I'm reminded of the old story where an elephant is brought into a room full of blind men.  Each is asked to describe the elephant.  One feels the elephants trunk.  Another feels it's ears. Another feels it's sides, and another feels it's tail.  When asked what the elephant looked like, all had a completely different description of an elephant.  That's called "not seeing the whole picture".

As we approach the one year anniversary of the panic of 2008 and the demise of the investment banking industry, I thought it would be interesting to focus on all the parts of the crisis (at least to the best that I can identify them) instead of the sound bite type analysis you'll hear on TV or read in headlines.

It pretty much began with the Congress passing legislation that promoted the disadvantaged getting mortgages that they could barely afford.  This was called the Community Reinvestment Act. It required banks to make a percentage of their loans to below medium income applicants.  These were the first sub prime loans.

Sub prime loans were packaged by originating banks into mortgage backed securities, MBS's, and sold off to insurance companies, pension funds, investment banks, hedge funds, etc and eventually ended up in the far corners of the world.  Rating agencies were charged with rating the quality of mortgages.  If a mortgage was rated AAA it could be sold to almost anyone, anywhere.  And it was.

Fanny Mae and Freddie Mac, formed as government sponsored enterprises, GSE's, bought mortgages on the secondary market.  They pooled them and sold them as mortgage baked securities to investors.  Since GSE's are partly government owned, investors rated these mortgages higher than their competitors since it was implied that the taxpayer would back these mortgages if ever needed.  (In fact, that is exactly what eventually happened).

Mortgage companies and banks started offering no doc loans, (called "liar loans" in the business), low teaser rates, and up to 125% mortgages which increased the amount of mortgage backed securities available to package.  No longer were time tested credit standards adhered to.  Applicants and loan officers alike lied about incomes and other "deal breaking" details allowing more sub-prime mortgages to enter the system.  Soon, mortgages became non-recourse loans, meaning that the originators of these fraudulent loans were no longer liable for any losses.  They simply sold them off.  Everyone wanted in on the act.

Wall Street jumped on the bandwagon and created collateralized debt obligations, CDO's.  They sliced and diced up mortgages backed securities from all parts of the country and from all spectrums of the risk curve and bundled them into multi billion dollar packages.  These were non-transparent investment vehicles.  No one really knew what they were buying.  Normally investors wouldn't touch such an investment but  they were rated AAA.  That enabled them to be sold all over the world.

The Securities and Exchange Commission, SEC,  who was sadly lacking in performing their oversight duties, actually contributed to the problem.  They eliminated all controls on leverage for non bank banks just as the mortgage frenzy was really getting going.  For decades, leverage was held to about 12 to 1 in the commercial and S&L banking system.  But a "shadow banking system" developed consisting mainly of investment banks.  These were unregulated.  Most adhered to the long held 12 to 1 leverage rule that extended to all financial institutions. This rule preserved a degree of risk management.

This rule was discarded by the SEC to all non-bank banks and leverage increased to up to 45 to 1 levels, unseen since the roaring 20's.  Hedge funds margined not only fraudulent mortgages but now fraudulent CDO's in billion dollar bundles.  The goal was to spread risk, but in fact the SEC had just allowed it to increase four-fold.

Soon credit default swaps, CDS's, were increasingly being employed to manage risk.  These were insurance against defaults on such things as mortgages, municipal bonds, money market funds etc.  AIG led the sale of these instruments and guaranteed them even though they never had the money to back up what they sold.  Things like mortgages were never suppose to go down in value to any large extent, so reserves adequate to back these CDS's were never deemed necessary.

Meanwhile, long term interest rates fell to historic lows all over the world as savings increased from the world wide creation and accumulation of wealth, especially in China and India.  At the same time the Baby Boomers were looking to retire soon and positioned themselves by buying second homes and or vacation homes.  This led to a real estate boom.  Compounding the run into real estate were new investors who were burned by the stock market dot com crash of 2000.  They were looking for an alternative investment.  Why not real estate.  Real estate always goes up.  Certainly it would be safer than stocks.

From 2001 to 2007 home prices doubled even though national inflation rates remained historically low.  Flippers and speculators stoked the housing boom.  Through all of this, real estate appraisers served their banking clients and investors by valuing homes at whatever the selling price was.  This just added fuel to a burning fire.

By July 2007 some sub prime loans were beginning to default. Some hedge funds began to experience runs.  Investors became spooked and liquidity started drying up. Since mortgages are not liquid like stocks, many funds could not de-leverage fast enough.  What amounted to a slow run on financial institutions, especially the shadow banks, began to affect almost every investment bank and hedge fund around the world.  Soon brokerage firms like Merril Lynch, insurance companies like AIG, and mortgage banks like Country Wide came under suspicion.

As home prices began to fall and some institutions went bankrupt the stock market began to decline.  All eyes turned to the Federal Reserve Board.  What was the Fed's policy?  The Fed had held interest rates at very high real rates for over a year.  Even though all other market rates had been falling and a whiff of deflation was in the air the Fed artificially held the fed funds rate up to an artificially high 5.25%.  Even though signs of credit deterioration and liquidity problems were emerging they kept the money supply growth at zero percent.  This exasperated the liquidity crisis. Finally, the Fed realized it needed to move and it moved quickly to lower interest rates and increase money growth, but it was too late.  It had been sadly behind the curve for over a year.

Adding injury to insult, at the very time the stock market entered a bear market the government made two disastrous moves.  First, it imposed the mark to market rule.  Mark to market is common in free trade transactions but a government imposed mark to market rule is quite different.  Mark to market forced an "official" re-valuation of assets downward and thereby caused margin calls which forced further selling of assets.  This may be fine in orderly markets but not in a time of panic and especially not at a time when there is no market to sell into.

Further, the government allowed the uptick rule to expire for the first time since the Great Depression.  The uptick rule discouraged massive short selling.  By removing it as a governor on short selling it encouraged short selling just when the market began to dive. These were not only questionable moves, they could not have come at a worse time.   Both served to reduce liquidity just when increased liquidity was needed.

By September 2008, Lehman Bros, a firm that had been around for over a hundred years, survived the Great Depression and every panic and crisis of the 20th century, was being squeezed and in danger of going bankrupt.  The Fed had the authority to open the discount window and allow it to gain liquidity and at least some breathing room but decided against it.  Lehman Bros. folded that Friday. As the ramifications reverberated around the world things worsened dramatically.  Bear Sterns and Merrill lynch came under attack and were rumored to possibly go under on Monday.  The Fed opened the window to all comers and prevented a major international monetary crisis from deteriorating into collapse.

Eventually Merril Lynch and Country Wide were bought by BOA,  and Washington Mutual was bought by Chase.  AIG, Freddie and Fanny were  taken over out right by the government.  I believe that the failure of the Fed and the Treasury to come to the rescue of Lehman Bros. led to the subsequent melt down that still plagues us today.

In my opinion, the Fed should have moved to buy "toxic" assets off the books of institutions beginning in October of 2007.  By then it had become obvious that the free market could not resolve the problem.  Markets had frozen up.  There was in fact  no market. Had the Fed moved then, I believe they would have headed off the liquidity crisis that developed in 2008 and prevented much of what has happened to date.  They should have also increased the money supply and lowered interest rates far sooner than they did.  Instead they played defense, always being behind the curve.  Even today much of the bad paper is still lingering on bank books.  These bad debts will continue to haunt the banking system and the economy until they are dealt with.

This week end is the one year anniversary of the demise of Lehman Bros. and the beginning of the crisis that led to the end of the investment banking era.  You will hear the press and others assess blame and reduce the cause to one or two people or factors or conditions.  You will here that deregulation was to blame, that free enterprise was to blame, that Wall St. was to blame, that low interest rates were to blame, that derivatives were to blame, that government intervention was to blame, that lack of government intervention was to blame, that Alan Greenspan caused the crisis, that George Bush caused the crisis, That Henry Paulson caused the crisis together with Congress and the Administration when authorizing  TARP funds. Or that the housing boom and bust, falling home prices, and foreclosures were to blame.

When you hear these accusations I want you to remember the elephant in the room.  The elephant is the following list of causes (and probably some that I've missed) that together made up a perfect storm that hit this country a year ago.

In reviewing the list ask yourself if it is reasonable to blame one person or one condition or one factor that was responsible for the panic and crisis of 2007-2008.

The Community Reinvestment Act
Fannie and Freddie
Lax credit agency ratings
Lack of regulation and enforcement by government agencies and markets
SEC deregulation of leverage
Mandating a mark to market rule
Elimination of the Uptick Rule 
Refusal to save Lehman Bros.
The Fed's tight monetary policy and artificially high interest rates
Refusal of Treasury or Fed to buy toxic assets
Loan applicant fraud
Loan officer fraud
Mortgage Broker fraud
Appraiser fraud
No Doc Loans
125% loans
Zero down loans
Banks pushing adjustable rate loans at teaser rates
No counter party risk, no recourse
Creation of exotic new and unregulated and non-transparent derivatives
Securitization by banks and Wall St investment firms
Lowest long term interest rates in history due to world savings glut
Housing boom and bust
Flipping of houses
Real estate speculation
Baby Boomers buying retirement homes, vacation homes, and second homes
Falling home prices
Increasing home foreclosures

And that folks, is the elephant in the room.

Paul Nathan