The First Domino Falls
The Montgomery Bank of the century. It was a regional bank that first opened for business in Montgomery, the capital of Alabama, and wielded its greatest influence in Birmingham, the state's largest city. Yet its scale was so modest that it did not even rank among the top thirty banks in the United States, so the bankruptcy of Montgomery Bank was not national news. In Alabama, however, it was headline material. The bank had operated for nearly eighty years and had put down deep roots in the local community. That was precisely why Montgomery Bank's fundamentals had seemed so solid. Had it been based in New York, the financial capital of the world, or in California, whose economy surpassed that of most developed nations, it might have become a global institution. Alabama itself possessed considerable economic strength. As part of the Sun Belt, the emerging industrial region, the state had seen particularly rapid growth in heavy industry. Traditionally, it was home to NASA's Marshall Space Flight Center and Redstone Arsenal, which oversaw missile testing and development for the U.S. Army; the missile industry had in turn spurred aerospace development. More recently, the automotive sector had been expanding at a remarkable pace. If Detroit was America's traditional Motor City, then the rising automotive hub was Montgomery, Alabama.
Montgomery was where Mirae Motors, South Korea's leading automaker, was exploring a new plant, while Japan's Toyota and Honda had already established factories. Even Germany's Mercedes-Benz operated a facility there. Thanks to the influx of foreign automakers, Alabama's economy remained robust, and Montgomery Bank had grown on the strength of that regional prosperity. Most other local banks were no match for it. For such a solidly positioned institution to suddenly collapse at a moment no one had foreseen was simply beyond common sense.
Yoo Jae-won learned of Montgomery Bank's fate while traveling to the celebratory party after the completion ceremony and first ignition of the Mojave Thorium Reactor. He could not simply send the VIPs who had journeyed all the way to the desolate Mojave Desert back home without proper hospitality. Since a party inside the power plant was impractical, the plan was to move to Los Angeles for a lavish celebration. It was during that journey that Kim Dae-seok delivered his report on events that had unfolded during the ceremony. The most shocking item concerned Montgomery.
"What? Montgomery Bank went bankrupt?"
"Yes, sir. Here is the related report."
Kim Dae-seok handed over an Android tablet. News articles that had broken only moments earlier were clipped across the screen.
- Montgomery Bank collapses after failed investments in subprime mortgage derivatives.
- Losses exceed total deposits!
- Investors stunned; regulators scramble to prevent bank run.
As expected. A regional bank that, only a few years earlier, had relied solely on its soundness to remain independent rather than be absorbed by a larger institution had been destroyed in an instant by reckless greed and irrational investments. A traditional bank's core business was simple: taking deposits and making loans. It paid interest on deposits and earned interest on loans, profiting from the spread. While this was money earned while sitting still, relying solely on the interest-rate differential was unbearably dull. Banks therefore adopted new lines of business with remarkable speed. Selling insurance and mutual funds inside bank branches had been part of that same effort to improve returns. In the tedium of conventional banking, subprime mortgage lending had seemed like an entirely new world. Earning a mere 1 percent spread on deposits and loans was one thing; achieving 8 or 9 percent returns simply by selling CDOs was something else entirely. Subprime mortgage derivatives, which promised virtually unlimited profits, represented a complete upheaval of the old order.
Once Montgomery Bank began dealing in subprime-related products, its earnings multiplied several times over compared with the era when it had operated as a conventional bank. The bank's major shareholders had instantly become addicted to the taste of easy money. The one who had tried to restrain them was the bank president. The shareholders moved against him. The previous president had risen through the ranks from ordinary teller to chief executive—an exemplary career. Conservative by nature, he believed a bank should stick to banking and had opposed expanding subprime investments. The board, dominated by major shareholders, dismissed him. In his place they installed a new president who had come from an investment firm and was steeped in Wall Street's advanced financial techniques.
As a result, Montgomery Bank's exposure to subprime loans surged within just a few years. The bank also began trading derivatives without hesitation. Naturally, it took an extreme long position. Then the U.S. economy entered a brief lull, and subprime mortgages that had been issued without proper verification of borrowers' qualifications began to show rising delinquencies. Those delinquencies immediately eroded CDO yields. For derivatives whose underlying assets were CDOs, defaults became routine. That was precisely the situation with the CDOs and derivatives in which Montgomery Bank had invested. The volatility had been so extreme that the bank's management only realized bankruptcy was imminent two days before they were forced to declare it. In other words, just three days earlier, yields had plummeted but had not yet reached default levels. Then, as the expiration dates of several derivatives—particularly put options—approached, delinquency rates on subprime mortgages spiked, making it possible to exercise puts that had previously seemed worthless. Conversely, the call options that management had expected to be exercisable became impossible to exercise, and losses snowballed.
Strictly speaking, it was illegal for a bank to trade derivatives directly, yet in recent years the prevailing mood had been that anyone who did not invest was a fool. It truly seemed as though money was making money with no risk whatsoever. Only after the collapse did they realize it had been speculation, not investment. As always, by the time they understood, it was far too late to reverse course. Montgomery Bank went under before it could even apply for a government bailout. From the perspective of the broader U.S. economy, however, its share was so small that few people recognized the danger signaled by its failure.
"Good heavens."
Aaron Fuld, CFO of Lehman Brothers, was one of those who did perceive the crisis through Montgomery Bank's collapse. Even without Montgomery Bank, he had already been gripped by a sense of impending doom ever since watching The Wolf of Wall Street. That was why, after seeing the film, he had returned to the office and placed bets on declining overseas markets rather than going out for drinks. As time passed, negative signals regarding subprime mortgages continued to mount. What Aaron Fuld monitored most closely were delinquency and default rates. Reality was unfolding with startling similarity to the projections the film's protagonist had presented as his own forecasts. Lehman's supercomputer models had predicted stabilization after July, yet in reality delinquency rates kept climbing. Against that backdrop, news of Montgomery Bank's bankruptcy in Alabama flashed a bright red warning light in Aaron Fuld's mind. The same was true for everyone at Lehman Brothers who had been deeply involved in subprime mortgage investments. An emergency meeting was immediately convened, and Aaron Fuld attended.
At that meeting, Aaron Fuld was the first to speak loudly and clearly.
"If we can hold on until October 31, we win."
Remarkably, the conclusion Aaron Fuld reached defied common sense. October 31—exactly one hundred days from now. His verdict was that they must survive until then, no matter what. Richard Fuld, Lehman's CEO and a man of conventional thinking, was about to ask for an explanation when Aaron Fuld continued even faster.
"I've prepared a presentation to explain."
Lehman Brothers also used a laser projector and large screen for important meetings, with a computer connected to run presentation software. The operating system was, of course, Android, and the presentation program was ID Office. Displayed on the screen was the October calendar. The thirty-first was an ordinary Tuesday with no special significance. For Lehman Brothers, however, it carried profound meaning. It was the day the previous year when Vincent Greenhill, president of ID Investment, had personally visited Lehman and the firm had issued put options on subprime mortgage CDOs. The notional amount of that contract alone was a staggering two billion dollars. Although AIG and Citigroup had each sold identical puts worth five hundred million dollars, Lehman Brothers held the record for the largest single options product at two billion. Even after that, Lehman continued to issue massive volumes of CDO-linked options, but the symbolic weight of that first transaction remained unmatched, concentrating everyone's attention solely on Lehman.
Especially after The Wolf of Wall Street became a major hit, interest from people across North America and around the world focused on the put options purchased by ID Investment. In the film the protagonist boldly bought puts and, at the end, scored an enormous windfall—not merely a big win, but a thousandfold return that instantly elevated him to billionaire status. Given that ID Investment had invested an even larger sum than the movie depicted, everyone was intensely curious about how its story would conclude.
"If ID Investment's put options expire without being exercised, the dark clouds hanging over the subprime mortgage market will also disappear."
When Aaron Fuld finished, CEO Richard and the other executives fell into deep thought. The product had been approved by Richard himself at issuance and had been under continuous monitoring ever since. Consequently, even Richard, as CEO, was well acquainted with the detailed terms, including the exercise conditions. The threshold at which the puts could be exercised was when the yield on Lehman's highest-rated A-class subprime CDOs fell to 5 percent or below. Yet even at 5 percent, success was not guaranteed. For ID Investment to break even after exercising the puts, the payout had to exceed two billion dollars.
"That threshold is 3 percent."
To recover the full two-billion-dollar principal, the yield would have to drop below 3 percent, just as Vincent Greenhill had reported to Yoo Jae-won.
"The current yield on A-class CDOs stands at 6.25 percent. It has already fallen roughly 4 percent from the 10.25 percent recorded at the beginning of the year, but holding above 3 percent through the end of October is entirely feasible."
At Aaron Fuld's words, the Lehman executives grew pensive. A-class CDOs at 3 percent. The Federal Reserve had cut its benchmark rate once the previous year to 2.75 percent and had kept it frozen since. For a risky CDO to trade at a yield only 0.25 percent above the federal funds rate would mean the subprime mortgage derivatives market had been utterly destroyed. The 3 percent line had to be defended not merely to prevent ID Investment from exercising its puts, but to protect the entire derivatives market.
"The final line in the sand is 5 percent."
Lehman's CEO Richard set the ultimate defensive line even higher, at 5 percent.
"Five percent is also achievable," Aaron Fuld replied firmly.
Until that moment, every other Lehman executive had likewise believed it was entirely possible to keep A-class CDO yields above 5 percent. In the White House, however, the atmosphere was different. At roughly the same time:
"We need a stable soft landing. Inflation concerns are rising, and the housing market has become far too overheated."
Housing Secretary Mel Martinez continued speaking at an emergency cabinet-level policy meeting convened at the White House following news of Montgomery Bank's collapse. Although Yoo Jae-won had been sending consistent warning messages since the previous year, they had failed to resonate with White House staff or even with President Al Gore. As president, Al Gore understood better than anyone the formidable capabilities Yoo Jae-won possessed, yet he still believed that allowing the market to correct itself was preferable to premature intervention. That did not mean Al Gore was a blind adherent of market fundamentalism in the style of neoliberal ideologues. He was prepared to intervene if necessary, but he did not yet see the necessity. Moreover, the housing market's growth, alongside IT, formed one of the twin engines driving America's overall economic expansion, so concerns about overheating took a back seat to the priority of continued growth.
"It is a localized problem, but it would be advisable to request a more conservative assessment from the Federal Reserve."
Accordingly, the White House viewed Montgomery Bank's failure not as a systemic issue affecting the entire housing market but as the personal failure of a bank's management team. The resulting policy response was therefore cautious. Yet Montgomery Bank's collapse was in fact the unmistakable harbinger of the rot beneath the subprime mortgage loans propping up the U.S. housing market. The ripple effects were already spreading far wider and faster than the White House, Lehman Brothers, or anyone else had anticipated. A few days later, just as the Federal Reserve was locked in debate over whether to raise interest rates, rumors began circulating that New Century Financial, the industry's second-largest subprime lender, was in serious trouble.
