1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page i PRAISE FOR THE PREVIOUS EDITION OF THE TWO TRILLION DOLLAR MELTDOWN A New York Times bestseller A Wall Street Journal bestseller “Few writers are as good as Morris at making financial arcana un- derstandable and even fascinating.” —Floyd Norris, New York Times Book Review “[The Trillion Dollar Meltdown] is an absolutely excellent narrative of the horror that we have in the credit markets right now. It’s a wonderful explanation of how it happened and why it’s so rotten, and why it will take a long time to unwind.” —Paul Steiger, editor-in-chief, ProPublica, and former managing editor, The Wall Street Journal “[A] shrewd primer.… [Morris] writes with tight clarity and blistering pace.” —James Pressley, Bloomberg News “Morris, a former banker, [earned] rock-solid status as a predictor of the crash. He homes in on the complexity and the paradoxical un- predictability of these financial instruments, which were supposed to manage risk and ended up magnifying it.” —New Yorker “Morris provides a comprehensive and jargon-free description of the hideously complex financial securities that have brought the credit system to collapse. It is a remarkable story.” —Sunday Times (London) “Charles Morris provides an excellent and timely analysis of the ori- gins, causes, and turbo-charged financial engineering that allowed cheap and excessive debt to create a bloated financial system.” —Satyajit Das, author of Traders, Guns & Money: Knowns & Unknowns in the Dazzling World of Derivatives 1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page ii “Amid the hyperbole, several financial-scare books stand out for their high credibility and low hysteria. The Trillion Dollar Meltdown by Charles R. Morris … avoid[s] the wild predictions of mass eco- nomic destruction, instead giving thoughtful, if alarming, histories and analyses of how we got into the mess we’re in today.” —Susan Antilla, Bloomberg News “Charles Morris, author of The Trillion Dollar Meltdown, isn’t one for sugarcoating. His analysis is dour and grim, but certainly not dull. And when read against a backdrop of an ever-weaker economy, increasingly anxious economists, and a stream of gloomy predic- tions, it can be downright scary. Morris serves up a sharp, thought- provoking historical wrap-up of the U.S. economy and its markets, along with clear scrutiny of today’s economic woes.” —USA Today “My favorite single book account [of the subprime crisis].” —Business & Economics Correspondent Adam Davidson, NPR’s “Planet Money” “Millions of words have been written about the ongoing financial disaster largely caused by the subprime mortgage mess. But the most concise and easiest to understand handbook on the issue is almost certainly Charles R. Morris’ The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash.” —Robert Bryce, The Texas Observer “[A] masterful and sobering book.” —Commonweal “To better understand how the world economy has been pushed to the brink and what the post-crash political/economic environment might eventually look like, this book provides both insight and a possible peek into our future.” —Larry Cox, Tucson Citizen “Will provide some important background that will help decipher the meaning behind today’s gloomy financial headlines. For those who wonder ‘Why?’, here’s a place to get some answers!” —Watsonville (CA) Register-Pajaronian 1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page iii THE TWO TRILLION DOLLAR MELTDOWN Easy Money, High Rollers, and the Great Credit Crash CHARLES R. MORRIS PublicAffairs New York 1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page iv Copyright © 2008 by Charles R. Morris. Hardcover published as The Trillion Dollar Meltdown in 2008. Published in the United States by PublicAffairs™, a member of the Perseus Books Group. All rights reserved. Printed in the United States of America. No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews. For information, address PublicAffairs, 250 West 57th Street, Suite 1321, New York, NY 10107. PublicAffairs books are available at special discounts for bulk purchases in the U.S. by corporations, institutions, and other organizations. For more information, please contact the Special Markets Department at the Perseus Books Group, 2300 Chestnut Street, Suite 200, Philadelphia, PA, 19103, call (800) 810-4145 ext. 5000, or email [email protected]. The Library of Congress catalogued the hardcover edition as follows: Morris, Charles R. The trillion-dollar meltdown : easy money, high rollers, and the great credit crash / Charles R. Morris. — 1st ed. p. cm. Includes bibliographical references and index. ISBN 978-1-58648-563-4 (hbk.) ISBN 978-1-58648-691-4 (pbk.) 1. Capital market—United States. 2. Finance—United States. 3. Financial crises—United States. I. Title. HG4910.M667 2008 332'.04150973—dc22 2007048207 First Edition 10 9 8 7 6 5 4 3 2 1 1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page v For Charlie-chan 1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page vi This page intentionally left blank 1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page vii CONTENTS Foreword to the Paperback Edition ix Chapter One The Death of Liberalism 1 Chapter Two Wall Street Finds Religion 19 Chapter Three Bubble Land: Practice Runs 37 Chapter Four A Wall of Money 59 Chapter Five A Tsunami of Dollars 87 Chapter Six The Great Unwinding 113 Chapter Seven Picking through the Shards 143 Chapter Eight Recovering Balance 161 Notes 179 Index 193 1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page viii This page intentionally left blank 1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page ix FOREWORD TO THE PAPERBACK EDITION Sometime in October 2008, markets finally “got it.” The world was stuck in a vicious credit crunch and teetering on the brink of a frightening recession. Stock markets plunged everywhere, currencies whipsawed violently, interbank lend- ing seized up. Governments poured out trillions in loans, eq- uity infusions, and bailouts, while credit markets stayed obstinately stuck on “Closed.” The U.S. Federal Reserve Bank, in an unprecedented, and unilateral, expansion of its powers, pumped out $1.1 trillion in new lending in about six weeks—to banks, broker-dealers, a big insurer, commercial paper issuers, and money market funds. A $700 billion bank bailout bill was rammed through the American Congress on the promise that it would get at “the root cause” of the crisis by buying up toxic assets from banks’ books. European governments, led by Great Britain, trumped ix 1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page x x FOREWORD the American bailout with the much more focused strategem of equity infusions directly into the banks. Treasury Secretary Henry Paulson, a former president of Goldman Sachs and arch-antagonist of interventional government, was grudg- ingly forced to follow suit, only to find the queue of petition- ers lengthening by the day—not just banks, but insurance companies, state governments, and automobile companies. There was even talk of lending to hedge funds. For the first time, finance ministers realized how deeply the lethal new financial instruments from America had pene- trated global investment portfolios; and how far their own banks, especially in Europe, had gone in emulating the Amer- ican giants. Europe’s hope that it could “de-couple” its econ- omy from America’s vanished, as the continent slid toward negative growth. The petrostates—Russia, Venezuela, Iran, and the Arab states—who had linked their spending to the infinite gluttony of the American consumer, stared into the abyss. Even economies—like those of Korea, Taiwan, and Brazil—that had maintained strong reserves and mostly sound practices were staggered in the gusts. Iceland, which had taken a riskier path, went bankrupt. The global crisis, however, was indeed made in America, despite the sins of its imitators and fellow travelers. At its core, it was a crisis of the classic “Argentinean” variety—a debt-fed party, marked by a consumer binge on imported goods, and the strutting of an ostentatious new class of super- rich, who had invented nothing and built nothing, except in- tricate chains of paper claims that duller people mistook for wealth. This was the same America, of course, that had preached the strait-laced “Washington consensus”—increase 1586486914-Morris.qxd:1586484141-fm.qxd 11/26/08 9:09 AM Page xi FOREWORD xi savings, balance budgets, run trade surpluses—in the wake of the Latin American and Asian crises of the 1980s and 1990s. This new edition of the book goes to press in the early months of Year Two of the Great Credit Crunch. Since the first edition was completed in November 2007, when the crash was still in its early stages, a brief summary of Year One is in order. From today’s perspective, the late spring of 2007 seems like a different era. American financial markets were unusually sunny; consumer spending was growing strongly; the market for investment-grade credit was booming; and the premiums demanded to invest in riskier forms of debt were at an all- time low. The S&P 500 jumped more than 9 percent just from March through May. A first seismic quiver came in mid-June when it was dis- closed that two Bear Stearns mortgage hedge funds could not meet margin calls. A Moody’s downgrade had reduced the value of certain of their investment-grade “subprime” mortgage-based bonds.