Financial Alchemy: Collateralized Loan Obligations (CLOs) Transform Junk Loans into Investment Grade Securities

A week ago, we described commercial loans in general, and how they differ from bonds. Companies nearly always need money to make money, and thus have to borrow money in addition to selling stock shares. Companies that are new or smaller or doing poorly or have already borrowed a lot can still get loans, but these loans typically come with stringent conditions and require paying relatively high interest. These “leveraged loans” are the loan equivalent of “junk” bonds. When a bank lends money as a “Senior Secured Loan”, this entails agreements (“covenants”) which may specify that in event of default, this loan gets paid off ahead of any other creditor, and also that some specific asset held by the company, such as a building or an oil field, will be given over to the bank.

Financial institutions like insurance companies and pension funds are hungry for “investment grade” securities like bonds rated BBB or higher. Normally, these institutions would not consider buying into the senior loan marketplace, since these instruments are not considered investment grade.

Enter “Collateralized Loan Obligations” (CLOs). With a CLO, 200 or so loans which have been made by banks and then sold off into the market are bundled together, and then the cash flow from the interest paid on these loans plus the principal paid back is repackaged into slices or “tranches”. The highest level tranches get first dibs on being paid from the overall CLO cash flow, then the lower and lower tranches. The majority of bank loans today end up being packaged into CLOs.  CLOs are an example of a lucrative operation known as “securitization”:   “Securitization is the process of taking an illiquid asset or group of assets and, through financial engineering, transforming it (or them) into a security” (per Investopedia).

The rate of loan defaults in recent years has been only 3-4%, and on average the recovery on a given defaulted senior secured loan has been around 80%. So the actual losses (e.g. 4% x 20%, or 0.8% net) have been quite low. The highest annual default rate in recent memory was about 10%, in the Global Financial Crisis of 2008-2009.

The theory is that, although any particular loan has a nontrivial chance of defaulting, it is unthinkable that more than say 20% of all loans would default; and even if a full 20% of the loans did default, we would expect that the actual losses after liquidating the pledged collateral would be more like 4% of the entire loan portfolio (i.e. 20% defaults x 20% loss per default). This means that the top 95% or so of CLO cash flow should be considered very secure, and the top 60-70% are utterly secure.

Thus, the top 60-65% of the CLO cash flow is packaged as super secure, relatively low-yielding AAA rated debt, and as such is bought up by conservative financial institutions, including banks. This arrangement keeps those institutions happy, and also facilitates the making of loans to the needy companies who are taking out the underlying loans.

The figure below from an Eagle Point Investment Company presentation depicts typical CLO tranches:

The lower the position in the CLO cash flow “waterfall”, the higher the yield and the higher the risk of non-payment. The AA, A, and BBB debt tranches are all considered investment grade, though with higher risk and higher yields than the AAA tranche. The Eagle Point Investment Company happens to buy into the BB-rated debt tranche, which is just below investment grade. You, the public, can buy shares Eagle Point Investment (stock symbol EIC). These shares pay about 7% yield, after hefty management fees have been subtracted.

The equity tranche lies at the very bottom of the CLO heap. If there were, say, 20% loan defaults with only 50% recovery of the loans, the equity tranche might get completely wiped out. So these are more risky investments. As usual, there is high reward along with the risk. Oxford Lane Capital (OXLC) deals in CLO equity, and it will pay you about 15% per year, which is huge in today’s low-interest world. But….you need to be prepared to have the stock value cut in half every ten years or so, whenever there is a big hiccup in the financial world.

Anyone who was an economics-savvy adult during the GFC should be asking, “But, but, but…aren’t these CLOs essentially the same thing as the collateralized debt obligations (CDOs) that blew up the world in 2008?”  The answer is partly yes, in that in both cases a bunch of loans get bundled together and then resliced into tranches. That said, we hope that the underlying loans in today’s CLOs are more robust than the massively shady home mortgage loans of 2003-2008 that fed into those CDOs. Back then, unscrupulous banks and mortgage companies handed out thousands of housing loans to ill-informed private individuals who did not remotely qualify for them, and then the banks dumped these loans out into the broader financial markets via CDOs. The bank loans behind today’s CLOs are more sober, serious, vetted affairs than those ridiculous subprime home mortgages.

This past summer, in the thick of the Covid shutdowns which have stressed small businesses,  The Atlantic published a dire assessment of the potential for CLOs to sink the system, with the catchy title “The Looming Bank Collapse “. The article noted, fairly enough, that there has been a trend in the past few years to weaken the covenants on loans which would normally protect the lender against losses. Most loans these days are considered “covenant-lite”, compared to several years ago. There is genuine concern that the recovery on these loans might be more like 40-50%, instead of the historic 70-80%. On the other hand, the looser requirements on these loans may mean that fewer of them will technically violate these looser covenants and thus fewer companies will actually default. A recent survey estimates that the default rate in the $ 1.2 trillion dollar leveraged loan universe will peak at only 6.6% in 2021.

Also, today’s CLOs seem to be rated by the major ratings agencies more responsibly than the notoriously optimistic ratings given to CDO’s back in 2008.  “CLOs are usually rated by two of the three major ratings agencies and impose a series of covenant tests on collateral managers, including minimum rating, industry diversification, and maximum default basket”, according to an article by S&P Global Market Intelligence. That article has a good description of CLOs, including a brief tutorial video on the nuts and bolts of how they work.

Raising Cash: Corporate Bonds versus Corporate Loans

Corporations raise money in various ways to invest in their operation. A company may sell common stock to the public; the shareholders are not guaranteed any particular return on their investment, but if the company does well, the share price and the dividends paid by the stock can be expected to go up.

Preferred stock falls in between common stock and bonds. Investors mainly buy preferred stock for its dividends. Typically, the price of the preferred stock doesn’t go up like common stock can, but the company cannot pay any dividends on the common unless all of the promised dividends on the preferred are paid up.

CORPORATE BONDS: INVESTMENT GRADE AND JUNK

Companies can sell bonds to raise money. Bonds are somewhat standardized securities, which are marketed to the broad investing community. The company is legally bound to pay the interest, and eventually the principal, of a bond. Bonds are senior to stocks in case of extracting value from a company that has gone bankrupt. Some bonds are more senior than others, depending on the “covenants” in the fine print of the bond description (debenture). For smaller, less stable companies, the only way they may get someone to buy their bonds is to agree to certain conditions that make it more likely the bond will be repaid. For instance, the company selling the bond might be restricted from issuing more than a certain amount of total debt relative to its earnings, or from taking on additional debt which might be senior to its existing debt.

Bonds are rated by agencies such as Moody’s and Standard and Poor’s. Large, stable companies get high ratings (e.g. AA), and can pay lower interest. You, the public, can buy into investment grade bonds through funds such as iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD). This fund currently pays about 2.6%, but most of the returns in the past several years have been from an increase in the price of the fund shares. (For longer term bonds, the market price of a previously-issued bond increases as market interest falls, which it has in recent years).

The lowest investment grade is BBB. The bonds of shakier companies are rated at BB or lower, and have pay higher interest. This is called high yield debt or junk bonds. You can invest in junk bonds through funds such as JNK and HYG.

CORPORATE BANK LOANS

Companies also obtain loans from banks. Banks scrutinize the operations of the company to decide whether they want to risk their money in making a loan. Banks usually demand restrictions and guarantees to help ensure the loan will paid back. These restrictions are called covenants. Sometimes the payback of the loan is tied to a specified asset. For instance, if the income of a company falls below a certain level (which might imperil paying off the loan), the covenant may require the company to give ownership of some asset, like a building or a set of oil wells, to the bank, so the bank can sell it to pay back the loan immediately, before economic conditions worsen.

This graphic shows some of the conditions a company might have to sign to in order to get a loan from a bank:

Source: https://www.wallstreetmojo.com/debt-covenants-bond/

Here is a summary of the differences between bonds and loans, courtesy of WallStreetMojo (slightly edited):

  • The main difference is that a bond is highly tradeable. If you purchase a bond, there is usually a market place where you can trade it. It means you can even sell the bond, rather than waiting for the end of the thirty years. In practice, people purchase bonds when they wish to increase their portfolio in that way. Loans tend to be the agreements between borrowers and the banks. Loans are generally non-tradeable, and the bank will be obliged to see out the entire term of the loan.
  • In the case of repayments, bonds tend to be only repaid in full at the maturity of the bond – e.g., 10, 20, or 30 years. With bank loans, both principal and interest are paid down during the repayment period at regular intervals (like a home mortgage).
  • Issuing bonds give the corporations significantly greater freedom to operate as they deem fit because it frees them from the restrictions that are often attached to the loans that are lent by the banks. Consider, for example, that lenders or the creditors often require corporates to agree to a variety of limitations, such as not to issue more debt or not to make corporate acquisitions until their loans are repaid entirely.
  • The rate of interest that the companies pay the bond investors is often less than the rate of interest that they would be required to pay to obtain the loan from the bank. Sometimes the interest on the loan is not a fixed percent, but “floats” with general short-term interest rates.
  • A bond that is traded in the market possesses a credit rating, which is issued by the credit rating agencies, which starts from investment grade to speculative grade, where investment-grade bonds are considered to be of low risk and usually have low yields. On the contrary, a loan don’t have any such concept; instead, the creditworthiness is checked by the creditor.

LEVERAGED LOANS

The rough equivalent of a junk bond in the world of corporate loans is called a “leveraged loan”. A leveraged loan is a type of loan that is extended to companies or individuals that already have considerable amounts of debt or poor credit history. Lenders consider leveraged loans to carry a higher risk of default, and so they demand higher interest on the loan. Leveraged loans and junk bonds play a key role in helping smaller or struggling companies achieve their financial goals. Leveraged loans are widely used to fund mergers and acquisitions.

Because the company itself is considered shaky, creditors typically require that the company offers some specific asset for collateral to “secure” the loan. Also, the loan is typically written to be “senior” to other debt, including bonds, in case of bankruptcy. Historically, the recovery rate for such senior secured loans has been about 80%, as compared to a recovery of about 40% for unsecured bonds, if the company goes bankrupt.

Typically, a bank would not want to take all the risk of such a loan upon itself. Therefore, for a leveraged loan, the bank arranges for a syndicate of multiple banks or other financial institutions to own pieces of the loan. You, too, can get a piece of this action by buying shares of the fund Invesco Senior Loan ETF (BKLN), which is currently yielding 3.2%.

S&P Global Market Intelligence offers a primer on leveraged loans, complete with tutorial videos. As shown below, the market for leveraged loans in the U.S. is now over $ 1 trillion:

Source: https://www.spglobal.com/marketintelligence/en/pages/toc-primer/lcd-primer#sec2

Huge Prison Population in the U.S.

During some general reading on finance, I ran across the following two information-rich graphics from Hoya Capital on the U.S. prison population. On the first graph, the blue areas show the absolute numbers, and the green line shows the percent incarceration rate. A rate of 0.5% comes to 500 prisoners per 100,000 population.

This graph shows a huge rise in the state and federal prison population between 1980 and 2000. There seems general agreement that much of that increase in the prison population is due to mandatory sentencing laws, which require relatively long sentences. In particular, “three strikes and you’re out” laws may demand a life sentence for three felony convictions, if at least one of them is for a serious violent crime. Another factor was the increased criminalization of drug use (possession), in addition to drug dealing.

The graphic below shows the particular classes of crimes of which inmates of the state and federal prison systems have been convicted. The largest single category is violent crimes, but other types are significant, such as drug and property crimes, and “public order” crimes. Public order crimes include activities such as prostitution, gambling, alcohol, child pornography, and some drug charges. This graphic also includes the large number of people in local jails, most of whom are imprisoned awaiting trial or sentencing.

The total number of people under legal supervision in the U.S., including probation and parole, is over 6 million:

Source: Wikipedia

The U.S. has by far the largest official prison population in the world, and the highest incarceration rate. The following graph from Wikipedia depicts incarceration rates for several countries or regions as of 2009:

Most developed countries have incarceration rates of around 100-200 per 100,000, which is where the U.S. was in about 1970. The relatively high rate for Russia is attributed in large part to strict “zero tolerance” laws on drugs.

Again, the main driver for the high rates in the U.S. is the long sentences, driven by mandates. Wikipedia notes that there are other countries, including some in Europe, which have higher annual admissions to prison per capita than in the U.S. However, “The typical mandatory sentence for a first-time drug offense in federal court is five or ten years, compared to other developed countries around the world where a first time offense would warrant at most 6 months in jail… The average burglary sentence in the United States is 16 months, compared to 5 months in Canada and 7 months in England.” 

Policy debates on this topic continue. Obviously, we want to protect society from dangerous predators, but the direct and indirect costs to society for this level of incarceration are high. It seems like an area which is ripe for reform of some kind, though I do not claim to have a novel proposal.

Brighten Your Day with a Light Therapy Lamp

It is that time of year in the Northern Hemisphere when the days are getting shorter, the nights longer, and the sun hangs lower in the sky. Seasonal Affect Disorder (SAD) probably affects all of us to some extent. What to do?

Well, I understand that studies have shown that exposing your retinas to bright light, in the sunlight wavelengths, can improve mood and functioning. A variety of therapeutic lamps are available. Some of the least expensive ones sit on your table or desk, and shine up at a slight angle while you read or watch a movie. An example of this type is the Nature Bright SunTouch Plus ( $49 ), shown below. The lamp is ideally positioned quite close to your eyes, say 12 inches (30 cm), in order to get the recommended photons into them.

Our family has gotten a lot of mileage out of a somewhat more expensive but more versatile lamp. This is the Day-Light Sky lamp  ($113).

It has joints at the top and the bottom of its support arm, so you can use it like a desk lamp, to give strong lighting to some project you are working on, or have it therapeutically shine into your eyes, like this happy camper:

In that mode, you’d want to keep your gaze level or only slightly downward, since not much light would get into your pupils if you had your head down reading. Our family uses this on the counter or table whilst preparing or eating breakfast (it is best to get your photons in early in the day). It also works well positioned beside your shoulder as a cheery reading light.

Camping in Style in an “Instant Cabin” Tent

This is the time of year when we often think of gifts to give to others, or for others to give to us, if they are so moved. So I will share an item which took a bit of research to lock in on, and which has worked out very well in practice.

When I was in my teens, I was content to throw a sleeping bag on a tarp right on the ground when camping. In my 20s, I used a half inch thick dense foam pad, a classic Ridge Rest. I wanted a little more cushion under me in my 30s, and so graduated to a 1.5 inch thick self-inflating sleeping pad like this Stansport. For backpacking in my 40s and 50s, I craved yet more air space underneath me, especially for curling up on my side, and got good usage out of a narrow, 2.5 inch thick inflatable sleeping pad.

Now my wife and I are pretty much done with roughing it. We still enjoy the great outdoors, but find we enjoy it even more when we have essentially all the comforts of home, which includes a full size queen air mattress. It takes a pretty big tent to accommodate that plus all our other gear, without feeling squashed.

I have had some large tents in the past, which were very tedious to set up. So I was pleased to find a huge, airy tent, which almost erects itself. This is the Ozark Trails 9-Person Instant Cabin.

Image from Amazon website

The main room is 9 x 14 ft, which is plenty big for glamor-camping (glamping) for two people. In huddled masses mode, probably 8 bodies would fit comfortably. The tent has a screen room across the front, for a bug-free place to sit. The fly over the screen room provides a roof over the door to the main room, keeping out rain even when the tent door is opened.  Here are two views from within on our latest camping trip, first looking out the door through the screen room, and then looking straight up through the roof before we put the fly over the tent at the end of the day.

As an engineer, I am tickled by the clever joints that allow you to make the structure arise with just a few strategic tugs. Going from stage 2 to stage 3 in the photo below takes all of fifteen seconds. Taking the tent down for storage simply involves doing all these motions in reverse. The tent itself stays always attached to the poles.

Image from Amazon website

The only major drawback is the price, about $300, which is a lot for a tent. Considering our wants at this stage, for us that is a fair exchange. It gives us much of the space and utility of a small pop-up camper trailer, for a fraction of the cost.

Review of: “How the Scots Invented the Modern World”, by Arthur Herman

This book describes the development of intellectual life and related events in Scotland from about 1700 onward. Scotland in 1700 was a small, poor, largely agrarian independent nation, still characterized in large part by feudalism. In much of the country, clansmen in their kilts constantly robbed and fought each other. By 1800, it was an economically thriving section of the United Kingdom of Great Britain, and a huge contributor to modern thought on many levels. The subtitle on the front jacket of the book expansively portrays its contents as: “The True Story of How Western Europe’s Poorest Nation Created Our World & Everything in It”.

A key event which helped launch this flowering was an economic one. The 1690’s were an unusually cold decade, leading to famine and poverty in the more northern European countries like Scotland. Scottish trade and industry were constricted by the policies of England, their more powerful neighbor to the south. Other nations of Western Europe in the 1600’s had colonies in the Americas, which seemed to be a source of national wealth and influence. Scotland tried to found her own colony, called Darien, on the coast of the Isthmus of Panama. A huge fraction of the wealth of Scotland was invested in this venture. It failed, for various reasons, which was an economic disaster for the country.

This led to a willingness on the part of the Scottish elite to surrender their independence in return for the chance to participate in commerce on the same terms as the English and under the protection of the Royal Navy. An Act of Union between the two kingdoms was approved in 1707. This led to a rise in prosperity and helped set in motion various influences of modernization.

A lively intellectual life in the burgeoning cities of the Scottish lowlands put Scotland at the forefront of the 18th century enlightenment. The Scottish Enlightenment was more practical and aligned with common sense than was the Enlightenment of the French philosophes.  David Hume and Adam Smith are just two of the significant Scottish thinkers of this era. The works of Hume and of Smith (e.g. The Wealth of Nations) are still required reading today in the fields of philosophy and of economics.

Scots likewise made great contributions to science and technology. Today we measure power in terms of “watts”, a tribute to James Watt, whose improvements to steam engines made them finally practical for widespread use. We drive on “macadam” roads, initially developed by John McAdam.

How the Scots Invented the Modern World weaves all these themes together, going into enough detail with key actors to make them come alive as real persons. Since there are so many books and so little time, I rarely go back and reread a book. Also, I ruthlessly pruned my collection as part of our recent household interstate move. But I have found myself picking up this volume from time to time, and so it survived the cut. I recommend it as an entertaining and enlightening read.

Timeline of the Global Financial Crisis, Part 1: January-September, 2008

The sudden shutdown of much of the economy of the U.S. and of the world starting in February and March of 2020 led to deep concern, if not panic, in world financial markets. Millions of people were suddenly unemployed or furloughed, millions of small businesses faced bankruptcy, and stocks plunged some 30% in the fastest fall of global markets in history. Demand collapsed, and prices for nearly all financial assets fell. Trillions of dollars of financial transactions were in danger of unravelling.

The Federal Reserve immediately rode to the rescue, slashing interest rates and buying up all kinds of financial assets. These purchases of bonds and similar products injected cash into the markets to provide much-needed liquidity, and kept the system on track. In late March, the U.S. federal government authorized trillions of dollars of payments to individuals and businesses to stave off bankruptcy, and forbade foreclosures on mortgages, to keep people from losing their homes (at least in the near term). Banks and governments in other nations took similar measures. By May, it was clear that the worst scenarios had been averted, even though there will be significant lingering consequences of the Covid shutdowns.

The speed and scale of the Fed and government responses in March, 2020, may be attributed in part to learnings from the 2008-2009 Global Financial Crisis (GFC). In that crisis, the severity of the problem was not understood at first. There was naturally reluctance to take unprecedented actions to do what was perceived as bailing out of irresponsible banks and other companies. Over a period of many months, various measures were implemented to address some immediate needs, but then more and more problems kept cropping up. It was a macroeconomic game of whack-a-mole.

As a bit of a history lesson, here is a timeline of the main financial events of January-September, 2008. These descriptions are taken, with only minor editing, from an article by Kimberly Amadeo in The Balance.

~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~

January 2008: Fed Tries to Stop Housing Bust

Easy credit and expectations of always-increasing home prices led to a speculative run-up in housing in 2002-2006. Mortgages were given to people who really could not afford them, and billions of dollars of those unsound sub-prime mortgages were repackaged and sold into the broad financial system. That all began to unravel in 2006-2007. In response to a struggling housing market, the Federal Market Open Committee began lowering the fed funds rate. It dropped the rate to 3.5% on January 22, 2008, then to 3.0% a week later. Economic analysts thought lower rates would be enough to restore demand for homes.

It didn’t help the millions of homeowners who had adjustable-rate mortgages.

February 2008: Bush Signs Tax Rebate as Home Sales Continue to Plummet

President Bush signed a tax rebate bill to help the struggling housing market. The bill increased limits for Federal Housing Administration loans and allowed Freddie Mac to repurchase jumbo loans.

February’s homes sales fell 24% year-over-year. It reached 5.03 million according to the National Association of Realtors. The median resale home price was $195,900, down 8.2% year-over-year.  Foreclosures were up.

March 2008: Fed Begins Bailouts

The Fed Chair realized the Fed needed to take aggressive action. It had to prevent a more serious recession. Falling oil prices meant the Fed was not concerned about inflation. When inflation isn’t a concern, the Fed can use expansionary monetary policy. The Fed’s goal was to lower the LIBOR benchmark interest rate, and keep adjustable-rate mortgages affordable. In its role of “bank of last resort,” it became the only bank willing to lend.

It increased its Term Auction Facility program to $50 billion. It also initiated a series of term repurchase transactions. These were 28-day term repurchase agreements with primary dealers. The Fed’s goal was to pump $100 billion into the economy.

March 11: The Fed announced it would lend $200 billion in Treasury notes to bail out bond dealers. They were stuck with mortgage-backed securities and other collateralized debt obligations. They couldn’t resell them on the secondary market. The subprime mortgage crisis dried up the secondary market for these debt products.

No one knew who had the bad debt or how much was out there. All buyers of debt instruments became afraid to buy and sell from each other. No one wanted to get caught with bad debt on their books. The Fed was trying to keep liquidity in the financial markets.

But the problem was not just one of liquidity, but also of solvency. Banks were playing a huge game of musical chairs, hoping that no one would get caught with more bad debt. The Fed tried to buy time by temporarily taking on the bad debt itself. It protected itself by only holding the debt for 28 days and only accepting AAA-rated debt.

March 14: The Federal Reserve held its first emergency weekend meeting in 30 years. On March 17, it announced it would guarantee Bear Stearns‘ bad loans. It wanted JP Morgan to purchase Bear and prevent bankruptcy. Bear Stearns’ had about $10 trillion in securities on its books. If it had gone under, these securities would have become worthless. That would have jeopardized the global financial system.

March 18: The Federal Open Market Committee (FOMC) lowered the fed funds rate by 0.75% to 2.25%. It had halved the interest rate in six months. That put downward pressure on the dollar, which increased oil prices.

That same day, federal regulators agreed to let Fannie Mae and Freddie Mac take on another $200 billion in subprime mortgage debt. The two government-sponsored enterprises would buy mortgages from banks. This process is known as buying on the secondary market. They then package these into mortgage-backed securities and resell them on Wall Street. All goes well if the mortgages are good, but if they turn south, then the two GSEs would be liable for the debt.

The Federal Housing Finance Board also took action. It authorized the regional Federal Home Loan Banks to take an extra $100 billion in subprime mortgage debt. The loans had to be guaranteed by Fannie and Freddie Mac

Fed Chair Ben Bernanke and U.S. Treasury Secretary Hank Paulson thought this would take care of the problem. They underestimated how extensive the crisis had become. These bailouts only further destabilized the two mortgage giants.

April – June: Fed Lowers Rate and Buys More Toxic Bank Debt

April 30: The FOMC lowered the fed funds rate to 2%.

April 7 and April 21: The Fed added another $50 billion each through its Term Auction Facility.

May 20: The Fed auctioned another $150 billion through the Term Auction Facility.

By June 2, the Fed auctions totaled $1.2 trillion. In June, the Federal Reserve lent $225 billion through its Term Auction Facility. This temporary stop-gap measure of adding liquidity had become a permanent fixture.

July 11, 2008: IndyMac Bank Fails

July 11: The Office of Thrift Supervision closed IndyMac Bank. Los Angeles police warned angry IndyMac depositors to remain calm while they waited in line to withdraw funds from the failed bank. About 100 people worried they would lose their deposit. The Federal Deposit Insurance Corporation (FDIC) only insured amounts up to $100,000. This was later raised to $250,000.

July 23: Treasury Secretary Paulson made the Sunday talk show rounds. He explained the need for a bailout of Fannie Mae and Freddie Mac. The two agencies themselves held or guaranteed almost half of the $12 trillion of the nation’s mortgages.

Wall Street’s fears that these loans would default caused Fannie’s and Freddie’s shares to tumble. This made it more difficult for private companies to raise capital themselves. Paulson reassured talk show listeners that the banking system was solid, even though other banks might fail like IndyMac.

July 30: Congress passed the Housing and Economic Recovery Act. It gave the Treasury Department authority to guarantee as much as $25 billion in loans held by Fannie Mae and Freddie Mac.

September 7: Treasury Nationalizes Fannie and Freddie

The FHFA placed Fannie and Freddie under conservatorship. It allowed the government to run the two until they were strong enough to return to independent management. 

The FHFA allowed Treasury to purchase preferred stock of the two to keep them afloat. They could also borrow from the Treasury. Last but not least, Treasury was allowed to purchase their mortgage-backed securities. 

The Fannie and Freddie bailout initially cost taxpayers $187 billion. But over time, they two paid back all costs plus added $58 billion in profit to the general fund. 

September 15, 2008: Lehman Brothers Bankruptcy Triggered Global Panic

Paulson urged Lehman Brothers to find a buyer. Only two banks were interested: Bank of America and British Barclays.

Bank of America didn’t want a loan. It wanted the government to cover $65 billion to $70 billion in anticipated losses. Paulson said no. The U.S. Treasury had no legal authority to invest capital in Lehman Brothers, as Congress hadn’t yet authorized the Troubled Asset Relief Program. Barclays announced its British regulators would not approve a Lehman Brothers deal.

Since Lehman Brothers was an investment bank, the government could not nationalize it like it did government enterprises Fannie Mae and Freddie Mac. For that same reason, no federal regulator, like the FDIC, could take it over.  Moreover, the Fed couldn’t guarantee a loan as it did with Bear Stearns. Lehman Brothers didn’t have enough assets to secure one. 

When Lehman’s declared bankruptcy, financial markets reeled. The Dow fell 504 points, its worst decline in seven years. U.S. Treasury bond prices rose as investors fled to their relative safety. Oil prices tanked.

Later that day, Bank of America announced it would purchase struggling Merrill Lynch for $50 billion. 

September 16, 2008: Fed Buys AIG for $85 Billion

The American International Group Inc. turned to the Federal Reserve for emergency funding. The company had insured trillions of dollars of mortgages throughout the world. If it had fallen, so would the global banking system. Bernanke said that this bailout made him angrier than anything else. AIG took risks with cash from supposedly ultra-safe insurance policies. It used it to boost profits by offering unregulated credit default swaps.

October 8, 2008: The Federal lent another $37.8 billion to AIG subsidiaries in exchange for fixed-income securities.

November 10, 2008: The Fed restructured its aid package. It reduced its $85 billion loan to $60 billion. The $37.8 billion loan was repaid and terminated.The Treasury Department purchased $40 billion in AIG preferred shares. The funds allowed AIG to retire its credit default swaps rationally, stave off bankruptcy, and protect the government’s original investment. 

September 17, 2008: Economy Almost Collapsed

Due to losses from Lehman’s bankruptcy, investors fled money market mutual funds. That’s where companies obtain their short-term cash.

September 16: The Reserve Primary Fund “broke the buck.” It didn’t have enough cash on hand to pay out all the redemptions that were occurring.

September 17: The attack spread. Investors withdrew a record $172 billion from their money market accounts. During a typical week, only about $7 billion is withdrawn. If it had continued, companies couldn’t get money to fund their day-to-day operations. In just a few weeks, shippers wouldn’t have had the cash to deliver food to grocery stores. We were that close to a complete collapse. 

September 19, 2008: Paulson and Bernanke Meet with Congress

U.S. Treasury Secretary Henry Paulson (L) speaks as Federal Reserve Board Chairman Ben Bernanke (R) listens during a hearing before the House Financial Services Committee on Capitol Hill September 24, 2008 in Washington, DC. Photo: Alex Wong/Getty Images

September 19: Paulson and Bernanke met with Congressional leaders to explain the crisis. Republicans and Democrats alike were stunned by the somber warnings. They realized that credit markets were only a few days away from a meltdown. 

The leaders were prepared to work together in a bipartisan fashion to craft a solution. But many rank-and-file members of Congress were not on board. 

Bernanke announced the Fed would lend the money needed by banks and businesses to operate so they wouldn’t have to pull out the cash in money market funds. This, along with the announcement of the bailout package, calmed the markets enough keep the economy functioning.

September 20, 2008: Treasury Submits Legislation to Congress

On September 20, Paulson submitted a three-page document that asked Congress to approve a $700 billion bailout. Treasury would use the funds to buy up mortgage-backed securities that were in danger of defaulting. By doing so, Paulson wanted to take these debts off the books of banks, hedge funds, and pension funds that held them.

When asked what would happen if Congress didn’t approve the bailout, Paulson replied, “If it doesn’t pass, then heaven help us all.”

September 21, 2008: The End of the “Greed Is Good” Era

Goldman Sachs and Morgan Stanley, two of the most successful investment banks on Wall Street, applied to become regular commercial banks. They wanted the Fed’s protection.

September 26, 2008: WaMu Goes Bankrupt

Washington Mutual Bank went bankrupt when its panicked depositors withdrew $16.7 billion in 10 days. It had insufficient capital to run its business. The FDIC then took over. The bank was sold to J.P. Morgan for $1.9 billion.

September 29, 2008: Stock Market Crashes as Bailout Rejected

A trader gestures as he works on the floor of the New York Stock Exchange September 29, 2008 in New York City. U.S. stocks took a nosedive in reaction to the global credit crisis and as the U.S. House of Representatives rejected the $700 billion rescue package, 228-205. Photo by Spencer Platt/Getty Images

The stock market collapsed when the U.S. House of Representatives rejected the bailout bill. Opponents were rightly concerned that their constituents saw the bill as bailing out Wall Street at the expense of taxpayers. But they didn’t realize that the future of the global economy was at stake.

Stock investors did, sending the ​Dow Jones Industrial Average down 770 points. It was the most in any single day in history. It didn’t stop there. Global markets panicked: The Morgan Stanley Capital International World Index dropped 6% in one day, the most since its creation in 1970.

To restore financial stability, the Federal Reserve doubled its currency swaps with foreign central banks in Europe, England, and Japan to $620 billion. The governments of the world were forced to provide all the liquidity for frozen credit markets.

[Again, these descriptions are taken nearly verbatim from 2008 Financial Crisis Timeline, by Kimberly Amadeo. See her article for coverage of the rest of 2008, and the ending of the recession in 2009.]

C. S. Lewis on the Medieval Mind

I recently read C. S. Lewis’ The Discarded Image: An Introduction to Medieval and Renaissance Literature for a Zoom reading club at Samford University. It is based on his course lectures given at Oxford. I had expected a somewhat boring discussion of one obscure manuscript after another. But the book went in a different, highly engaging direction.

The Medieval Model

Lewis spends much of his time in describing the general mindset and methodology of the medieval writers, what Lewis terms their “Model”, to give us the necessary background for understanding and appreciating medieval literature. This helped me to better understand how people were thinking back in the Middle Ages (c. 500-1500 A.D.). Obviously, the particulars of their model of the universe were incorrect. But having a comprehensive model of reality which worked at the time helped to ground them, so they did not experience the sort of alienation which characterizes our age. 


Medieval and early Renaissance authors did not generally just make things up. They very much relied on whatever Greek and Roman texts they had from pre-Middle Ages or early Middle Ages, which included a mix of philosophical/scientific (e.g. Platonic, Aristotelean, neo-Platonic), historical, and mythological treatises. In the medieval model of the universe (which was pieced together from readings of pre-500 A.D. authors), things below the orbit of the moon were contingent and corruptible and somewhat unpredictable. This was the realm of which we would call “nature”.


From the moon upward, was a more exalted realm, where the seven visible “planets”, which included the moon and sun, was each carried on its own transparent sphere. And also there was a sphere holding the stars. All these concentric spheres moved regularly (with some complications) and predictably.  Beyond that was the “prime mobile” sphere, invisible to us, which gave motion to all the other spheres within it.  God is the “Unmoved Mover” who gives motion to everything else.

Above the moon the space was filled with rarefied “aether”, instead of the thick, sometimes noxious air down closer to earth. Up there, it was always light, not dark, as we now think of “space”. (They understood the darkness seen when we look up at night as simply the relatively narrow shadow cast by the earth; everyplace else in the heavens was bathed in light).  The heavens rang with the beautiful “music of the spheres”, and was inhabited only by good, incorruptible beings such as angels and the stars and planets, and, of course, God. Any daemons or other evil spirits were down in the thick air closer to earth, below the level of the moon.

The planets (which included the sun and moon) and the stars were perhaps not fully conscious beings, but they were not dead lumps of rock and gas. They were, in some sense, intelligent beings who were happy doing what they were made for as they danced their patterns in the heavens over and over again. They had effects or “influences” on the affairs of men. The moon could make people a little crazy, Venus called forth romance, Mars promoted warring passions, and so on. This influencing was not some kind of creepy, occult operation, but just the way things are, a more or less natural principle like gravity. 

Some people could take this to a fatalistic determinism. The more judicious thinkers held that, while the planets and stars did indeed exert such influences, humans could and should exercise their reason and free will to resist being driven solely by such propensities. This nuanced notion carries down into Shakespeare, writing around 1600: “Men are at some time master of our fates: The fault, dear Brutus, is not in our stars, but in ourselves, that we are underlings.” (Julius Caesar)

Feeling at Home in the Universe

Medieval folks were aware that the universe was really, really huge. The earth was a tiny speck compared to the whole universe. However, the universe was finite, not infinite. That meant when they looked up, it was like looking up into a huge towering cathedral, not into empty space. So they would not experience what Pascal referred to as the frightening infinite dark empty silences of space. Also, they were looking up at a realm which was essentially happy and orderly, with each planet and star fulfilling its proper destiny.

I will close with a set of excerpts which convey their sense of being at home within a well-functioning universe and also their feeling of relatively seamless continuity with many previous centuries of interesting and often honorable human history. Their technology of plows drawn by oxen and of wars fought with swords and shields was not too different from the physical world of ancient Greece and Rome, and their culture of honor was likewise similar. I italicized some phrases which seemed particularly illuminating:

“Because the medieval universe is finite, it has a shape, the perfect spherical shape, containing within itself an ordered variety. Hence to look out on the night sky with modern eyes is like looking out over a sea that fades away into mist, or looking about one and a trackless forest – trees forever and no horizon. To look up at the towering medieval universe is much more like looking at a great building. The great ‘space’ of modern astronomy may arouse terror, or bewilderment or vague reverie; the spheres of the old present us with an object in which the mind can rest, overwhelming in its greatness but satisfying in its harmony.
…This explains why all sense of the pathless, the baffling, and the utterly alien – all agoraphobia – is so markedly absent from medieval poetry when it leads us, as so often, into the sky. ”  

“Thanks to his deficiency in the sense of period, that packed and gorgeous past [i.e. of classical myth and history] was [i.e. seemed or felt] far more immediate to him in the dark and bestial past could ever be to a Lecky or a Wells [i.e. modern science or science fiction of cave men, etc.]. It differed from the present only by being better. Hector was like any other knight, only braver. The saints looked down on one’s spiritual life, the kings, sages, and warriors on one’s secular life, the great lovers of old on one’s own armours, to foster, encourage, and instruct. There were friends, ancestors, patrons in every age. One had one’s place, however modest, in a great succession; one need to be neither proud nor lonely.”

“Other ages have not had a Model so universally accepted as theirs, so imaginable, and so satisfying to the imagination…. Every particular fact and story became more interesting and more pleasurable if, by being properly fitted in, it carried one’s mind back to the Model as a whole.”

     “If I am right, the man of genius then found himself in a situation very different from that of his modern successor. Such a man today often, perhaps usually, feels himself confronted with a reality whose significance he cannot know, or a reality that has no significance… It is for him, by his own sensibility, to discover a meaning, or, out of his own subjectivity, to give a meaning – or at least a shape – to what in itself had neither. But the Model universe of our ancestors had a built-in significance.”

“I doubt they would have understood our demand for originality… [Why would one want to] spin something out of one’s own head when the world teems with so many noble deeds, wholesome examples, pitiful tragedies, strange adventures, and merry jests which have never yet been set forth quite so well as they deserve? The originality which we regard as a sign of wealth might have seemed to them a confession of property. Why make things for oneself like the lonely Robinson Crusoe when there is riches all about you to be had for the taking? The modern artist often does not think the riches is there. He is the alchemist who must turn base metal into gold.”

[Abridged from  C. S. Lewis on the Medieval Mind , which includes literature references]

Easy Baking: Popovers and Soda Bread

Now that cool weather has finally arrived, here are two quick, rewarding baking recipes.

( 1 ) WHOLE WHEAT POPOVERS

 (This is sized for twelve-cup popover pan;  reduce recipe to 2/3 size for 6 cup pan, i.e.: 2 eggs, 1 c milk, 1 c flour)

Instructions

  • 3 large eggs, warmed (microwave them together for about 15 sec)
  • 1 1/2 cups (355 ml) milk (skim, low-fat, or full-fat), lukewarm  (can microwave milk 40 sec)
  • 3/4 teaspoon salt
  • 3/4 cup (110 g) all purpose (white) flour
  • A scant  3/4 cup (100 g) whole wheat flour
  • 2 tablespoons melted butter
  1. Preheat the oven to 440-450°F (230 °C). Position a rack on a lower-middle shelf. The top of the fully risen popovers should be about midway up the oven. You don’t want the tops of the popping popovers to be too close to the top of the oven, as they might burn.
  2. Use 12 cup nonstick popover pan, e.g. Chicago Metallic. Lightly grease the cups (may not be necessary every time). It is possible to use a standard, i.e. non-popover 12-cup metal muffin tin, one whose cups are close to 2 1/2″ wide x 1 1/2″ deep, though results may not be quite as good unless you preheat the muffin tin in the over for five minutes. As noted above, reduce recipe size for 6-cup popover pan (where each cup is somewhat larger than with the 12-cup popover pans).
  3. Use a wire whisk or beater on low speed to beat together the eggs, milk, and salt. Whisk till the egg and milk are well combined, with no streaks of yolk showing.
  4. Add the flour all at once, and beat till frothy; there shouldn’t be any large lumps in the batter, but smaller lumps are OK. 
  5. Stir in the melted butter, combining quickly. Best to let batter then rest at least 10 minutes, e.g. while oven preheats.
  6. Pour the batter into the popover cups, evenly; about 2/3 full. [For 12 standard muffin cups: fill them about 2/3 to 3/4 full. ]
  7. Make absolutely certain your oven is heated, 440- 450°F.
  8. Bake the popovers for 19-20 minutes without opening the oven door. Reduce the heat to 360 °F [180 °C] (again without opening the door), and bake for an additional 15-20 minutes, until they’re a deep, golden brown. [If using muffin tins, for second phase cook only 10-15 min at 350 F].   Preferable: pierce them about 2 minutes before removing from oven to release steam.
  9. If the popovers seem to be browning too quickly, reduce temperature a little.

NOTES ON MAKING POPOVERS:

( A ) These are fairly healthy and easy to make, and taste delicious split open and served warm, with butter and jelly, for dessert or snack.  Can also serve with things like chili or stew. Get creative and fill with pudding or whipped cream and fruit. Popovers taste almost like pastry, but without all the fat. The larger popovers from the 6-cup pans look more dramatic, and have big cavity inside them, especially when made with all white flour.

( B ) These are best cooked in special popover pans. These have typically six or twelve metal cups, joined by fairly thin metal rods, so heat can get quickly to the cups. It is possible to cook popovers in regular muffin tins.

( C ) The oven needs to be hot, and the oven door kept closed to keep moisture in, in order for the popovers to rise. They rise because steam gets trapped in sticky eggy dough.

( D ) You can make these with all white flour. Use a full 1.5 c white flour. (I cut back a little with the amount of whole wheat flour, since it absorbs more liquid than white flour). Using all white flour tends to make the popovers rise more, with thinner, drier walls. I like them a little thicker and chewier, hence the whole wheat.

( 2 ) TRADITIONAL IRISH SODA BREAD (NO YEAST)

INGREDIENTS

  • 4 cups (580g) all-purpose flour
  • 1½ teaspoons baking soda
  • 1 teaspoon salt
  • Scant 2 cups (470ml) cold buttermilk

INSTRUCTIONS

( 1) If you don’t have buttermilk, first make it by adding 3.5 T vinegar or fresh lemon juice to measuring cup, and filling to two cups with whole or 2% milk (i.e. a scant 2 T vinegar per cup of milk). Stir and let sit for at least ten minutes for milk to sour. I used apple cider vinegar for a faint fruity aura.

(2) Preheat oven to 425 degrees F (218 degrees C) , or slightly hotter if your oven runs cool.  Line a baking sheet with parchment paper or grease well; set aside. You can also use an 8″ cake pan or oven proof skillet.

(3) In a large bowl whisk together the flour, baking soda, and salt. Stir in the buttermilk just until combined and the dough starts to become too stiff to stir. Transfer to work surface and with floured hands lightly knead the dough 5-10 times or until all the flour is moistened and the dough comes together.

(4) Form dough into a 1 ½” (4 cm) high round, approximately 8” (20 cm) diameter. Place on prepared pan. With a serrated or very sharp knife cut a deep cross on the top from side to side, cutting about a third of the way deep into the dough. Bake for 30-35 minutes or until golden brown and it sounds hollow when tapped on the bottom. Alternatively, bake at 425-440 F for 20 min, then turn down to 400 F for last 15 or so minutes.

RECIPE NOTES FOR SODA BREAD

( A ) Note the dough for soda bread is NOT kneaded to the point of being smooth, but just enough to barely hold together, still looking “shaggy”. The reason is that with the baking soda, all the CO2 is released in a relatively short time as the dough heats up, so the dough has to be soft (not tough and cohesive) so it can quickly stretch. (This is the opposite from yeast bread, where you knead the dough long and hard to build gluten chains to strengthen the dough, so the CO2 produced slowly from the yeast during rising will not escape.)

( B ) The deep cross cut in the dough helps it expand, and helps heat to get to the center of the loaf.

( C ) This is authentic, basic Irish soda bread. The crust comes out pretty hard. It is great for dipping in stew or soup, or just spread with butter while warm and chew carefully.  I like to have the crust a bit softer, so I brush the loaf with buttermilk or butter just before baking. When cooling the loaf, cooking on rack will make crust crispy, while being covered with tea towel will soften the crust.

( D ) As with most real bread, this goes stale very fast. I suggest cutting off whatever portion you will not eat that day, and freezing it. It is fine thawed. Bread that is not too stale can be partly, temporarily resuscitated by wetting the crust, and baking it for say 12 minutes at 350 F.

(This recipe above was mainly taken from: https://www.curiouscuisiniere.com/irish-soda-bread/ )

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https://www.simplyrecipes.com/recipes/irish_soda_bread/

This is a slightly more complex recipe for Irish soda bread, including butter, egg, a little sugar, and currants or raisins. Gives softer, sweeter version, verging on scone, instead of plain soda bread with tough crust. Has nice short confidence-building video showing how to work the dough. And has good photos of what dough should look like at each stage.

How Much Money Is There?

It is not straightforward to define what “money” is in a modern national economy. Simply tallying the amount of coins and paper currency is inadequate. Most buying and selling is now done by shifting numbers between abstract bank accounts, not by pushing a bundle of bills across a table.  Thus, these bank accounts serve the functions of money (medium of exchange and store of value). The question then arises as to which of these financial accounts to regard as money.

Among financial assets, there is a broad spectrum of liquidity. Typically you can write a check on your checking account which, when it clears, provides immediate and final settlement for a purchase.  On the other hand, if you want to tap your brokerage account with its holdings of Apple stock to buy a television, you would typically have to sell (liquidate) your stock. A third party would have to be willing to give you something more money-like (e.g. credit your money market fund at your brokerage) in exchange for the stock at some negotiated price. Then you might have to transfer the funds from your brokerage fund into your bank checking account before you can actually buy that TV.  Because of all these intermediate steps, and the fluctuating value of the stock before you complete the sale, the stock holding would not be counted as “money”, even though its value enabled you to ultimately make your purchase.

There are a number of measures of money in modern economies. In the U.S. some of these are:

M0: The total of all physical currency (coins and paper bills).

MB (“Monetary Base”): The total of all physical currency (coins and bill) plus Federal Reserve  Deposits (special deposits that only banks can have at the Fed). This is money essentially created by the government plus the Federal Reserve, which does not necessarily enter the private economy to be spent.

M1: Physical currency circulating outside of the Fed and private banking system, plus the amount of demand deposits, travelers’ checks and other checkable deposits. This is highly “liquid” money, i.e. accepted and used for transactions in the private economy.

M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000). The funds in these additional savings and money market accounts can in general be easily transferred to checkable accounts, and thus could go towards making purchases if desired.

MZM: “Money Zero Maturity” is one of the most popular aggregates in use by the Fed because its velocity has historically been the most accurate predictor of inflation. It is M2 – time deposits + institutional money market funds.

Below is a chart showing the growth in the U.S. in the past fifteen years of M0 (total currency, labeled “currency in circulation), MB, M1, and M2. The grayed areas are recessions, i.e. 2008-2009 and the present.  [1]

Various Measures of “Money” in the U.S.

The M1 money supply (green line) was about $1.4 trillion ( $1,400 billion on the chart) in 2005, was fairly steady for several years, then started a steady ramp up to $4 trillion by January, 2020. Due to the extraordinary events associated with the Covid-19 shutdown (government stimulus package plus Fed purchases of securities), M1 jumped up to $ 5.4 trillion by August of this year. M2 followed similar trends, though on a much larger scale, rising to$18.3 trillion this year. This compares to a current U. S. total GDP of about $21 trillion.

The lowest line on the chart is the physical currency (blue line), which has grown slowly but steadily. The “Total MB” (red) line, was essentially on top of the blue line up until the 2008-2009 recession. Since MB = physical currency plus reserves, this meant that the amount of money in the reserve balances at the Fed of the private banks was nearly zero before 2008. The reserves jumped up (difference between the red and blue lines) in 2009, with the onset of massive purchases of securities by the Fed (“quantitative easing”). The Fed buys these securities from the banks, and credits their reserve accounts. The Fed has tried to taper down its holdings in recent years (red line declining 2015-2019), but suddenly purchased trillions more this spring (red line jumping up in 2020).  Most pundits hold that all this Fed money injected into the financial system has been the major cause of the enormous rise in stock prices in the past decade, especially in the past six months.

[1] Chart produced on the St. Louis Fed “FRED” site, https://fred.stlouisfed.org/categories/24 . This site has a wealth of economic data. Unfortunately, it is not easy to change units, so I was stuck with “billions” instead of “trillions” for the axis labels. Also, the M0 and MB numbers were only available in “millions”, so I had to divide those numbers by 1000 to get them to fit on the plot with M1 and M2. The grayed out spots on the graph labels is where I blotted out the “ /1000 ” which the plotting software put in. It would have been cleaner, in retrospect, to have exported the data to Excel and replotted it there.