Subprime Crisis Begins (Chart 9.1, Event 1)

Subprime mortgage specialists began to suffer losses in 2006. Their problems were widely discussed among financial experts, but major firms that bought mortgages and securities from them continued supporting their investments until July 2007. As we’ve already noted, some of the more aggressive loan originators, such as Countrywide and Washington Mutual, were then showing signs of operational stress. Yet most market participants were either unaware of these developments or unwilling to take notice of the obvious signs of danger. This lack of recognition of the obvious signs of market stress was significant because, as former Federal Reserve Bank of New York President E. Gerald Corrigan once wryly noted, the very definition of a systemic event is when markets are surprised.

That surprise came in July 2007 when Bear, Stearns revealed it would no longer support two mortgage investment funds it sponsored. People in Bear, Stearns’ mortgage group had a long history in that market. Some were at Kidder, Peabody when the 1994 crisis, triggered by increases in the Fed funds rate, exploded the toxic waste securities of Fannie Mae and Freddie Mac that hid huge amounts of negative convexity, as discussed earlier.

If experts at Bear, Stearns & Co. and other firms lost enough faith in the market to back away from losses in funds they helped create, it was clear that a lot of trouble lay ahead. Chris participated in a meeting of some of the largest hedge funds in the world during this time period and none of these firms were facing Bear, Stearns in the markets. By June of 2007, Merrill Lynch was threatening to liquidate almost $1 billion worth of mortgage securities seized from the Bear, Stearns hedge funds sending “shudders across Wall Street,” as Mark Pittman of Bloomberg News reported at the time.

To cover a default on mortgage paper sponsored by firms such as Bear, Stearns and others, many investors purchased insurance in the form of CDSs issued (or supported) by AIG Financial Products. As the magnitude of expected defaults increased, some very large-buy side entities began to question AIG’s ability to survive. Credit spreads spiked 100 basis points in a week or so. That represented a $1 trillion hit to the annual wealth-generating capacity of the U.S. economy. For the first time in years a financial crisis loomed.

Fed Reduces Discount Rate (Chart 9.1, Event 2)

As Event 1 triggered the interest rate-spread spike shown on Chart 9.1, the spread for U.S. banks (see Chart 9.3) popped up into the crisis zone (marked on all three charts). Businesses and banks were experiencing the same funding concerns. The Fed reduced the discount rate. That meant the Fed was giving banks with good assets that needed funds a right to borrow more cheaply. That right is rarely used, however, because it means a bank would disclose it was not able to address funding needs anonymously in the Fed funds market.

Chairman Bernanke and Vice Chairman Kohn both knew—or should have known—the meaning of the rise in spreads that had just occurred. Was the Fed indicating that the situation was worse than expected, or was the Fed signaling that it was having trouble understanding what caused the rise in spread? Either way, this relief led to a further increase in credit spreads. The minutes of the Federal Open Market Committee (FOMC) meeting for this period suggest that most Fed officials still did not understand just how serious was the loss of investor confidence in mortgage markets.

Fed Speeches in NYC and Berlin (Chart 9.1, Event 3)

In mid-September of 2007, Mr. Kohn made a speech in New York City that demonstrated that the Fed understood exactly what was going on in the U.S. markets in macroeconomic terms. The next day, Mr. Bernanke gave the keynote address at a Berlin gathering to celebrate the fiftieth anniversary of the post-war Bundesbank. It was a discussion of international imbalances.

Shortly after he began, Bernanke stated an equation that proved the Fed understood all the worldwide issues that led to the crisis:

National income accounting identities imply that the current account deficit equals the excess of domestic investment in capital goods, including housing, over domestic savings . . .

Bernanke, “Global Imbalances: Recent Developments and Prospects,” Berlin, September 11, 2007.

The audience included representatives of central banks and finance ministries from around the globe. In terms that are inoffensive yet obvious to any economist with international trade experience, he told the world that the United States and all the exporting nations had created a huge mortgage bubble (and muddle). By those same words, he dismissed arguments that this was just a U.S. problem.

But neither Bernanke nor Kohn then had a full appreciation for just how the market reaction to fraud and malfeasance by leading Wall Street firms would soon destabilize the entire financial system.

The cause was an accumulated international trade imbalance that every major trading nation on earth had ignored for its own national purposes. For the most part, moreover, that imbalance ($30 trillion for the United States and $67 trillion worldwide) was hidden as off-balance sheet liabilities of GSEs and government guaranteed banks, using various accounting gimmicks. The logical (indeed, axiomatic) consequence of these accumulated imbalances was enormous, but Bernanke made clear that there was no reason why a world built from the ashes of the worst war in history by forgiveness of debt (and worse deeds) could not resolve these imbalances peacefully.

Fed Reduces Rates (Chart 9.1, Event 4)

After Messrs. Kohn and Bernanke returned to Washington, the FOMC met and announced it was cutting the Fed funds target rate. This time, there was no doubt about the Fed’s actions. Investors responded by reducing credit spreads. By mid-October of 2007 it appeared the crisis was over. Investors were confident that leadership of the U.S. Fed would act, and do so properly, as the need arose.

Treasury Announces SIV Fund (Chart 9.1, Event 5)

In October 2007, Treasury Secretary Paulson made what could be the dumbest economic policy move since the Great Depression. Most errors leading to the Great Depression were, with hindsight, due to legal restraints, and not the Treasury’s fault. His announcement that Treasury would support creation of a master liquidity enhancement conduit (or Super SIV fund) was a monumental blunder. It destroyed the positive impact of the Fed’s decisive action in September of 2007 and focused investor attention on problems at the largest U.S. banks, especially Citigroup.

At the time, Citibank was literally choking on its own SIVs (off-balance sheet entities, fully guaranteed by Citibank, where it hid rampant speculation). Investors were redeeming obligations of the SIVs in droves. Paulson, being a relationship banker for Goldman Sachs and not a financial technician, probably did not think of the Super SIV idea himself. The reasons behind the Super SIV idea are consistent with the discussion in the book up to this point: namely, the SEC’s adoption of amendments to Rule 2a-7 in 1998 and the monopoly that resulted in the market for asset-backed commercial paper.

In the fall of 2007, attention became focused on specific SIVs that were unable to find buyers for their commercial paper. As these SIVs were forced to redeem commercial paper for cash, sponsoring banks were being forced (by prior agreements) to take the vehicles onto their balance sheets and recognize previously hidden losses, effectively admitting that the transactions to create the SIVs had been a sham. A number of large banks met with officials at the U.S. Treasury to craft a solution for the problem that would not force the repatriation of these off-balance sheet vehicles back onto the books of the sponsoring institutions.

The Super SIV proposal was the result. Paulson met with members of the national media in an attempt to sell the idea, but was remarkably inarticulate in those meetings. New York Fed President Timothy Geithner, who was closely tied politically to former Treasury Secretary and Citigroup Chairman Robert Rubin, also supported the plan in meetings with investors and journalists in New York.

Fred Feldkamp was traveling in France with his wife at the time of the announcement. He had logged on to U.S. business websites to see the news from home and was flabbergasted by an announcement that the U.S. Treasury would support a special investment vehicle (SIV) that would take on the losses from off-balance sheet investment gambles by Citigroup. The plan had plenty of critics, including former Federal Reserve chief Alan Greenspan, who suggested that the Super SIV could do more harm than good. That was, perhaps, the understatement of the decade. Fred relayed grave concerns to clients and correspondents.

When Treasury announced its Super SIV plan in October of 2007, in a joint press release with JPMorgan Chase, Citigroup, and Bank of America, the Federal Reserve made no comment on the plan (then or later). The fact that Secretary Paulson had not sought the endorsement or involvement of the Fed, the FDIC, and other federal bank regulators speaks volumes for the hastiness and lack of thought behind the proposal. Again, Paulson was not a banking expert by training and it seems extremely unlikely that the idea was his own, but he is ultimately responsible for assuring that whatever he proposes is credible.

By embracing this proposal, Treasury Secretary Paulson unknowingly risked doom for the entire U.S. financial system. By saying that the U.S. Treasury needed to save Citibank he was undermining the system. But, as soon as he spoke, Paulson couldn’t retract the announcement. The markets reacted badly to the concept, which could not possibly succeed. There was no legal foundation upon which the United States could absorb such losses without putting Citibank in receivership and, perhaps, invoking systemic failure provisions of a 1991 law that seemed entirely inapplicable at that point. The 2007 summer crisis was over but the crisis of that fall was, by that announcement, just starting.

In November 2008, strategist Ed Yardeni stated that “everything that [Hank] Paulson has done or endorsed has worsened the credit crisis and sent stocks reeling . . . Paulson’s Super-SIV proposal was a distraction that went nowhere. It was the first clue that he likes half-baked schemes that are hard to implement.” He then continued to list over a dozen of Paulson’s most egregious errors, including, “Letting investment banks borrow from the Fed’s discount window just after Bear, Stearns failed suggests that letting the firm go was done as a risky gesture to the principle of avoiding moral hazard, which has subsequently been thrown out the window (Pethokoukis 2008).”

The message Secretary Paulson conveyed with the Super SIV proposal was that a leading U.S. money-center bank was broke and that the top three banks in terms of assets in the United States required extraordinary assistance. Even if true, no responsible financial leader would say that without having the FDIC prepared to take over the banks that very day. Over its 75 years of receivership experience, the public procedure of the FDIC has been to never discuss a particular bank’s problems unless it has been seized by that agency.

Worse yet, officials at Citigroup seemed to be behind the proposal, further undermining confidence in the bank. By mid-December 2007, Treasury and the banks were forced to abandon the Super SIV plan and Citigroup announced it would take the $49 billion in assets held by its seven SIVs back onto its balance sheet. Revelation of this heretofore hidden leverage only increased market uncertainty and nervousness regarding Citigroup’s soundness. The use of SIVs to fund assets off-balance sheet was shown to be a sham and a pretense on the part of Citigroup, which had to accept the fact that these transactions were in fact secured borrowings and thus fraud on its face, to paraphrase Justice Brandeis.

Chairman Bernanke had settled the nervousness of the investment world by his Berlin speech in September. All of the major counterparties in the U.S. financial markets knew that Citibank had big troubles, but the bank was not having difficulty funding deposits as it relied on too-big-to-fail policies. Going forward with the Super SIV proposal would certainly trigger an electronic run by uninsured depositors at every major U.S. bank, but the damage was done.

The proposal about a year later to buy bad assets from the banks under the TARP law came from the same failed logic as the Super SIV proposal. With one brief respite in March of 2008, Secretary Paulson’s announcement began the process leading to an Armageddon that all but bankrupted the world thirteen months later.

Fed Reduces Rates (Chart 9.1, Events 6 and 7)

Twice after the Treasury’s October 2007 SIV blunder, the FOMC announced cuts in the Fed funds target rate. In each case, however, credit spreads widened, illustrating the loss of confidence and credibility that had been suffered by U.S. officials because of Hank Paulson’s folly. It was unclear to the markets who was in charge of U.S. monetary policy. If it was Secretary Paulson, then the SIV announcement proved he was dangerous. If it was Fed Chairman Bernanke and Vice Chairman Kohn, then they needed to do things more assertively than the business as usual rate cuts. After Paulson’s comments pushed U.S. credit spreads well into the crisis zones on Charts 9.1, 9.2, and 9.3, the need for even more decisive action grew with each passing day.

Citigroup Reports Loss (Chart 9.1, Event 8)

Most investors understand the accounting processes by which losses on bank loans lag their internal realization at banks. At year-end 2007, Citigroup’s losses were not of a size that came close to justifying Paulson’s SIV announcement. Investors therefore understood the Paulson proposal to mean that things were, in fact, far worse at Citibank than implied by the bank’s public disclosure. The assumption behind the Super SIV proposal, at least as explained by Treasury officials, was that the prices for mortgage-backed securities inside the SIVs were below intrinsic value, but nobody in the market believed that fiction. To believe that meant the law of compound interest had ceased to function.

Soon after the bank’s announcement, investors bid U.S. credit spreads to a level that was 400 basis points higher than when Treasury announced the Super SIV fund. Investors in U.S. markets were now seeing wealth depressed by $4 trillion per year compared to market conditions after the rally that followed the September 2007 speeches by Kohn and Bernanke.

This put the wealth effect in reverse, and in a very short period of time. More action was clearly required. In his 2014 book, Stress Test, Tim Geithner notes that this is the time when Chairman Bernanke decided history would judge him based on what would occur in the economy, not what he would wish to occur. Therefore, rather than appease doubters among his colleagues at the Fed, he decided it was necessary for him to push what he understood to be correct.

With hindsight, Mr. Bernanke’s advice, judgment, and actions proved remarkably accurate, saving the world from what might have become a worse calamity than the Great Depression and the war that followed it.

Tax Cuts Approved (Chart 9.1, Event 9)

Early 2008 was the beginning of an election year. Congress had no reason to support the lame duck Bush administration, but self-preservation prevailed and Congress cut taxes in an effort to stimulate a recovery. Economists were recognizing that the United States (and the world) faced a debt-contraction deflation scenario not unlike the Great Depression. The tax cuts helped, however, since the U.S. economy had officially been in recession since 2006. The Economic Stimulus Act of 2008 and the American Recovery and Reinvestment Act of 2009 took the federal budget deficit from low single-digits in 2007 to almost 10 percent of GDP. But even with the tax cuts, the financial crisis continued to grow, albeit at a slower pace.

After the tax cuts passed, spreads fell by more than 100 basis points, reducing the relative drag on wealth production by $1 trillion, to only $3 trillion per year. A $1 trillion per annum benefit was enough improvement in credit spreads to pay for the tax cuts, however, and then some.

ISM Service Sector Report (Chart 9.1, Event 10)

The next shoe to drop in the expansion of the financial crisis was the ISM (Institute of Supply Management) Service Sector Report of January 2008. It showed a sharper than expected contraction in the service sector of the economy. Contractions in this very large sector demonstrated what economists had feared, namely a deflationary contraction in demand. The economic problem was far larger than Congress or the Bush Administration seemed to understand. Spreads expanded after the report was released and pushed the rate of wealth contraction back up to $4 trillion per year.

Then came March 2008.

PWG Report and Bear’s Crisis (Chart 9.1, Event 11)

The first of these combined events confirmed what many suspected after the SIV announcement—Treasury (which headed PWG, the President’s Working Group) did not have a clue about what to do. If you look at Chart 9.3, you will see that spreads for banks and other high-grade bond issuers immediately rose above that chart’s crisis zone. That’s one reason Bear, Stearns found it could not fund overnight needs. It was in a state of equitable (if not legal) insolvency and many other firms on Wall Street were heading in the same direction. Buy side firms (institutions that buy investment services) were turning away from the smaller dealers in droves.

The funding crisis affecting Bear, Stearns & Co. was the first such situation that appeared to justify exercising the 1991 systemic relief authority granted in reforms enacted in response to the 1980s S&L crisis. After months of conflict, the Bear, Stearns resolution and takeover, moreover, showed that someone in DC understood what was required when a systemic failure occurs.

Bear, Stearns faced equitable insolvency when spreads skyrocketed and it needed assistance to fund ongoing debt payment obligations. The acquisition of Bear, Stearns followed the basic playbook of larger firms buying smaller failed securities dealers that goes back a century, except that (1) a federal guaranty of the dealer’s assets was needed (like those offered by FDIC in bank receiverships) and (2) Bear Stearns was not placed in receivership. That’s how Bear, Stearns’ sale revealed a fundamental flaw in the 1991 legal architecture—receivership proceedings were not available. The Bear, Stearns insolvency, moreover, was not the end of the crisis.

Helped greatly by aggressive moves by the Fed to provide liquidity to markets and specific institutions (discussed below), credit spreads fell more than 150 basis points after Bear was sold to JPMorgan Chase. Chairman Bernanke told a congressional hearing in April 2008 that the U.S. government had saved Bear, Stearns from bankruptcy because a collapse of the investment bank would have reverberated throughout the economy—increasing the risk of lower incomes, lower home values, and unemployment for ordinary Americans. Again, the worry was the very deflation that the ISM report had illustrated.

JPMorgan Chase initially agreed to purchase Bear, Stearns & Co. for $2 per share in March of 2008, but the employees and large shareholders of Bear resisted. Bear CEO Alan Schwartz had told employees that the firm’s building on Madison Avenue was worth $8 per share, so the deal started to fall apart as Bear, Stearns threatened to undo its government-supported sale and bailout by filing for reorganization under Chapter 11 of the U.S. Bankruptcy Code.

As discussed earlier in regard to concerns over the ability of subsequently appointed state receivers to undermine Fed assistance to banks before the FDIC was created in 1933, without the appointment of a receiver, bankruptcy raised the possibility of a challenge to assistance the Fed provided to JPMorgan. The threat worked. Bear, Stearns’ shareholders received $10 per share to go along with the JPMorgan purchase.

Former Treasury secretary, Goldman Sachs CEO, and Citigroup executive Robert Rubin incorrectly described the situation involving Bear, Stearns & Co as uncharted waters, in a March 2008 interview with the Wall Street Journal. The problem that arose in Bear’s situation is very well-known and fully understood by the FDIC. It has decades of experience with assistance provided (1) in bank receiverships, and (2) by experimentation with open bank assistance programs.

Unless assistance is carefully planned and implemented to eliminate benefits for shareholders and managers who conducted operations in a manner that created the need for assistance in the first place, (1) assistance that is successful will have bailed out those that caused the problem, and (2) assistance that is not successful will be seen as a waste of taxpayer money. It is irresponsible for Congress to provide means for granting government support to any firm without taking the steps needed to assure that the investment is both wise and effective.

Equitable insolvency occurs, by definition, without notice. When a firm’s equitable insolvency threatens the U.S. financial system, there is no time to analyze and assure the wisdom and effectiveness of supporting action. That could take months (e.g., the 2009 reorganizations of GM and Chrysler). Therefore, without the means for instantaneous elimination of managers and shareholders, it cannot be a long-term U.S. financial market policy to offer the Greenspan put without first placing firms that receive assistance into receivership. By U.S. law, instant elimination of managers and shareholders is only available in court-ordered receivership proceedings.

In 2010, the Dodd-Frank Orderly Liquidation Authority (OLA) resolved the problem that the Bear, Stearns situation had exposed by forcing each systemically significant entity that needs federal assistance into receivership under federal law. Payment of depositors and creditors is required before shareholders have any rights in receivership. If the federal government uses debt to bail out the entity, the FDIC serves as receiver under OLA. If it must inject capital, that investment is senior to rights of prereceivership shareholders, and managers can be replaced at will.

The OLA assures taxpayers that the government’s assistance will be repaid before anything can be paid to former owners of the assisted entity. This has been the case for U.S. banks since 1933, but the shareholders of Bear, Stearns were spared that standard receivership consequence. It is obvious from the comments of Mr. Rubin, moreover, that Wall Street executives either do not understand or remain unwilling to accept this eminently logical policy requirement. Many still complain that OLA goes too far.

In view of what was revealed in the case of Bear, Stearns, it remains one of the more surprising aspects of the post-2008 period that many observers in the world of finance and economics have still not figured out why government assistance was not available to continue the operation of Lehman Brothers. The Bush administration proved it would not repeat what happened in the Bear, Stearns resolution when it refused to compensate even the preferred shareholders of Fannie Mae and Freddie Mac when those GSEs were placed in conservatorship the week before Lehman failed.

Before the 2010 OLA, consent to total loss would have been required from thousands of Lehman shareholders to end their rights and still there would have been bankruptcy threats. Except as permitted by TARP, assistance to GM and Chrysler was only provided after the firms filed for Chapter 11. That is standard when providing major funding to troubled firms. It reduces the need to compensate shareholders exposed by Bear, Stearns (but only receivership eliminates that threat). But, then again, most people have never been involved in a bank receivership proceeding and so they do not know the difference between a receivership and a Chapter 11 bankruptcy.

Since the flaws in U.S. law that were exposed when Bear, Stearns became equitably insolvent were not yet resolved, bankruptcy was the only choice for Lehman Brothers in September of 2008. Without a statute prescribing receivership, proof of intentional fraud or outright theft would have been required to put Lehman in an equity receivership under supervision of a federal district judge. We will explain later that there was a second reason the 1991 FDICIA law allowing FDIC assistance could not be used for Lehman. Finally, since there was no collateral of assured value at the time, neither the Fed nor the Treasury would get involved when Lehman failed.

The FDIC did not have authority on its own to bail out the parent of a broker-dealer. Even though Lehman did own a small FDIC insured thrift that it used as a conduit for mortgage securitization activities, there was no means for its assistance that would have helped. In the previous two years, Lehman had tried unsuccessfully to sell itself but could not strike a deal, in part because nobody in the firm could attest to the firm’s mortgage assets. Thus, unless someone would have bought Lehman without U.S. assistance (and Barclays Bank decided it would not do so until after Lehman was put in Chapter 11 bankruptcy proceedings), the only choice facing Lehman management (and the firms’ creditors) was Chapter 11, with SIPC (Securities Investor Protection Corporation) as its designated trustee for customer accounts.

If a systemically important financial firm is assisted in the future, the FDIC will be named receiver for the firm. The government’s priority status is then assured and shareholders will get nothing until all investments by government and other creditors are paid in full. Thus, to those who understand the difference between Chapter 11 and FDIC receivership and agree with the process, Dodd-Frank does not permit future bailouts. The financial system can be saved by preventing failure of one firm in triggering the loss of many other firms, as we do with insured banks Those who consider any intervention—even to save the system—a bailout, however, do not perceive Dodd-Frank as solving the problem.

Fed Announces the PDCF and Reduces Rates; GSE Relief (Chart 9.1, Event 12)

Just days after the acquisition of Bear, Stearns & Co., the Fed put in place the Primary Dealer Credit Facility (PDCF). This was an overnight loan facility that provided funding to primary dealers in exchange for a specified range of eligible collateral and was intended to foster the functioning of financial markets more generally. The PDCF began operations March 17, 2008, and was closed February 1, 2010. Had the facility been in place just a few weeks earlier, the sale of Bear, Stearns & Co. to JPMorgan Chase might not have been necessary.

The Fed also substantially lowered interest rates and put in place other credit facilities to address the wholesale collapse of the institutional credit markets. By this combined package, the Fed used emergency lending authority to extend relief beyond banks in the form of a credit facility to make loans against collateral pledged by any primary dealer. At the same time, the FOMC announced a further rate reduction and relief to assure the continuing function of the government’s troubled mortgage GSEs, Fannie Mae and Freddie Mac.

By these actions, it was clear the Fed knew the crisis extended beyond the banking system. Finding some way to reduce spreads in mortgage markets was necessary.

Fed Announces the TSLF (Chart 9.1, Event 13)

Though not yet willing to reduce mortgage spreads by direct investments in mortgage securities, the Fed’s Term Securities Lending Facility (TSLF) made clear that the Fed understood that without a vibrant mortgage market the nation faced a serious risk of long-term deflation. Under the TSLF, the Fed offered Treasury securities held by the System Open Market Account (SOMA) for loan over a one-month term against other program-eligible general collateral. The TSLF was announced on March 11, 2008, and the first auction was conducted on March 27, 2008. The TSLF was closed on February 1, 2010.

Via the TSLF, the Fed agreed to lend Treasury securities based on pledges of GSE mortgage-backed securities to dealers for terms during which the dealers could exchange Treasury securities to raise money to purchase more mortgage-backed securities. Spreads in mortgage markets responded favorably.

After the steps taken by the Fed described above, corporate bond credit spreads fell by a bit less than 200 basis points and stabilized until June of 2008.

Treasury Questions Fed Emergency Power (Chart 9.1, Event 14)

By June it seemed possible that the beneficial effects of the Fed’s actions had begun to stabilize U.S. credit markets. Credit spreads were still well into the crisis zone on Charts 9.1, 9.2, and 9.3 but had come down significantly. Yet due to the widespread panic in the markets and also among the public, spreads remained considerably higher than they were when Secretary Paulson announced Treasury support for the Super SIV fund, a move that could only be legitimized by an emergency.

One might have thought that in the wake of the Treasury’s abortive attempt to float the idea of a Super SIV fund, the agency might have learned a lesson in humility. Nevertheless, Treasury publicly questioned whether the Fed could continue exercising its emergency powers. The short-term effect of this public statement by Treasury was a flight by investors that had bought securities of GSEs and primary dealers, in partial reliance on the Fed’s March actions described above.

Corporate bond credit spreads quickly shot back up to where they were when Bear, Stearns failed. Investors, therefore, answered Treasury’s question. They sold enough bonds to assure that an emergency still existed. This action of the Treasury, and the market reaction, opened the path to even more dreadful events in September 2008.

Treasury Introduces Covered Bonds (Chart 9.1, Event 15)

Not content with its failure with respect to the Super SIV fund and by questioning the Fed’s emergency lending operations, the Treasury under Hank Paulson came up with yet another dumb idea: using covered bonds to finance home mortgages.

The proposal was not well considered, and further eroded confidence in U.S. Treasury officials. Former Treasury secretary Lawrence Summers noted in the Financial Times on November 2, 2011: “[D]ubious assertions by policymakers end up undermining confidence. Like the 13th chime of a clock, policymakers who deny the obvious or claim to know the unknowable call into question all that they say.”

Paulson’s covered bond proposal ultimately went nowhere on Capitol Hill. Not surprisingly, coincident with the appearance of the covered bond proposal, credit spreads soon rose (for the first time) above the crisis zone on Chart 9.1

Covered bonds are securities that are secured by a specific pool of mortgages, known as the cover pool, but remain on the books of the financial institution. In that sense, covered bonds are different from an MBS in that the collateral is not sold by the sponsor to another entity prior to the issuance of securities. Covered bonds have worked to finance mortgages in nations such as Germany and Denmark using a collective system of mortgage trusts that are still part of the issuing banks. By these arrangements, issuers guaranty repayment of bonds secured by mortgages when the bond terms to maturity do not match those of underlying mortgages. Providing this type of guaranty requires credit controls like those of the 1930s, controls that have historically proved unworkable in the United States (see our earlier discussion of what occurred during the 1960s). The U.S. economy and mortgage market is too large and diverse for such a vehicle to be successful.

Using covered bonds requires that banks guarantee reinvestment of early mortgage payments (so they will support later bond payments) and that bond payments that are not made from mortgage proceeds (due to unexpected delays) will be funded by the bank’s payment of the bonds from other funds. We’ve seen that GSEs can do this in the United States, but private-sector entities that are not insured by the government cannot. Thus, covered bonds create a more entrenched government monopoly of mortgage credit.

The covered bond proposal was just another path to a government-bank financial monopoly, in this case proposed by Hank Paulson, the former CEO of Goldman Sachs. The large banks supported the proposal on Capitol Hill, where it was championed by Rep. Scott Garrett (D-NJ). But FDIC Chairman Sheila Bair made clear that the agency opposed the proposal, because in the event that the issuing bank failed, covered bonds might ultimately increase the cost of a collapse to the FDIC’s insurance fund. In a conversation between Garret’s staff and a member of the Bair kitchen cabinet, it was made clear that the FDIC would not tolerate legislation that allowed assets other than residential mortgages in any legislative proposal sponsored by Garrett and his supporters. The FDIC also stated unequivocally that a covered bond could only have a 2 percent overcollateralization rate, meaning that only prime mortgages would be allowed.

The United States has a much more active credit environment than Germany and other Northern European nations, where covered bonds are used. Some U.S. enterprises (largely in New York) issued bonds in this form before the Great Depression and just about all of the issuers went broke. That’s why participants in private-sector U.S. mortgage markets (i.e., non-GSEs) promise only to pay bonds from proceeds of the mortgages as they are received. It is economically and financially impossible for a private issuer to guarantee the payment of principal and interest on the bonds if the underlying mortgages prepay less rapidly than planned because interest rates have risen. Indeed, the notion of converting GSEs into issuers of covered bonds had such an adverse effect on market confidence that the GSEs were pushed into conservatorship within a couple of months after Paulson’s proposal.

GSE Conservatorship (Chart 9.1, Event 16)

On September 6, 2008, the director of the Federal Housing Finance Agency (FHFA), James B. Lockhart III, announced his decision to place two government-sponsored enterprises, Fannie Mae and Freddie Mac, into conservatorship. The run on collateral and liquidity that had begun in 2007 with the closure or failure of nonbank mortgage issuers (such as New Century Financial, Freemont, and Ameriquest) and continued with Bear, Stearns had finally run up the credit ladder to the GSEs.

This event intensified and expanded the 2007–2009 financial crash. The significance of the conservatorship of the GSEs is clear from a puzzling difference in market reactions shown by Charts 9.1 and 9.3 The spread on Chart 9.1 actually fell (roughly 50 basis points) for a few days after this event.

Generally, that would be a $500 billion gain for the economy. That change in spreads made no sense, however, so Fred started asking questions of people in Washington, DC.

As part of the conservatorships, all GSE preferred stock would have to be written off. It seemed the Treasury wanted to show investors that the United States would not make another mistake like the one that gave Bear, Stearns’ shareholders $10 per share before repayment of U.S. assistance. So, the Treasury decided to discipline investors that bought the GSEs’ preferred securities.

While it can be argued that the private investors were really superfluous to the financial soundness of the GSEs, which ultimately required the backing of the U.S. government, the timing of the Treasury’s actions was once again unfortunate and served to damage market confidence even more. Many of the holders of GSE preferred securities were other financial institutions, which now had to write down these investments to zero. The decision by Secretary Paulson was the equivalent of firing a gun before removing it from the holster and thereby shooting off your foot.

Holders of GSE preferred stock included U.S. commercial banks that had been allowed by regulators (that report to the Treasury, of course) to use the stock as primary capital. Treasury’s attempt to restore market discipline caused loss of commercial banks’ capital at precisely the wrong time. Those securities were capital backing for $1.6 trillion of loans by banks to U.S. consumers and businesses.

Chart 9.3 shows the consequence: spreads for high grade bonds of banks jumped by a record amount compared to 10-year Treasury bonds. The graph line on Chart 9.1 fell only because banks’ funding costs zoomed up far faster than more risky high yield corporate bonds. The write-off of GSE preferred stock approved by the Paulson Treasury triggered a run on the bonds of high grade banks. Banks’ bonds were soon trading at higher rates than when Bear, Stearns was forced out of business. Moreover, to make up for the lost capital, many banks began shrinking their assets by demanding repayment of otherwise well-performing commercial loans to U.S. businesses.

The GSE conservatorship, therefore, triggered a classic bank run.

Events of the following weeks, including the failure of Lehman Brothers and the government rescue of AIG, are the ones most people remember from that period and are the events that led to TARP. But it was the elimination of the GSE preferred stock, we believe, that caused the spike in credit spreads which ultimately destroyed Lehman and nearly wiped out every corporate debtor in the United States. Once again, Hank Paulson proved that during 2008 he was the chief source of instability in the U.S. financial markets. History may prove otherwise, but after the fall of the GSEs it seems that the Paulson Treasury decided it should get out of the way of the Federal Reserve Board and let Ben do it.

Better late than never.

Lehman Chapter 11 (Chart 9.1, Event 17)

On the next Sunday following conservatorship of the GSEs, Lehman Brothers filed for Chapter 11. Unlike the collapse of Bear, Stearns before Lehman, and the AIG situation after, there was no systemic failure relief for Lehman. The only reason given to distinguish the assistance given Bear, Stearns and AIG, but not Lehman, was that assisting Lehman was illegal. The reality, in terms of the market, is that the failure of Lehman was unexpected and thus accelerated what had started with the GSE conservatorships and eventually became the largest systemic event since the bank holiday of 1933.

In addition to the matters discussed above raised by the Bear, Stearns transactions, the 1991 FDICIA established a specific process to make any such assistance legal. No responsible entity starts an approval process for something like this if the process cannot be finished. Therefore, the Treasury, the Fed, and the FDIC (all of which must act to make the assistance legal) certainly conducted research to learn what would be required to obtain all requisite approvals before taking the first step in that direction.

The law says two-thirds of the Board of Governors of the Federal Reserve System and of the FDIC’s board of directors must approve assistance. After that, authorization must be given by the Secretary of the Treasury of the United States upon consultation with the President of the United States. Nothing in the law authorizes delegation of that authority in the event of a conflict of interest.

Even if the FDIC and Fed had approved assistance for Lehman, Secretary Paulson and President Bush both had relatives who worked at Lehman. Short of resignations at the highest national level (which could have proven disastrous at that point), therefore, it would be hard to see how any authorization process to legally assist Lehman could proceed to conclusion. Two of the essential approvals required action by persons with a conflict of interest. If an action cannot be completed, the best legal advice is to take no action and declare illegality the reason. Between the lack of clear authority in the law for a government receivership of a nonbank firm and these personal conflicts, it seems that no action was the only course available.

In several respects, the failure to fund Lehman belongs in the same category with inability of the Fed to follow Bagehot’s dictum between 1929 and 1933. The 1991 FDICIA law did not provide for the receivership process by which the 1933 FDIC law overcame risk that any assistance to Lehman could later be challenged. Moreover, Congress demanded presidential consultation and Treasury secretary authorization under the 1991 law before there could be assistance to Lehman. In each case, the hurdles could not, it appears, be overcome. So, assistance by Treasury or a takeover by the FDIC was illegal under the laws that existed at the time. And, interestingly enough, Lehman apparently could not borrow from the Fed based upon good collateral.

The arguments made by members of the economics profession that Lehman should not have been allowed to fail miss this key point. For reasons of the law and also personal conflict, the firm could not be saved. Only persons that do not deserve our trust act contrary to the rule of law. When a law bars action, leaders must suck it up and move on to find other means for attaining a goal.

The sad conclusion seems to be that the Treasury, through the missteps we have discussed above during 2008, accelerated the crisis and ultimately made the sale or salvation of Lehman Brothers impossible. Treasury Secretary Paulson should have cooperated with (and supported) Chairman Bernanke much more forcefully and much earlier in the crisis. Such cooperation might have prevented the collapse that followed Lehman’s bankruptcy. But when looking at the narrow question of whether the U.S. government could save Lehman Brothers in September 2008, if the above analysis of actions in response to the Lehman situation is correct, Messrs. Paulson and Bernanke and the other regulators have our praise. They made the required decision, disastrous as it may have been.

Lehman’s bankruptcy had a disastrous effect on the world. It triggered (1) the loss of AIG within three days, (2) the insolvency and rare emergency seizure of Washington Mutual (WaMu) by Thursday of that week, (3) forced sale of Wachovia Corp. a week later, and (4) the biggest financial crisis in world history within 60 days. The impact was so disastrous, however, that it forced the United States to take actions that saved the world from financial ruin within six months. More than five years later, the problems caused by the Lehman surprise persist. But that’s because the problems, even in hindsight, were far worse than almost anyone believed at the time.

In the 60 days after Lehman fell, further adverse credit spread trends tore another $10.5 trillion from the annual growth capacity of the U.S. economy. The world faced a $67 trillion hole in the accumulated balance sheet of worldwide wealth caused by the creation of fraudulent securities. About half of that wealth was destroyed before the bleeding ended. But most important, by the cooperative efforts of two presidents and some truly remarkable leadership at the Fed, the worldwide bleeding of economic capital ended quickly. Investors have now enjoyed several years of recovery.

Unlike the mistakes that led to the Great Depression, world leaders have, for the most part, not fanned the flames of world war. While there are people and nations in very bad economic circumstances at the moment, there are signs of recovery (and new bubbles) sprouting in many places around the world. It is only by continued benevolence and empathy that the world will fully recover. Let’s now finish the path to Armageddon so we can get on to some overall comments and discuss the resurrection and recovery phases of the crisis.

G-7 Nationalization cum Monetization (Chart 9.1, Event 18)

From Lehman’s filing until the G-7 nations acted in concert to effectively guarantee the entire remaining financial market, spreads zoomed up in a manner that has never previously been observed in real time. Chart 9.3—bank spreads—displays a near vertical climb from the GSE takeover to this point. Between September 6 and the beginning of October, Treasury Secretary Paulson devised yet another ill-considered scheme, the Troubled Asset Relief Program, or TARP. Like the abortive Super SIV proposal authored by the Paulson Treasury, the idea behind TARP was to somehow purchase bad assets from banks—an idea that was yet another nonstarter. Neither Paulson nor the senior career officials at the Treasury apparently understood that having the U.S. government buy bad assets from the commercial banking industry was legally and financially impossible.

Not only was it functionally impossible for the Treasury to actually purchase these assets from private banks under current law—a reality that only became clear just before President Bush left office—but once again the Paulson Treasury was signaling to the markets that there was an immediate problem with the largest U.S. banks when in fact none existed. Ed Yardeni again comments on Paulson’s missteps in 2008:

As a method for buying “troubled assets,” TARP was a bad idea. By inciting a panic, and sending the global economy into a tailspin, however, the law passed because it became essential. Claiming that the Treasury could purchase one-of-a-kind troubled assets in reverse auctions made no sense. The RTC [Resolution Trust Corporation] solution to the S&L crisis of the early 1990s won’t work to end this crisis.

Richard Kovacevich, chairman of Wells Fargo from 2001–2009, vociferously objected to the TARP proposal and confronted Paulson and Federal Reserve Bank of New York President Timothy Geithner after the legislation eventually was passed by Congress. Kovacevich castigated Secretary Paulson in a January 5, 2012 interview with the PBS program Frontline and illustrated why the approach by the Federal Reserve Board was far superior to the proposals by Treasury:

I have no issue if a financial institution needs money. It’s not bankrupt, it’s not failing, but it’s got liquidity issues. It can be rescued; it can give back. If the government wants to give money to a financial institution to get them through a crisis, to make sure the crisis doesn’t expand, they need the money, I have no issue with that. That’s been done a lot over a long period of time. My objection was that if you give it to people who are perceived not to need it, it’s going to destroy confidence in the industry; it’s not going to restore confidence in the industry. And that’s exactly what happened. They exacerbated the panic.

Mr. Kovacevich is an outstanding banker who demonstrated extraordinary confidence in the U.S. power to recover from the crisis when he outbid an FDIC-backed package to acquire Wachovia Corp. His bank is primarily a West Coast firm, however, and his comments on the need for capital infusions were not shared by colleagues on the East Coast. In hindsight, the capital infusions had the effect of calming investors to such a degree that they were a key turning point in the crisis.

As the Fed and Treasury struggled to fashion a reasonable response to the crisis, events continued to unfold. It was early October when Wells Fargo announced the competing proposal to purchase Wachovia Corp. that did not require assistance from the FDIC. That same day, Congress passed the Emergency Economic Stabilization Act, which provided the legal authority for the Treasury to spend $700 billion under the TARP program. Three days later and perhaps more significantly, the Fed relied on the same law in announcing that it would pay interest on depository institutions’ reserve balances. The Fed also put in place another emergency facility for commercial paper.

There was one sharp upward spike in credit spreads when Congress initially rejected TARP and one enormous recovery when Congress approved TARP. The TARP originally proposed by Secretary Paulson soon proved senseless. Just about everyone came to a conclusion that there was no possible way to extract enough of America’s troubled assets from their deeply embedded positions for a troubled asset relief program to work. Weeks went by during which officials at the Treasury tried in vain to make the asset purchase model workable. Credit spreads immediately resumed an unprecedented upward path toward the destruction of everything in finance that we hold dear (and essential for a functioning economy).

While the Paulson Treasury was struggling to fashion a reasonable approach to the crisis, the Fed did the only reasonable thing it could and provided liquidity to the markets in vast and increasing amounts. On September 19, 2008, the U.S. Treasury announced the establishment of a temporary guarantee program to protect shareholders of money market mutual funds—and on September 29 officially opened the program to eligible money market funds. By no coincidence, the FDIC announced the emergency increase of federal deposit insurance to $250,000 from $100,000 and blanket coverage of all transaction accounts via the Transaction Account Guarantee Program. The Fed also was deeply involved in the rescue of AIG in the early days of October, adding still more liquidity to the system during those terrible days.

By the middle of October 2008, Paulson and Bernanke moved to the only economic solution that works: nationalization cum monetization. Since all money originates with the government, when the system falls apart government needs to step in and take over the means of monetary intermediation. Government must temporarily fill the hole generated by a crisis to prevent all of the private capital in the system from being consumed. Once confidence returns, it must then turn the intermediation process back over to the private sector. In specific terms, the Treasury changed plans and decided to make investments in banks to shore up their capital rather than attempt to purchase bad assets from these banks. That same day, the FDIC provided yet another significant liquidity facility for uninsured deposits that again helped to reassure businesses that their funds would be safe in America’s banking institutions.

Nationalization cum monetization is the only known process that works in these situations, and it did in this one. Markets confirmed that it worked by another huge recovery in spread following the actions by the Fed and other G-7 central banks. The credit spreads shown on Chart 9.3 finally began to decline. One last issue, however, required resolution before the graph lines on Chart 9.1 would confirm those on Chart 9.3.

U.S. Election Day (Chart 9.1, Event 19)

Between the G-7 nationalization of major financial institutions and the U.S. election, it became clear that Mr. Obama would win. Investors in the United States have (perhaps with good reason) grown insecure whenever one political party holds all the levers of power in Washington. That election gave the presidency and control of both houses of Congress to Democrats. Obviously, people didn’t want the GOP to continue to have power, but did they really want a political monopoly for Democrats? Both parties are equally disparaged by a large portion of Americans.

Investors did not know what that election result might do to our financial system. For reasons discussed above, investors don’t like the financial system that created the subprime crisis. But most Americans likewise understand that we cannot revert to the Depression-era model of government control that caused an 87 percent contraction in business and consumer lending between 1929 and 1955, and helped create the Great Inflation (and contraction) of the 1970s and 1980s. Therefore, because of this basic uncertainty over economic leadership, credit spreads were to skyrocket one more time.

Obama Economic Team Announced (Chart 9.1, Event 20)

On November 20, 2008, President-Elect Obama announced the proposed heads for several financial service areas of the new administration and his White House economic team. Sheila Bair would stay as FDIC Chair. Mr. Bernanke was praised at the Fed. Tim Geithner was selected as Secretary of Treasury and Larry Summers was to be an advisor to Mr. Obama. In effect, the status quo was confirmed both with respect to economic policy and also defense, where President Bush’s Defense Secretary Robert Gates agreed to stay on and did not even require confirmation by the Senate.

Lots of people have said lots of things, good and bad, about each of these selections. It is only the reaction of investors, however, that really matters, and investors primarily means bond buyers. If bond investors like what the United States is doing, they vote by investing more money in the United States and spreads fall (and vice versa when they dislike something). Confirming more than twenty years of day-by-day observation by Fred, when bond spreads fall, equity markets and the economy rise (and vice versa when they rise). This follows because the law of compound interest works.

That investors approved was soon clear. From the date of Mr. Obama’s announcement to his January 20, 2009, inauguration, the corporate bond spread on Chart 9.1 fell more than 750 basis points, a $7.5 trillion boost to the annual wealth-generation potential of the U.S. economy. A long road to recovery lay ahead, but the United States and worldwide financial system was resurrected in the 60 days after November 20, 2008.

AIG: One More Event from 2008 and a Math Footnote

Absent from the above list of events is the bailout of AIG that began a few days after Lehman’s bankruptcy filing. AIG’s failure did not change the course of credit markets—those markets were already plummeting at the fastest rate anyone had ever seen (for reasons explained above). AIG, however, represented the largest accumulation of toxic waste in the U.S. generated by all the bad policy judgments made since 1998 and so is worth discussing.

AIG Financial Products (AIGFP) was founded in 1987 by three Drexel Burnham Lambert traders and led by financial scholar Howard Sosin. They convinced AIG CEO Hank Greenberg to branch out from his core insurance business by creating a division focused on complex derivatives trades that took advantage of AIG’s AAA credit rating. Significantly, Sosin brought two other DBL bankers, Thomas R. Savage and Joseph Cassano, along with him. ⁴

Much of the activities of AIGFP were largely the creation of Tom Savage’s math genius. He became CEO in 1988 after a career at First Boston and DBL. He wrote many of the algorithms that allowed the creation of stand-alone CMOs. He understood the complexities of insurance, securities, and derivatives in ways that few do. During much of the period that Savage ran AIGFP, it seemed clear to most observers who dealt with the firm that its aggregate liabilities (whether measured today, 40 years into the future, or at any point between) would always be far less than its aggregate assets and that its cash flows would always be favorable by every conceivable measure.

Savage decided to retire in 2001 at a young age to take up passions in life other than math. When he left, AIGFP had over $500 million in revenue and was a major profit center for AIG. A couple of years before he left, however, Savage gave the green light to Cassano to start writing insurance on the default of bonds issued by JPMorgan. Using the work of a Yale professor named Gary Gorton, AIGFP wrote default protection on these securities on the assumption that the likelihood of a payout was remote because the money center bank was too big to fail.

The involvement of AIGFP in credit default insurance accelerated and expanded significantly after the departure of Savage. Not content with the pedestrian growth profiles of underwriting property and casualty insurance and investing the proceeds, AIG made a decision to chase revenue and earnings growth by moving up the risk curve in all types of CDSs after Cassano replaced Savage. For example, AIG wrote default insurance on collateralized debt obligations (CDOs), then purchased the senior and subordinated tranches of the same security. Specifically, AIG went from the low-beta, low-growth world of underwriting real-world risks (such as ships sinking and hurricanes) to the high-beta world of financial products.

According to a schedule prepared by Goldman Sachs for the Financial Crisis Inquiry Commission (detailing trades on its notorious Abacus synthetic CDOs), AIG bought subordinate tranches of Abacus 2005-3, Abacus 2005-CB1, and Abacus 2005-2. The other big investor in the subordinated tranches was Goldman’s own CDO desk.

Writing insurance on the default of a corporate or mortgage bond or an executive facing a shareholder lawsuit are risks that are highly correlated to the financial markets, while writing risk on a ship sinking is uncorrelated to the markets. Going back to the founding of the Lloyds of London insurance market, writing insurance was seen as a natural hedge by farmers whose primary activity was agriculture. Hank Greenberg, the managers of AIGFP, and the board of AIG made the fundamental error of thinking that writing risk on loan or bond defaults, or other highly correlated risks, was nearly as profitable in risk-adjusted terms as simply writing insurance policies. In fact, even though AIGFP was reporting impressive revenue and earnings, it was actually losing money when measured against the risks taken.

In a September 2008 interview in the Institutional Risk Analyst, Robert Arvanitis of Risk Finance Advisors, who worked at AIG during its heyday and then at Merrill Lynch, described the monumental error in judgment committed by AIG as well as other insurers in chasing high-beta financial risk:

Low beta is uncorrelated, non-market risk. This is the type of risk that insurers used to price the sinking of ships, hurricanes. Nonmarket, uncorrelated risks. Now 300 years before Harry Markowitz, landed English gentry instinctively realized that their money came from land rents and crops, so they put some of their money to work by investing in Lloyds of London. If the crop was good this year, but a few ships sank, you made money on crops and lost on ships. The next year, the crops were lousy but no ships sank, so you made money on insurance. Lloyds was the insurance industry’s first effort at diversification and they stuck to their knitting and underwrote real-world risk events like hurricanes and fires, which were uncorrelated to other markets. The insurance industry grew out of its crib and now does more and more underwriting in high-beta risks. They sell liability insurance, D&O coverage, surety, and, good lord, they even get into bond insurance. CDS is a bridge even further removed from the basic, low-beta model from which insurance comes. The risk taken by insurers is more and more high beta, and by doing so they spoiled a perfectly good racket.

By virtue of its perceived success in writing CDSs, AIGFP filled a void in terms of providing liquidity to the financial derivatives markets—it became the market maker for unregulated derivatives trading in contracts that nobody else wanted—and also took a lot of financial and liquidity risk that neither its traders nor its managers understood. In effect, AIG became a one-firm clearing house for a whole class of CDS contracts that were not well understood on Wall Street. Generally, a clearing house must be regulated because it is where all incomplete trades of any participant in a market will end up when the participant becomes insolvent. Without the power of a federal receiver to sort out the trades on behalf of innocent creditors, any clearing house can be driven broke if it makes even one small error (in finance, any error can morph into an overnight nightmare).

AIGFP’s master craftsmen thought that they understood the problems and how to protect the firm. Almost nobody, however, could anticipate what would happen as CDS investors and the dealers who trade in these unregulated insurance contracts began to gang up on less sophisticated players. AIG thought it was a dealer in CDS, but in fact is was a retail customer at the mercy of derivatives dealer banks like JPMorgan and Goldman Sachs. It belonged in the same category as the mortgage issuers that originated and sold securities backed by dumb and dumber loans to mercantilist exporting nations and other sucker bond buyers. Those risks, moreover, related to long-term assets: meaning portfolio growth necessarily masks the extent of deferred risks. It took years for the risks of Drexel’s 1980s junk bond monopoly to mature. When it did, the risk was more than 15 times as great as initially estimated.

If that wasn’t bad enough, AIGFP’s parent firm, AIG, was structured so that all its units had access to cheap money by a joint and several guaranty that allowed each unit to finance at AIG’s valued AAA rating level. It was an idea that was “very good indeed” when times were good. In bad times, however, that idea proved “horrid.”

In the rating game, an airplane example is used to differentiate good and bad corporate structures. Each unit within the enterprise is an engine. A plane with two is safer than a plane with one if either engine can lift the plane. If both engines are required, however, two engines are more risky than one (because there is twice the risk of failure). In fact, all of the insurance units of AIG had cross-guaranteed one another and were infected by the CDS default risk of AIGFP, meaning that the firms could not be broken without catastrophic results. When AIGFP flipped, from an engine that lifted everyone to one that could not do so, this cross-guarantee caused everything to collapse at once.

The day after Lehman failed, Fred was asked by someone from Washington, DC, who was participating in these market events why the government should save an insurance company that’s not federally regulated. Knowing the likely CDS exposure of AIGFP at that point (every U.S. credit, all the way up the quality ladder to GE, was at risk of being unable to pay short-term debt, necessitating bankruptcy), if AIG was the entity at risk, the reason to fund it through the crisis was clear. Without saving the CDS clearing house on which everyone relied every participating member is likely to fail. Going back to Bagehot’s dictum, AIG deserved punishment for being supremely stupid, but the cost of any punitive action to the rest of the market was prohibitive. Moreover, the AIG joint and several guaranty among entities drove the risk of AIGFP into each and every insurer AIG owned. Fred said federal assistance was probably the only option.

Due to AIG’s enormous size, international spread, and intercompany guaranty agreement, failure to fund AIGFP would likely bankrupt all of AIG’s many affiliates and force the insurance units into state receiverships, under which protecting policyholders was the first concern. That in turn would likely result in bankruptcy for just about every large bank, broker, and insurance firm in the world, without regard to whether they were active counterparties to AIG.

Unlike Lehman, AIG had plenty of good collateral to offer and presented no conflict of interest. Nothing could be done to prevent Lehman’s failure. Bagehot’s dictum, however, certainly justified becoming a lender of last resort to save AIG. Doing so prevented a spread of the run that Lehman’s bankruptcy and the GSE conservatorships triggered to all the areas, worldwide, where AIG had relationships.

What would it have cost to let all those entities fail? Let’s turn to Table 9.1.

Each of the 12 boxes within Table 9.1 reflects the total wealth (upper left) and equity (lower right) implications for different bond market scenarios. Across the top are three assumptions for the base rate (the rate for risk-free U.S. debt). Along the left side are four spread assumptions. The top-center box shows the approximate total wealth (stocks and bonds) of the United States in 2005 ($100 trillion) and the amount of that wealth represented by equity (about $50 trillion).

Markets in 2005 were as close as we’ve come to a complete market, in which 10-year Treasury bonds sold at about 5 percent rates and spreads were low (estimated in footnote 2 of the table).

Applying reverse math to total wealth and total debt in 2005, we can calculate the level of annual cash flow that supports that level of wealth. We can then use the same cash flow to calculate the eleven other boxes using different base rates and spread assumptions.

The results correlate with expectations reflected in markets and observed in day-by-day analyses since 1998 (and reverse analysis back to 1987). While equity markets did not hit bottom until March 2009, investors likely perceived that the Fed would push rates to 0 percent, if necessary, by late November 2008. Using that as the base rate and adding spreads observed in November 2008, total wealth was going down 25 percent (to $75.4 trillion).

Since $50 trillion of debt would have first dibs on that wealth, the equity component of total wealth would be seen by investors as declining about 50 percent, to $25.4 trillion.

Table 9.1 also shows what the impact would have been if the deflation scenario solution used early in the Great Depression had been chosen by the Fed in 2008. If rates had been pushed up to 10 percent to support the dollar (or whatever reason may have been argued to justify this step), the table shows that application of the formula for compound interest pushes 2005 total wealth down to $53.5 trillion and 2005 net equity down by 93 percent, from $50 trillion to just $3.5 trillion, a rate of decline consistent with the Depression-era experience.

In 1933, Irving Fisher, considered by many observers to be the greatest U.S. economist of all, analyzed what amounts to a deflation solution of liquidating bad debt. He compared it to a physician who recommends that a pneumonia patient do nothing and let the disease run its course. Sadly, some doctors elected to Congress seem to advise economic solutions of this type.

If AIG had been allowed to die and spreads rose by a few hundred more basis points as a result, Fisher’s 1933 prediction of total worldwide bankruptcy could have come true. The equity of the global economy would have been consumed, leaving no foundation upon which to rebuild. Of course, like J. Pierpont Morgan and Henry Ford in their day, those who advocate the liquidation of bad debts (as occurred in the 1930s) would have sold every investment other than cash before implementing the advice. Henry Ford, when confronted by representatives of the Hoover Administration early in 1933, dismissed their warnings about the effect of looming bank failures and merely said that he would rebuild on his own. As a result, the likes of Morgan and Ford alone would have money and could buy up everything as everyone else went broke. But, then again, maybe that’s the reason they urge an otherwise insane course of action.