Ray Dalio showed up on CNBC Tuesday morning to discuss some of his theories about where we are in the current economic cycle, as he’s wont to do.
But this wasn’t just any Dalio cameo because this isn’t just any week. Dalio’s comments on “Squawk Box” are part of the financial media’s ongoing efforts to commemorate the 10th anniversary of the crisis. Everybody who’s anybody has to weigh in on this, and Dalio being Dalio, he wrote a 500-page book for the occasion called “A Template For Understanding Big Debt Crises”.
As far as what Ray thinks about the U.S. economy in its current state, he told CNBC on Tuesday that we’re in the “7th” inning, meaning the cycle is getting a little “stretched” (and yes, there’s a baseball pun in there somewhere), but there are still 2 years left to go. Here’s the clip:
Below, you can find the chapter from Ray’s new book that recounts the Lehman collapse, complete with excerpts from some of Bridgewater’s Daily Observations notes which give you an idea of what the firm was thinking at the time. You can download the full book at the link below the excerpted Lehman chapter.
By Ray Dalio, excerpted from “A Template For Understanding Big Debt Crises”
Lehman Goes Bankrupt: September 8–15
Stocks rose about two percent on Monday, September 8, as the market responded positively to news of the nationalization of Fannie and Freddie, a bold move that would have been unthinkable months before. The New York Times wrote that “financial stocks led the surge, propelled by hope that the government’s decision had averted a calamity and marked a possible turning point in the credit crisis that has troubled banks for nearly a year” (my emphasis). Boy, was that wrong.
Writers of accounts such as this one, who have the benefit of hindsight, typically paint pictures of what happened in ways that make what happened seem obvious. However, as that rally and comment reflect, it is an entirely different matter when one is in the moment. Just days before the crisis would become much worse, the New York Times wrote on three separate occasions (September 3, 5, and 10) about “bargain hunters” coming in with the stock market down around 20 percent from peak and many individual stocks down much more. Lehman Brothers, for instance, was trading down some 80 percent, but it was a company with a good reputation, a nearly 160-year history, and it looked to be on the verge of finding a buyer or strategic investor. Below is its share price through early September. While the picture is clearly within the downtrend, there were rallies, and in just about all of them, one could make the argument that the bottom was being made. In investing, it’s at least as important to know when not to be confident and when not to make a bet as it is to have an opinion and make one.
The strategic investor who would come in and save Lehman never materialized and Lehman’s stock fell by almost 50 percent on Tuesday. Other major bank stocks, including Citigroup, Morgan Stanley, and Merrill, sold off 5–10 percent, while the overall market was down about 3 percent, and credit spreads widened substantially. Both investors and regulators began to wonder whether Lehman could survive until the weekend.
There were no clear, legally acceptable paths for saving failing investment banks, yet these investment banks were “systemically important” (i.e., they could easily take the whole system down with them). While the Fed was able to lend to Lehman to alleviate its liquidity problem, there were limitations on how much they should under these conditions. And since Lehman faced a solvency problem in addition to a liquidity problem, it wasn’t even clear that more liquidity could save it.
As we described earlier, a solvency problem can only be dealt with by provid- ing more equity capital (or changing the accounting/regulatory rules). This meant that some entity needed to invest in it or acquire it. Neither the Fed nor the Treasury had the authority to provide that. Hence, there was a need to find a private sector investor/buyer, like Bear Stearns had with JPMorgan. But finding an investor for Lehman was harder than it was for Bear. Lehman was bigger, with a bigger, more complicated, and murkier mess of losing positions.
Finding a buyer was made even harder by the fact that Lehman wasn’t the only investment bank needing a buyer to survive. Merrill Lynch, another iconic Wall Street investment bank, was in a similarly dire situation. As with Lehman, many believed that without an investor Merrill was no more than a week away from bankruptcy.37
On Thursday Lehman’s shares continued their free fall, declining another 42 percent as rumors swirled that Barclays and Bank of America, though inter- ested, were unwilling to buy without government assistance. At this point, Lehman was continually rolling $200 billion in overnight loans just to stay running, putting it at huge risk of a pullback in credit.38
On Friday Lehman’s shares dropped 17 percent on news that neither the Fed nor the Treasury would backstop any deal. Lehman’s failure would pass through the system quickly, causing a domino effect that took a toll on AIG (its stock fell 31 percent). But, remarkably, most of the market still believed that the financial sector’s problems would be contained. The overall market closed on Friday up 0.4 percent, aided by falling oil prices.
On Friday evening, reports surfaced that Fed officials had gathered the heads of Wall Street’s major banks—from Goldman Sachs to the Bank of New York Mellon—to urge them to bail out Lehman. Whether there would be any takers remained to be seen. Bank of America, Barclays, and HSBC had reportedly expressed interest, but none wanted to do the deal without government support. And Treasury officials publicly insisted no support would come.
Paulson had hoped that by motivating a consortium of financial institutions to take on Lehman’s bad loans, a potential acquisition of Lehman could be facilitated (as a potential buyer could leave a substantial portion of Lehman’s bad assets behind when they acquired the firm). But while some progress was made with the consor- tium, no potential buyer emerged. Without a potential buyer, the Fed did not have any authorities which would have been effective in preventing the failure of a nonbank in the midst of a panic-driven run, according to Paulson, Bernanke, and Geithner.39
Bernanke and Geithner had many conversations together and with Paulson about what they could do to help prevent Lehman’s failure, but, as in the case of Bear Stearns, they did not believe that a Fed loan would be effective. They believed that the legal requirement that a loan had to be “secured to their satisfaction” limited the amount they could lend, and that meant they could not lend Lehman enough to save it or guarantee its trading book. The weeks before that fateful weekend were consumed by the effort to figure out a way to prevent Lehman’s failure despite those constraints. They were willing to be very creative with their authority and to take a lot of risk, but only within the bounds of what the law allowed. They erred on the side of doing more, not less, but Section 13(3) (the section of the Federal Reserve Act that allowed for emergency lending to a wider set of borrow- ers) did not make them alchemists. Loans were not equity, and they had to be guided by what would work in practice.
Most everyone agrees that it would have been a lot better if these policy makers had the authority to liquidate Lehman in an orderly way; this was another classic example of how political constraints together with imperfectly thought-out legal constraints can get in the way of actions that are widely agreed to be beneficial.
On Sunday afternoon the news broke that Lehman was headed for bankruptcy, and all hell broke loose. The shock was way bigger than any before because of Lehman’s size and interconnectedness to other vulnerable institutions, which made it clear that the contagion would spread. Even worse, the government’s failure to save it raised doubts about whether it could save the system. Lehman’s failure was particularly scary because of its large and poorly understood interconnectedness with the rest of the financial system.
There were a couple of major channels of potential contagion. The most important (and least clear) was Lehman’s substantial presence in derivatives markets. At the time of its bankruptcy, Lehman was a party to between $4 and $6 trillion worth of exposure in CDS, accounting for about 8 percent of the total market. Though many of these exposures were offsetting—Lehman did not actually owe huge sums on net—its failure sent clients scrambling to find new counterparties. At the time, no one knew how large Lehman’s net exposure was, or who was on the other side of it; we were crossing the line into a big, disastrous unknown. On September 11, we wrote in the Daily Observations:
The uncertainty of this situation is tremendous. What happens when you go to settle a currency forward transac- tion with a counterparty that suddenly doesn’t exist? Maybe everything goes fine, but maybe some unexpected condition bites you in the ass. What if you haven’t been collecting mark-to-market gains from one of your dealers (we collect constantly from everyone), they go down, and now you are a general creditor? Who do you transfer the risk to? Maybe Merrill is right behind Lehman. What do you about that? And who might be behind it? If everyone is asking these questions the natural path is to cut back on trading and concentrate positions with a few firms. But these few firms have the incentive to ration their capacity to the highest quality financial institutions and managers. The inevitable result is substantially lower liquidity, higher transactions cost, and higher volatility. Higher volatility then feeds back into the real economy because people and businesses transact at these prices. And capital constraints in the financial sector mean that credit growth remains low, which undermines economic growth. We are getting very close to crossing this line.
While Lehman’s bankruptcy was the largest in US history (and still is), with some $600 billion in reported assets, it was only about two-thirds the size of Goldman Sachs, and a quarter as large as JPMorgan. They were all connected and the losses and liquidity problems were spreading fast.
We called this stage of the crisis the “avalanche”—the point at which a smaller problem in one corner of the financial system (subprime mortgages) was building in self-reinforcing ways into much bigger problems, and fast.
Aftermath of the Lehman Collapse: September 15–18
On Monday morning, September 15, Lehman Brothers filed for bankruptcy, and the stock market fell by nearly 5 percent. No industry was spared, though the financial sector took the brunt of the pain, with shares of banks and insurers falling by about 10 percent. Credit spreads blew out and credit flow ground to a halt. Over the course of the following week, markets, policy makers, and we at Bridgewater struggled to figure out the ripple effects from Lehman, which of course we couldn’t because the interrelationships and exposures were too complex and too opaque. It was clear to us that blanket protections would have to be put into place, because the consequences of the uncertainties themselves would be devastating as everyone ran from any entity that could go under. But if policy makers couldn’t or wouldn’t save Lehman Brothers, how could they save the system?
One of the Fed’s immediate responses, announced the night before, was an unprecedented expansion in the “Primary Dealer Credit Facility”: They were willing to lend to investment banks against almost any collateral, including extremely risky instruments—e.g., equities, subprime mortgages, and junk bonds. It should have been seen as an enormous step for a central bank to take, and in a more normal environment, it would have been. But the Lehman collapse overshadowed it.
Paulson would later write in his book that he felt constrained from even being able to explain in a forthright way why Lehman had failed without creating more problems—a common issue policy makers face when commu- nicating during a crisis. As he put it:
“I was in a painful bind that I all too frequently found myself in as a public official. Although it’s my nature to be forthright, it was important to convey a sense of resolution and confidence to calm the markets and to help Americans make sense of things…I did not want to suggest that we were powerless. I could not say, for example, that we did not have the statutory authority to save Lehman—even though it was true. Say that and it would be the end of Morgan Stanley, which was in far superior financial shape to Lehman but was already under an assault that would dramatically intensify in the coming days. Lose Morgan Stanley, and Goldman Sachs would be next in line—if they fell, the financial system might vaporize and with it, the economy.”40
With big questions on the direction policy was heading, I wrote the following note to our clients on September 15:
(BDO) September 15: Where We Are Now
We have known about the losses that had to be taken by financial institutions for some time. They were discussed and conveyed to you in the tables that we sent to you repeatedly, over the last year. So, these problems were known. We described them as ‘known and manageable’ because, besides being known, we felt that they were manageable via sensible government policies—of providing liquidity (by the Fed), changing accounting rules and/or creating a safety net (by the Treasury, in cooperation with Congress)—and then clearly articulating these policies to provide the necessary confidence that would allow the debt restructur- ing process to progress in an orderly manner…
While we are still trying to figure out what the Treasury and Fed’s approaches are, over the last few days they made some more things clear by innuendo. They made clear that they’re willing to take the chance of diving into the depths of the scary unknown without a clear safety net in place. So, now we sit and wait to see if they have some hidden trick up their sleeves or if they really are as reckless as they seem. With interest rates heading toward 0 percent, financial intermediaries broken and the deleveraging well under way,
it appears that we are headed into a new domain in which the classic monetary tools won’t work and the Japan in the 1990s and US in the 1930’s dynamic will drive things.
Meanwhile, reports came in showing how the financial meltdown was passing to the economy, leading it to plummet. A Fed report showed industrial output down sharply in August; AIG saw its credit ratings downgraded, potentially triggering additional collateral requirements; and Hewlett-Packard announced it was cutting 25,000 jobs. With America’s financial system obviously in crisis, the problems quickly spread globally, prompting European and Asian central banks to announce new liquidity provision measures to shore up their own markets.
Credit markets were in turmoil. As financial players sorted through the tangle of counterparty risks and obligations created by Lehman’s failure, interbank lending seized up and Libor (the rate at which banks lend to each other) settled at almost twice the prior week’s levels. The contagion was spreading to everyone, even the strongest. Privately, executives from blue-chip firms like GE admitted to regulators that even they were having trouble borrowing in the commercial paper market, which could put them in a cash-flow bind and force them to default. Prime money market funds started to register increasing stress, high redemptions, and losses (we’ll discuss this in more detail a little later). By the end of the day, credit spreads on Morgan Stanley widened to levels greater than those for Lehman on Friday.
Throughout the day, regulators scrambled to keep up with AIG’s rapid decline. AIG was one of the largest insurers, with around $1 trillion in assets at peak. Its problems centered around it having issued hundreds of billions of dollars of insurance contracts on bonds (called CDS and CDOs), which required it to pay out if a bond faced losses. Many of these insured bonds were repackaged subprime mortgages, so AIG was exposed to a staggering amount of losses. Since many other financial institutions were counting on these insurance contracts, AIG was systemically important. And it looked to be heading toward failure fast. On Sunday, it had said it would need $40 billion in funding. Now, just a day later, it was suggesting it would need $85 billion.
On Tuesday, the Fed made two surprising policy moves—one far bolder than expected, the other more timid. On the one hand, the Fed, in a regularly scheduled meeting to set interest rates, decided not to change them, when the market expected them to be lowered—a significant disappointment that hurt the markets. Remarkably, even as the market looked to be on the verge of a depression, the Fed remained concerned about inflation, putting in their statement, “The downside risks to growth and the upside risks to inflation are both of significant concern to the Committee.” In his memoir, Bernanke would later write that “in retrospect, that decision was certainly a mistake,” caused in part by “substantial sentiment at the meeting in favor of holding our fire until we had a better sense of how the Lehman situation would play out.”42
However, more importantly, the Fed also made an announcement that redefined the limits of US central banking. It courageously announced that it would provide $85 billion in emergency funding to AIG. The deal, drafted in a rush on the afternoon of Tuesday, September 16, came with tough terms attached. AIG would pay a floating interest rate starting at 11.5 percent, while giving the government an 80 percent ownership stake in the company. Because AIG did not have enough safe financial assets to secure the loan, it pledged nearly everything else it owned as collateral—including its insurance subsidiaries, financial services companies, and various real estate holdings (including a ski resort!). The Fed loan worked because the market believed AIG was solvent (because of the value of its insurance subsidiaries, which had investment-grade credit ratings). The fact that these served as collateral for the Fed’s loan was also critical to the Fed’s decision.43
But even under these terms, the loan was an unusually risky one for the Fed—after all, the companies AIG put up as collateral were not nearly as easy to value or to sell as the AAA securities the Fed accepted in normal times. And there was still a risk that AIG would go under, despite the Fed’s help. Geithner would later say, “Deciding to support AIG was one of the most difficult choices I have ever been involved in in over 20 years of public service.”44
News of AIG’s bailout did not lift markets on Wednesday. Instead, stocks slid by about 4.7 percent, with shares of major financial institutions down by double digits. Rates on commercial paper continued to rise, while yields on three-month treasury bills fell to just above 0 percent (down from around 1.6 percent a week before) as investors fled to safety. Through this chaos, regulators announced a series of stabilizing measures. The SEC moved to tighten controls over short sellers (a common crisis response), and bank regulators proposed revisions to accounting rules to help dress up bank balance sheets.
Let’s spend a minute on the importance of accounting, especially mark-to-market accounting. For banks, some assets are “marked-to-market,” which means that every day banks take a look at what they could sell those assets for, and value them at those prices. Other assets are allowed to be valued in different ways, often by an in-house methodology that depends on the asset. When an asset that banks are required to mark-to-market is selling at fire-sale prices, any bank holding it looks like they are taking significant losses, which reduces their capital and thus requires them to raise money or sell assets, which further strains liquidity and puts further downward pressure on assets. It also scares the hell out of people dealing with them. Accounting changes that allow banks to realize losses over a longer time period (i.e., not marking assets to market) prevents some of these problems. Of course, changing accounting rules to hide losses during a financial crisis doesn’t engender confidence either, so regulators have to be careful.
But accounting changes wouldn’t change the more fundamental issue—that overindebted US households and financial institutions were defaulting on their debts because they were overlevered. It was clear that financial institutions needed to be recapitalized (e.g., via an equity investment), and they needed to find buyers for their more troubled assets. So Paulson turned to Congress for funding and authorization for the Treasury department to play that role.