The Bubble
How the housing bust started a panic in Florida, felled a storied bank and raised the specter of recession.

By Alec Klein and Zachary A. Goldfarb
The Washington Post
Tuesday, June 17, 2008

Jackie Pons, the affable superintendent of the Leon County school district in Tallahassee, was worried about his $30 million.

One Wednesday last November, he got on a conference call with Florida officials and financial advisers representing cities, towns and school boards throughout the state. The officials hoped to calm nerves. Localities had started to pull huge sums of money -- billions of dollars -- out of their accounts in a state-run investment pool, panicking that the fund was vulnerable to the financial alarm sweeping the nation over the collapse of the housing market.

After years of giving out mortgages to millions of people with less-than-stellar credit histories, lenders were imploding as subprime borrowers defaulted on their loans. The contagion spread quickly to Wall Street, which had packaged those risky loans and sold the securities to big investors in the United States and around the world.

Investors, in turn, wondered whether the problems in the financial system would extend beyond subprime-backed securities to investments backed by conventional mortgages -- or even other assets.

In Florida, the crisis was about to filter down to the lives of people who had no obvious connection to the financial world. Officials in charge of the state-run investment pool had for months maintained that the money was safe. "I want you to know I have no serious concerns at this time about any of our exposures," the then-head of the fund wrote in an e-mail to the office of Florida's chief financial officer.

But now state officials were trying to stave off a run on the fund by officials like Pons. His district was considering withdrawing the approximately $30 million it kept in the pool, which served as a kind of money-market account for localities to cover their payrolls and other operating costs. On the conference call, state officials assured the gathering that the fund had lost only a fraction in value and that everything was fine. "I believed them," Pons said. "I took them for their word."

The next day, Thursday, state officials abruptly shut down the pool to put an end to the run. About 1,000 localities couldn't withdraw their money.

Pons wondered where he would find $10 million overnight to meet the next day's monthly payroll. "I'm sitting there going, 'Whoa.' We're sitting here with no access to dollars," he said.

The superintendent was acutely aware that many of his employees lived paycheck to paycheck. "This is like, no, this is America, these are our dollars, they can't stop us, we're going to miss a payroll," he said. "This is what you read about in other countries."

The pool, after all, was supposed to be safe, investing public money in such boring instruments as Treasury bills. But as interest rates fell in recent years, the pool began moving toward higher-yielding, complex investments such as short-term corporate debt.

"The pool was certainly trying to get reasonable returns within the boundaries of being a money-market fund," said Robert Milligan, a retired Marine lieutenant general who is interim executive director of the board overseeing Florida-run funds. Milligan said the pool invested only in securities with high grades from credit-rating companies.

Only a small percentage was invested in mortgage-backed securities, and an even tinier amount -- 0.03 percent -- was in subprimes. But Florida was swept up in the national frenzy as some of its mortgage-backed investments were downgraded by the credit raters.

By that Thursday evening, Pons was attending a community schools buffet dinner, not eating, still wondering how he would pay his teachers the next day. He stepped out on the patio, a cellphone to each ear -- one silver for official business, the other blue usually for personal calls -- talking to the school board attorney and other officials. Pons, born and raised in Tallahassee, knew that the head of the local bank lived in town. He called the banker at home.

Thomas A. Barron, president of Capital City Bank, was at dinner with his family. He took the call at his antique mahogany desk in his home office, confronted by a situation he'd never faced in 34 years of banking: "Not that kind of money and not overnight and not just to make payroll," he said.

But Barron reckoned the school district was good for the money. He authorized the loan on the spot, calling his lawyers and bankers to get the paperwork going. The next morning, Friday, Pons and the bank president signed for a $10 million week-long loan. It cost the school district $13,000 in interest. A bank executive stood in line at the teller window to deposit the funds in the school account.

Pons felt hugely relieved; his teachers would get paid. He didn't even mind when he became the butt of a joke around town: "If you need $10 million," people would tell him, "don't call me."

Chapter X Loaded for Bear

Jan. 10, 2008. In his first public remarks of the year, Fed Chairman Ben S. Bernanke acknowledges that the problems that had begun in the subprime market now "affected the prospects for the broader economy."

Unemployment was rapidly rising, hitting its highest point -- 5 percent -- since November 2005. On Jan. 19, a Saturday, a weekend of urgent conference calls among Fed officials began.

Bernanke and his colleagues -- Vice Chairman Donald L. Kohn, Fed Governor Kevin M. Warsh, New York Fed President Timothy F. Geithner and others -- agreed that the central bank needed to sharply cut interest rates to stimulate the economy. But they debated whether a big cut before a routine meeting -- only a week and a half later -- would make the Fed seem as if it were simply responding to declining stock markets. Bernanke implored the group: If it's time to act, the Fed should act.

Two days later, on Martin Luther King Jr. Day, stock markets throughout the world suffered some of their largest drops since Sept. 11, 2001. Meeting by videoconference, the Fed voted to cut its key rate three-quarters of a point, the biggest single-day cut in nearly a quarter-century, and announced the move before U.S. markets opened Tuesday. The Fed continued to lower rates but couldn't stop the economy's plunge. More banks reported losses.

Meanwhile, President Bush, working with Congress, signed into law a $168 billion economic stimulus package, offering tax rebate checks.

On March 12, concern intensified about the soundness of one important financial player with heavy exposure to subprime securities: Bear Stearns. The chief executive of the 85-year-old New York investment bank, Alan Schwartz, tried to calm investors by going on television to say his firm had a $17 billion cash cushion.

Overnight, though, Bear Stearns's lenders cut off the company. Customers demanded their cash. Bankruptcy was imminent. On March 13, Schwartz called Jamie Dimon, chief executive of J.P. Morgan Chase, who answered on a special cellphone reserved for his three daughters and few others. Schwartz wanted J.P. Morgan to buy Bear Stearns. Dimon wouldn't agree to do so without more time but promised to work on the problem. He dispatched hundreds of J.P. Morgan employees back to the office to review Bear Stearns's books.

As he learned about the unfolding crisis, Bernanke feared a global economic collapse if Bear Stearns went under. Money-market funds where Americans deposit billions of dollars in savings had lent money to Bear Stearns. And the company's important role in the financial markets -- trading countless securities for big investors -- would come to a halt. Other investment banks, Bernanke worried, would be next.

The Fed wanted to get cash to Bear Stearns to keep it afloat. By 7 a.m. the next day, the central bank had helped arrange a loan to Bear Stearns, the first time since the Great Depression that the Fed had intervened with public money on behalf of an institution other than an ordinary commercial bank with regular deposits.

Over the weekend, Treasury Secretary Henry M. Paulson Jr. helped manage negotiations over whether J.P. Morgan should buy Bear Stearns. Some suitors were contemplating bidding only for pieces of the company, but Paulson wanted all of Bear Stearns to be sold. That Sunday night, J.P. Morgan agreed to buy Bear Stearns but only if the Fed agreed to take $30 billion of mortgage-backed securities on Bear Stearns's books, putting the risk of default on taxpayers. The Fed, believing it had no better option, accepted the deal.

J.P. Morgan announced it would pay $236 million for Bear Stearns -- or $2 per share -- 99 percent below its value a year earlier. Paulson wanted to keep the sale price low so it wouldn't seem as though the government were bailing out Bear Stearns. Within a few days, Bear Stearns had negotiated the price up to $10. Critics still argued that the Fed took unprecedented action to bail out a private financial firm, raising the likelihood that other investment firms would be emboldened to take similar risks.

Chapter XI 'Return to Basics'

Four business days after shutting down the Florida investment pool, the state reopened it, and by late March, in the aftermath of the run on the pool, localities had pulled about $17 billion from their accounts, some two-thirds of the pool's total. The localities have limited access to their money; they pay a penalty if they take out more than a set amount. Not all of the money in the fund is available for withdrawal because the fund's managers have set aside the investments that have lost the most value in the hope that they will bounce back.

Milligan, the interim head of the state-run funds, maintains that the pool's problems were exaggerated. "There's c ertainly nothing wrong with investing in mortgage-backed investments," he said. But he added that the fund is no longer investing in them.

That's not good enough for Pons, the Leon County superintendent. "Everybody was chasing the interest rates," he said. Pons has been pulling out funds from the pool, and he plans to get out the rest -- about $20 million -- as restrictions permit. His new strategy: He's parked the school district's money over at Capital City Bank, where his good friends gave him the emergency loan. "So I can get to it," he said.

Kevin Connelly, a Vienna mortgage broker who had seen borrowers and lenders push the envelope, sought security, too. He had to find another job when Pinnacle Financial was sold to a California mortgage company, Impac, that tried to resuscitate the business but failed. He was worried about the effect on his family -- his wife; his daughter, a 20-year-old student at Northern Virginia Community College; and his son, 17. "It's been difficult," he said. "My family has been accustomed to a lifestyle that my current income doesn't sustain." He's had to sell investment properties and dip into his savings to keep things afloat.

Connelly decided to become a loan officer at an Arlington branch of a large regional bank. No more subprime loans. No more mortgages without income documentation. Extensive training programs for loan officers. "I was looking for someplace where I could reinvent myself," he said. In many ways, the mortgage business has reverted to the way it was when Connelly started nearly 30 years ago. Loans come with employment verification and a sizeable down payment.

"It's a return to the basics," he said.

Chapter XII History Rewritten

By April, it was widely feared that the United States was falling into recession. Bernanke, appearing before Congress, would only allow that a "recession is possible."

Some of the nation's biggest banks have lost billions of dollars and have booted out their top executives. Some forecasters predict that 3 million more homes could go into foreclosure in coming years. The housing problems are often concentrated in low-income, high-immigration neighborhoods in places such as Prince William County, where there were 3,344 foreclosures last year, up from 282 in 2006 and 52 in 2005, county records show.

At the Fed, Bernanke has been working to expand the agency's role in monitoring how Wall Street bundles mortgages. The central bank is closely studying a wider range of financial institutions than ever before. Meanwhile, the Fed has so far this year provided $435 billion in short-term loans to squeezed banks.

The Fed chairman remains convinced that the central bank's role in rescuing Bear Stearns helped avert a global financial disaster.

Some economists have said that the Fed played a role in creating the problem. "The U.S. was too ambitious in trying to prop up growth in the early 2000s through low interest rates, through aggressive fiscal policy, in ways that weren't sustainable," said Kenneth Rogoff of Harvard University, a former chief economist for the International Monetary Fund. "It exacerbated these risks down the road."

Alan Greenspan, who was famously opaque while presiding over the Fed during the bubble, bluntly defends his tenure. "The prevailing notion is that the bubble is indigenous to the United States, is caused by Federal Reserve policy and if the people at the Federal Reserve, especially the chairman, were sensible, this thing would not have happened," Greenspan said in an interview. "History is being rewritten, and I will tell you this is not the history that I remember."

His view is that long-term global interest rates, not the short-term rates that the Fed controls, drove housing bubbles around the world in the past decade. "The tie between Federal Reserve policy and housing prices is just not there," Greenspan said.

On Capitol Hill, the credit raters have come under heavy criticism as well. House Financial Services Committee Chairman Barney Frank (D-Mass.) and other critics question whether the raters need to be replaced by a more effective gatekeeper to the global financial markets. The rating companies recently agreed to changes in how they charge for some ratings.

Lawmakers also have pursued housing bills to help troubled borrowers trade problematic mortgages for more affordable government-backed loans. But President Bush and his allies in Congress threatened to block the proposals, saying they would cost taxpayers too much.

Chapter XIII 'Everybody's Culpable'

David E. Zimmer began putting out job feelers after being laid off as an executive at People's Choice, a subprime lender, interviewing with hedge funds and others to see whether there was any interest in his expertise in the arcane world of structured finance. There wasn't. He blamed it on the falling-knife syndrome: The market for subprimes made firms wary of investing in the field and hiring someone like him who specialized in it.

"Who wants to catch the knife?" he said.

Zimmer, though, figured there was a need for his kind of specialized knowledge. He started a consulting business, Princeton Structured Finance Analytics Group, assessing the value of institutional investors' holdings in mortgages and the underlining loans in securities. Already, he said, there's a lot of interest from accounting firms, auditors and others.

Looking back on the past few years, he said: "Everybody's culpable in this -- everybody -- Wall Street, investors, originators, brokers. At every point in the process, something broke down."

He added, "Do you want to get philosophical? Are people self interested? Absolutely. It's what makes capital markets efficient. As we've learned, it's also what makes them dangerous."

Staff writers David Cho and Neil Irwin and staff researchers Richard Drezen and Rena Kirsch contributed to this report.

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