In 1985, Salomon chief John Gutfreund made $5.8 million (todays dollars); in 2007, Goldman Sachs CEO Lloyd Blankfein pulled in $54 million.
Wall Street easily converted its permanent subsidy into hard cash. The growth and consolidation of the financial sector over the last 20 years have been dizzying, note Simon Johnson, an MIT entrepreneurship professor, and James Kwak, a former McKinsey consultant, in 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown. In 1985, Salomon Brothers boasted $122 billion in assets (in todays dollars); by 2008, Goldman Sachs had amassed $890 billion. In 1985, Salomon chief John Gutfreund took home $5.8 million (also in todays dollars); in 2007, Goldman Sachs CEO Lloyd Blankfein pulled in $54 million.
Not content with removing discipline from its own financial markets, America exported its “too big to fail” policy to the rest of the world. Englands version of Wall Street, the City of London, was more than happy to trade and structure the mountains of debt that the U.S. governments backing enabled banks to issue. As former banker Philip Augar writes in Reckless: The Rise and Fall of the City, after the mid-nineties, “the perception that the U.S. central bank would bail out markets whenever necessary” helped propel the City to new heights.
The City got creative, too, turning American mortgage-backed debt into fodder for credit derivatives and “structured investment vehicles.” As the City, Wall Streets chief competitor, gained market share, the fear that America would lose more of this lucrative business to London was another reason for regulators here to tolerate untenable risks. In failing to govern new derivatives markets with clear rules, regulators let financial engineers multiply many times over the danger that housing debt posed to the economy.
America also imported the developing worlds bad habits. Throughout the mid-nineties, the West had lent so much money to big, politically connected Asian industrial firms, particularly in South Korea, that the borrowers could never reasonably repay it. Global lenders had assumed that Asias political-corporate giants “were too important for the government[s] to let them go bankrupt,” Johnson and Kwak explain. The lenders proved correct in 1997 and 1998, when the Asian countries secured loans from the International Monetary Fund and rescued Western creditors with part of the money. The bailed-out lenders learned a dangerous lesson: “Its always best to invest in the firms with the most political power.”
Presidents Bill Clinton and George W. Bush both had faith that markets could magically achieve government goals, with zero pain to the taxpayer.
In America, Wall Streets political power derived from a very different source, Johnson and Kwak continue: its “ability to wrap itself in the ideology of homeownership.” That brings us to Fannie Mae and Freddie Mac, Americas two home-mortgage giants—nominally private companies that nevertheless “met virtually nobodys definition of firms in a free market,” economist Thomas Sowell writes in The Housing Boom and Bust. Fannie and Freddie enjoyed implicit government backing, meaning that they could borrow cheaply and use the money both to guarantee mortgages against default and to buy massive portfolios of mortgage securities from lenders, so lenders could then issue even more mortgages. Policymakers endorsed this system because it made people feel richer. Americans could buy homes that they couldnt have afforded otherwise and then watch the values rise.
The government directed housing policy not by bald bureaucratic pronouncement but through financial markets. Presidents Bill Clinton and George W. Bush both had faith that markets could magically achieve government goals, with zero pain to the taxpayer and plenty of profit for the private sector. Back in the early eighties, pioneering bond guys at Salomon and Merrill Lynch, discerning that a wave of baby boomers equaled more demand for middle-class housing, had joined forces with Fannie and Freddie to churn out housing-backed bonds for the purpose, Gasparino writes. Clinton, a New Democrat who believed that “the business community could help achieve the aims of government,” later applied the same logic to the poor, asking Fannie and Freddie to buy more mortgages for affordable housing.
Fannie and Freddie helped distend a housing market that couldnt withstand the slightest downturn. Housing, then, posed an ever-bigger danger to the economy. But regulators failed to do obvious things like requiring even modest down payments to cushion possible losses, since doing so would have made housing less “affordable” in the short term. As Sowell makes clear in detailing a centurys worth of “affordable” housing policies—from the construction of the first public-housing towers in the early 1900s to the ever-growing lending quotas that banks had to meet under the 1977 Community Reinvestment Act— making housing less “affordable” would have gone against every natural instinct of nearly every politician, not just in Washington but in states and cities, too.
By the mid-2000s, the Wall Street firms that had so long worked with Fannie and Freddie decided that they could cut out the two lumbering middlemen and keep the profits for themselves. Banks issued mortgages without Fannie or Freddie guarantees and sold securities backed by the mortgages directly to international investors. For many critics, thats evidence that free markets caused the crisis. The true problem was just the opposite—that financiers had grown accustomed to a quarter-centurys worth of risk-free, government-encouraged mortgage lending.
Burry knew as early as 2003, as he wrote in an e-mail then, that the consequences of a lending drought “could very easily be a 50 percent drop in residential real estate.”
Meanwhile, free-market forces, hobbled though they were by governmental meddling, were trying hard to tell the world that the governments economic-development policy—supporting ever-growing financial firms to serve as conduits of debt to overextended American home buyers—wasnt working. The great thing about markets is that you dont need special access to see the truth. The hedge-fund managers whom Lewis describes in The Big Short had nothing but information and analysis on their side.
Take Michael Burry, manager of the Scion Capital hedge fund. Burry knew as early as 2003, as he wrote in an e-mail then, that the consequences of a lending drought “could very easily be a 50 percent drop in residential real estate” with “collateral damage likely orders of magnitude worse than anyone now considers.” Burry has Aspergers syndrome, an autism-spectrum disorder that makes him prefer reading to talking. He scrutinized the thousands of pages of required disclosures that mortgage-securities salesmen had to produce, and as the 2000s advanced, he realized that loan quality had declined. From 2004 to 2005, in one sampling, borrowers credit scores had remained the same, but they were taking out riskier mortgages. The percentage of teaser-rate mortgages had quadrupled in a single year.
Over at another fund, a unit of the Morgan Stanley–backed FrontPoint Partners, Steve Eisman took a different approach and came to the same conclusion. Eisman knew that in the nineties, smaller predecessors to the subprime-lending industry had gone bankrupt after lending too much, too fast, too cheaply, often obscuring to their customers what the true costs would be a few years down the road. Now he saw the same thing happening again. This time, however, the enablers werent small-enough-to-fail firms; they were the giant Wall Street banks, which were packaging up the mortgages into securities, both to sell globally and to trade on their own books. Eismans colleague Vincent Daniel smelled trouble: nearly two decades earlier, he had quit his job as a junior Arthur Andersen accountant after finding it impossible to audit an investment banks books.
So the hedge-fund guys decided to bet against the gargantuan housing and finance businesses. They bought credit derivatives—unregulated financial instruments that would pay more and more as the value of a particular group of mortgage securities fell. The investors had no difficulty in getting Wall Street to sell them these derivatives. Burry, for one, was surprised that Deutsche Bank and Goldman Sachs, in early 2005, seemed unconcerned as he pored through lists of mortgage securities, trying to “cherry-pick the absolute worst ones” and amassing hundreds of millions of dollars in potential payoffs.
The investors feared that when the mortgages went bust, the banks would wriggle out of their obligation to pay up.
What did give the hedge-fund guys a hard time was the feds failure to maintain free-market infrastructure. The government didnt require a fair, transparent trading exchange—as it requires for stocks and options—for mortgage bonds and their derivatives. So unlike the prices of stocks, the prices of mortgage bonds and their derivatives werent “determined by an open and free market,” Lewis writes. They were “determined by Goldman Sachs and Bank of America and Morgan Stanley, who decided each day whether Mike Burrys credit default swaps had made or lost money.” The investors feared that when the mortgages went bust, the banks would wriggle out of their obligation to pay up. And for a while, the banks did use their discretion to claim that the price of the mortgage bonds was rising, which allowed them to avoid paying the hedge-funders until news of losses on similar investments became too insistent to ignore.
The investors also had to account for the governments seemingly random decisions about who would get a bailout. By mid-2007, one small money-management outfit, Cornwall Capital, had bought hundreds of millions of dollars worth of credit derivatives that would pay off if mortgage values fell. But Cornwall had bought much of the protection from Bear Stearns, and that summer, two of Bears own hedge funds went belly-up because of mortgage losses. Realizing that Bear could likewise go bankrupt and fail to pay up on the derivatives, Cornwall quickly sold them to another bank, the Swiss giant UBS. UBS expressed not “the faintest reservations that they were now assuming the risk that Bear Stearns might fail,” Lewis writes. Why not? UBS likely understood the politics and figured that the U.S. government would keep Bear from collapsing. As it turned out, UBS was right, and Cornwall could have safely kept the derivatives. But if Cornwall had bought them from, say, Lehman—which the government decided not to bail out—they would have been worthless.
In the end, the market realized—with explosive consequences—that the hedge-fund managers were correct about the value of mortgage bonds. Remember Eismans complaint about the absence of an “authority” to check the excesses of the market? That authority was Eisman himself. He, his colleagues, and his competitors took on the twin pillars of stealthy central planning in Americas economy: our too-big-to-fail financial system and our government policy of universal homeownership. And they won.
In September and October 2008, he [Paulson] “had been forced to do things I did not believe in to save what I did believe in.”
In the late summer and autumn of 2008, the Treasury Department and the Federal Reserve embarked upon the deepest interventions in the (nominally) private sector that America had ever seen. Overseeing the Treasury was Hank Paulson, the former Goldman chief, who in his recent book, On The Brink: Inside the Race to Stop the Collapse of the Global Financial System, comes across as a decent man thrust into an unwinnable position. Paulson writes—in the passive voice, tellingly—that in September and October 2008, he “had been forced to do things I did not believe in to save what I did believe in.” But decent men are no substitute for consistent rules that mark a clear line between the public and private sectors. As Paulsons book, along with New York Times reporter Andrew Ross Sorkins Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves, makes clear, rules and lines vanished altogether in autumn 2008—and Washingtons arbitrary actions back then created precedents that now seem certain to lead to the next crisis.
That autumn was a watershed. The Treasury and the Fed spent the first weekend of September bailing out Fannies and Freddies creditors by nationalizing both behemoths. In the second weekend, the government refused to bail out creditors to Lehman Brothers. After Lehmans collapse cratered the financial system, the Treasury and the Fed concocted the most complex bailout in history to save insurer AIGs creditors, including banks owed tens of billions of dollars on mortgage-related credit derivatives. And in early October, Congress passed the Troubled Asset Relief Program (TARP). Using TARPs authority and other measures, Paulson, along with the FDIC and the Fed, forcibly injected capital into the nations biggest banks. The government also guaranteed new debt issued by banks corporate holding companies, thus encouraging investors worldwide to buy it, which helped the banks and investment firms pay off their panicked short-term lenders.
TARPs forced capital injections sought to thwart the markets distinguishing between good banks and bad. It had long been clear, as New York Times Magazine writer Roger Lowenstein shows in The End of Wall Street, that Citigroups executives were far less competent than, say, JPMorgan Chases. In late 2006, while Citigroup continued to lend freely, JPMorgan chief Jamie Dimon noticed that people had stopped paying their mortgages even as they paid other debt. Dimon told his employees to “sell or hedge” some of their exposure to mortgage and other debt, and in his annual report, he soberly projected losses, saying that his intention was not to worry shareholders but to prepare them. Meantime, in his annual report, Citigroup chief Charles Prince devoted “precisely two sentences to credit markets,” which he said could suffer only “moderate deterioration,” Lowenstein notes.
The extent to which government threw away the rule of law in 2008 was shocking.
Since the crisis started, markets have easily distinguished between the well-managed JPMorgan Chase and the too-big-to-manage Citigroup. But the Citi bailout has kept the economy from benefiting enough from that distinction. To this day, investors continue to direct capital to Citigroup, knowing that the government will never let it fail. The economy could put that capital to better use elsewhere—in a superior bank, or a company outside finance altogether.
Similarly deep differences existed among investment banks—differences that bailouts muted but couldnt obliterate. Bear Stearns, for example, relied dangerously on short-term funding markets, which left it acutely vulnerable to a panic. Conversely, Goldman Sachs was obsessed with having cash on hand for an emergency. “To be on the safe side, we kept a lockbox at the Bank of New York filled with bonds that we never invested or lent out,” Paulson remembers of his Goldman days. “Knowing we had that cushion helped me sleep at night.”
The extent to which government threw away the rule of law in 2008 was shocking. Paulson kicks his book off with a description of his forced nationalization of Fannie and Freddie, observing that his subordinates concern—that the politically coddled mortgage giants would fight the effort—was groundless: “I didnt think they completely recognized the awesome power of government and what it would mean for Ben [Bernanke, the Federal Reserve chairman] and me to sit across from the boards of Fannie Mae and Freddie Mac and tell them what we thought was necessary for them to do.” Paulson instinctively used threats in his meeting with the two companies management. If they resigned and handed over the reins quietly, he told Fannies and Freddies executives, he wouldnt blame them for the firms failure. “I left unspoken what I would say publicly if they didnt acquiesce.”
Aside from their unfairness, such government-arranged rescues of the weak by the strong injure the best-managed companies, thus hurting the economy.
Using government might to bully two nominally private firms makes it easier to do the same to others. As the crisis intensified in 2008, the government threw companies together in shotgun marriages, even as the firms sometimes resisted. Tim Geithner, then the president of the New York Fed, tried to force Jamie Dimon to merge JPMorgan with the flailing Morgan Stanley; Dimon repeatedly had to ward off Geithner and his colleagues with firm noes. On another occasion, Geithner “insisted” that Goldmans Lloyd Blankfein call Citigroup chief Vikram Pandit to launch a merger. Blankfein was “shocked at the directness of the request,” Sorkin writes. Thanks to management resistance, the craziest of these mergers—Goldman and Citi—never happened.
But the result of all the “successful” deals is an even more concentrated and hard-to-manage financial industry, made up of firms immune to market discipline because the economy cant withstand their failure. Consider Bank of Americas purchase of Merrill Lynch. In December 2008, Bank of America head Ken Lewis came to Paulson, threatening to back out of the deal as Merrill Lynchs losses piled up. Paulson asserted that such a decision could, in the governments eyes, represent a catastrophic error in judgment—one that would justify the Federal Reserve in removing Bank of Americas management. (Lewis, for his part, probably made his threat in order to secure more bailout money; it isnt good for the nation that financial executives have tried to hone their skill at gaming their arbitrary political overlords.)
It was Blankfein who best voiced the danger of the governments actions. During that second week in September, the Treasury and the Fed sought to avert the Lehman bankruptcy by forcing the firms competitors to purchase its worst assets and then getting Britains Barclays Capital to buy the rest. “We must be responsible for our own balance sheet and now were responsible for others?” Blankfein objected at the gathering of bank chiefs that Paulson and Geithner had convened.
Blankfeins argument “had to trouble every free-marketer in the room,” Paulson muses. “Potential investors assessing any banks balance sheets would have to consider . . . whether it had properly accounted for the risk that it might have to bail out any one of its competitors.” But at the time, Paulson—who had once helped Goldman amass that big cash cushion to protect it from the unforeseeable—had no problem asking Goldman to endanger it to blunt the impact of a competing firms failure to do the same. Even aside from their unfairness, such government-arranged rescues of the weak by the strong injure the best-managed companies, thus hurting the economy.
Its appalling, too, that Bush staffers toyed with the idea of asking the president to call Chinese leader Hu Jintao in order to arrange an investment in Morgan Stanley by a Chinese-owned financial firm. In Paulsons plan, Bush would make clear to Hu that if the Chinese company invested, America would make sure that it wouldnt lose its money. Paulson recalls that “any such contact would have to be set up carefully, because the president of the United States should not appear to directly ask the president of China to invest in a U.S. institution.” Indeed.
Washingtons extraordinary actions are now precedent, most of the authors agree. What was once a “vague expectation” that government would rescue financial firms in a crisis is now “a virtual certainty,” Johnson and Kwak write. Nouriel Roubini, the New York University professor who famously saw the disaster early, and Stephen Mihm, a history professor at the University of Georgia, note in Crisis Economics: A Crash Course in the Future of Finance that “the Fed has sent a clear message to the financial markets that it will do almost anything and everything to prevent a financial crisis from spinning out of control.” Says Lowenstein: “Wall Street institutions emerged from the crisis more protected than ever.” Even the one exception to “too big to fail” seems to prove the new rule: its now conventional wisdom in Washington that letting Lehman collapse was a mistake.
Federal officials are egotistical and short-termist enough to think that todays pronouncements—No more bailouts, and this time we mean it!—matter more than yesterdays actions. Paulson offers a few accidental laughs in this respect. When he was trying to strong-arm competing financial firms into bailing out Lehman, he recalls, he told executives and the press that “there could be no government money involved in any rescue. I knew that unless I explicitly said this, some of them might think that Good Old Hank would come to the rescue.” And in the case of Lehman, he was telling the truth. But why should the bankers have believed him when a quarter-centurys worth of precedent, including a bailout of Fannies and Freddies bondholders just a week earlier, contradicted him—and when, two days later, the government bailed out AIG?
What Washington has created, then, is best summed up in Johnson and Kwaks title. The “13 bankers” are the CEOs of the surviving big banks, whom President Obama summoned to the White House just weeks after his inauguration. Obama had convened the bankers to show the public that he was firmly in command of the institutions that the government had rescued. But what markets perceived was protection. “It was clear that the thirteen bankers needed the government,” Johnson and Kwak write. “But why did the government need the bankers?” In pumping trillions of dollars in cash and guarantees into the financial system without demanding change, Johnson and Kwak say, we risk creating a “uniquely American oligarchy”—one that will harm Americas growth, just as similar oligarchies have harmed other nations growth throughout history.
The financial fixes that Congress passed would further entrench this oligarchy and institutionalize Washingtons 2008 powers. Consider the creation of a “financial stability oversight council,” a centerpiece of the new financial-regulatory reform bill. The council would supposedly end “too big to fail” by preventing failure in the first place. But markets will know that this is impossible. A stability overseer cant predict the future any better than other Washington bureaucracies could. As Paulson admits about his first Camp David meeting with President Bush in 2006, “notably absent from my presentation was any mention of problems in housing or mortgages.” This omission came at a time when the hedge-fund guys whom Lewis chronicles were largely done making their bets against the mortgage market. Couldnt the council just listen to guys like Mike Burry? Impossible: Washington group thinkers are never ever going to take advice from people who dont spout the conventional wisdom.
As Wall Street and Washington both depend increasingly on the issuance of cheap government debt, the two partners have an even bigger incentive to warp the free-market infrastructure.
Congress also seems oblivious to the fact that, throughout history, financial crises have come about because of two factors: too much debt and too much hidden risk. Thats why Roubini and Mihm rightly call for a “robust set of simple rules”—not coincidentally, largely the same ones that governed finance from the thirties through the eighties, when financial crises were rarer and milder than today—to prevent future crises. Forcing credit derivatives onto stock-market-style public exchanges and limiting borrowing across financial firms and instruments “should be absolute and should be applied across the board,” they say, with heavy borrowing restrictions and disclosure requirements for any “customized” derivatives. In fact, they would go even further, separating commercial and investment banks to break “too-big-to-fail” giants into smaller units that pose less risk to the economy. Not even the more modest of these steps, however, is in the congressional bill.
Somewhere, small-time money managers are making bets against the new conventional wisdom, just as they bet against the governments housing-and-banking monolith half a decade ago. But its harder now. Banks can borrow at the Federal Reserves zero-percent interest rates, artificially inflating asset prices. The Fed itself has bought a trillion dollars worth of mortgages, keeping securities and home prices too high. Washington has let banks carry overvalued securities on their books, delaying necessary price corrections to jump-start the real market.
The too-big-to-fail financial firms, thanks to mergers encouraged by the government, are bigger and more powerful than ever, with just five banks controlling nearly all of the credit-derivatives market, meaning that they can delay the results of their future mistakes for longer. Investors cant analyze just markets and companies anymore; they also have to figure out what arbitrary moves the government will make. And as Wall Street and Washington both depend increasingly on the issuance of cheap government debt, the two partners have an even bigger incentive to warp the free-market infrastructure so that dissenting voices have a harder time getting vital information across to the economy.
Most American politicians would laugh at solutions like the ones that French economist Jacques Attali proposes in his book After the Crisis: How Did This Happen? Attali would like to see “a Keynesian state on a global level” that would “set up supranational regulation and governance” and “launch great worldwide projects aimed at reorienting growth” toward government-approved projects. Central planning? How un-American!
Yet to some degree, weve already been following this path for decades: deficit spending and willfully “orientating” growth toward the housing and financial sectors, expanding on John Maynard Keyness suggestions that government control demand. Americas pols should be honest about what their fixes and non-fixes amount to: yet more central planning, which jeopardizes our sovereign credit, endangers the Western worlds ability to grow its way out of a crippling recession, and makes it even harder for free markets to fight government mistakes.
Original Source: http://www.thefiscaltimes.com/Issues/The-Economy/2010/07/19/Financial-Crisis-Surveying-the-Wreckage.aspx