Chapter 3. Financial Chaos

As the second half of 2006 progressed, all the reckless financial behavior that had underpinned the constant buying and selling of properties up to that point during the credit boom was starting to collapse under its own weight. In our earlier discussion of gimmicky loans and their explosive penetration into housing finance, we detailed how the majority of those loans were adjustable-rate mortgages (ARMs) whose low interest rates were set to expire after a given period of time. Because this form of financing was most preferred among speculators whose only intention was to play the rising prices, it actually created what amounted to a ticking time bomb of selling activity. In other words, as the ARMs on these waves of speculative purchases approached their reset dates, more and more houses were placed on the market, which increased supply. Likewise, as the rates began to reset in 2006 on the 2/28 ARMs (two years fixed, 28 years floating), the payments that these stretched purchasers had to make in order to carry their inventory of listings began to spike. This created a greater sense of urgency among the sellers. Still other sellers, the bottom-of-the-barrel subprime borrowers who were piling into the market toward the end thanks to aggressive mortgage brokers, were now going belly-up on their loans in as little as a month or two into their purchase. The net effect of these fundamental drivers was that by the end of 2006, the supply of vacant homes for sale on the entire U.S. market had jumped 34% from the beginning of the year (see Figure 3.1). Although eye-catching, this data does not even do justice to more specific geographic areas such as the Northeast that had been more deeply affected by the credit boom. There, vacant homes for sale had increased nearly 100% from a year earlier. Suddenly, many forces in the market were beginning to conspire against the tired bull, and, not surprisingly, its legs began to slow.

Figure 3.1. Vacant housing units for sale (in thousands)

Source: U.S. Census Bureau

Prices in the housing market began to give way under the pressure of increasingly desperate sellers and rising defaults. Sometimes there is no better way to capture a moment than to go back and examine what was being said at the time. A July 30, 2006 article in the New York Times, “Taking the Measure of the Market,”¹ featured an interview with a real estate agent in Long Beach, New York. She described a recent experience with a couple who had just listed their home: “A couple in their late 30s came in to price their three-bedroom ranch. The interest rate on their mortgage had risen to 9.5 percent, from 3.5 percent three years ago. They didn’t have the equity or good credit to qualify for refinancing at a lower rate. To make matters worse, on July 1 the City of Long Beach raised property taxes 25 percent. ‘They needed to get out because they were so overwhelmed.’” As more and more sellers attempted to unload on the market because their ARM was resetting, due to a simple inability to keep up with so many payments, or because of the race to get out, prices in the market continued to decline as 2006 moved into 2007. As the “not possible” reality of falling home prices firmly set in during 2007 (see Figure 3.2), it was clear that the rush to get out of real estate was trending toward a stampede.

Figure 3.2. Case-Shiller composite 20 home price index

Source: Bloomberg

As prices in the housing market continued to decline during 2007, defaults on subprime mortgages continued to surge. Based on data from Bloomberg, the number of subprime mortgages that had gone 90 days without payment (that were in default) taken as a percentage of the total was 6.6% at the beginning of 2006. By the end of 2007, this number had climbed to a staggering 15.8% of the total in only 12 months. The jump in defaults during 2007 started to produce more visible effects on the financial system as a multitude of mortgage lenders started to drop like flies due to the carnage. In 2007, about 200 mortgage lenders failed—and this was only what was reported. The problems facing mortgage lenders in 2007 were numerous. For one thing, the existing inventory of loans in the system was going south through default. Second, lenders’ sources of funding relied on cash flows from sales or near-term borrowings, because many of these largest mortgage originators were not deposit-based institutions. Among these types of large nondeposit institutions that came to dominate mortgage origination, Countrywide Financial was the poster child for rapid growth, corporate excesses, and eventually a total meltdown. Countrywide, much like the consumers it lent to and the creditors it borrowed from, was heavily reliant on being able to continuously borrow in short-term loans to fund its operations. In August 2007, Countrywide got an up-close preview of what happens when suddenly a lending institution cannot access sources of near-term debt as its own lenders turn to it and say, “No more for you.” The firm had to quickly borrow $11.5 billion from 40 different banks. Countrywide was accustomed to funding its operations by issuing commercial paper (short-term debt paid back in nine months or less). In the weeks preceding August, the firm claimed to have had easy access to over $50 billion of the stuff. By mid-August, though, that access had changed, and changed quickly. As Countrywide went to the commercial paper market to borrow money, no lenders could be found. As it were, the investments tied to subprime lending were unraveling so quickly that the market for loans shut down almost instantly. This ostensibly spelled game over for mortgage lenders that relied on obtaining short-term borrowings to fund their operations. Figure 3.3 shows a brief timeline of some key events tied to this phenomenon in 2007. It includes the Bear Stearns hedge funds implosions, Countrywide’s liquidity crunch, and the massive write-downs of subprime-related securities held on the books of the investment banks in October 2007.

Figure 3.3. Subprime mortgage delinquency rates 90+ days as a percentage of the total

Source: Bloomberg, ml-implode.com

As defaults on subprime loans surged during 2007, consequences arose across the financial system. Entities that had invested in the collateralized debt obligation (CDO) products that were tied to these loans also started to default, causing large losses among hedge funds and the investment banks that held the securities. Likewise, the market for issuing new CDOs on which the investment banks had become so reliant as a part of their earnings stream also evaporated beginning in the third quarter of 2007 (see Figure 3.4). As investors were being stung by rapid losses in their portfolios, their appetite for more of the securities went from rabid to practically nonexistent in a little over a year.

Figure 3.4. CDO issuance in millions of dollars

Source: SIFMA

The closing of the CDO market should have meant the quick dismantling of a ridiculous investing paradigm in which investment banks were facilitating reckless lending to consumers and selling their institutional clients overpriced slop. But that was wishful thinking. The game had persisted long enough to present substantial problems on a broader scale. As the investment banks found that the market for their CDO issues was drying up, the inventory that they were constructing for sale began to back up onto their shelves. Instead of being a mere conduit from the borrowers to the creditors, the investment banks had become de facto creditors during late 2007 and into 2008. In the meantime, in the stock market the subprime debacle had certainly grabbed headlines and was on investors’ minds, but by and large it remained somewhat of a novelty. Stock investors on average continued to see the subprime mess as a problem contained to reckless borrowers and the fixed-income investors who had become their creditors. On October 2, 2007, a New York Times article titled “Stocks Soar on Hopes Credit Crisis Is Over”² captured the mood. One commentator’s quote in particular summarized the feeling: “Whatever problems emerged last quarter are last quarter’s problems. They’re over; that’s it; they’re done. So let’s move on to the next thing.” Although the worsening credit environment, defaults, and tremors created by liquidity problems at Countrywide had not gone unnoticed, there was a general feeling that the worst was over. In fact, on October 9, 2007 the S&P 500 climbed to an all-time high. If October 2007 presented a moment of stock market complacency, the months afterward were marked with deepening worry.

If Bear Stearns was the first investment bank to signal problems cropping up through its various exploitations of the subprime lending market, perhaps it was apropos that it was the first investment banking firm to be shown the door from the public market. By March 2008, the firm had already been through the ringer for its losses in the subprime market. Along with several other investment banks, Bear had reported its first-ever loss on its quarterly income in the prior quarter. Bear’s chairman, James Cayne, had ceded his CEO title in January to the firm’s widely respected top investment banker, Alan Schwartz. Mr. Schwartz had the unfortunate job of trying to extinguish a growing firestorm of distrust. People doubted that Bear Stearns could continue to exist under the weight of its losses and exposure to mortgage-backed securities given its number two position as a mortgage-backed securities issuer behind Lehman Brothers. One of the unique qualities of financial firms is that prophecies can become instantaneously self-fulfilling. In mid March 2008, Bear’s creditors were beginning to pull back on the money they extended to the firm in short-term loans. Even worse, Bear’s clients began to withdraw their assets from their accounts. This was an old-fashioned Depression-style run on the bank, in an updated 2.0 version. Incidentally, the short-term loans and client assets provided much-needed liquidity that cushioned Bear against the write-downs in mortgage-related securities. On March 12, 2008, Mr. Schwartz appeared on CNBC. “The reluctant CEO,” as he came to be known due to his rather ad hoc appointment, talked down the growing skepticism of Bear’s financial condition. Despite his best efforts to channel Jimmy Stewart in a reprise of George Bailey, confidence in Bear had already been too destroyed to stave off the ensuing run. In just a matter of days, Bear Stearns’ cash position had fallen nearly 70%, from $18.3 billion to $5.9 billion. Hedge fund clients, trading partners, creditors, and bond funds almost simultaneously broke their ties with the firm and pulled their money. Recognizing that drastic times call for drastic measures, Mr. Schwartz phoned James Dimon, the CEO of J.P. Morgan, at a family gathering for his 52nd birthday. He suggested urgently that something needed to be done before Bear went under. Using the Federal Reserve as the backstop to guarantee the credit, J.P. Morgan announced that it would provide Bear Stearns with as much credit as needed over the coming 28 days. Although the stock traded down 47% on Friday, March 14 following the news, Schwartz felt as if he had bought the necessary time to find a suitor to buy the firm. Not so fast. According to later reports from the Wall Street Journal, Mr. Schwartz did not even make it home that Friday before Treasury Secretary Henry Paulson and New York Federal Reserve President Timothy Geithner phoned him. They told him he needed to have a deal worked out to sell Bear by Sunday night. As it turned out, and in the face of much employee and investor dissent, Bear Stearns announced that it would be sold to J.P. Morgan at $2 a share on Sunday, March 16. In what amounted to a costly oversight based on reports from the Wall Street Journal, the terms of the contract allowed for the guaranteed backing of financing Bear’s trading activity for a year. As Mr. Dimon discovered this detail, he contacted Mr. Schwartz, informing him that “we” have a problem. But the beleaguered banker had finally caught a break, and he simply responded “What do you mean ‘we’?” Realizing that Bear shareholders could vote down the deal and still keep Bear running for a year thanks to the financing guarantee, J.P. Morgan raised its offer to $10 a share, and the deal was done. The deal allowed Bear to survive in the corporate nest of J.P. Morgan. The firm’s shareholders received a lesson in how swiftly these firms could unravel thanks to their massive leverage and just how vulnerable they were to losses in the mortgage-related securities held on the books of the investment banks. In just a week’s time, prior to the revamped $10 deal, Bear shareholders had lost 92% of their money in the stock.

As the summer of 2008 began to move toward fall, the situation in the mortgage default arena was transitioning from calamity to meltdown. By July 2008 nearly one quarter of the loans made in the subprime category of the mortgage market were defaulting. This deterioration produced more casualties. They were becoming larger and even more headline-grabbing as the seventh-largest mortgage lender, IndyMac Corp., failed and was seized by regulators. We pick up in the action by extending our earlier subprime default timeline, as shown in Figure 3.5.

Figure 3.5. Subprime mortgage delinquency rates 90+ days as a percentage of the total

Source: Bloomberg

During the summer of 2008, the foreclosure crisis was reaching such a fever pitch that there was rampant news of borrowers who simply walked away from their homes. They had decided that they were too far underwater on their home loans (market value less than loan outstanding) due to a combination of aggressive financing and a continued decline in house prices. Based on data from Moody’s,³ by the summer of 2008 approximately 9 million households, or 10.3% of all single-family homes, were underwater on their loans. Most notable were reports of relatively high-profile celebrities who had been sucked into the credit craze. To start, there were reports that the retired Major Leaguer and American League MVP Jose Canseco had walked away from his $2.5 million home near Los Angeles. Likewise, there were reports that Ed McMahon, Johnny Carson’s long-time sidekick, was facing foreclosure after becoming $644,000 in arrears on payments tied to his plush Beverly Hills abode. While engaging, and capturing the public’s attention, these events were merely sideshows to the main event that was about to unfold in September 2008.

The Crisis Moves from Subprime to Prime Time

In the second week of August 2008, the New York Times ran an article titled “Mortgage Giants to Buy Fewer Risky Home Loans.”⁴ It described the staggering losses that were now unfolding in the financial statements of Fannie Mae and Freddie Mac. The headline was responding to comments from Fannie Mae executives who were now attempting to push back from the trough after reporting losses that were three times greater than analysts’ estimates for the recent quarter ended. The executives at Fannie Mae unveiled their plans to cease purchasing Alt-A mortgages by year end and said that generally they would slow their overall purchase of mortgages. Although they were a little late in the game, these moves were probably essential for the government-sponsored entity if it were to have any hope of not failing as losses continued to mount. At the same time, these decisions could spell disaster for the already-reeling mortgage market as ARMs were resetting. Any pushback in demand from the only clowns still buying these mortgages would send mortgage rates skyrocketing and break the backs of borrowers who were still vulnerable to higher rates. Also in August, Freddie Mac had announced in its earnings filings that there was “a significant possibility that continued adverse developments” could cause the firm to fall below its government-mandated capital levels. This may have well been code that the end was near, because there was no sign of relief in the housing market. Incidentally, Treasury Secretary Paulson had already received approval from Congress to deploy funds to rescue the firms should that become necessary. In early September, the necessary occurred, and Fannie Mae and Freddie Mac were placed into conservatorship by the U.S. government. In one day of trading, shortly after the government’s announcement, shares in Fannie Mae fell 90% to close at $0.73.

Financial chaos had arrived. Next the focus shifted to the mortgage-backed mavericks at Lehman Brothers, who were scrambling for alternative courses of action as they too faced a loss of confidence in the market in almost identical fashion to Bear Stearns six months earlier. One idea that Mr. Fuld, the CEO of Lehman, was considering was jettisoning the rotting subprime assets from the firm’s balance sheet in a spin-off move following the “good bank/bad bank” model from historical banking crises. In any event, in the week leading up to Fannie and Freddie’s takeover, Lehman was still seen as a viable going concern in a rough patch. Even Mad Money’s Jim Cramer saw the stock as a “screaming buy.” As the Fannie and Freddie news hit and trading opened on Monday, September 8, the picture for Lehman as it was portrayed in the stock market was set to unravel. Many investors and financial pundits had likened Lehman’s situation to that of Bear Stearns and figured that another version of a U.S. government-brokered transaction would emerge. This widely held consensus was primed to take a major hit on Tuesday, though, as three pieces of information were about to enter the market. To begin with, Lehman had been in talks to raise funds through an equity stake purchased by the Korea Development Bank. As these talks reportedly fell through on Tuesday, Lehman shares dropped 45%. Then, on Wednesday, the firm reported a $3.9 billion loss for its most recent quarter. As is often the case, the credit rating agencies came in belatedly and pointed out the obvious—that the firm needed capital, or even a partner, to get on stronger financial footing. Nevertheless, on Thursday the stock fell another 42%. With the stock now down to just $4.22, from $16.22 on the previous Friday, some white knights had started to reveal themselves. As reported in the Wall Street Journal, Bank of America and Barclays were showing interest in a possible purchase of some kind. At the same time, in comments that might not have been taken at their full value, the U.S. government was posturing that Lehman would need to take care of itself. Also, Federal funds would likely be unavailable, as they were in the Bear Stearns transaction. In an outspoken version of this message, William Poole, the former president of the Federal Reserve of St. Louis, gave an interview⁵ that Thursday. He stated, “Absolutely, I would say we cannot provide assistance in this case... This case is different, and we’re not going to provide that assistance, and you’ve got to make your own decision. We’ll help you work through it, but we’re not going to give you any cash... Lehman needs to resolve this situation quickly, and the more quickly, the better.” This advice proved prescient, but as Friday’s trading concluded, Lehman shares had fallen a modest 14% in comparison to sessions earlier in the week. Many believed that, like Bear Stearns before it, Lehman would hash out a deal over the weekend, since Bank of America and Barclays were clearly kicking the tires. That Friday afternoon, though, Treasury Secretary Paulson and New York Fed President Geithner called in the heads of the largest investment banks in New York for a meeting. According to reports in the New York Times, Geithner stressed to the investment banking heads that the U.S. government would not put taxpayer money on the line for this rescue, and that the ball was in the court of these bank chiefs. What Paulson and Geithner hoped for was a replay of the events in 1998, when the investment banks pooled resources to stave off the collapse of Long Term Capital Management. Ultimately, though, no agreement could be reached, and Bank of America, lacking the form of U.S. government guarantee that was in place for the Bear Stearns deal, also backed out. The last hope was Barclays, which was still interested but that simply could not arrange the necessary shareholder vote by Monday morning in accord with London Stock Exchange rules in order to approve a transaction. Lehman had reached the end of the line. In what proved to be a busy weekend for Wall Street bankers and the government officials from the Fed and Treasury who were charged with overseeing the chaos, Treasury Secretary Paulson received additional word that the world’s largest insurance company, AIG, was on the verge of collapse. AIG was not an obvious casualty of the subprime fiasco until the late innings of the game. The firm was well known for its size, strong balance sheet, and reach into the global insurance markets. But like many other financial firms in the credit bonanza, it had spotted and successfully exploited its own role in the credit mania. It would write insurance against the potential default of CDOs by selling an instrument called a credit default swap (CDS). AIG Financial Products (AIGFP), which was the small division of the insurance giant responsible for underwriting the business, was incredibly buoyant and confident in the fast-growing earnings stream it had produced over the years. In what can only now be seen as a fit of hubris reserved for instances of “pride goeth before a fall,” in 2007, the head of AIGFP made the following comment to an audience during a presentation: “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”⁶ A little over a year later, AIG’s small financial products division, with only 377 employees compared to the 116,000 employed throughout the company, was on the verge of taking down the entire conglomerate, and perhaps more. Sophisticated financial risk engineers apparently overlooked the simple arithmetic of what could happen if you suddenly owe too many people too much money all at once by trying to guarantee these CDOs. In financial parlance, these risks are often called “fat tailed” risk in reference to their probabilities lying so many standard deviations from the mean, or in the “fat tails” of the risk curve. The financial markets and the world itself have shown us too many times that the occurrence of events does not conform to this risk curve paradigm, yet academics and practitioners alike cling to this idea with unwavering resolve. In any event, the message Mr. Paulson received that weekend in September as Lehman was headed toward a bankruptcy filing was that AIG needed at least $30 billion to $40 billion immediately—or else. The Federal Reserve and Treasury were sufficiently spooked by the potential fallout from AIG’s counterparties, which included the investment banks, as well as a global spider web of financial firms. As the weekend concluded, Lehman was thrown out into the cold, and it faced a bankruptcy filing the next day. AIG was a matter that had been heavily resisted by U.S. government officials, and it remained unresolved. On Monday, September 15, 2008, Lehman filed for bankruptcy, and its stock collapsed in a 94% decline. In just a little over a week, more than $11 billion of shareholder wealth had been vaporized.

As all eyes turned to AIG, and U.S. government officials had not intervened, its stock too entered free fall. On Wednesday of the same week, sufficiently concerned with how many businesses would be deeply affected by AIG’s failure, the U.S. government surprised nearly everyone with an offer of a two-year loan of $85 billion and the issue of warrants that could be exercised to control 80% of AIG’s shares. While the lifeline meant that AIG would continue as a going concern, shareholders had been whipsawed by a 91% decline in a mere week and a half. Shareholders also had taken a backseat to the U.S. government, which had, for all intents and purposes, just nationalized the country’s largest insurer. The financial markets were tenuous, and these were unmistakably uncharted waters for investors accustomed to comparatively laissez faire markets. Far from being over, though, the week had already provided additional fireworks. Merrill Lynch, sensing its own mortality during the Lehman powwow, had sneaked off with Bank of America in what amounted to a corporate makeout session to see if the two could get along as partners. Incidentally, the CEO of Bank of America, Ken Lewis, and the CEO of Merrill, John Thain, thought the firms made a good pair. So a deal for B of A to buy Merrill through a stock transaction was announced. Despite Merrill’s status as a Wall Street icon with its famous bull, it too had been deeply mired in the mortgage security debacle. It had already taken $45 billion in write-downs and ousted its CEO, Stanley O’Neal. Far from being complacent over the subprime crisis, Thain had already been raising money in a total of seven transactions. These included selling assets such as the firm’s stake in the Bloomberg empire, completing an equity offering for $9.8 billion, and unloading mortgage-related assets at deep discounts. Although this was a disappointing end for many who cherished the firm’s independent culture, at least it could now live for another day. Its chances of doing so without a deal were slim. Needless to say, the broader equity markets did not digest this information with ease. Measures of volatility for the stock market such as the volatility index (VIX) rose sharply, as what was once seen as a subprime problem was now looking like a prime time problem. In a matter of weeks in September 2008, the markets for financial instruments of all varieties were being called into question. Bankers who would have lent to anyone just a year ago with no proof of income suddenly would not even lend to their thrifty grandmother. Lending institutions around the world almost instantly and all at once realized the severity of the situation and cut off lending in nearly all forms, launching into a state of self-preservation. Anyone and everyone who attempted to borrow under these conditions was presumed guilty before being proven innocent. GMAC, the industrial loan company (ILC) of GM, found this out when it borrowed one-week commercial paper at an interest rate of 5.25%. U.S. Treasuries rallied so sharply in a flight to safety from all other assets that yields shot to zero on near-term issues. The entire stock market continued to seesaw in wild gyrations and fits of anxiety. On September 25, just a week or so after the initial shock and awe began, the largest bank failure in U.S. history was announced. The Fed seized Washington Mutual, and the firm was promptly sold to J.P. Morgan. As the panic heightened surrounding nearly all financial instruments, one of the more unimaginable events that unfolded was when the money market mutual funds “broke the buck.” Breaking the buck means that investors who had stored their cash savings in a money market fund with the expectation that every dollar invested would still equal at least a dollar when they went to withdraw their funds suddenly heard otherwise. As we said earlier, money market funds had been enticed by the fool’s gold of AAA ratings on CDOs and had bought these instruments for their funds. As the crisis increased in intensity, one dollar invested was suddenly worth $0.97, and the fund managers halted redemptions, thereby locking up investors’ cash. The anxiety this created among the innocents of the world, with little hands-on knowledge of the turmoil ravaging the financial markets, was now palpable. In an article from Bloomberg titled “Reserve Fund Investors Wonder When They Will Get Access to Their Cash” from September 29, an investor in the famous and well-reputed originator of the money market funds had this to say: “When I ask TD Ameritrade when I can get my hands on my money, they refuse to give me an answer. I have insomnia, heart palpitations—my entire life seems to be in disarray.”⁷

If the 8.9% decline in the S&P 500 during September was not enough for investors, the 16.8% decline in October surely would be. With the crisis still rampaging through the credit markets in October, Wachovia, whose stock had plummeted on the news of the Washington Mutual seizure, began to experience increasingly heavy customer withdrawals in the following days. Over the weekend that followed WaMu’s seizure, Wachovia was bleeding deposits at an alarming rate, according to interviews after the fact, and larger clients were lowering their deposits to under the $100,000 threshold for FDIC insurance. It was clear that confidence in the bank was failing and action was needed. Over the weekend Wachovia mobilized to sell itself and struck a deal with Citigroup, only to later sell itself in another offer from Wells Fargo a few days later instead. Also in the first week of October, AIG was back in line with its hat in hand. It received an additional $37.8 billion on top of its original $85 billion from just a couple of weeks earlier. This was a remarkable event, because the company had already blown through $61 billion in a just a week or so after having the money. In effect, we can see how the bailout of AIG was just as likely a de facto bailout of the investment banks and others who sat on the counterparty side of the contracts that AIG could not honor in absence of additional funds from the government. So, in the end, there was the taxpayer, getting hammered by house price declines and stock market declines, helping siphon money into AIG, which in turn could honor its reckless insurance contracts, made with reckless investment banks that had leveraged themselves to speculate in the credit mania. Elsewhere in the stock market, many hedge funds that had grown used to applying large amounts of leverage in their portfolios were receiving margin calls to sell and take down their borrowing. In some cases, this was because they were sustaining losses. In other cases it was because their prime broker, a division of an investment bank, was crying uncle and trying to deleverage its own books, raise cash, and eliminate financial risk. The massive deleveraging in the stock market forced the selling into overdrive. As prime brokers instructed funds to raise cash, this forced selling, and the selling forced down share prices, which in turn led to a new round of margin calls. Anyone using too much leverage in this market sell-off would have been wiped out in short order. This market was evolving into a brutal bear that spared no one, from Warren Buffett all the way down to a teenager opening her first stock account.

In the meantime, the political scene in Washington was also in a volatile state. The presidential election race between Barack Obama and John McCain was drawing toward its November 6 conclusion. In Congress, debates were heated over a bailout package in the banking system. By this time it was becoming evident that without the flow of credit through the U.S. financial system (and beyond), the wheels were coming off the economy. In fact, by late October, there was ample evidence that the entire global economy had been stopped in its tracks. Because banks had become too skittish to even transact with one another, ships transporting cargo around the world were stopped before entering port, because the bank had not secured a letter of credit. The exporter would not deliver the goods in absence of a guarantee that it would be paid by the importer, and the banks would not back the purchaser with credit. At the most fundamental level, global commerce had stopped.

The world economy was in a bad spot, and the U.S. consumer who had become so accustomed to the easy flow of credit during the past five years suddenly was experiencing life with little or no access to credit. On top of the sudden withdrawal of credit in the financial system, which was sharply affecting consumers and businesses that relied on access to near-term credit, the U.S. household was now witnessing a reversal in the large amount of wealth it had presumably built since the early 2000s. In short, wealth thought to have been stored in houses and stocks was being destroyed at record speed. In one year, during 2008, Americans saw over $2 trillion of their wealth stored in real estate vanish. As if that were not enough, this same group had lost an additional $3.7 trillion in the stock market. All told, across U.S. households’ balance sheet, $11 trillion in net worth was gone by the end of 2008. This meant that despite all the wild spending, house speculation, and general feeling of prosperity that occurred over the past several years, they were actually no better off than they were in 2004 from a net worth perspective. All the supposed wealth that had accumulated had been hitched to a growing mountain of debt, but the wealth was gone and the debt remained (see Figure 3.6). Taken on a historic basis, we can see the effects of what happened and just how much the U.S. consumer’s balance sheet expanded its use of debt—debt that in time needs to be paid down.

Figure 3.6. Household debt divided by household net worth

Source: Federal Reserve

Feeling whipsawed and disillusioned in the fourth quarter of 2008, Americans sought change and elected it by making Barack Obama their 44th president. In a worsening economic landscape, Americans looked to their government, of all places, for answers despite the thinly veiled reality that the government had facilitated several aspects of the current predicament. In any event, the alarm was sounded, and the cavalry prepared to rush to the scene: bailout mania, spendthrift policy makers, feuding regulators, political favoritism, and all things Washington.

The free markets are dead; long live the free markets!

Endnotes

¹ Valerie Cotsalas. “Taking the Measure of the Market.” New York Times, July 30, 2006.

² Michael M. Grynbaum. “Stocks Soar on Hopes Credit Crisis Is Over.” New York Times, October 2, 2007.

³ Edmund L. Andrews and Louis Uchitelle. “Rescue for Homeowners in Debt Weighed.” New York Times, February 22, 2008.

⁴ Charles Duhigg. “Mortgage Giants to Buy Fewer Risky Home Loans.” New York Times, August 8, 2008.

⁵ William Poole. “Poole Says Fed Shouldn’t Give Funding to Any Lehman Agreement.” Bloomberg Television, September 12, 2008.

⁶ Anna Schecter, Brian Ross, and Justin Rood. “The Executive Who Brought Down AIG.” www.abcnews.go.com, March 30, 2009.

⁷ Alexis Leondis. “Reserve Fund Investors Wonder When They Will Get Access to Their Cash.” Bloomberg, September 29, 2008.