Market Epicurean


The Month I Could Never Forget: A Not-So Happy Anniversary - PART ONE

Pipe

Getting Your Fannie Whipped

As we launch a multi-part series to cover the ten-year anniversary of the financial crisis, let us not forget the most important thing people need to understand about the crisis itself: September 2008 is not really the month “it all began.”  We are choosing to follow this calendar guide because virtually everyone will remember, for good reason, the events of September 2008 as the milestone moments they permanently associate with the financial crisis.  indeed, the entire month ran for me as a really bad mini-series, with each episode actually more traumatic than the one prior.  September 2008 was the most significant month of my career, and perhaps the most important month in capital markets since October of 1929 – but it was neither the beginning nor the end, of the financial crisis (the “Great Recession”).  Rather, it was the manifestation of so much of the financial crisis – a crisis that had been building for many, many years.

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I wrote a year ago that August 2007 [An Anniversary To Never Forget] was probably the more accurate month to call the “crisis launch” – for it was August 2007 when credit markets really broke.  The subprime market went bust, and financial traders began realizing losses en masse around derivative positions that were completely and totally unknown in size to the rest of the world (as we now know, basically to the heads of the firms themselves).  Fall 2007 created a dislocation in swaps, in CLO’s, in subprime synthetics, and began a spiral of big-firm write-downs.  A couple mortgage hedge funds at Bear Stearns went bust.  It was brutal.  But no one will ever associate it with “the financial crisis,” because the dam didn’t burst.  Equities didn’t peak until late October.  The run on Bear Stearns didn’t climax until March of 2008.  At this point, the world was still turning with mostly functioning capital markets.  It was September 2008 when everything came together – and that is why it will represent the focal point of this series.

I do intend to try and captivate you with a play-by-play of my own reminiscing through that month’s events.  Certain days and milestone events stick out more than others, and I have chosen those truly vivid memories and iconic occurrences to focus on in this series.  I recognize my own recollections and biographical context may not be captivating at all to many of you, but it is the optimal way for me to explore such a profoundly significant month in American economic history.  I really hope you will find the series of short articles beneficial, if not captivating.

Too many people talk as if the domino of financial catastrophes started in September with the Lehman Brothers bankruptcy, for certainly, that was (and always will be) the marker by which we look at the permanent changing of Wall Street.  But we should never forget the event that actually preceded Lehman’s fall by eight days – one with even greater significance to taxpayers to this day – and that was the government’s seizing of Fannie Mae and Freddie Mac on Saturday, September 6.

The history is actually really easy: Fannie and Freddie were created by acts of Congress as “government-sponsored enterprises” – a term so nebulous and non-specific, you can be forgiven for assuming it meant they were official government agencies.  They were not.  They were publicly traded corporations where shareholders kept profits – not government bureaus.  However, this public-private milieu meant that they functioned with a sort of implicit backstop from the government, giving them the ability to issue far more debt than anyone could imagine, at far lower cost than any other private actor.  We now know, of course, that the real stirring of a brutal mortgage and housing bubble were well under-way before the spring of 2008, yet in the spring Fannie and Freddie continued to add to their pool of leveraged subprime securities.  By July of 2008, Treasury Secretary, Hank Paulson, sought and received permission from the Congress to guarantee $25 billion of Fannie and Freddie bonds (a laughable number relative to the $5 trillion of mortgages Fannie and Freddie had guaranteed).  The same bill sought to give the Treasury Department other means and tools should they be necessary for the future.  (To this day, I believe the Secretary that in July, when he sought this “bazooka,” as he famously called it, he did not know or believe that he would end up having to use it).

By September 6, things had completely and totally unraveled.  Demand for Fannie and Freddie bonds dried up as domestic and foreign investors sought the security of Treasuries and some greater assurance that the Federal government would backstop this exposure.  Mortgages rates flew higher (a 30-year fixed mortgage at 6.52% – imagine that!) – and Fannie and Freddie were in a death spiral.  Like a Ponzi scheme, they required continued funding from capital markets to sustain their highly leveraged balance sheet, and as that crisis of confidence blew up new funding, the death spiral had arrived.

The government put Fannie and Freddie into “conservatorship,” which essentially wiped out their stockholders completely.  The equity was worthless anyway, but global markets needed to know there was a backstop to the mortgage obligations that had an “implicit guarantee” from a “government-sponsored enterprise.”  Everything transcended “implicit” and “sponsored” after September 6.

My wife and I were driving for home from a weekend anniversary trip when the news broke.  My immediate response was one of anger – I had been an outspoken critic of the whole concept of Fannie and Freddie for years.  I am sad to say, my immediate response was not to understand what systemic damage this would mean for the whole system.  For indeed, while Fannie’s common stock was dead (for good reason), and their bonds were now backed by the government, they had $36 billion of “preferred stock” outstanding, capital the holders of which were sorely counting on!  Ultimately, the realization that these capital instruments were not safe meant that a whole lot of capital instruments were not safe – and that chain reaction did not move slowly.

By market open on Monday, the 8th, commercial paper was called into question, along with Lehman’s ownership of Fannie preferred stock, along with, well, almost everything else.  The week that followed would serve as the final calm before the week that forever changed Wall Street – and which will feature several milestones in the next three or four issues of our series!

David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com

The Bahnsen Group
www.thebahnsengroup.com

The Bahnsen Group is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.

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