Thread by @jaltucher

Twitter Class on the real roots/causes/solutions of The Great Recession of 2008: good guys, the scumbags, IMPORTANT case study to understand NOW and even relates to The Great Depression. . . No econ knowledge required. (1/30): 1994....

1994 - Clinton used an executive order to create the National Home Ownership Strategy with the very good Intention of: everyone should be able to afford a home. Started to reduce borrowing standards so more people could get loans. 1995...

1995 - Presidential executive orders forced banks to establish a quota of lending up to six trillion dollars to people who were not able to afford a home. Again, very good intentions. I don't blame Clinton. Owning a home was considered a source of pride. Good intentions lead to..

Good intentions often lead to very BAD outcomes. Seemingly unrelated: 1998: 1998 - the hedge fund, Long Term Capital Management (LTCM) set up by top investor John Merriweather and two Nobel Prize winners, was hit by disaster. So leveraged they almost tanked the world until....

1998 - all of the major banks joined together to bail out LTCM to save financial system. Well...all of the banks except TWO: Lehman Bros and Bear Stearns. This is relevant later....
1999....

1999. Glass-Steagall Act passed -- deregulating banks. Allowing banks to also form hedge funds that could invest more aggressively than the bank normally would. Which also allows banks to lend more. Good intentions again...

2000/2001 - Internet bust and Recession. 9/11. Market collapses. Interest rates are deeply cut to re-stimulate economy, allowing more subprime borrowers to take out "no money down, interest only loans". Again, good intentions. Until...

2002-2006 - low interest rates + more lending + more investors allowed banks to lend to subprime borrowers with the following terms: interest only loans, no money down. Many subprime borrowers bought homes. Anyone who wanted could own a home. Good intentions...

1999-2006 - Govt promised to backstop the loans (reduce risk for the banks so they can lend more): Fannie Mae would "buy" the loans as soon as they were made and the banks were simply paid to collect the money (exactly like the PPP loans today. Fed Reserve buying the loans...)

2000-2006 as result of the above, banks had zero risk in lending. So they lent as much as possible, would resell loans to govt, service the loans, take a fee. EXACTLY how the PPP loans today will work. But then derivatives....

2000-2005 - hedge funds (often run by the banks) start buying the loans since the mathematical models showed that risk of default in a diversified portfolio of mortgages have never failed. Then mortgages were bundled together to create "mortgage backed securities"....

2005 - Note: the mathematical models hedge funds and banks were using never considered subprime borrowers. Hedge funds are borrowing at 1%, buying as much MBS as they could at 4%. Banks, funds, brokers, making money. People buying homes, homes going up in value...

As a result, economy heats up. So Fed starts raising interest rates. From 1% to 5%. Now people who borrowed "interest only" loans at 1% have to pay 5x a month more in payments. Subprime starts to default...

2006-2007 - housing actually bottoms and would've come back quickly. However, nobody counted on the disaster of "mortgage backed securities" and a small unnoticed change in the banking laws...

2006-2007 - hedge funds start to crack. The mortgage backed securities start to default. If a hedge fund was leveraged 100:1 (as some bank hedge funds were), then a 1% drop in MBS meant the hedge fund had a 100% (!) loss (because of the 100:1) leverage. But it gets worse...

2005-7 - credit default swaps are created. If a lender was nervous that a borrower would default, a credit default swap was "insurance" that the lender would get paid in full. The lender would have to BUY the credit default swap from someone. Hedge funds got involved....

Hedge funds would SELL the insurance (the CDS). It was free money for the hedge funds since defaults up until then were basically zero if you sold a basket of diversified credit default swaps. This was a ton of free money for the hedge funds. But HUGE HUGE leverage...

2006 - a few hedge funds (John Paulson, Michael Burry got smart and started buying tons of credit default swaps from hedge funds. The sellers (hedge funds acting like insurance cos on subprime loans) were laughing all the way to the bank until...

The hedge funds who were buying the insurance (John Paulson, Michael Burry) were losing money every month. Their long term bet is that system collapses. John Paulson pitched me on his fund and I left his office thinking, "Holy fuck, we are screwed". Paulson only had 1 worry...

Paulson told me in 2006 (way before the top of the market) was that he was afraid the banks would go out of business before he could get his money out. Two years later this almost came true because...

2007 - the hedge funds of banks & insurance cos were selling a TON of CDS at the very top. AIG, Lehman, Goldman, everyone. Hedge funds even created offshore insurance companies to create even more insurance products they could sell. Nobody believed defaults would happen...

2007-8. Higher interest rates, more defaults from subprime borrowers, caused credit default swaps to trigger and the hedge funds who sold these had to start paying up. The system was cracking. But the banks were able to hold on UNTIL the worst happened.....

2007 (critical moment): FASB 157 was passed. This was a new rule that required banks to "mark to market" their assets in order for regulators and customers to determine the financial health of a bank. Again, good intentions. BUT this is what it means....

For 70 YEARS, banks "marked to value". Example: your house is worth $200,000. You know this because of the history of house sales in your area. You paid $170k a few years ago, etc. Normal house appreciation. But what if...

- Your neighbors are getting divorced and fire sale their house. They live next door to you and their house is exactly like yours. They sell for $125,000 but you think, "no big deal. That was a weird situation." That's "mark to value". "Mark to market" turns it upside down...

"Mark to Market" forces you to use the last comparable house sale and NOW that's what your house is worth: $125k. Not $200k. You don't care because you know it will bounce back. And banks are now more transparent. Good intentions again BUT....

But a bank that switches from Mark to Value to Mark to Market, RIGHT IN THE MIDDLE OF SUBPRIME DEFAULTS, suddenly has to mark down their entire portfolio. Still, not quite a disaster yet. BUT...what if the banks borrowed too much....

But a bank that switches from Mark to Value to Mark to Market, RIGHT IN THE MIDDLE OF SUBPRIME DEFAULTS, suddenly has to mark down their entire portfolio. Still, not quite a disaster yet. BUT...what if the banks borrowed too much....

If a bank or fund used 100:1 leverage then even if 1% down (caused by the defauilts ,plus some manipulation) will wipe out an entire trillion dollar bank (Lehman brothers) or insurance company (AIG) or dozens of hedge funds and basically every bank on Wall Street.

Lehman Brothers collapses. Lehman was one of the only banks that didn't help in the bailout of the highly leveraged Long-Term Capital hedge fund (LTCM) in 1998. The decision-maker Treas Secy Hank Paulson, former CEO of Goldman Sachs, so had a 10 year grudge. One day later...

1 day later...Paulson saved Merrill Lynch by arranging a sweetheart deal with Bank of America.
NOW: because of FASB 157, nobody can lend to the banks anymore (they had to mark their assets to less than zero)...Which means banks can't loan to companies to make payroll....

The American system collapses. The Great Recession begins. Nobody can get cash into the system. Paulson arranges TARP (semi-nationalizing the banks) and arranges the Bailout (same as now - exact same playbook). But some important notes....

- November, 2007, when FASB 157 passes, was the top of the stock market
- Mark to market was the law in the early 20th century but outlawed by FDR in 1938, which probably led to the end of the Great Depression as banks were able to lend more.
So how did Recession end?....

- In early 2009 FASB 157 was a huge debate. On March 12 Congress met to discuss and eventually FASB 157 and new rules were passed allow mark-to-value again.
- March 9, the market started going straight up until Feb 2020 (coronavirus)..... Similar to The Great Depression...

From 1938 - 2007 because of Mark-to-Value there was no Depression. Without the TARP, then the bank bailout in early 2009, then the repeat of FASB 157, we would've had a depression. BUT, "mark to value" is often called "mark to myth". Who benefited? and who is benefiting now...

- John Paulson turned $100,000,000 into SIX BILLION dollars. (I wish I had invested when he asked me to).

- Bill Ackman turned a $27mm investment last month into $2.6 BILLION. He went on CNBC saying the world was going to hell. He sold his investment right after. BUT....

The point is: have to be careful of good intentions. Nobody is to blame:
- blame Clinton for loosening borrowing requirements?
- blame FASB 157
- blame hedge funds for speculating
- blame Glass-Steagall for deregulating banks
OR....

- blame mortgage brokers for convincing subprime borrowers to buy houses
- blame banks for lending the money
- blame hedge funds for manipulating the market of MBS
- blame Bush for not seeing this coming
- blame Paulson for the bailouts
The point is....

Government, leaders, voters, often have the best intentions but don't realize consequences that could be yrs later. Watch out for student loans & watch out for future bubbles in this bailout. There WILL be a crisis, 2-5 years down the road created by current good intentions.

Not sure why I did this. I wanted to show how when you connect the dots, something complicated could be presented in a simple fashion. Also wanted to underline future unknowns in what is happening now by looking at the past. AND, see if Twitter is good place to "teach". THANKS!