The Wall Street Journal Blog "Mean Street" was out with this yesterday It's Time To Enshrine Hank Paulson as National Hero . Hmmm. Have a read. The actual piece isn't nearly as dramatic as the title, except at the end where Mr. Newmark says, "If something works, it works. Just give credit where it’s due. And that would be with Hank Paulson, national hero." Personally, I think that had Paulson truly understood the magnitude of what was happening during the latter half of 2007 and throughout 2008, the complete collapse that Paulson and Bernanke averted in October 2008, may not have gone down the way it did.
Let me be clear on one big point. The credit disaster that started in residential mortgages and the chain reaction that took down (or is in the process of taking down) commercial mortgages, corporate loans and emerging market debt, was fully baked in the cake by the end of 2006. Probably sooner. The bonds were bad and the financial system and investors were very highly levered. The sucker was going to blow when in late 2006 subprime loans started going delinquent and then defaulting about 3 months from origination! The Street tried to put the loans back to the titans of subprime finance like Ameriquest and New Century and those institutions showed what they were.....machines cranking out horrible loans to feed the Street's securitization factory, with little to no capital. Boom! All the dominoes started to fall. Liquidity and risk license were violently pulled across all structured credit product and you know the rest of the story. Paulson got to Treasury in mid-2006. I think you have to be fair to him that by the time he figured out where the men's room was at Treasury, there wasn't much to do to stop the explosion.
However, I think it's pretty apparent that Paulson underestimated what was going on throughout 2007 and was pretty oblivious to the catastrophe that was on its way for 2008. It would have helped if others in positions of power, like Tim Geithner and Ben Bernanke, had recognized the problems that could have been at least partially mitigated. However, they were no help either. Nevertheless, Hank Paulson should have, based on the fact that he came from and ran a large investment bank, known the following;
- Investment banks such as Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley had tremendous exposure to the above mentioned assets.
- Any one of these practically unregulated institutions had the ability to take the whole system down if they failed.
- All of these institutions were highly leveraged with mostly wholesale funding. They did not have access to the Fed window and had a huge presence in the commercial paper markets, thus threatening the all important money markets.
- AIG was a gigantic presence in all the structured credit markets. You wanted a guarantee on just about ANYTHING, you knew you could go to AIG. AIG was one of the great common denominators in this crisis. If you ran Goldman Sachs you have to have known that AIG was a repository of risk and they weren't exactly charging an arm and a leg for it. Anything happens to them (and lets not forget that everyone on the Street knew that AIG had been monkeying around with their capital and reserve levels as well as much of reinsurance industry for years. There was a little trial going on sending the heads of Gen Re to jail for its dealings with AIG) and Houston we have a problem.
- Like AIG, the monolines like MBIA, Ambac, FGIC, etc...were in the same systemic risk bucket as AIG.
- While we are on the subject of "guarantors of risk", Freddie and Fannie were on their way down the toilet too. You just had to do the arithmetic on a $3.5 trillion guarantor book. One-percent loss = $35 billion. Two-percent loss = $70 billion.....game over.
- The all important commercial paper markets had nearly $1 trillion of assets backed by structured securities and many of the issuers were members of our banking system, running SIVs and asset-backed commercial paper conduits. If the commercial paper investors didn't want to play anymore, somebody had to come up with nearly $1 trillion of balance sheet....fast.
Imagine if Paulson started taking action, behind the scenes as much as possible, to get the investment banks to raise more capital in early '07, improve their liquidity profiles and start slowly delevering. What if he made it known to Freddie and Fannie to immediately cease and desist guaranteeing subprime and Alt-A crap? What if he and Bernanke spotted the coming disaster in the CP markets and moved, again behind the scenes to get a facility in place to back stop the money market mutual fund market. This way if one of the investment banks went down, they could flick a switch and the MMMF's like Reserve Fund wouldn't break the buck and cause a run on the bank (which is what happened in September after Lehman went down). What if Hank paid Marty Sullivan at AIG a visit (along with the monolines) and told them their capital positions versus their risk were making him very uncomfortable. What if Hank polled the investment banks on their exposure to AIG?
I can go on and on. I can say, if you have read this blog for a while, we called a lot of this because we were in these markets and saw what was happening. Therefore, this isn't all Monday morning quarterbacking. If we knew, how come Hank didn't? Sorry, but you can't call Hank Paulson a hero in my book. There was plenty he could have done to lessen this crisis. He didn't.