10 Years Out: What’s with the Bear in the Middle?
[NB: Check the byline — it’s me, Rayne. I am not a registered financial representative or a lawyer; this post is based on my own observations and opinions. As always, your mileage may vary.]
On a chilly March evening ten years ago tonight, I was yelling at loved ones: Sell. For gods’ sake, SELL.
My own household had moved its investments from a number of mutual funds to guaranteed income. Every fund in the portfolio to that point contained a chunk of an investment bank and was therefore exposed to what I felt was sure to come.
It was obvious to anyone who was really paying attention that something was really off. Trying to buy a house in 2004 was almost impossible where I live, in spite of the ongoing migration of manufacturing jobs offshore. In the target price range for a 2000-square foot house, there were only a handful of homes listed and they all needed more than $50K in improvements. The nearby farmers’ fields were full of a new crop: single-family homes, mostly 3-bedroom and up, had eaten acres and acres in less than a year. It was insanity — there was no way this pace could be maintained, not with my state’s problematic over-reliance on the automobile industry.
Instead of buying an existing home, I built a new one. It didn’t make sense to spend $50K on improvements requiring a lot of construction if I couldn’t guarantee I could hire a contractor when new construction was so hot. I didn’t build in the top end neighborhood, either. I left myself some room in case I had to leave the area quickly for a new job; I also left room for the market to improve.
Except it didn’t. The last landscaping contractor must have pulled away from my new home in 2005 just as the bubble began to deflate. There were signs it was going to get worse, too, what with fuel prices skyrocketing. Banks increasingly offered crazy terms on mortgages just so they could something, anything, not taking the hint the market was saturated. Given the number of people relying too heavily on adjustable rate mortgages with ridiculously low entry rates, the increased gasoline price costing the average family more than $1000 a year was certain to cause credit card defaults and foreclosures.
Something ugly was coming.
~ ~ ~
In March 2008 — almost exactly a month after the Washington Post published an op-ed by New York’s then-Governor Eliot Spitzer exhorting action on subprime mortgages — 85-year-old American investment bank Bear Stearns crashed and burned.
After urgent, fancy foot work by the Federal Reserve Bank, J.P. Morgan and other key investors, settlements were made with bail out money and remnants of the firm were ultimately snapped up by J.P. Morgan for what amounted to the cost of Bear Stearn’s headquarters building, about $2 per share. By St. Patrick’s Day, Bear Stearns was no more, completely subsumed.
It would be another six months before the next large investment bank crashed — Lehman Brothers — taking the global economy with it.
~ ~ ~
At the time the crash was blamed on lax controls on lending to home buyers, encouraging an excess of subprime mortgages, combined with investment banks’ more recent taste for collateralized debt obligations bundling mortgages into tranches for slicing up and trading.
But not all of the trash loans were residential mortgages stuffed into tranches. Some of the loans were to developers and contractors who were building commercial facilities and multi-family buildings. Some of these loans were packaged into funds which were more like offshore corporations.
The two funds triggering Bear Stearns’ meltdown were just that: offshore funds incorporated in the Cayman Islands in 2003, holding various assets including tranches of poorly-collateralized mortgages, managed by Bear Stearns Asset Management (BSAM). What mortgages were in these two funds the public doesn’t really know; were they single-family residential mortgages or commercial facilities mortgages, or some combination? The information is out there somewhere but it’s not at the public’s fingertips.
The financial media still paints a messy picture even a decade later, blaming Bear Stearns management but not its own persistent failure to provide a more comprehensive and accessible picture of the financial industry’s health.
These two funds collapsed because too many mortgages within their CDOs failed; the effect on the bank was like pulling out two critical load-bearing pieces in a game of Jenga. The cascading demand for cash to resolve the failures may have pushed other investment banks’ equally sketchy funds to fail as well, crashing the entire heap nearly a decade ago.
~ ~ ~
It was a surprise blast from the unpleasant past to see Bear Stearns’ name pop up in the middle of recent testimony before the House Permanent Subcommittee on Intelligence. Fusion GPS’ Glenn Simpson cited the investment bank as a source of financing for Donald Trump and some sketchy condominium development.
[SIMPSON]… There’s the Trump vodka business that was earlier. And then ultimately, you know, what we came to realize was that the money was actually coming out of Russia and going into his properties in Florida and New York and Panama and Toronto and these other places.
And what we, you know, gradually begun to understand, which, you know, I suppose I should kick myself for not figuring out earlier, but I don’t know that much about the real estate business, which is I alluded to this earlier, so, you know, by 2003, 2004, Donald Trump was not able to get bank credit for — and if you’re a real estate developer and you can’t get bank loans, you know, you’ve got a problem.
And all these guys, they used leverage like, you know, — so there’s alternative systems of financing, and sometimes it’s — well, there’s a variety of alternative systems of financing. But in any case, you need alternative financing.
One of the things that we now know about how the condo projects were financed is that you have to — you can get credit if you can show that you’ve sold a certain number of units.
So it turns out that, you know, one of the most important things to look at is — this is especially true of the early overseas developments, like Toronto and Panama — you can get credit if you can show that you sold a certain percentage of your units.
And so the real trick is to get people who say they’ve bought those units, and that’s where the Russians are to be found, is in some of those pre-sales, is what they’re called. And that’s how, for instance, in Panama they got the credit of — they got a — Bear Stearns to issue a bond by telling Bear Stearns that they’d sold a bunch of units to a bunch of Russian gangsters.
And, of course, they didn’t put that in the underwriting information, they just said, we’ve sold a bunch of units and here’s who bought them, and that’s how they got the credit. So that’s sort of an example of the alternative financing. … [bold mine, excerpt pages 95-96]
The timing mentioned, 2003-2004, is very close to the time that Bear Stearns launched the two Cayman-based funds which failed first. Is it possible Trump’s financing provided by Bear Stearns ended up in the funds’ CDOs? Probably not — Simpson refers to bonds. But let’s look at a financial statement from one of the subject funds:
It’s difficult to tell what’s in any of the CDOs listed in this summary. Who knows what mortgages are in them or from where they originated without access to more details?
Note the bonds at the bottom — again, what’s in them? What percentage of these bonds consisted of dicey or outright fraudulent financing for construction related to money laundering? Again, we can’t tell without access to more granular details. We don’t know whether bond(s) offered to Trump developments were in Bear Stearns’ first two failed funds or if they helped cause the eventual financial pyroclastic flow toward Bear Stearns’ end.
~ ~ ~
Another thing sticks in my craw — a bit from Michael Lewis’ The Big Short:
The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure. Even as it came to dwarf the stock market, the bond market eluded serious regulation. Bond salesmen could say and do anything without fear that they’d be reported to some authority. Bond traders could explore inside information without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation — one reason why so many derivatives had been derived, one way or another, from bonds. … [bold mine]
In other words, nobody would look askance at all at bonds sold to finance a condominium development with rather thin commitment to payment. Nobody looked askance at the ratio of CDOs to bonds, either, though Bear Stearns would try to offset the CDOs’ losses by liquidating bonds. This fund as an example couldn’t manage this offset based on the ratio alone; it would have been catastrophically worse if the collateral beneath the bonds was as fraudulent as many subprime adjustable rate mortgages in CDOs were at the time.
The root cause of the 2008 crash remains the collapse of poorly collateralized as well as fraudulent mortgages. But I have to wonder:
— With so much attention on CDOs and mortgage defaults combined with a lack of bond market adequate monitoring, how much did crappy bonds, based on fraudulent representations of collateral, contribute to the crash?
— If there was so little regulation and oversight of the bond market, how much sketchy or fraudulent project financing was in bonds on the banks’ books — including projects like Trump’s, based on promises to pay made by offshore vehicles or non-U.S. citizens?
— With so little regulation and oversight, would it have been possible for one or more nation-states using offshore finance vehicles to “weaponize” banks’ books? How many of the crappy bonds contributing to the 2008 crash were based on poorly collateralized pre-sales to Russian oligarchs and gangsters?
— What assurances do we have today — especially with Mick Mulvaney defunding the Consumer Finance Protection Bureau and knocking off an opportunity to look more deeply into credit reporting by killing off the Equifax investigation — that investment banks have changed their practices and ensured legitimate projects are financed?
—What assurances do we have that our legislators see the slippery slip when they approve legislation like S. 2155 just this week, weakening Dodd-Frank reforms?
~ ~ ~
Recall the state of the economy between Bear Stearns’ and Lehman Brothers’ crashes. Oil prices rose to over $150/barrel, resulting in $4/gallon gasoline. Other commodity prices rose in tandem with fuel prices. The home buyers who could least afford any change in their household expenses were the same ones targeted for subprime mortgages with shady terms; it came down to paying for gas to get to work and feeding the family, or making the mortgage payment.
The price of oil at the time had been driven up by excess speculation. Legislation passed in June 2008 requiring all commodity futures trading to require a minimum of 30% margin upfront rather than 10%. Oil prices dropped drastically and reduced in volatility almost overnight, but it was already too late. Too many home buyers could no longer afford their payments and mortgage defaults began to snowball.
Which brings me to yet another question: if the bond market could have been “weaponized” at that time, could a volatile commodities market likewise have been used as a trigger?
Are there any other weak points in our market which could be “weaponized,” for that matter?
~ ~ ~
On this tenth anniversary after the crash began with Bear Stearns’ collapse, I feel more secure about my retirement portfolio. There were no frantic phone calls to family members exhorting moves to safety this evening. My exposure to the remaining weaknesses of investment banking have been minimized as much as possible, though I remain vulnerable because I have a mortgage. Real estate isn’t the sure return it once was. Only uber-wealthy investors buying into certain urban markets come out on top. But wealthy real estate investors can still cause self-inflicted damage.
Atlanta, Georgia’s market has turned around since the crash — but it was home to another failed Trump real estate project, a 363-unit Trump Tower which went into foreclosure with pre-sales of only 100 units. (In January 2017, Trump ranted about Atlanta as Rep. John Lewis’ district, calling it “falling apart” and “crime infested.” One wonders what crime he meant…)
Hollywood, Florida had a brush with a failed Trump project:
In 2006, he and billionaire condo king Jorge Perez began selling a 23-story apartment building near Mar-a-Lago, but the project was abandoned a year later because of slow sales. Another Perez-Trump deal, the 200-unit Hollywood oceanfront tower, was foreclosed in 2010 after selling less than 15% of its units. (The building eventually opened, still Trump-branded, but without Perez.)
So did the Miami, Florida area:
Trump Sunny Isles, a three-tower residential complex outside Miami, has also struggled. Trump partnered with Perez again and another developer named Gil Dezer to build the project, which targeted wealthy Latin Americans. . . .
Unfortunately, the last two towers of the development opened in the middle of the financial crisis, and Perez bailed on them. . . .
And Puerto Rico, too, was home to a Trump-branded golf course which failed in 2015.
Though with so many failures followed by continued attempts, it’s worth asking if this is a business model. How does Trump continue to benefit from so much failure? How do the backers he has benefit from staking Trump money or title?
Trump’s business alone wasn’t the cause of the 2008 crash. There were far more players involved — millions, if we want to blame residential homeowners who were misled by banks to believe they could safely contract a mortgage in spite of either inadequate collateral or income and ultimately forced into foreclosure. But at least one of Trump’s business projects was in the mix if Fusion’s Simpson’s testimony is truthful; what would keep Trump or real estate investors like Trump from contributing to (if not causing) another crash today?
We must ask when we see that Trump’s former campaign manager Paul Manafort and his former son-in-law Jeffrey Yohai were engaged in sketchy real estate development projects the community/regional Banc of California may have deterred by forcibly shutting their accounts.
And ask again when we see a community bank like The Federal Savings Bank of Chicago involved in another of Manafort’s bank frauds.
The damage could be even worse, in the case of Trump’s son-in-law Jared Kushner, who is over his head in debt on 666 Fifth Avenue and whose family business is distressed, possibly causing geopolitical turmoil to shakedown new financing.
How many of these flimsy real estate deals and junky mortgages, loans, and bonds are there in the system when we can now see these affiliated with the president and his campaign advisers? How many of them will it take to cause another crash if legislators continue to pick away at safeguards?
Let’s hope I’m not writing another financial postmortem like this one in March 2028.
Some of the deals you mentioned look like they may have been in good faith and just went bad because of the market, Trump doesn’t seem to leave much margin for error.
But failed real estate deals can be good if you’re laundering money.
The Russia scandal is shining a light on how commercial real estate deals work, and it’s surprising to see how easy it is to commit fraud. During the housing bubble a lot of homeowners were overextended, but many commercial real estate companies were too. Kushner probably thought his skyscraper would have doubled by now.
Sort of an aside, to your piece. I’m probably stating what everyone knows. If too stupid, please remove at your discretion:
I don’t know how the banks make money from it, but the developers get so many benefits, they place the risk on existing taxpayers, with a nod from politicians. They get tax abatements and PILOT programs. The PILOTs are set up where no tax dollars go to public education, which is where the bulk of tax expense generally comes from, the money goes to gov’t administration of the town/city. The city loves it, because they get an influx of cash, give themselves raises or hire more people. The rest of the taxpayers may see increases because of the need for more services; police, fire, higher number of students in schools, etc.
Since the PILOTS are often calculated based on profit, if a developer needs to show a loss because s/he is killing it elsewhere, they will leave vacancies and their costs to the program are lowered. Some might ‘cook the books’ (Trump/NYC). Any additional cost burden then falls on the town or city taxpayers. To wit, they also often get ‘free’ infrastructure as part of these agreements; roadways, street lights, sewerage, water pipes, etc., always with the promise that, eventually, general taxes will go down, when the PILOT ends (sometimes in 20 years or MORE). Imagine if someone gave you those incentives to build a house.
Trump actually got caught underplaying the profit back in the 70s/80s in NYC, when the city was in a devastating financial wreck. He and a band of developers seem to be at least partially the originators of this racket. (There’s a documentary about it somewhere, that I watched, but I could only find this link making reference to it):
The Trump Files: How Donald Screwed Over New York City on His Tax Bill
https://www.motherjones.com/politics/2016/10/trump-files-how-donald-screwed-over-new-york-city-his-tax-bill/
Of course, before this system gets set in motion, they grease the wheels by contributing to political campaigns, wine and dine them, join boards in communities, etc. It doesn’t even take that much to buy off a politician. Local cronies make out like bandits in engineering, legal, and other professional services, as part of this Faustian bargain.
Personally, they suffer no liability with separate LLCs created for each individual project. They use contractors and subcontractors to float expenses, leaving long gaps in payment schedules. Sometimes they don’t pay at all, but if it’s a small operation, they can’t afford the additional expense of taking it to court, so they absorb the losses, rather than the developer.
Talk about a rigged system.
This is why Trump was always selling the “I’m so successful” BS; as a way to continue to get financing. When the banks finally figured it out, it makes sense he would go toward rich oligarchs, who were also thieves, who wouldn’t mind getting less on the return, because then it would be ‘clean’ and it wasn’t their money (they worked for) to begin with anyway.
Perks granted by states/municipalities don’t convert to cash, though, at least in most cases. If this is a business model (and I use the word business very loosely here) based on getting cash out of the process, more interest by governments is not a good thing. This is why I think Trump liked the condos — they weren’t necessarily going to attract government attention as much as buyers’ attention because of branding. And each condo was a sale; he’d be out of it once the condos were sold, but could still milk the benefits of the branding. But this isn’t a quick means to pump money in and push money out; maybe cooking the books is part of the process. This part of the model I don’t yet grasp but then I’m still trying to learn how to think like a money launderer. Wasn’t included in my B-school education, I’m afraid.
And casinos. Where a certain amount of money laundering is expected. Exceptional cases draw attention only.
Trump’s business model shifted somewhat into selling the name only, versus being the entity behind the entire development. Hasn’t it? He was given an assist by the Apprentice Show, which promoted him as a successful, competent businessman. A huge facade, just like the Trump name on a building; ‘branding’. It also created the consequence that Trump would seem accomplished enough to sit as president, for those who think business people are suited for the job.
When are localities going to stop being chumps? Modest example: Discovery HQ, Silver Spring, MD. In 1998, the county provided $35M in subsidies, with additional tax exemptions for 20 yrs to “renew” SS CBD. Not hard to guess what now: Discovery relocating to Knoxville.
Municipalities are beginning to catch on; there’s been quite a bit of pushback with regard to Amazon’s HQ2 development. There was a movement for more progressive cities to collectively agree not to offer incentives to Amazon because the low wage jobs combined with increased infrastructure requirements would be a net drain on most cities.
That’s encouraging, thanks.
” Oil prices rose to over $150/barrel, resulting in $4/gallon gasoline. ”
Made me laugh. Price today is ~$60 and it’s easy to find stations in Los Angeles selling $4 gas.
$4/gallon national average, not California, and definitely not Hawaii, both of which are exceptions because of state taxes and distribution costs.
Lowest gas price per gallon here in MI right now is $2.19; national average is $2.53 as I type this. If national price rose to $4.00, that’d eat $1470 a year from average family’s budget, and roughly half of Americans can’t scrape up $400 cash for an emergency. While Californians would face a rise to $4.87/gal (based on current CA state average of $3.40), it would still result in same $1470 loss per year per family.
At least much of CA doesn’t have the same total energy cost, one of the ten lowest in the country and getting cheaper because of solar generation. In Michigan we have to heat at least 6 months out of the year; southern MI can be ugly without AC during July/Aug. Northern California is pretty comfortable most of the year without HVAC, in comparison.
Rayne:
Don’t take this the wrong way, but you mix up a lot of terminology. For example, you seem to think CDOs are different than bonds, but a CDO is a type of bond. Another thing is that residential and commercial mortgage markets are completely different animals. One is backed by individual households, the other is income-producing properties. The junior bonds produced are structured differently. The resi market dwarfs the commercial market in size, so even though some securitized commercial loans went bad, the losses it produced were a rounding error in terms of the banking system and not a major factor in the crisis.
And in commercial, some mortgages are securitized, but construction loans are not, they are funded and held by the lender.
Having been in the CMBS market for 20 years, I could go on all day about what went wrong and regulations. Email me at the address in the comment section if you want to discuss.
I’m aware that a “collateralized debt obligation” is a securitized loan; I use “CDO” versus as I do because Bear Stearns’ statements (see excerpt above) divided the residential mortgage-backed securities’ bundles into segments separate from their commercial bonds. In addition to obtaining more credit as the crash loomed, they tried to unload commercial bonds to offset failures of the mortgage-backed securities bundles. But they didn’t have enough commercial bonds as the market questioned their valuation.
Jesus, their due diligence questionnaire for 2006 was a freaking joke: “Additionally, the Fund’s positions are fairly liquid due to its position in the capital structure.” They simply stuffed a bunch of crap in a casing — including commercial bonds on which they did little due diligence — and hoped for profitable sausage.
Trump and Sater were gnats compared to rest of the Wall Street crooks. Check out Bill Black for control fraud and transfer pricing. Transfer pricing was how Browder, Rich, and the rest of the oligarchs world wide siphoned off the wealth, offshore tax evaded the wealth and generate funds to control more victims.
The jails are littered with billion dollar criminals who had their stealings stolen in turn by WS. The formula is sick, never be in debt when someone else controls the mark to market. The multi player organism is adapted to taking all the money off the table leaving original victims and original scammers empty handed.
@posaune (comments dumped me from direct reply)
The federal govt needs to end this race-to-the-bottom abuse by prohibiting these subsidies and tax abatements, or taxing them very heavily, even 100%. Location/relocation offers like these are pure corporate welfare.
The credit default swap market also had a huge influence on the meltdown. These investment banks sold derivatives that were bets that firms would (or would not, depending on which side of the bet you wanted) default on their financial obligations i.e. go bankrupt.
If Bear defaulted on its credit obligations, any bank that sold swaps on Bear would owe the counterparty the notional amount of the swap, far, far exceeding the fee received when sold. These firms were rated “investment grade” by the ratings agencies (S&P and Moody’s).
The notional amount of all CDS were orders of magnitude larger than the entire US economy at that time. A conservative estimate is 10x.
Hypothetical: Lehman would go bankrupt paying out all of the swaps it sold on Bear. BofA would go bankrupt paying out all of the swaps on Lehman. The dominoes would fall in rapid succession and the entire global financial system would collapse. That was the “abyss” we were staring into.
And oh-by-the-way…default swaps were also sold on residential cdos where they were packaged up into synthetic cdos which was gasoline on the dynamite.
Yeah, that — my Jenga analogy was the best I could summon to depict the cascading collapse. I don’t know that all swaps entailed such geometric exposure (at least not early on), but the loss of anticipated income creating massive liability was horrific in impact. I still can’t get over Michael Lewis’ depiction of the bond market in The Big Short, that it was backward-looking. In retrospect this was absolutely true and still is; investments based on debt look at history through actuarial lenses, colored by a layer of ratings. Yet the economic forecast going forward was utter shite and they couldn’t see it coming.
All compounded by investors who relied on banksters’ expertise when their own knowledge was inadequate. Before 2000 I worked for a Fortune 100 manufacturing company in a division responsible for risk management; management began to use swaps as an alternative to insurance. The swaps were supposed to provide smoothing of risk while reducing operating expenses. It took management many meetings and months to work out how these instruments worked. My head aches just thinking of all the ISDA boilerplate and contract terms I had to sort through for each meeting. And always the squadron of dark-suited slick-haired be-tied banksters arriving in a flock before the meetings — some of them from the very firms involved, like Bear Stearns and Lehman Bros and J.P. Morgan. Vultures. They wanted to count coup, bag a Fortune 100 company so they could underwrite more of these products. It makes me queasy thinking I was watching the birth of a monster that ate the economy.
I was sitting at a GE Capital business that was shrinking its balance sheet and securitizing synthetic leases among other shady things to generate income. Fun times. Not so much.
Rayne, I’m not trying to be a jerk, because I think we probably agree on a lot, but it’s hard to respond to your comment because I’m not sure what you are referring to. Bear originated commercial mortgages to sell, of course they were always going to sell whatever they funded, that was the whole business. It wasn’t a bank that held loans. They didn’t sell CMBS to prop up anything or to cover losses elsewhere. It was a CMBS operation, write, fund and sell as quickly as possible.
Bear was a lead on a whole lot of aggressive commercial loans in the run-up to the crisis, including a $20 billion package to finance an M&A deal involving Hilton Hotels. The big losers were the private equity funds that provided the $6 billion of mezzanine debt, they all lost everything. While interesting, though, that didn’t create a crisis.
Trent has it right above, the crash was mostly caused by the “synthetic” market, the CDS deals that dwarfed the size of the real market. First, residential mortgage brokers started writing loans and market players made money by volume, the risk was borne by the junior bond buyers, who because the rating agencies didn’t do their jobs, were buying junk without knowing it.
On the CMBS side, the first-loss bonds were bought for many years by B-piece investors who scrubbed loans for quality because they suffered when loans defaulted. But around 2005 they began to put their junk-rated CMBS into CDOs, so they cashed out and the investors of the CDOs bore the risk. As a result, the B-piece buyers no longer cared about collateral quality, which meant nobody was watching the store.
Back to CDS. AIG started this business where they would act as insurer of swaps between banks and funds. If prices moved one way or another n a reference pool of bonds, one party would collect. If they couldn’t pay, AIG would. But unlike life or property insurance, AIG had no capital reserves because it was a new and unregulated business. (BTW, AIG as JT alone, but I’m using them as an example.) they never expected to have to pay out.
When the market crashed, suddenly there were a lot of defaults and AIG had no means to make the payments they contracted to.
One other point: the parties in CDS didn’t have to own the bonds that were being hedged. If they did, then losses would have been limited to an cut all number. But because it was unregulated, the synthetic market was unlimited and created these systemic issues.
Finally, the ratings agencies. Was wondering when that bit would get brought up.
Their “opinions”, WRT the risks of investment products sold worldwide, were intrinsic to the meltdown.
And they walked away from the whole fraud unscathed.
Yeah, the Big Three ratings agencies. I can’t tell you how stressful it was around the tiny risk management division I worked for when ratings reports loomed. Not hitting the anticipated mark could cost a division president and his upper management team their jobs. We were audited by a dozen or more government entities every year (which is fairly normal for an outfit participating in insurance industry), but we still sweated that Moody’s rating.
And then years later, to find out it was all pure bullshit? That the hoops we jumped through as a tiny little speck on a Fortune 100 company’s ass were never really applied to the investment banksters who often strode through our halls hawking their crapware? I’m surprised more executives didn’t walk away or commit suicide.
Appreciate the further explanation. Those synapses haven’t fired in awhile. Surprised they did at all after waking up stateside today after a week in Costa Rica.
Trent, some of that is garbled because I’m writing on an iPad.