Capitalisn’t: The Build-Up

Speaker 1: Mark your calendars, because this is the 10-year anniversary of Lehman Brothers’ collapse.

Kate: Hi. I’m Kate Waldock from Georgetown University.

Luigi: And I’m Luigi Zingales at the University of Chicago.

Kate: You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.

Luigi: And, most importantly, what isn’t.

Speaking about what isn’t working in capitalism, today is the 10th anniversary of the last day in which Lehman was trading as an independent company.

Kate: It’s a death day.

Luigi: Yeah, it is a death day. And where were you, Kate, at the time?

Kate: I think that I was in my dorm room. I was back from my junior internship, which was at Lehman, that summer, the summer of 2008. By September, I was out of my internship for two weeks, back at school, watching the stock price fall.

Luigi: Now I understand why you have so much interest in bankruptcy, because you started experiencing bankruptcy from day one.

Kate: Yeah, it’s weird. When I started my PhD, I was like, I’m interested in shadow banking and bankruptcy, but I don’t know why.

Luigi: So, Kate, you had unique insight. You were in Lehman just before the collapse. How was life on the verge of death?

Kate: I guess I have to say that I don’t have a tremendous amount of insight into what was frantically going on in the background, because I was just an intern. I was only there at the very end. But I will say that I was on the fixed-income trading floor, and they had ... at the top of the floor, the center of the room, Lehman’s stock price with the LEH sticker in front of it. It had been blinking green for the most part for the past 10 years, and that summer it was just blinking red, every day. I mean, that weighed pretty heavily on people’s moods.

Even though my desk was reasonably secure—I was on the government bonds desk, so everyone always needs that sort of trading desk in an investment bank—moods were high, tensions were high. I think the managing director threw the phone against the wall once.

Luigi: And did you lose any money?

Kate: OK. I don’t know if this qualifies as insider trading. I don’t think it does, because I didn’t have any special information, but everyone on my desk was convinced that Lehman would be OK. They were convinced that either they would survive through the weekend, or they would be purchased, like acquired by another bank for a reasonable amount, and that their jobs would remain.

Just based on that vague information alone, based on everyone’s optimism, the weekend before Lehman failed, I used all my summer internship money to buy Lehman’s stock. And then on Monday morning—

Luigi: Wow. That was a good trade.

Kate: Yeah, it was a great trade. On Monday morning, I woke up right after my summer internship and had no money left.

Luigi: So that’s the reason why you became a professor.

Kate: Exactly. Extremely risk averse now.

Luigi: Let’s now try to go back to what led to the Lehman weekend and to that disaster. I think that your position is interesting, because a lot of people back then, and a lot of people even today, are wondering, should Lehman have failed? But, before entering this discussion, let’s give our listeners a short recap of how we arrived at that dramatic weekend of 10 years ago.

Kate: In celebration of the 10-year death day of Lehman, we’re going to be doing a three-part series. This first episode we’re going to talk mostly about the causes of the financial crisis. On the next episode, we’re going to talk about the aftermath, and then, on our last episode, we’re going to talk about whether there’s a crisis brewing in the future.

Luigi: Yes, but let’s start with history, which is easier, and let’s go to ... In your view, what caused the crisis? How did it start?

Kate: All right. So, we’re standing in 2007. There had been a real-estate bubble in the United States. So, to give you some sense of that, house prices had risen 91 percent between 1995 and 2003. And then, between 2004 and mid-2006, they rose another 36 percent.

Luigi: But not just in the United States, they went up everywhere. They went up in the UK, went up in Spain, went up in Australia. In all these places, by a bigger factor than in the United States. So, yes, there was a dramatic rise in real estate, but it’s not like there was a gigantic real-estate bubble. I think that the problem was that a lot of people bought in very highly levered positions, and the second is there was a lot, in my view, a lot of fraud, but this is something that we can discuss later.

Kate: Yeah, absolutely. So, to your point about household debt, between 2001 and 2007, US mortgage debt basically doubled, and so households had a lot more debt than they did in the beginning of the century.

Luigi: Yes, but this can explain why, in 2008 and 2009, we see families cutting down consumption because of the high leverage. However, what generated, really, the financial crisis was not so much the leverage of their households, it is the fact that many households started to default, and many financial institutions were heavily exposed to the risk of this default.

Kate: Right, so when you talk about risk, a lot of that was coming about through this popular word, “subprime,” that entered everyone’s vernacular around 2007. Subprime mortgage origination had always been about 10 percent of all mortgage origination in the late ‘90s, and by 2006 it was almost a quarter of all mortgage originations. The types of housing loans that were being made had gotten a lot worse in quality throughout the early 2000s, and that was a big part of why, at least in the United States, the bubble started to deflate around 2006.

Luigi: Yes, because traditionally mortgages were issued by banks and then were sold by two government-sponsored entities, Fannie and Freddie, that were repackaging these mortgages into what are called mortgage-backed securities, and selling them to the financial markets. So, historically, these repackaged mortgages were relatively safe because they were issued under strict guidelines, but in the early 2000s, the playbook was thrown out, and many mortgages were issued without strict guidelines and with the understanding that the market will take the risk.

Not only were there so many of these mortgages being sold, but these mortgages were further repackaged and sliced in different tranches, giving different degrees of priority to investors. The frenziedness was such that this operation took place many, many times and, in fact, some investment banks started to bet on those mortgages even if those mortgages were not issued—what is called, in jargon, synthetic mortgages.

Kate: Yeah, so around mid-2007, people started to get really worried about this. In particular, in between April and June, Bear Stearns had a bunch of hedge funds that it sponsored. One, in particular, had been doing gangbusters. In 2004, it earned 17 percent for investors, in 2005, it earned 10 percent, and so they started another, similar fund, both of these heavily exposed to these risky mortgages, and there was $18 billion of capital invested in these hedge funds by 2006. And yet, by June of 2007, these hedge funds failed and Bear Stearns had to bail them out.

After this, it set off a bit of a panic in financial markets. People typically say that the financial crisis started around August or late summer of 2007, when financial markets really started to react to the fact that these two large mortgage-exposed hedge funds had failed.

Luigi: However, to be fair, the stock market peaked in the fall of 2007, so, in spite of the early warnings in 2007, the market as a whole was going up, and the first really big wakeup call was in March 2008, when Bear Stearns, which was an investment bank, basically was rescued at the last minute in an operation joined by the Fed and JPMorgan.

Kate: So, why did they need rescuing? This has to do with the fragile nature of the way that investment banks are set up. If you’re an investment bank, you probably have a portfolio of securities called a security inventory, and, oddly enough, these securities are financed on a very short-term basis. If Bear Stearns held, for example, a bunch of mortgage-backed securities in its inventory, it was financing those mortgage-backed securities not by owning them outright, but by borrowing money to buy them and then having to reborrow that money every single day.

It was essentially borrowing on a very short-term basis where each loan was due the next day, and it was just expecting these loans to be rolled over every single day. In March of 2008, that stopped. It couldn’t borrow anymore against these securities that it held in its inventory, and so that’s why it needed a bailout.

Luigi: What is interesting is that, number one, in a matter of a week they lost tens of billions of dollars of liquidity. So, at the beginning of the week, they still had plenty of liquidity in their portfolio, and by the end of the week, actually by Thursday, they had to get special loans from the Fed in order to be able to operate on Friday. And then they were rescued during the weekend. One thing that surprised the market is that not only did they find it difficult to borrow against these mortgage-backed securities, they found it difficult to borrow even against Treasurys.

This is the stuff that surprised everybody, because Treasurys are super safe, and you expect that everybody is willing to lend you money against Treasurys as collateral. However, when people perceive you might not be around tomorrow, they don’t want to take the risk, even to have the inconvenience to be stuck with some Treasurys or some securities they don’t want to hold.

Kate: To highlight how exposed Bear Stearns was to this really short-term repo financing, I like an example that was provided by the Financial Crisis Inquiry Commission in a special report that they did, which is to say that Bear Stearns’ leverage and their exposure to short-term financing was about the equivalent of a small business with $50,000 in equity borrowing $1.6 million overall and having about $300,000 of that due every single day. So, having to rely on refinancing your loan, your $300,000 loan, every single day, even if you only have $50,000 in equity. That’s how much Bear Stearns was exposed, and one day that liquidity just dried up and they had to be bailed out.

Luigi: Let’s actually discuss for a second how it was bailed out, because it’s interesting. So, normally, in normal times, the Federal Reserve makes loans only to depository institutions, normal commercial banks. However, in the Fed statute, there was an article that has been modified slightly in 2010, but there was an article called 13(3) that says that under unusual and exigent circumstances, then the Fed can lend to other institutions that are not depository institutions. What is interesting is Bear Stearns asked for this possibility and this possibility was denied, but then, immediately after the failure, or the quasi-failure, of Bear Stearns, the Federal Reserve opened a particular kind of facility called the primary dealer facility that extended the access to loans to primary dealers including Bear Stearns and Lehman.

Kate: But it was kind of too little, too late, because I think it was either on the same day that the Fed announced this, or the next day, Bear Stearns was downgraded way below junk status by Moody’s. That was enough to scare the market, so even though Bear Stearns had access to this financing, its liquidity dried up anyway, because its credit rating was downgraded.

Luigi: And the result for Bear Stearns was that the Fed made a loan to JPMorgan, and JPMorgan bought out Bear Stearns at a very low price and, by doing so, also guaranteed the liabilities of Bear Stearns. Nobody lost money except the shareholders of Bear Stearns, so the market got spooked a bit afterward, and people started to worry about who was going to be next after Bear Stearns, but the market continued operating rather normally until, basically, the summer.

Kate: Yeah, so then, six months later, a similar type of panic happens for Lehman Brothers. Lehman was highly exposed to real estate. At that point, it was clear that the US was experiencing a full-fledged mortgage-backed-security, subprime-mortgage-backed-security crisis. Because of Lehman’s exposure to these types of securities, there was a similar liquidity run on Lehman. They also used a lot of short-term financing that was really susceptible to drying up overnight.

Luigi: Now, what is interesting is that Lehman, at the beginning of the week that ends with September 13, they had $41 billion in liquidity. By the end of the week they had $1.4 billion. This is literally a bank run of the type that we have seen in movies like “It’s a Wonderful Life,” but a bank run where the runners are not the depositors, but are the institutions that lend to Lehman in this repo transaction.

Kate: So, this time, Lehman was not bailed out, and some people argue that this is part of why the financial crisis was so bad, because there was a little bit of inconsistency in terms of what the government was doing. It brokered a deal so that Bear Stearns could be acquired by JPMorgan, it brokered a deal so that Merrill Lynch could be acquired by Bank of America, but it didn’t really facilitate a deal for Lehman to be acquired by another bank. Even though there—

Luigi: A little bit of inconsistency? I think you might be … There was a gigantic inconsistency.

Kate: OK, I don’t want to be too harsh on Geithner or Bernanke—

Luigi: Let me quote David Swensen, a legendary investor who runs the portfolio of the Yale endowment. He said that you have to try hard to have the kind of inconsistency that was shown in the 2008 approach to the problem. Every time there was a new approach that was designed ex novoand then caught the investors by surprise.

Kate: To be fair, though, I think the reasoning on the part of the federal government was that they didn’t want to just bail out every single bank, because that would send a message to markets that banks could take a lot of risk and then be reasonably assured that they would be bailed out later on, so that would create a moral hazard problem.

Luigi: It’s true, but remember, the reason why the Federal Reserve was created was to intervene in situations of panics. The Fed was created in 1913 in response to the 1907 panic, where the financial markets were cornered by the only provider of liquidity at the time, that was JP Morgan. Not just the bank, but the person.

Kate: The individual.

Luigi: And so, what is a bit strange is, over the years, this notion of the Fed has kind of gone by the wayside. If you look in macroeconomic textbooks, between the late ‘80s and the financial crisis, they only talk about inflation as the main job of the Fed. The Fed was not created to control inflation, the Fed was created to control panics in financial crises. The article I mentioned, the 13(3), of unusual and exigent circumstances, is precisely the article that says, in those situations, the Fed should intervene by lending, against good collateral but lending freely against, or generously against, good collateral. That’s the part that, in my view, but we can come back later, the Fed did not do.

Kate: Look, I’m not trying to say that I’m defending Tim Geithner, I’m defending Ben Bernanke, but part of the reason why they didn’t necessarily want to bail out all the banks was because of this moral hazard issue.

Luigi: I, at the time, was against a bailout, too. But part of the problem, in my view, is part of the way economics thinks about this issue. To what extent you have panics, to what extent you have a liquidity crisis, to what extend you have a solvency crisis. One of the big issues, and we’re going to return to that, but one of the big issues is, was Lehman insolvent at the time, and could the Fed have lent to Lehman or not? Ben Bernanke came out saying that he could not have lent to Lehman, because it was too risky. A macroeconomist, Larry Ball, came out with a book recently showing, in excruciating detail, that is actually false. That the Fed could, and, in his view, should have lent to Lehman.

Kate: Well, I think another part of why the Fed was reluctant was because they simply didn’t know how exposed Lehman was to the global markets. The way that banks were structured then, and still are now, except there’s more transparency now, is that they finance a lot of their inventory on a very short-term basis, and it’s not just like a mortgage-backed security is being financed overnight by one company. It’s that that company that provides the overnight financing then also gets a loan to be able to do that, and whoever they got the loan from is also getting a loan to be able to provide the loan provider with the financing.

So, there were these long chains of interconnectedness, some of which had to do with derivative exposure that was all very opaque. It was not all reported to the government, and so, it was hard for the government to know exactly how systemically risky Lehman Brothers was.

Luigi: To be fair, until March 2008, the Fed was not supervising Lehman at all, because Lehman was an investment bank, like Bear Stearns, and they should have been supervised. They were supervised by the Securities and Exchange Commission, who wasn’t particularly aggressive in doing so. However, when they opened the primary dealer facility, the Fed started to have some people at Lehman overseeing what Lehman was doing. So, there was a team from the New York Fed inside Lehman during the summer you were working there and at the time Lehman fell.

Kate: I didn’t see them. Yeah, but again, it was sort of too little, too late. In Lehman’s bankruptcy, it took years to unravel and at least figure out who owed who what. Having six months over the summer in the middle of a panic just wasn’t enough time for the government to really get up to speed on what was going on within Lehman.

Luigi: OK, but the day after Lehman fell, the Fed got another phone call saying that AIG was in trouble. Now, full disclosure, I testified on behalf of AIG in a case that involved an AIG owner against the US government, but the only thing I testified was that there was a taking by the US government, which was proven in court.

Kate: And, full disclosure, I did some research on the other side, on the side of the US government arguing against Luigi’s position.

Luigi: Good. So, I think that overall, we are not biased.

Kate: We’re balanced.

Luigi: AIG found itself in a major liquidity crisis due to the fact that it was insuring a lot of those mortgage-backed securities that were failing. It was insuring them not in a traditional insurance form, but through this instrument that goes under the name of credit default swap, which is the factor in insurance that repays you in full in case a bond defaults.

Kate: So, credit default swaps written by AIG, I think, covered over $440 billion in bonds that day that it needed to be bailed out. The government decided in the case of AIG, it was too risky to just let it collapse, because all this insurance that it had provided to other financial institutions, it would have disappeared. And then, those bonds failing would have meant that those financial institutions would have then collapsed, and so, it would have been a huge house of cards. The government decided to rescue AIG by essentially purchasing it outright.

Luigi: They were in the process of dropping in value. The cash needs of AIG were not to pay for defaulted bonds but were as collateral, because they were providing this insurance as collateral for people that were insured with AIG that, in case things went badly, they would be able to pay. Interestingly, among the institutions that were asking very aggressively for more and more collateral was, on the other side, Goldman Sachs. Goldman Sachs was valuing the insurance that was provided by AIG at a very low price and was demanding from AIG a lot of collateral, and, as a result, AIG needed some liquidity. It went to the Fed and asked to be accepted in the primary dealer facility or some form of facility like that facility.

The Fed denied that but made a very special loan at a very high rate with also some warrant that would allow the Fed, basically, to control AIG. In fact, the CEO of AIG resigned, and who did they put as CEO of AIG? They put a board member of Goldman Sachs, who was actually on the risk committee of Goldman Sachs. The weekend of the 19th and 20th of September, he was both participating in the meetings of the risk committee of Goldman Sachs and deciding what to do for AIG, which was a counterparty to Goldman Sachs.

Kate: That’s a little bit shady. I didn’t know about that.

Luigi: But anyway, the important part for our listeners is that the Fed did rescue AIG, issuing very large loans, but financial markets got even worse because the default of Lehman caused major losses in money market funds, and money market funds have, or used to have, this promise to redeem the investors always at par, 100 cents on the dollar. Some of these funds, in particular one fund, the Reserve Primary Fund, had invested so much in Lehman bonds, and that caused, basically, a run on the money market funds that created a panic in the entire money market industry.

However, big crises, of course, are not caused by one factor alone, but if you were to go retrospectively, in your view, Kate, what is the main cause, or the main causes, of the crisis?

Kate: In my mind, I like to frame this as a supply and demand issue. On the demand side, there was global demand for very safe assets that could be a sure store of wealth. This is coming from emerging markets, it was coming from China, it was coming from countries where there was a lot of saving. It was also coming from government institutions. Fannie and Freddie, which we’ve talked about as these safe, government-sponsored entities, were investing heavily in these subprime mortgages that were being securitized by the private sector.

So, there was this significant demand coming from all over the world for these very safe securities that had to be created through this bundling and securitization process that made it very lucrative for investment banks to put whatever they could possibly find in these pools of mortgages and that, in turn, spread down to mortgage originators who were willing to push basically junk, crap mortgages, on whoever was willing to take them out and buy a new house. Even if they couldn’t afford it. Even if they didn’t have a job.

I think there was kind of this pull coming from a lot of different participants, international and domestic, but there was also the supply of terrible mortgages that was aggravated by the fact that ... As you mentioned earlier, there was fraud going on, the incentives of the investment banks and the mortgage originators were so perverse that people who absolutely had no business buying mansions were buying multiple mansions. On top of that, there was very lax oversight of this whole system, and, sitting in the middle, were the ratings agencies that said everything was OK.

So, I think I just listed 50 different causes, but—

Luigi: You put it very nicely. I will be more rough. And I would say that, in my view, the real problem was the pervasiveness of fraud and the inability of institutions to weed out that fraud. In fact, they probably wanted to encourage and push that fraud throughout the system. It’s true that there is demand for stuff, but if you cannot supply that stuff and you fake it, I don’t call it demand and supply. I call that fraud. I think institutions who were supposed to lend with the prospect of repayment in mind violated those conditions simply because there were some willing buyers on the other side, and they faked much of the documentation. Now, there are papers documenting that there were double liens that were not reported, the fact that you were an investor rather than a homeowner, so that you had multiple properties, was not reported properly, and so on and so forth.

There was a laissez-faire attitude that really cultivated, in a moment of market euphoria, the possibility for vast fraud. Once the market stopped going up, the US stock market stopped going up, people started to realize that the mortgages were much, much worse than they expected. There was a gigantic uncertainty of who would bear the losses and how big those losses were. I think that that is what created a situation of frozen markets. In this difficult situation, the Fed behaved in a very inconsistent way. A great economist, Allan Meltzer, who studied the history of the Federal Reserve, wrote extensively about the fact that the Fed never developed a policy of lender of last resort.

Kate: I completely agree with you that there was rampant fraud in the mortgage market in the early 2000s, particularly in subprime mortgages. I completely agree with you that the inconsistency of the government’s actions was part of what amplified the crisis, but I belabor this point about the demand side, the global capital being invested in safe US securities, because there were housing bubbles as well in France, Australia, Italy, Spain, and they also, at least some of them, experienced significant housing drops around the same time.

A lot of European banks failed as well, and this happened in countries that didn’t have the same sort of securitization process that we have here. They didn’t have investment banks going out and pooling together subprime loans, and yet they also experienced significant drops in housing prices and bank failures. So even though I completely agree with you that what happened in the United States, the rampant fraud that we experienced, was a big part of the crisis here, I think that the story about global capital being invested in Europe and the US, therefore pushing down long-term interest rates, therefore increasing housing prices, I don’t think that that gets enough attention.

Luigi: Certainly, there were enabling conditions, and these conditions can be different. So, for example, in Europe, there wasn’t a huge influx of foreign money, but in some parts of Europe, there was a huge influx of German money coming down. So, in Ireland and Spain, there was a huge amount of loans made by German banks to Spanish banks, and the influx of easy money is what made ... what enabled, I think, a lot of bad loans. There is a fundamental difference between Spain, Ireland, and the United States, and it is that in Spain and Ireland, the number of actual people who defaulted was relatively limited because all the mortgages there are full recourse.

If you abandon your house, the banks will come after you for the difference between the value of the house and the value of the mortgage. In the United States, some states are fully nonrecourse, some are more ambiguous, but there is a greater tolerance toward other people who walk away from the house and don’t pay the mortgage. And so, in situations like this, it’s a much greater responsibility of the lender to be very careful on the way they lend. Financial institutions not only gave up that carefulness, but also lied about the objective characteristics of the mortgages.

This created not only large defaults, but also an enormous amount of uncertainty. At some point during the crisis, there was even the possibility that all the mortgages would be considered not valid. Why? Because they were not properly transferred according to some legal rules. If fact, some borrowers got away paying nothing, because they could prove that their mortgages were not properly endorsed. Later, Congress fixed the problem with the law, because otherwise the entire mortgage market in the United States would have collapsed.

Kate: One thing we haven’t mentioned, or at least explicitly discussed, is who ends up holding the risk, and why was it that these banks were engaging in so much fraud and pushing these no-documentation or no-income mortgages on people who couldn’t afford them. I think part of the reason is that there was this huge separation between who was ultimately holding onto the risk and who was issuing the mortgages. So, there were mortgage originators, like Countrywide, on the ground knocking on doors, trying to convince people to take out these terrible term mortgages.

Those mortgages were then sold to investment banks like Goldman Sachs, Morgan Stanley, Lehman Brothers, who then put them in the big pools, securitized them, and then sold them off in pieces either to domestic investors, foreign investors, or, for riskier parts of the pool of mortgages, to hedge funds. The people who ultimately bore the risk were pretty separated in this long chain from the people who were on the ground making the loans. If you were making a fraudulent loan, it didn’t really matter, because you were so far removed from the consequences of it that, basically, you were just being incentivized by the fee that you were making on the loan. All you cared about was maximizing volume, the quality didn’t matter to you.

Luigi: Yeah, but, Kate, you’re forgetting an important part. You describe, perfectly, this chain and the fact that this chain somehow did not work properly. However, if I am Countrywide and I make loans and then I sell them to you, let’s say Lehman, so that you repackage and you resell them, I attach to these loans what is called rep and warranty. I make some statements about the way those loans are made and the reliability of the parameters under which those loans were made. If any of this is false, I need to pay for damages. Number one.

Number two, most of the time, those portfolios are audited by the Big Four audit firms. How do they audit? Do they look at every single mortgage? Of course not. But they have some system of random checking that should enable them to catch the problems. And here, both of these things fail. Number one, the audit firms were not able to identify them early, and with a single exception of PricewaterhouseCoopers, PWC, that was held liable in the Colonial Bank trial for not doing that properly, we have not seen the Big Four paying for these mistakes.

And, number two, many firms got away with not paying their responsibility of reps and warrants, because, actually, once the Fed got control of AIG, it waived the ability to sue the banks for having violated these reps and warrants. I think that there was a major failure in compliance, a major failure in audit, a major amount of fraud in the system. One thing that offends me is the fact that, while there were a lot of fines paid by banks in the aftermath of the financial crisis, basically no financial executives went to jail, or was even prosecuted for those frauds. In fact, many of the same financial executives who committed those frauds are back in business like nothing happened.

Kate: The fraud that you’ve been talking about was, for the most part, on the part of the mortgage originators, the people on the ground making loans face to face. But I think the real failure of the investment banks was in the way that they turned these mortgages into actual securities. Banks were basically making securities out of thin air, even though there was no underlying pool of mortgages to back them up. And they did this using bets on the original pool. That way, you could take a pool of mortgages and the securities that stem from them and replicate them as many times over as you possibly wanted. This, I think, led to a lot of the amplification of the crisis that these synthetic instruments really had no underlying securities to back them up.

I think another issue was in the way that tranches of mortgage-backed securities that were not considered super safe were then repackaged together to create what was deemed by the rating agency as super safe, even though it was just kind of a mixture of crap from the lower tranches of other mortgage-backed securities.

I guess the point that I’m trying to make is that there was a lot of risk amplified many times over by the type of engineering that these investment banks were doing, and I think that was maybe not explicitly fraud, but that was where investment banks contributed to a huge amplification of the crisis.

Luigi: By the end of that week ... So, the week that starts with the bankruptcy of Lehman is September the 15th, by that Friday, which is the 19th, the situation is really tense, and it’s pretty clear … Both Goldman and Morgan tell the Fed that they’re not sure they’re going to open on Monday morning. That’s when two things happened. Number one is the Fed intervenes by allowing Morgan and Goldman to transform into bank holding companies, and, two, the first proposal by Paulson to intervene with some government help that will try to stabilize the situation—what eventually became the Troubled Asset Purchase Program, better known as TARP, floated on the 19th of September.

And then, on the 23rd, George W. Bush goes on TV in front of the nation.

George W. Bush: Good evening. This is an extraordinary period for America’s economy. Over the past few weeks, many Americans have felt anxiety about their finances and their future…

Luigi: So, listen to George W. Bush, president at the time, reassure the country that everything is fine, he says.

George W. Bush: …collapse. The government’s top economic experts warn that without immediate action by Congress, America could slip into a financial panic and a distressing scenario would unfold. More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet…

Luigi: And people heard their president saying that we are about to face a new Great Depression. They stop spending, they stop investing. They stop consuming. I think that that is, at least in part, what brought the economy into a tailspin.

George W. Bush: …and, ultimately, our country could experience a long and painful recession.

Kate: Yeah, I can relate to that, because as I was sitting in my dorm room watching Lehman collapse and seeing all my summer money disappear, a couple of weeks later I thought to myself, you’re screwed. There’s no way you’re getting a job. There’s no way you’re going to have anything to do after you graduate, because the economy is just going to be completely tanked. At that point, I decided to quit school. I used the couple of hundred dollars that I had recovered from selling my Lehman stock for pennies on the dollar to buy a one-way ticket to California and just kind of hiked around hoping that I could wait out the crisis and hoping that the economy would recover a year later.

I consider myself one of the lucky ones. At least I had that option. At least I knew that I would be able to return to school the next year, unlike many millions of Americans, who just completely lost their jobs and didn’t have many other options.

Luigi: In the next episodes, we’re going to discuss what we have learned and how we’ve made the system better, or to what extent we’ve made the system better. And, finally, we’re going to discuss, in the third episode, what holes are still there and face the very difficult question of where the next financial crisis will come from.