Butch Cooley Comments (Butch is founder of Leg Up House and the Butch Cooley Worldwide Hunting and Fishing . He has been an active trader for decades.)

Market Comments

The Financial and Market Collapse of 2007/2008: A Recap: Part 1

With the recent news reports and Congressional investigations into Bank of America, and Merrill Lynch deal, involving the Federal Reserve Bank and Paulson and Bernanke, I felt it prudent to take a look at the events that started in early 2007, and  at a few preceding years.. I'm talking about the events that lead us to our current financial situation. There have been some serious allegations made this week pertaining to what Chairman Bernanke did or might have done or not done, behind closed doors, in his handling of business to head off a so called meltdown in the world economy. I don't want to deal with opinions or speculation as to the Chairman's part at this point. That is for someone else, maybe another day. I do want to deal with more of a recap of what we do know, not so much what we don't know.

The talk, the scuttlebutt if you will, started in the spring of 2007. To be honest, I had thoughts of some kind of failure in the housing industry since I had first heard of an Adjustable Rate Mortgage. At the time, I had very little idea what they were. They made very little sense to me, and not something I was interested in. I had been used to what was commonly referred to as the 10 year housing cycle. Housing would reach a peak every 10 years or so, then taper off. This was around 2004, and we had just come off the end of the dot.com era, another major bubble, the markets had dropped, and we were all still talking about Enron and the dot.com bubble. Housing had come off it's 10 year high, but instead of dropping, it took off. The stock markets we coming back in 2004, so my investment lie there.. But I had reservations that 1% Fed money should have continued for as long as it did. I didn't think Alan Greenspan had handled the dot.com era correctly but I was not very critical, as I, along with many others, had made money from 1998 to 2001. I really never saw much value in the Federal Reserve for most of my trading life. They were always a dime late and dollar short when it came to making moves. They were too conservative, and from my point of view, had long lost any real value. However, I did not have a clue what should have been put in their place. So I was silent. And, I was making pretty good returns. And I think that makes a difference. Because, if we are doing well, good returns on our investments, well, damn the torpedoes.

I was living in the Seattle area at the time, in a suburb of the city. I was watching what was known as flipping houses beginning to take off. At first this too made no sense to me. I couldn't really understand how people could pull this off. Where was the money coming from? But I realized many were using equity lines of credit, (also something new) to buy a house, do a fast remodel, put it back on the market, and make a profit. It made no sense, but then they were doing it and making money. As I have often said, I make investments, and risk is always an issue to me. And flipping just seemed way too risky for my blood.

But it didn't end there. I saw people buying the “flipped house”, then tear it down, put in a new foundation, and build a multimillion dollar home in it's place....and sell it!! For a whopping profit!! I was amazed. And it's was becoming the norm where I lived. I talked to many who were in the business, and many were using interest only notes....another first for me. I knew the banks had to be in approval, as you just can't buy a house, mortgage it through a bank and then tear it down. They frown on stuff like this. Yet, here it was happening, and no one was frowning. In fact, many were getting rich. Lots of smiles at the time. I had  not yet heard of sub prime, CDOs, SIV, liar's loans. All that was yet to come.

But sub prime and bundling had been around a lot longer than I realized at the time. I can remember being somewhat curious about the sheer number of new mortgage companies that seemed to spring up every other week. I had a very good friend who was a broker/builder in the Seattle area. He was making a fortune, building and selling houses, and arranging financing. He was deep into sub prime at the time, but I simply saw it all as part of a housing boom, as did a lot of other people. I had no idea the depths to which this type of financing was going.

There are many stories written about one office companies that boomed and become national corporations within a few years. Most of them are out of business now. I even recall reading a story about a bus boy working a party for one of these companies. They hired him as a loan officer and within a few months he was making 6 figures a year. And the business was selling sub prime mortgages. And they were selling them to people who otherwise could not qualify for a normal housing loan. And investment banks were buying these things up as fast as they could be written, bundling them, and selling them all over the world. I recall one story told to me by a loan officer about Greenspan and the Federal Reserve. A 30 year mortgage had dropped to 5.8%, the lowest since the 1960's. But his company was writing ARMs at 3 1/2%. Just before Greenspan left his job as Fed Chairman in January 2006, he had seen numbers that stated sub prime mortgages accounted at that time for about 20% of all mortgages that had been written. He didn't believe the numbers. There is doubt that he even told Ben Bernanke about the increases when they changed the guard. Greenspan was actually proud that so many houses were being sold. Little did he know.

And two weeks into Bernanke's new job, he appeared before Congress and reported that ownership in housing in America had jumped to 70%, and this was mainly due to the availability of sub prime notes. He viewed this as a very positive economic sign. I have no doubt he does not believe that anymore.

It became apparent in 2007 that the housing boom, had become a bubble, and had burst. There was a drop in the markets in early March as reports of increasing foreclosures came to bear. We came back, hit some new highs, and then fell off again in July and August. It was summer, and this was to be expected. But not too many thought things were all that bad. A correction maybe. And in October 2007, the Dow hit a new all time high. But now we were all hearing new terms, toxic assets, tons of possible bad mortgages, maybe trillions of dollars. Trillions?? Could this really be possible?? There were rumors that Bear Stearns was in trouble, running out of money. It was all surreal. This couldn't happen, could it??

I first heard of the Bear Stearns problems when David Faber of CNBC broke the news. It stopped me in my tracks. Because, if what David was saying, that Bear Stearns, an investment bank, was actually running out of cash, then Wall Street was up to their noses in trouble. If this news was true, then a number of investment banks were going to be illiquid too. The only other time I had this kind of pit in my stomach was during the Cuban crisis, and back then, nuclear war seemed possible, almost eminent. But it would soon become very clear, this was only the tip of the iceberg.

In June 2007, two hedge funds of Bear Stearns went into bankruptcy. The news was big, but not really big. Bond markets were keeping an eye on BS. Both funds had been invested deeply into sub prime. But things really started to go bad on March 10, 2008. The rumors had surfaced in the news, and it was not good. Bear Stearns could be running out of money. The stock started to collapse. By the mid afternoon, BS was trading around $60 a share. Earlier in the year BS had been above $170 a share. Of course, the company denied the rumors, they had plenty of money, $18 billion sticks in my head. They were fine, and these rumors were just ridiculous. But no one is listening, and BS is experiencing a run on the bank. March 12, CEO Alan Schwartz goes on CNBC to get his message out with David Faber. No one is reassured and by afternoon, the rumor is BS will not be able to renew loans in the morning. It's really starting to look bleak. There are late night meetings at BS as they look to see what options they have, if any.

The next day Schwartz tells employees that the rumors are nothing but “noise”. It's reported that by the end of trading, BS cash reserves are down below $4 billion. Now things really start to move. JPM CEO Jamie Dimon is at a family gathering, and gets a call that night from Schwartz. Schwartz is in trouble, and needs an immediate shot of cash to the tune of about $30 billion. Dimon puts a team together to look at books, but also tells Schwartz to bring in Treasury and the Fed. Geithner is head of the NY Fed Reserve Bank, and he gets notified that evening also. So he too puts a team together. It's Friday early am, March 14^th, 2008. And Bear Stearns is in real trouble. JP Morgan and the NY Fed now know that BS is holding a ton of sludge, what will become known as toxic assets. Much of this junk is in the form of sub prime mortgage loans and credit derivatives. That alone is pretty scary, but it gets much worse. Bears Stearns junk is tied to many other banks. So BS junk is now other people's junk. So about 4 o'clock in the morning, Geithner puts a call into Fed Chairman Bernnake. That had to be a fun call!!

Things are moving fast now. The Fed can not lend directly to an investment bank. So a deal is in the works to get JP Morgan to lend the money. The loan for this money is from the Fed. And this will give Bear Stearns about 30 days of life, to get things resolved. So now the markets open and BS gets hit hard again. But Schwartz goes home with at least 30 days to get things back to normal. But this all falls apart with one phone call from Treasury Secretary Paulson. No 30 days, he wants the deal done by 6.30 pm on Sunday when the Asia markets open. If the deal is not done, then the SEC puts a call into the Asian markets and BS doesn't trade anymore. End of story. So BS has the weekend only to fix this mess. BS closed on that Friday at $32/share.

On March 16^th, after everyone with an interest has gone through BS's books, JPM figures they can offer some where between $12 to $18 a share. Sounds like a done deal. But on Sunday morning, JPM execs are having second thoughts. They withdraw the offer and BS is back to square one. With time running out, Bernanke brings $30 billion to the table to guarantee Bear's toxic sludge. JPM takes the $30 billion and makes an offer of $4 a share. Paulson then steps in and quoting some laws pertaining to moral hazard, something that will be heard of again in coming months, he insists that JPM only offer $2/share. The Bear Stearns board is really upset by all this, but what the heck, this is the only deal on the table. And they agree. March 16^th, 2008. Not really that long ago, but how many have forgotten??

Paulson doesn't get his way on the $2, and JPM offers $10 a share (still unbelievably cheap) to get the BS stockholders to approve the sale. And it's a done deal on March 26^th, 2008. Bear Sterns is gone. But what is about to happen, no one was prepared for. Wall Street, everyone, all the investment banks will be gone shortly.

Part 2 will deal with Lehman and Merrill Lynch and AIG.

BC