Monday, March 1, 2010

Bailout Nation

Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy 

This is the second book on the global econo-financial meltdown I have read, and is much larger in scope than the first one I read (The Looting of America, review). A related one is The Future of Hedge Fund Investing: A Regulatory and Structural Solution for a Fallen Industry (Wiley Finance) (my review post, and review).
    What is depressing is the realization that taxpayer funded bailouts have been happening for decades. Each bailout only makes things worse, and sets the stage for a larger bailout down the road. Companies and industries lobby for these bailouts, get them, and yet find themselves out of business a decade or two later, despite the bailouts. The Federal Reserve, ever expanding its mandate and powers, personified and led by the blind pursuit of an intellectual belief in the self-correcting powers of the market by Alan Greenspan, has probably done more damage to the US economy than any other single player or institution. Politicians, US Presidents, and the Congress, Democrats and Republicans alike, have allowed themselves to be corrupted by the banking lobby. Treasury Secretaries have been like the proverbial wolves set to protect the sheep from the wolves. And this is without getting to the banks, the traders, the investment firms... Everyone has been relentless in their pillage of the taxpayer.

    The bailout numbers are huge. They start out relatively modest, in the low hundreds of millions of dollars, with the bailout of Lockheed Aircraft Corporation in 1971, then with the Chrysler bailout, and by the time we reach the end of the last decade, they are flowing like a torrent, gushing hundreds of billions of dollars, to all and sundry. Numbers so large they dwarf the cost of the Second World War, of the rebuilding of Europe, of the New Deal. Not only the amounts, but also the frequency is mind-boggling. A cash injection of $45 billion dollars and guarantees of $306 billion to the Bank of America. A $700 billion TARP program. The takeover of AIG - $173 billion. $249 billion in guarantees to Citi. And on and on.

    Barry Ritholtz takes his pen to the crisis and paints a rogues' gallery of players, all with their noses to the trough. Take the SEC, which holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation's stock and options exchanges, and other electronic securities markets. How in heaven's name can you expect effective regulation when the head of the SEC believes in less regulation, or is on record having advised companies to destroy evidence??!!
    Bush’s first SEC appointment, Harvey Pitt ... as a Wall Street lawyer, Pitt had “recommended that clients destroy sensitive documents before they could be used against them [page 241]
    What about the Treasury Secretaries - Hank Paulson under George Bush, and Tim Geithner under Barack Obama; they are all cut from the same cloth.
    "... are bankers, first and foremost. As such, they do what most professionals do when their industry is under assault: protect the institutions. ... The obvious solution—put the insolvent banks into FDIC receivership, fire management, liquidate holdings, sell the assets off, wipe out shareholders, and pay the bondholders whatever was left over - was simply unthinkable." [page 221]

    The less said about the Congress the better. Maybe Mark Twain said it first, and said it best.
    “Suppose you were an idiot. And suppose you were a member of Congress. But I repeat myself.” [page 245]

    Ritholtz singles out former Federal Reserve chairman, Alan Greenspan, as the single most culpable player in this entire meltdown, and for the most withering of criticisms. Once seen as a demi-god, about whom Senator John McCain would go so far as to state during the GOP debate of 2000, "I would not only reappoint Mr. Greenspan - if Mr. Greenspan should happen to die, God forbid . . . I’d prop him up and put a pair of dark glasses on him and keep him as long as we could." ... "By 2008, the man formerly known as the Maestro saw his reputation in tatters." [page 61]

    Under the guidance of Alan Greenspan, the Federal Reserve abused monetary policy, ignored critical lending issues, and failed to regulate new and irresponsible banking products. ... Most of all, it was his deeply held philosophical conviction that all regulations are bad, and are to be avoided at all cost. [page 233]

    The U.S. central bank created moral hazard not by targeting inflation or the business cycle, but instead by focusing on asset prices. [page 58]
    Rather than seeing markets as a sign of the economy’s health, the Fed chair tended to see asset prices as an end unto themselves. [page 60]
    With the World Trade Center smoldering in ruins, the Fed sat around and waited. Wednesday, Thursday, Friday - nothing. It wasn’t until right before the markets reopened - when it would matter most to asset prices - that it finally did something. On September 17, 2001, almost one week after the attack, and precisely one hour before markets reopened, the Fed slashed rates another half point.
    Whatever doubts there were that Greenspan was supporting asset prices disappeared forever that morning. [page 86]

    For a person who believed in the markets' ability to "self-regulate", Fed chairman Alan Greenspan's repeated interventions to bailout markets and companies is astounding.
    And the unstinting champion of these unregulated derivatives was Alan Greenspan - "We think it would be a mistake to more deeply regulate the contracts." [page 138]

    Tom Savage, the president of FP, summed up the free lunch (on Credit Default Swaps) mantra succinctly: “The models suggested that the risk was so remote that the fees were almost free money. Just put it on your books and enjoy.” [page 205]

    " it was then Fed Governor Bernanke who ... provided the framework and intellectual cover for Greenspan’s ultra-easy money circa 2001 to 2003." [page 235]

    Under the leadership of then Chair Alan Greenspan, the Fed began the most significant rate-cutting cycle in its history. From pre-crash highs of 6.5 percent, the Fed took rates all the way down to 1.75 percent. [page 94]
    ... With wages stagnant, Americans turned to home equity withdrawals in order to maintain their standard of living. ... Mortgage equity withdrawals (MEWs)—normally a small portion of consumer debt—exploded. The accelerating borrowing against their homes allowed consumers to keep on spending, even as their savings rate went negative for the first time since the 1930s. [page 95]

    Just how deeply in bed (if that is indeed the right phrase) are politicians with corrupt industry can be gauged from these excerpts.
    The Glass-Steagall Act of 1933 not only established the Federal Deposit Insurance Coporation (FDIC) but also established separation between commercial banking and the securities industry. This Act was repealed in 1999 through the Financial Services Modernization Act, and set the stage for the rampant speculation by banks.
    "The CFMA removed derivatives and credit default swaps from any and all state and federal regulatory oversight." [page 138]
    Prior to the passage of the CFMA, unregulated credit default swaps were under $100 billion—a sizable, if manageable, amount of derivatives contracts. By 2008, they had grown to over $50 trillion. [page 138]
    "Among the over-the-counter derivatives freed from any federal jurisdiction by the CFMA were energy futures.... A key sponsor of the CFMA was Texas Senator Phil Gramm, whose wife, Dr. Wendy Gramm, was a member of Enron’s board...
    Enron paid Dr. Gramm between $915,000 and $1.85 million in salary, attendance fees, stock option sales, and dividends from 1993 to 2001.
    Days before her attorneys informed Enron in December 1998 that Wendy Gramm’s control of Enron stock might pose a conflict of interest with her husband’s work, she sold $276,912 worth of Enron stock."
    [pages 139, 140]
    ... Senator Phil Gramm ... was the senator behind the Commodity Futures Modernization Act of 2000 (CFMA), and spearheaded the repeal of Glass-Steagall.
    ... Placing any blame on deregulation was simply “an emerging myth,” the retired Texas senator has said.   Deregulation “played virtually no role” in the economic turmoil engulfing the globe, Gramm claimed
    in November 2008.
    What shameless nonsense. You will not come across a greater example of cognitive dissonance in your lifetime.  ... The inconsistency of his deeply held philosophy and the results thereof are logically incomprehensible to Gramm’s conflicted brain. If he were ever to admit the truth, he would likely go stark, raving mad [pages 235, 236]

    Thomas Jefferson, the principal author of the Declaration of Independence, argued that since the Constitution did not specifically empower Congress to create a central bank, doing so would be unconstitutional.
    “Banking establishments are more dangerous than standing armies,” Jefferson famously declared [page 15]

    One of the best books written on the collapse of the hedge fund, LCTM, is When Genius Failed: The Rise and Fall of Long-Term Capital Management

    The year 1998 saw the last opportunity to avoid moral hazard on a grand scale. A huge opportunity was lost, and the genesis of our current crisis was born. The missed opportunity in question involved Long-Term Capital
    Management (LTCM), a hedge fund that specialized in fixed-income arbitrage. [pages 68, 69]

    Much has been written about sub-prime mortgages that were bundled into mortgage backed securities and sold off, re-packaged and sliced-and-diced and re-sold.
    Allowing banks to give money to people regardless of their ability to pay it back is at the heart of the current situation. That factor, combined with the ultra low interest rates created by the Fed to bail out the prior market crash, sent the credit market cascading toward disaster. [pages 101, 102, 103]
     How could near-junk instruments like CDOs be rated AAA. And how could government debt also be rated AAA at the same time? Especially if there was a massive difference in returns between the two. Higher returns imply higher risk. Higher risk has to result in a lower rating. Because higher risk essentially means a higher probability of default. So why the identical ratings???
    Either this was a brilliant heretofore unrealized insight or it was a massive fraud. [page 111]

    It turns out that the three ratings agencies - Standard & Poor, Fitch, and Moodys - were rating these instruments. At the same time they were also helping create and package these instruments. Like a student who not only sets the question paper, and then writes it, but also gets to grade his own paper. Conflict of interest? You bet!
    The sellers of these mortgages made warranties to the Wall Street buyers of this paper that the borrowers would not default for 90 days - enough time for the loans to be sold off and repackaged as residential mortgage-backed securities (RMBSs). [pages 120, 121]

    Banks have a funny way of looking at lending: It’s not the loans you reject; it’s the ones you approve that get you into trouble. [page 119]
    And banks were approving trillions of dollars of mortgages a year. When interest rates are at historic lows, people want to lock their mortgages to these low rates. Logical. So... ask yourself:

    Why would ARMs make up so much lending when mortgage rates were at their lowest levels in 50 years? The only possible answer was to sell more - and bigger - loans. Getting people into teaser-rate mortgages, regardless of suitability, would get them past that default period covered by the initial warranty. This was the sub-prime mortgage industry’s primary raison d’╦ćetre. [page 128]

    The Oracle of Omaha, Warren Buffet, was unsurprisingly prescient:
    The rapidly growing trade in derivatives poses a “mega-catastrophic risk.” . . . (F)or the economy, derivatives are financial weapons of mass destruction that could harm not only their buyers and sellers, but the whole economic system. - Warren Buffett, Berkshire Hathaway 2002 Annual Report [page 137]

    What serves as a chilling reminder of the law of unintended consequences and of the hubris that attends possibly accidental success is articulated in Chapter 12 - "Strange Connections, Unintended Consequences". The 1996 Telecommunications Reform Act eliminated media ownership regulations, resulted in Clear Chanel Communications owning 1200 channels nationwide, getting rewarded with a stock price of $70 and a $40 billion market cap. "now it trades for pennies. ... an under $1 billion market cap." Why??? It fired its local talent, replacing their programming with "... a homogenized playlist feed from a central bunker in Texas"

    The root cause - the root of the greed, the craziness, the mad dash to leverage, all of it - according to Ritholtz, was the result of "dot-com stock option p*nis envy". Yes. Not the first rush of technology driven billionaires like Oracle, Microsoft, EMC, Intel, Cisco, Dell, etc... Not even the second rush in the 1990s - Netscape, Yahoo!, RIM, etc... It was the dot-com boom where nerdy students with nothing more than gluttonous greed in their eyes and a paper-napkin thin business plans becoming paper millionaires that drove Wall Street bankers crazy. With envy. With greed. With a sense of an intellectual inferiority complex. Hence the rise of the quants on Wall Street.
    “We’re engineers, too - financial engineers! We design derivatives and securitize debt! We have access to massive leverage! Hey, everybody, we’re all gonna get laid!” [page 197]
    The problem was that banks are not the same as technology startups. When a tech start-up fails, the cost is minimal. A few million dollars at the most. Not so with banks. Add to that the hundreds of millions of dollars in bonuses that executives paid themselves. This is true of industries beyond Wall Street though.
    Then there are the so-called compensation consultants. They did a horrific disservice to the shareholders as well as the companies. The role of these primarily ethicless weasels was to give cover for these ridiculous compensation packages. [page 199]

    In 1836, Mayer Rothschild wrote, “Give me control of a nation’s money, and I care not who makes the laws.” [page 234]

    Some solutions are suggested towards the end of the book. Some are practical, some too idealistic; but at the end of the day, almost every one of those suggestions is better than keeping the status quo. And unfortunately, the status quo is what has actually been preserved. A free lunch to the pillagers of the American economy, fully paid-for by the taxpayer.
    Newsletter writer John Mauldin concurs: “Bring in one million fairly affluent, legal immigrants, and you put a floor (and maybe some bounce) in the housing markets at all levels. [page 289]
    This is a suggestion that is going to be anathema to both sides of the political spectrum, for various reasons.

    The US pumped in $170 billion into AIG - money that has most certainly gone down the drain, completely. Instead, if this money had been earmarked over a 10 year period to help fund research into green technologies, the payoff would have been much, much greater. The government could grant $100 million to 100 universities. That would be only $10 billion. Grant $100 each million to 100 startups in the energy technology sector. That's another $10 billion. Provide a $1000 credit to 10 million homeowners who install energy saving insulation, or upgrade their heating systems to greener alternatives. That's $10 billion. And so on...

    For $35 billion you could "...'fund four years of public college education for every student in high school with at least a B average." [page 294]
    This is less than one-fourth of the money pumped into one single entity - AIG!!! This amount is less than 5% of the money under the TARP program!!

    © 2010, Abhinav Agarwal. All rights reserved.