[Stealth3si]

Too Big to Fail - Wikipedia, the free encyclopedia

Too Big to Fail is a drama television movie in the United States broadcast on HBO on May 23, 2011. [2] It is based on the non-fiction book Too Big to Fail by Andrew Ross Sorkin. The TV film was directed by Curtis Hanson.

Too Big to Fail chronicles the 2008 financial meltdown, focusing on the actions of then Secretary of the Treasury Henry Paulson (William Hurt) to contain the unfolding catastrophe. Specifically, it focuses on the period of August 2008 to October 3, 2008, during which the stock price of Lehman Brothers declined precipitously as Lehman's large exposure to toxic housing assets became more and more apparent. ☺☺☺☺ Fuld (James Woods), CEO of Lehman Brothers, is seemingly in denial of Lehman's toxic assets and refuses several deals to potentially save the company, believing the housing market will recover. Paulson attempts to arrange a private solution to the Lehman problem, and both Bank of America and Barclays express interest in the "good" assets of Lehman. However, they want federal government loans to finance potential losses from Lehman's housing investments. Paulson wishes to avoid another government-sponsored purchase as Bear Stearns was, fearing the encouragement of "moral hazard", and refuses. Bank of America decides to buy Merrill Lynch on the cheap instead, as Merrill was in a marginally better situation than Lehman, yet still desperately needing capitalization. Barclays was still willing to purchase a selection of Lehman assets, but the Financial Services Authority (the British regulators) made it impossible to close the deal in time. Lehman Brothers, acting under the strong and quasi-legal encouragement of Paulson and the SEC, prepared the declaration of bankruptcy on Sunday, September 14, 2008.

Reaction to the Lehman Brothers bankruptcy was positive at first. The stock market as a whole barely nudged, and approving editorials were written of the federal government refusing to bailout corporate mistakes. However, ripples of Lehman's counterparty risk soon spread throughout the financial system, as many of these debts would now need to be written off. AIG, not even a bank at all, had provided insurance to nearly everyone on their housing assets. AIG had priced this insurance very cheaply under the assumption it was impossible for all of the housing market to go bad at once, thus massively underpricing risk. AIG was already losing money it couldn't cover, and the fall of Lehman Brothers hastened its demise, as its creditors refused to lend even more money to AIG's collapsing portfolio. A collapse of AIG would imperil the entire world banking system, as banks find their hedges against a decline in housing not honored by a bankrupt AIG, setting off a chain reaction of bankruptcies. Paulson moves to have the goverment guarantee AIG's bad insurance, but the global economy is still under threat. As banks reassess their balance sheets and realize their liabilities are much worse than they thought, they realize they have far less cash to lend out, creating a credit crunch that starts affecting "Main Street", normal companies who had nothing to do with financial services. Ben Bernanke (Paul Giamatti), Chairman of the Federal Reserve, believes that the only thing that might calm the economy is if the federal government had a gigantic pile of cash ready to smooth over any further disruptions and to get the credit markets moving again, but that such an act would require legitimacy - an act of Congress. Paulson is skeptical of the prospects of passing such legislation a mere two months before an election, and worries that the worst case scenario is Congress explicitly voting down such a tool. Bernanke notes the dire circumstances, and says Congress will act if they are as scared as he is.

Paulson and his staff brainstorm over how best to use such money, should they get it. The plan is "cash for trash" - buy the "toxic" assets of questionable worth off the banks, which will allow the banks to stabilize at a known valuation. Direct capital injection is considered as well, but written off as a political non-starter - a bailout to Democrats, and nationalization to Republicans. Timothy Geithner (Billy Crudup), President of the Federal Reserve Bank of New York, attempts to arrange mergers between "strong" banks and "weak" banks to stabilize the situation. Geither also seeks to end "investment banks," a model which failed, by merging any investment bank with normal depositor banks, bringing them under the regulation of the FDIC. Bernanke and Paulson lobby Congress, with Bernanke emphasizing that a lack of credit helped make the 1929 stock crash into the Great Depression, and that if Congress fails to act "we may not have an economy on Monday." The legislation looks likely to pass, but turbulence happens when John McCain suspends his campaign for president to join the negotiations - potentially restarting them from square 1. The vote moves forward regardless, but fails to pass the House after too many Republicans vote "no", causing an immediate drop in the Dow of 600 points. After a wave of panic and personal haranguing from President George W. Bush, the legislation passes on a second attempt, and the Emergency Economic Stabilization Act of 2008 is signed into law.

Paulson and his staff now have the money, but find that valuing the toxic assets to buy will take two months minimum, and may still not be reliable, as the banks all wish to claim face value for them. As a result, they decide that the only way to get credit flowing again is direct capital injections after all. Furthermore, capital injections to only the weakest banks would be counterproductive - it would declare to the world which exact banks were "weak" and by how much, which could potentially just create a run on these banks and require even more of a bailout. With the help of FDIC chair Sheila Bair and the threat of an FDIC audit, Paulson informs all the remaining banks that they will be receiving mandatory capital injections in the form of non-voting government owned stock, and that they were all to use this money to get credit moving again.

I didn't know about this movie but my curiosity is now looking for some decent insight into the cause(s) of the 2008 financial crisis. Sorry if this has been covered in CGR.

So I missed the movie and want to know if anyone here who has seen it if it's accurate to what you think contributed to the 'meltdown?'

From what I've read from the YT comments the banks seem to be the main factors. If that's true should we be concerned about letting banks hold our money or should we start using cash only?

[Chrysostom]

Originally Posted by Stealth3si

my curiosity is now looking for some decent insight into the cause(s) of the 2008 financial crisis. Sorry if this has been covered in CGR.

So I missed the movie and want to know if anyone here who has seen it if it's accurate to what you think contributed to the 'meltdown?'

From what I've read from the YT comments the banks seem to be the main factors. If that's true should we be concerned about letting banks hold our money or should we start using cash only?

There were a lot of factors, and how to weight them is an incredibly complex thing. Suffice it to say, lots of people with nobel prizes in economics tell different over-arching stories of the crash and therefore weight different factors differently. But I'll mention several of them.

- These are in no particular order, but here's an important preface re:"should we be concerned about letting banks hold our money?" Investment banks and depository banks are (historically) different kinds of institutions. There's a reason that your local community bank doesn't put together IPOs for hot tech firms, and it's not just size -- it's because that's a completely different kind of bank. Somebody who goes into investment banking is NOT trying to come up with a new type of checking account or something; that person is more likely developing financial instruments for exchanges.

- In the late 90s Congress repealed part of a law that had been in place since after the crash of '29. It kept investment banking separate from depositary banking. This is a very smart separation, in my opinion (some very smart people disagree with my judgement here), because investment bankers think of risk very differently from depository bankers. (Read up on the S&L crisis in the 80s, where lawmakers let regular banks engage in real estate speculation -- a combination of government and corporate foolishness is very dangerous.)

Example: I am a professional stock trader, and my father runs a loan department. If only 25% of my trades don't work, I would be one of the most successful traders out there. If even 5% of my dad's loans fail, he would be fired in a day. Investment bankers take on stuff that is very high risk and very high reward; depository bankers make money on a 6% mortgage when there is 3% inflation. It's the same reason you keep your military separate from your police force: Different mindsets, and mixing up either is dangerous. So, the kind of basic regulation that people knew needed to be put in place in 1933 was repealed in 1999. I'm not a fan of invasive regulation, but in my opinion this was really basic stuff. This is a fairly neutral problem, because it's not clear whether to place the blame on the corporate or political sphere here. They worked hand in hand.

- Housing prices started to skyrocket, and that had to do with a great many things. Average citizens contributed by demanding very nice houses, and increasingly by lying on mortgage applications to buy more house than they could afford. Banks relaxed their lending standards on the assumption that real estate prices would keep going up -- i.e., banks started engaging in real estate speculation. And the government was encouraging homebuying as best it could, especially by trying to get lots of new people into homes they weren't already buying because they couldn't already afford.

So everybody -- the people, banks, and the government -- built a house of cards that depended on that old god Progress to hold together. Once Progress slowed just a little bit, everything could fall apart rapidly, because way too many chips were on the table for just one hand. It's like doubling down every time you lose in Blackjack -- it keeps working until it doesn't, and then you really get crushed. The folks the government rushed into homebuying weren't ready for those big mortgages and had to dump their houses. Once the banks saw just a few mortgages go sour they were in trouble, because remember about that 5% failure rate I mentioned earlier? And once the people who lied on their applications and borrowed too much from the future got into more troubling times, they were like Wile E. Coyote running off a cliff, and fell all at once.

- There is another layer to put on top of this, however, and it really goes back to the mixture between investment and depository banking. You see, as part of its initiatives to help Americans realize the home-buying dream, the government sponsors some entities with names like Fannie Mae that provide a backstop for mortgages. This is why a standard US mortgage can be 30-yr at a fixed interest rate, but you don't see that elsewhere in the world: the government's subsidies make it profitable for banks where it would be risky otherwise. Now, people always expected that when push came to shove, the government would fully back Fannie Mae and so any Fannie promise was just as trustworthy as a US government promise. That means that Fannie Mae debt and debt guarantees were seen to be just as strong as US government debt.

So, some investment bankers came up with a way to wrap together a bunch of mortgages and let people invest in them. (There were some other financial instruments involved, too, but I'll just mention this one.) That's a fine idea on its own, I suppose, except that there was a bit of a mix-up: Even when some of the mortgages were questionable, the total debt package would get sold at a sort of "sure-thing" rate because it seemed to have that Fannie Mae/government guarantee of creditworthiness. And when your margins are thin and you start buying stuff that's a lot riskier than the price you're paying is worth, you're set up for a fall. Again, a House Of Cards.

- A final piece of the puzzle -- and this is already long, so I'll be brief -- is that the more committed everybody gets to that tempting god Progress the faster things can grind to a halt. This is called a Liquidity Problem. I'll give you one example of how it appeared, but this characterized stuff across the board and it is what made things really crash hard, instead of just a little crash. (Note: Average people and corporations can screw things up pretty bad on their own, but when you get the government in on it, too, you're really in trouble. If one of the three stays level-headed, you'll be a lot better off even when some problems come along.)

Along with the separation between investment and depository banking, 1933 laws established the FDIC to insure banking deposits. This helps out in case of the following problem, called a Liquidity Problem: Banks only have to keep a certain percentage of their deposits on hand -- "liquid," they call it -- in order to be able to return to customers who ask for their deposits back. The rest they loan out, which is a big source of income for them. Say they have 99% of their deposits loaned out, and 2% of their customers want their money back on the same day. The bank has no way of coming up with the cash right then because it's all loaned out, and those loans can't be converted back into cash very quickly -- you would say, loans are not very "liquid," they can't be liquidated into cash very quickly. Say that those 2% needed that money to buy things, which would transfer money to businesses, which would allow the businesses to pay back their loans, which would give the banks the money to return to their depositors.

It's a big interdependent circle, and once any link in the chain runs out of money to pass on to the next link everybody else is paralyzed. This is basically one reason that the Fed would dump money into the economy -- to provide some "liquidity" that gets the ball rolling again. It's also why the FDIC promised to guarantee bank deposits -- so that people wouldn't be afraid that if other people demanded their money out of banks the banks would run out of money and everything would come to a halt. Well, once investment and depository banking was put back together, some investment bankers figured out how to create what was effectively an alternative system of deposits that wouldn't be subject to all the rules of normal depository banking. Those very minimal, very powerful government regulations had no authority in this new "shadow banking" sector of financial instruments. And so -- surprise, surprise -- the problems that the minimal regulations were put in place to solve re-appeared here in the shadow banking sector. And so, predictably, things fell apart. Liquidity ran dry faster than it should have, and everything was in trouble all of a sudden.

- Finally, let me point out that a big part of the reason for the huge crash was the huge run-up that preceded the crash. People involved in real estate or the stock market prior to the crash were making money hand over fist. And once you speed up profits in too fast of a spiral, everything can coming crashing down much faster than it would otherwise. So, (1) actual stock and home prices weren't so bad off as long as you don't compare them to prices that were artificially caused by the foolish upward spiral that directly preceded the crash, and (2) the long-term problem is that prices didn't just fall, but all this infrastructure and expectations had developed alongside the spiral that hit the system with big long-term shocks. We had invested so heavily in something that wasn't sustainable in the long-term at the rates it was going at, so things needed to be moved around. Normally, there would be a short bit of pain and things would be shifted around. In this case, investment was really entrenched one direction, making it tough to redirect, and some (not all) of the government's actions held investment where it already was instead of letting it shift around. (For instance, bailing out certain banks just because they were big regardless of their prudence in the whole ordeal.)

- Who's at fault? The people did their part. The businesses did their part. The regulators did their part. Different observers will emphasize one part or another, just make sure that emphasis isn't driven wholly by precommitments about what is good and what is bad.

[Stealth3si]

Wow. Thanks a lot for this. Much easier to read than the wiki one.

Overall, I think your perspective is visionary, which I suspect may have helped you anticipate stocks in your profession, yes?

Are you a high frequency trader?

[Chrysostom]

I'm not a High-Frequency Trader, which is a technical term, but most of my trades are what investors would consider short in duration. High-Frequency Trading (HFT) uses very complicated computer algorithms to send out hundreds of millions of orders, almost none of which will ever actually be executed, in order to try to find these tiny fractions of a penny that are sitting out there in the market. (Get a fraction of a penny a million times a day and you're talking real cash.) I'm a hand trader by trade, meaning that I make my decisions and hit the keys myself, although I have purchased and/or designed some very complicated computer systems that help me make sense of the market and execute my strategies. I go wherever my imagination takes me, so sometimes I'll hold a position for well over a year and other times I'll hold it for just a few seconds. Because I'm a trader, not an investor, I'm mostly looking for two things: Either try to figure out how the market could run more smoothly and profit by making it do so, or "speculate" on the overall shape of the market and try to place bets that are good if I'm right about that market shape.

For instance, the first person who connected Chicago and New York by telegraph was able to profit from any differences in price on things traded at the two exchanges -- buy at $40 in Chicago and sell immediately at $45 in New York. Thanks to your buying and selling, that difference moves closer together -- maybe $42 x $43 instead of $40 x $45 -- and you profit from making the market more efficient. Or for an example of the second: in Spring 2009 the debt for just about every major financial institution was selling for a fraction of its value; if you thought the market would survive, you could buy that debt and make a killing, because upon maturity you would receive the full value of the debt, even though you paid just a fraction for it.

I hope you're right that this is why I keep making money, but I always feel like it's just a matter of time until I get swallowed up by a combination of big institutions (who get favorable regulatory treatment) and HFTers (who are only behind in creativity, but have the overpowering long-run advantage of much faster calculating capability).

We'll be in San Diego July 9-12 I think, if you're interested in getting breakfast or something. Send me an email, because I probably won't check CGR again until I'm back in Austin.