Prosperity was in the air in September 2007. And down the red lane, too; I drank wine at $200 a pop as a commercial real estate banker.
But banks had already begun to crash. BNP Paribas (French) went first, followed by Northern Rock (British). A global economic crash followed in 2008. The Queen went to the London School of Economics in 2009 and asked, “Why did nobody see this coming?” Her Majesty learnt that (a) many indeed did, but were ignored; (b) E = mc2 was no longer the world’s most dangerous equation. Wall Street had replaced it with:
This is the Black-Scholes equation for the mathematical valuation of options (investments). Like Einstein’s equation, it was innocuous at first but set off other developments. Number-crunchers called quantitative analysts (“quants”) showed that other investments could also be valued mathematically, as opposed to some seat-of-the-pants job. They became revered as the Einsteins of finance.
Next, other complex investments called “Collateralized Debt Obligations” (CDO’s) became popular. These were called “derivatives” as they derived their value from other investments. The quants could not use Black-Scholes to value them. However, they showed that CDOs could be sliced into levels, or “tranches,” which could be valued separately due to lack of “correlation” between the tranches.
Next, the top tranches were considered “Triple-A” investments by bond rating agencies (e.g., Standard & Poor’s, Moody’s). This meant they were considered low-risk and could be counted as capital by banks. All banks must have capital. This was always placed in safe but low-yielding investments. But now, capital could be put into CDOs, which promised equal safety but with higher returns. Who could doubt the brilliance of the quants?
Wall Street promptly bought up loans and mortgages and manufactured CDOs from them. They were sold to banks globally. Trillions of dollars rolled in. This gave more money for buying more loans, producing yet more CDOs, and so forth. There were even “CDO Squareds” and “Synthetic CDOs.” Selling these derivatives was highly profitable. High Street lenders cranked out loans to feed into Wall Street’s insatiable money machine, to get their share of the action.
Loans actually did become cheaper. Anybody could get one. People got bigger houses, fancy cars, vacations, etc. It was like free nuclear power! Those financial Einsteins had tamed the beast of risk! Wall Street could spin straw into gold! What could possibly go wrong?
Lucrative profits flowed in. Juicy bonuses were paid. I nearly fainted when a loan broker told me in 2003 he was raking in $100,000 a month. However, a few Cassandras griped about a “housing bubble.” And legendary investor Warren Buffett criticized derivatives severely, calling them “instruments of mass financial destruction.” Nobody cared.
But in July 2007, IKB Deutche Industriebank (German) rang the doorbell at Goldman Sachs, demanding big money. IKB was insolvent. It had bought a tranche of Goldman’s synthetic CDO called “Abacus 2007-AC1.” It soon became worthless. How so?
It is difficult now to comprehend the absolute impunity prevailing in those days. Many top-rated synthetic CDOs were actually known to be worthless and were actually intended to swindle their buyers. Abacus 2007-AC1 was expressly designed to steal one billion dollars from investors. I once did a TV presentation showing the 39 steps involved in this utterly cynical rip-off, including Goldman’s two completely brazen lies. However, in this one case, IKB had the right to ask for its money back.
Goldman could not raise $1BN. The house of cards began to wobble. Much worse, the housing bubble burst. House values began to fall; mortgage payments began to fall; payments on the CDOs from mortgages began to fall; companies holding CDOs began to fall. Down went Countrywide, Bear Stearns, Freddie Mac, Fannie Mae, Bank of America, and finally Lehman Brothers on September 15, 2008. Lehman’s collapse triggered mass panic, causing correlation theories to be junked. All CDO tranches became worthless.
CDOs usually had a “Credit Default Swap” (CDS) as insurance. AIG, a gigantic global insurance company, knew it was outside the ramshackle system of global regulation. It deliberately sold far, far too many CDSs. They were immensely profitable. But its CDSs all became payable when the CDOs crashed. It crashed. Financially speaking, AIG had been a nuclear meltdown waiting to happen. AIG’s collapse immediately pushed the entire US economy into a meltdown.
Globally, trillions of dollars of CDSs became worthless in a “double-whammy” for holders of CDOs. Soon, the entire global economy crashed. Yet AIG was too big to fail. It had to be rescued in the largest taxpayer bailout of a private company in American history.
You may imagine the bad jokes about Black-Scholes and black holes.