“If we don’t act boldly, we could be in a depression deeper than the Great Depression. This is the financial equivalent of war and we’re going to need wartime powers.” — Hank Paulson, former U.S. Treasury Secretary
If you unfold a newspaper to read the morning news, or turn on the TV set to listen to the evening news, or talk to one of your co-workers at the water cooler, or exchange courtesies with your neighbor while taking care of the lawn, it’s most likely the subject of all these activities will be the economy. The negative side of it. You’ll see violent protests across the United States and the major capitals of the world called Occupy Wall Street, student’s protests in London against high tuition fees, government bureaucrats dissenting in Greece because they have been fired or “Indignados” in Spain angry because their government has tightened up its belt and no public money is flowing as it used to be. The new economy in a state of shambles as a result of the meltdown of Wall Street in 2008. There is anger out there, and people are venting their anger everywhere.
Ever since the collapse of Lehman Brothers on September 15, 2008, I’ve dedicated lots of hours researching about this event which froze the global financial system. Credit dried up as the banking system seemed to run out of money. All banks need to lend to each other—short-term loans that get them through the night or the weekend and enable them to do their hour-by-hour business. None would lend now, except at high rates.
The toxic mortgages were out in the world in the poisonously bundled CDOs (Credit Default Obligations). Rather that dissipate the risk, the CDOs had sent it to investors all over the globe. The magic formula had not predicted that so many flawed mortgages would default at once. The black swan was alive; it was not a myth, and the banks were in a state of shock.
“Many short sellers made a bundle by betting that the market could crash. The insurance firms would have to pay big. Many buyers of credit default swaps were like vultures and hyenas on the lookout for rotting carcasses.”
This is the state of things Hank Paulson found when he became the 74th U.S. Secretary of Treasure in 2006. Two weeks ago, I finished reading his book, “On the Brink: Inside the Race to Stop the Collapse of the Global Financial System”. This book is Paulson’s first-person account of the desperate economic events of 2008 which are still reverberating in different parts of the world, even as we speak.
Paulson narrates all the intense moments he found at the Treasury as he addressed urgent market conditions, evaluated critical decisions, and debated policy and financial considerations with key players in Washington, such as: CEOs of top Wall Street firms, Ben Bernanke, Tim Geithner, Sheila Bair, Nancy Pelosi, Barney Frank, Barack Obama, John McCain and George W. Bush, just to name a few. It’s a long list of players.
Hank Paulson is a controversial figure. Many will say he’s a hero, whereas many other will say he’s a villain. The is what Times Magazine published about Paulson in an article called, “25 People to Blame for the Financial Crisis.”
“When Paulson left the top job at Goldman Sachs to become Treasury Secretary in 2006, his big concern was whether he’d have an impact. He ended up almost single-handedly running the country’s economic policy for the last year of the Bush Administration. Impact? You bet. Positive? Not yet. The three main gripes against Paulson are that he was late to the party in battling the financial crisis, letting Lehman Brothers fail was a big mistake, and the big bailout bill he pushed through Congress has been a wasteful mess.”
Hank Paulson together with Alan Greenspan, was a hands-off regulator, content to believe that participants in the marketplace would act rationally and do the right thing. Like most conservatives, he still honored the principle of “the invisible hand”—that widely held, neoclassical economic notion that official intervention was at best a last resort. As an example of this ideology, the SEC (Securities and Exchange Commission) had only a handful of regulators—seven to keep with on Wall Street’s combined assets of $4 trillion.
Salaries were very modest at the SEC. A SEC regulator would make about $120,000 a year against over $1 million earned by a Lehman Brothers specialist in Turkish or Scandinavian bonds. Keeping tabs on Wall Street banks was nearly impossible. Yet it was exactly what had to be done. Even bankers admit that the financial collapse of 2008 was partly caused by lax regulations. Chuck Prince, former CEO of Citigroup, is quoted as saying, “As long as the music is playing, you’ve got to get up and dance.”
“The regulatory structure, organized around traditional business lines, had not begun to keep up with the evolution of the markets. As a result, the country had a patchwork system of state and federal supervisors dating back 75 years. This might have been fine for the world of the Great Depression, but it had led to counterproductive competition among regulators, wasteful duplication in some areas, and gaping holes in others. This situation called for the Blueprint for a Modernized Financial Regulatory System unveiled on March 31, 2008. “
John Mack, CEO of Morgan Stanley, one of the largest investment banks in the United States, had this to say about regulations. “We cannot control ourselves. You have to step in and control The Street.” “Greed, leverage, and lax investor standards,” John Mack said. “We took conditions for granted, and we as an industry lost discipline.”
Below are Paul Hanks recollections of the financial scenario on September 2008:
“Back in my temporary office on the 13th floor, a jolt of fear suddenly overcame me as I thought for a moment of what lay head of us. Lehman was as good as dead, and AIG’s problems were spiraling out of control. With the U.S. sinking deeper into recession, the failure of a large institution would reverberate throughout the country—and far beyond our shores. I could see credit tightening, strapped companies slashing jobs, foreclosures rising ever faster: millions of Americans would lose their livelihoods and their homes. It would take years for us to dig ourselves out from under such a disaster.” This is the economic equivalent of war”, I said. “The market is ready to collapse.”
Between March and September 2008, eight major U.S. financial institutions failed—Bear Stearns, IndyMac, Fannie Mae, Freddie Mac, Lehman Brothers, AIG, Washington Mutual and Wachovia—six of them in September alone.
After Lehman Brother died, credit froze around the world. With banks clinging to whatever cash they had, companies around the world could not borrow the money they needed to live on a daily basis. Stock markets collapsed. Whole countries threatened to follow: Ireland, Iceland, Hungary, Ukraine, Greece, Portugal—the crisis even reached out to Central Asian republics. Huge bailouts and economic “stimulus” programs had to be put in place to keep the system running.
Frances Christine Lagarde, the former Minister of Economic Affairs, Finances and Industry of France commented; “All banks suddenly realized that no one was safe and that any bank could fall. At that point, they considered that their counterparts were vulnerable so they blocked all financing channels. The credit system stopped working at that moment.”
This is another dramatic narration of the calamitous period of September 2008:
“Paulson stepped out of a meeting room and found a quiet corner to call his wife Wendy on his cellphone. His voice immediately betrayed his own panic. ‘What if the system collapses?,’ he confided in her. ‘Everybody is looking to me, and I don’t have the answers. I’m really scared.'”
Wendy read back to him over the phone, Timothy 1:7; “For God hath not given us the spirit of fear, but of power, and of love, and of a sound mind.”
At the end of the book, Hank Paulson highlights four lessons that he learned could help the United States avoid a similar calamity in the future. This is what he wrote in his book:
1. The structural economic imbalances among the major economies of the world that led to massive cross-border capital flows are an important source of the justly criticized excesses in our financial system. These imbalances lay at the root of the crisis. Simply put, in the U.S. we save much less that we consume. This forces us to borrow large amounts of money from oil-exporting countries or from Asian nations, like China and Japan, with high savings rates and low shares of domestic consumption. The crisis has abated, but these imbalances persist and must be addressed.
2. Our regulatory system remains a hopelessly outmoded patchwork quilt built for another day and age.
3. The financial system contained far too much leverage, as evidenced by inadequate cushions of both capital and liquidity. Much of the leverage was embedded in largely opaque and highly complex financial products.
4- The largest financial institutions ar so big and complex that the pose a dangerously large risk. Today, the top ten financial institutions in the U.S. hold close to sixty percent of financial assets, up from ten percent in 1990.
I’ll close this post with a positive note. Angela Merkel, the Chancellor of Germany, and Nicolas Sarkozy, the 23rd and current President of the French Republic, came up with a bold plan to mend Europe’s deplorable financial mess. Greece’s chaotic situation will be taken care of, as well as the rest of the European countries on the brink of a financial default. The markets responded positively and investors are more relieved.
The world’s biggest economy—the United States—grew at a 2.5 percent annual pace in the July-September period, the best in a year, led by consumers and businesses, the Commerce Department said Thursday. Meanwhile, European leaders unveiled a plan to shield Greece from default, protect the region’s banks and keep the crisis from spreading to Italy and Spain. Despite a lack of key details, the accord eased concerns of an imminent new financial crisis that could derail the global economy.
“A month ago there were fears of a double-dip in the U.S. and a blowup in Europe. Those tail risks have diminished,” said Josh Feinman, global chief economist at DB Advisors.
Will the specter of Lehman Brothers still hover over the financial world in the future? Who knows? Time will tell. In the meantime, let’s hope for the best. Good Day.
Book: On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, written by Henry Paulson. Kindle Edition
Lingua Franca 
The problem with the SEC is that it is overloaded with lawyers. Their mode of operation is to deal with problems after they happen. There should be more accountants who could prevent problems.
The guy who blew the whistle on Madoof could not get the attention of the folks at the SEC.
Good Morning Richard:
Chris Dodd and Frank Barney made great efforts to tackle the problem of regulatory reform. How good they made it will be seen in the upcoming years. I’m pessimistic though.
Wall Street is too strong to be reigned in by Washington’s bureaucrats. I hope I’m wrong on my perception. We can’t afford another financial meltdown.
Enjoy your day on the cool highlands of Potrerillos,
Omar.-