15 Doug Noland, Credit Bubble Bulletin, February 25, 2006, p. 10.
16 From Office of the Controller of the Currency Quarterly Reports on Bank Derivative Activities.
17Federal Deposit and Insurance Commission, Statistics on Depository Institutions, March 31, 2007.
The Federal Reserve creates money but does not control where it flows. The banks distribute funding through the economy where they believe it will be most profitable to them. Funding brokerage operations was very profitable. It might also have been seen as necessary, since hedge funds were buying a large proportion of derivative securities, underwritten by the banks.
Mortgage securities had grown more complex. The asset-backed or mortgagebacked bonds of the late 1990s were gathered into collateralized debt obligations (CDOs). The volume of CDOs rose from $157 billion in 2004 to $557 billion in 2006. This does not include synthetic CDOs, which rose from $225 billion in 2005 to $450 billion in 2006.20 (Synthetic CDOs are derivatives of CDOs, so they are not backed by any mortgage payments, subprime or not.)
These numbers address only a portion of the rising risk in the financial institutions and hedge funds. The leverage employed at different levels of ownership was at least as important as the poor quality of the mortgages. Gillian Tett of the Financial Times quoted from an e-mail sent by a banker. The banker had worked “in the leveraged credit and distressed debt sector for 20 years.” His career had never been more exciting: “I don’t think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions … with very limited capacity to withstand adverse credit events and market downturns.” The leveraged-credit specialist described the case of a typical hedge fund, two times leveraged. That hedge fund is supported by a fund of funds, which is three times leveraged. The fund of funds invested in “deeply subordinated tranches of collateralized debt obligations, which are nine times leveraged.” The result: “Thus every $1 million of CDO bonds is supported by $20,000 of end user’s capital—a 2% decline in the CDO paper wipes out the capital supporting it.”21
18Financial Times, June 19, 2007. Also from McKinsey: “The global stock of financial assets had reached $140 trillion.”
19 Doug Noland, “Credit Bubble Bulletin,” Prudent Bear Web site, March 9, 2007, p. 11.
20Noland, “Credit Bubble Bulletin,” February 16, 2007, p. 8; Noland is quoting from Paul J. Davies, “Sales of Risky ‘Synthetic’ CDOS Boom,” Financial Times, February 12, 2007.
A CDO is a theoretical financial institution. In James Grant’s phrase, it is a “paper bank, lacking walls and depositors but possessing assets and liabilities and equity.”22 It collects various debt obligations—bonds, bank loans, car loans, and mortgages, for instance—and sells pieces of the package to different investors. The pieces of the package carry different investment grades, from AAA on down.
This complexity is beyond the resources of buyers. They rely on the credit rating agencies—Standard & Poor’s, Moody’s, and Fitch—which rate each tranche. The AAA ratings were taken as given by buyers, despite their undoubted poor understanding of what they were buying.
The complexity of the AAA-rated “ACE Securities, Series 2005-HE5 CDO” was not uncommon. It included 7,212 first-and second-lien mortgages when it was issued.23 Some of these CDOs owned pieces of millions of mortgages, sometimes owning the same mortgage three or four times, since one layer of a CDO might be owned by another layer and so on.
One other growing class of derivatives deserves mention, especially since Alan Greenspan sang its praises into 2008: credit default swaps (CDS). These were originally designed to hedge against losses should a company enter bankruptcy. The purchaser pays a premium for bankruptcy protection. Credit default swaps would appeal to General Motors bondholders who wanted to hedge—hold an “insurance” policy— against General Motors declaring bankruptcy.
The original intention expanded. Credit default swaps were written for other derivatives, such as CDOs. The complications of credit default swaps written on CDOs that combined several CDOs (CDOs squared) were recreational mathematics played with other people’s money.
21 Gillian Tett, “The Unease Bubbling in Today’s Brave New Financial World,” Financial Times (London edition), January 19, 2007, p. 36. Tett wrote that she did not know the banker, but the numbers put into writing what we were hearing at the time.
22 Grant’s Interest Rate Observer, April 6, 2007, p. 2.
23 Grant’s Interest Rate Observer, March 7, 2008, p. 10.
25
Fast Money on the Crack-Up
2006
I’m going to be a rich man when this war is over, Scarlett. … I told you once before that there were two times for making big money, one in the upbuilding of a country and the other in its destruction. Slow money on the upbuilding, fast money in the crack-up. Remember my words.1
—Rhett Butler, in Gone with the Wind (1936)
On February 12, 2006, two weeks after chairman Greenspan retired, he reportedly received $250,000 to speak at a dinner that Lehman Brothers hosted for hedgefund managers.2 It was a surprise to many that he spoke at all. That he spoke publicly, and for money, was undignified. This reflected solely on Greenspan. Worse, he was interfering with the Bernanke Fed. On the lecture circuit, he would talk about interest rates, inflation, and the dollar. His predictions overshadowed his successor’s attempts to establish credibility.
He told the Bond Market Association that “credit default swaps are becoming the most important instrument I’ve seen in decades. … For
1 Margaret Mitchell, Gone with the Wind (New York: Scribner, 1936), pp. 241–242.
2 Roddy Boyd and Niles Lathem, “Want Alan Greenspan to Come to Dinner? That’ll Be $250,000 …” New York Post, February 9, 2006.
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decades we used to have monetary crises because banks” could “freeze up.” Credit default swaps “lay off all these loans.”3 Greenspan could not have been more wrong if he tried, but he was speaking to the bond industry, so his listeners enjoyed the quotable endorsement. The failure of Lehman Brothers in 2008 would show the degree to which financial institutions froze up from exposure to credit default swaps. The Bond Market Association announced that it was creating the annual “Alan Greenspan Award for Market Leadership.”4
In October, speaking in Canada, Greenspan claimed that the housing boom was due to global integration, but the system “ran out of steam because no one could afford houses anymore.”5 Two weeks later, Greenspan claimed: “Most of the negatives in housing are probably behind us. It’s taking less out of the economy.”6 Exactly one week after Greenspan predicted a housing recovery, his opinion was expertly choreographed into a National Association of Realtors $40 million advertising campaign. The full-page newspaper ads spread good news: “It’s a Great Time to Buy or Sell a House.” Greenspan’s contribution to the layout (which filled the upper right-hand quadrant) fell under the heading of “Positive Outlook” He assured us that the fourth quarter of 2006 will “certainly be better than the third quarter.”7
In October, Greenspan also noted it was fashionable to short the dollar: “Central banks around the world and private investors are beginning to shift holdings from the dollar to the euro.” He contended that “the trade and budget deficits aren’t a problem.”8 They weren’t a problem, they were the problem. Some countries made no effort to disguise their antagonisms towards the United States, but it is doubtful that they would have threatened to leave the dollar orbit if the United States had paid its bills and ran an honest monetary policy.9 In December, he was once again down on the dollar because, with such a large current account deficit, it was “imprudent” to hold a single currency.”10
3 Caroline Salas, “Derivatives, Not Bonds, Show What Pimco, TIAA-CREF Really Think,” Bloomberg, May 31, 2006.
4 Press release, “Association Announces Creation of the Alan Greenspan Award for Market Leadership,” May 18, 2006.
; 5 Krishna Guha, “Housing Boom Due to Global Integration,” Financial Times, October 9, 2006.
6 Jessica Holzer, “Greenspan Sees a Soft Landing,” Forbes, October 26, 2006.
7 PDF of ad, from National Association of Realtors Web site: http://tinyurl.com/yz33ym. Under “Positive Outlook”: “Former Federal Reserve Chairman Alan Greenspan recently said that housing prospects are looking up. ‘Most of the negatives in housing are probably behind us. The fourth quarter should be reasonably good, certainly better then the third quarter.’”
8 Chuck Butler, “Greenspan Is Still Crazy,” Daily Reckoning, October 27, 2006.
Greenspan was as confused in retirement as he had been when he was at the Fed: nobody could afford a house; housing had bottomed. The current account deficit did not matter; the current account deficit was all that mattered.
Leveraged Buyouts, Again
By the middle of 2006, new dimensions were appearing too fast to comprehend. Privateequity firms elbowed hedge funds from the center ring. “Private equity” was this cycle’s euphemism.11 Conglomerateur was passé; entrepreneur was worn out; and the most accurate description, LBO firm, was not good for public relations. In July 2006, Kohlberg Kravis Roberts set a new LBO record with a $33 billion buyout of Hospital Corporation of America (HCA).12 Henry Kravis was elated: he had never seen a market with so much liquidity.13 A few months later, Kravis would crow: “The private equity world is in its golden era right now.”14
9 Several countries had recently threatened to conduct trade in other currencies. 10Chuck Butler, “Big Al Coming Over to Our Side,” Daily Reckoning, December ‘12,
2006.
11It was also confusing. “Equity” means the ownership in a company. But as the pri
vate equity boom proceeded, the private equity firms borrowed more to finance the
deals—they became more leveraged. The confusing terminology (thus, understanding) can be seen in the following: “[Blackstone Group] took on about $80 bn in debt
over the past three years. Blackstone . . . has deployed a total of $98 bn in financing
over the three years, including equity from its private equity funds. Sources close to
the company confirmed that about 80% of this was in debt financing.” Source: James
Mawson and David Rothnie, “Private equity group to use partnership structure,”
Financial News, March 22, 2007.
12“Hospital Move Presents Buy-Out Groups with New Risks,” Financial Times, July 25,
2006.
13James Taylor, “KKR Fund Splashes $200m on Mystery Investment,” Financial News
Online, August 18, 2006.
14Richard Teitelbaum, “KKR Outspends Blackstone, Instills Profit-First Creed,”
Bloomberg, June 29, 2007. Kravis had spoken at a dinner in April 2007.
Stephen Schwarzman’s Blackstone Group had raised $30 billion over the previous 12 months. This was only $2 billion short of the total it had raised in its previous 19 years of operation.15 On July 24, Reuters ran a headline that contradicted the central banking establishment, a confused flock that made speech after speech congratulating itself for stabilizing prices: “Bubbles Caused by Cheap Cash Menace World Economy.”16 Late in the summer, Ed Keon from Prudential Securities was more emphatic: “Clearly I’m exaggerating here, but what’s the difference between a $30 billion and a $300 billion deal? It’s just a few more phone calls.”17 If history was to repeat itself, asset levitation was peaking. Conglomerations of the early 1970s and LBOs of the late 1980s were the last word in excess.
As the bankruptcies of U.S. corporations pile up, private equity’s role should not be exaggerated. Corporate managements had gladly added debt to their balance sheets for decades. Financial theory (the efficient market hypothesis and its siblings) led corporations to borrow more to increase earnings. Theory took a practical form by suggesting that stock options for senior executives would prod them to work harder. This went under the banner of “maximizing shareholder value.” Stock options grew in stature, and LBO firms spread the gospel. In 1976, the average CEO was paid 36 times the average worker’s salary. In 1993, the multiple was 131. In 2006, it was 369 times average pay.18 Equity was often replaced with debt. Nonfinancial companies were paying out more than 100 percent of their profits in dividends and buybacks.19
Competition to lend to private equity firms was fierce. There was practically no spread between the borrowing and lending rates. Yet, bank loans to finance leveraged syndicated deals grew from $220 billion in 2005 to $360 billion in 2006, and to $570 billion in the first half of 2007.20 Recipients of funds warned the banks. Steven Rattner, managing principal of Quadrangle Group LLC, a successful privateequity fund, was quoted by Reuters in April 2007: “Of all the bubbles, the bubble in the credit market today is one of the greatest—it is beyond any rational measure. Frankly, we are feasting on the imprudence of our lenders. They are subsidizing our transactions and are allowing us to make deals that wouldn’t have made sense.”21
15 Peter Smith, “Blackstone Quickens Pace with $15.6bn Fund,” Financial Times, July 12, 2006.
16Stella Dawson, “Bubbles Caused by Cheap Cash Menace World Economy,” Reuters, July 24, 2006.
17“The LBO Gang Storms the Valley,” BusinessWeek, September 11, 2006.
18 Wall Street Journal, “Behind Executive Pay, Decades of Failed Restraints,” October 12, 2006.
19Andrew Smithers, “Why Balance Sheets Are Not in Good Shape,” Financial Times, August 30, 2007. Since 1984, stock buybacks and dividend payouts have exceeded profit retention. Equity of U.S. corporations has fallen more than 3 percent annually. A 3-percent-per-year decrease over 20 years is significant.
Why would banks take such risks? Lloyd Greif, an investment banker in Los Angeles, was quoted in the July 7, 2006, edition of American Banker: “The greed factor has kicked in as lenders see they can collect fees not just once or twice, but sometimes several times from refinancing leveraged buyout deals over and over again.”22
No one stopped the money machinery. The Fed cannot direct banks where to lend, but, as regulator, it has the authority to halt dangerous excesses. The Federal Reserve restricted bank credit used for acquisitions in 1980.23 It would have been worth the trouble to do so again. Bank loans to finance irrational deals started defaulting at a worrisome pace after Greenspan retired, but the latest LBO craze was destroying wealth while he was still at the Fed. Greenspan, unlike Bernanke, had had a front-row seat during the conglomerate and junkbond climaxes. The aftermath of both left companies and industries in ruin. It was happening again.
Despite Bernanke’s inexperience, he should have known. In March 2007, reporters at the Wall Street Journal told readers: “Hedgefund managers, buyout artists, and bankers get paid for short-term performance. … People inside the big banks … don’t want to get caught missing the next big deal. Their banks, and their own bonuses, might suffer.”24
20 Profits and Balance Sheet Developments at U.S. Commercial Banks in 2007, Federal Reserve Bulletin, Volume 94, 2008.
21 Mark McSherry, “LBO Players Say Debt Boom Won’t Go On Forever,” Reuters, April 11, 2007.
22 Lloyd Greif, “Lenders Absorbing More Risk in LBOs These Days,” American Banker, July 7, 2006.
23 Barrie A. Wigmore, Securities Markets in the 1980s, vol. 1 (New York: Oxford University Press, 1997), p. 354.
24 “Sketchy Loans Abound,” Wall Street Journal, March 28, 2007.
Hollowing Out America
The allotment of bank loans to private equity firms was the reason that a $300 billion deal was worth imagining. Chapter 3 quoted John Brooks’s assessment of how the conglomerate craze hollowed out the soul of America: “The result was the repeated reduction of midAmerican cities’ established industries from the independent ventures to subsidiaries of conglomerate spiderwebs based in New York or Los Angeles.”25
In 2005, David Urban, chief operating officer of Firebird Management LLC, New York, wrote about the declin
e of Wilkes-Barre, Pennsylvania, where he had grown up: “The manufacturing base had been hollowed out decades before. … In the mid to late 1980’s, banks from Pittsburgh and Philadelphia moved into the area pursuing their growth strategy by attempting to offer branch banking services on a statewide basis. All of the major banks were bought up and in the ensuing consolidations the back office and service jobs were cut in the area. The downtown fell into disrepair while corrupt politicians argued and pointed fingers over who was to blame while fattening the pockets of their supporters. The young people, as I was one, left the area to pursue better opportunities after high school since we did not see any value in staying behind. There were no growth industries and the jobs remaining were mainly family businesses or chain restaurants.”26
In 2009, the zany infatuation with “GDP growth,” no matter what the source, continues. Over 40 years ago, Robert Kennedy said that the gross national product “measures everything … except that which makes life worthwhile.”27
Proxmire’s Fear: The Leveraged Too-Big-To-Fail Megabank
The end was near. Stephen Schwatzman’s Blackstone Group paid $39 billion for Sam Zell’s Equity Office Properties. Zell had cashed out. Schwartzman started selling the properties immediately. Others were playing Russian roulette, borrowing as much as they could as fast as they could.
25 John Brooks, The Go-Go Years (New York: Weybright and Talley, 1973), p. 177.
26 Gloom, Boom & Doom Report, December 9, 2005.
27 Robert F. Kennedy, Remarks at the University of Kansas, March 18, 1968.
Senator William Proxmire foresaw the conflict of interests when he interrogated Alan Greenspan in 1987, though the senator probably did not imagine the “massive amount of liquidity” that now poured into buying and trading some of the largest corporations in the world. During the first quarter of 2007 (December 2006 through February 2007), the balance sheet assets of Goldman Sachs, Lehman Brothers, Morgan Stanley, and Bear Stearns rose by $237 billion, a $1 trillion annual rate and a 34 percent annualized growth rate.28 Goldman Sachs had a bigger balance sheet than the Fed’s.29 These were brokerage firms, not commercial banks.
Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession Page 35