the top tier represents the higher quality collateral and pays the lower interest rate; a middle tier is backed by riskier bonds and pays a higher rate; the bottom tier represents the lowest credit quality and, instead of receiving a fixed interest rate, receives the residual payments" (Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage Master Fund Financial Statement, 2006)
As you can see, the fund spelled out exactly what they were investing in, in black and white. A mix of synthetic securities with low liquidity and no secondary market.
They would use borrowed money to lever up and buy these synthetic securities. If they could borrow at a rate lower than the return, the managers thought they could safely buy as much as they possibly could afford. Because if you borrow at 1% and make anything higher, the more you borrow, the more you make.
The strategy didn't stop there, mainly because it was a bit too risky to buy synthetic junk bond portfolios with no insurance. That is why each manager would protect their investments with Credit Default Swaps. If anything went wrong in the credit markets, these insurance instruments were supposed to protect against losses.
Perhaps the final warning from the Bear Stearns High Grade Credit Fund Financial Statement in the financial disclosures was the most ominous:
"CDOs, CBOs, and CLOs are subject to credit, liquidity and interest rate risks. In particular, investment grade CDOs, CBOs, and CLOs will have greater liquidity risk than investment grade sovereign or corporate bonds. There is no established, liquid secondary market for many of the CDO, CBO, and CLO securities the Master Fund may purchase. The lack of such an established, liquid secondary market may have an adverse effect on the market value of such CDO. CBO and CLO securities and the Master Fund's ability to sell them. Further, CDOs, CBOs, and CLOs will be subject to certain transfer restrictions that may further restrict liquidity. Therefore, no assurance can be given that if the Master Fund were to dispose of a particular CDO, CBO, and CLO held by the Master Fund, it could dispose of such investment at the previously prevailing market price." (Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage Master Fund Financial Statement, 2006)
The structured credit fund was borrowing money to buy CDOs, CBOs and CLOs. They warned everyone about how illiquid the market could become and how there was no secondary market for many of these products.
They spelled out the fact that any range of market forces could adversely affect the price and liquidity of certain illiquid products. It was all plain to see if anyone ever bothered reading it. But they were all too busy trying to get rich.
As the housing market began to implode, so did the bids on some of these synthetic bond structures. The delinquency rates on some of the subprime bonds were causing losses to cascade down to other tranches of the securities. These Credit Default Swaps did not properly insure these layers and were useless in protecting the fall in value as the market dried up. Many investors began to hedge the lower grade bonds but did not do so in the higher-grade tranches.
Nobody was insuring the AAA tranches at the time. These were where the losses stemmed from, and with no secondary buyers, the CDO market began to bleed red.
Things got so bad that on June 22nd, 2007, then CEO Jimmy Cayne intervened to provide a $3.2 billion loan when no other Wall Street bank would lend money to the Bear Stearns High-Grade Credit Fund.
The fund was stuffed with stated income, and high loan-to-value loans in homes with prices that had been falling for over a year. In bad zip codes. Just because they were sliced and diced into "highly rated" securities did not make them marketable when the rain began to fall.
The loans had been steadily losing value, and with them the value of the lowest level tranches. These are the investments with the highest likelihood to default if any of the payments are not received in a timely manner. They are also the securities with the highest yields.
When Bear Stearns "bailed out" their hedge fund, they took on a lot of assets that would later be deemed "too risky." The move would soon prove to be the fatal error for the scrappy 85-year-old investment bank.
Two months later, in August of 2007, investors joined a class action lawsuit against Bear Stearns for "misleading investors" about the risks of investing in thinly-traded Collateralized Debt Obligations.
Bear Stearns was now loaded to the ceiling with illiquid mortgage assets, and the other entities were on notice to limit their exposure to the small Wall Street bank.
It was only a few months later that Bear Stearns reported a $1.2 billion write-down on mortgage assets and posted a 61% profit loss, mostly due to hedge fund losses.
By March of 2008, the floor was falling from folks' feet fast. Short sellers were...
