A Nation of Moochers

by Sykes, Charles J.

  Regulators, including Congress, not only failed to build the fences, but they turned out to be as clueless as many of the investors who bought the exotic and highly leveraged securities. The country’s biggest firms simply poured fuel on the conflagration.

  Casino

  In 2004 the Securities and Exchange Commission waived its leverage rules that had limited firms to a maximum debt-capital ratio of 12 to 1. The exemption freed five firms—Goldman Sachs, Bear Stearns, Merrill Lynch, Lehman Brothers, and Morgan Stanley—to leverage their bets up as high as 30 or even 40 to 1.

  These were casino-like wagers that would be considered certifiably insane, except for the belief that the value of real estate would continue to rise, as the banks apparently assumed. Here’s a simplified version (offered for demonstration purposes only) of the power and perils of leverage at this altitude: At a ratio of 40 to 1, a firm could buy $100 worth of subprime mortgages, for example, with just $2.50 of its own money. Here’s the upside: If the value of the investment rose by 5 percent to $105, the firm makes $5 on an investment of just $2.50—a profit of 100 percent, minus any interest payments. Brilliant.

  Here’s the downside: If our investment of $100 drops in value by 5 percent, it will be worth only $95—and the $2.50 cash investment is transformed into a $5 loss—a loss twice the original investment. If the value drops by 10 percent, the loss becomes four times the original investment. Multiply these numbers by billions of dollars and you realize the panic that began to sweep through Wall Street’s high-flying casinos in 2007 and 2008.

  As the Great Bailout began, the pattern of determining winners and losers shifted from the roulette wheel of the housing market to the halls of government. But the randomness remained: Some lenders were pressured by the feds to make concessions and take losses on their risky bets in exchange for bailouts; others were paid 100 cents on the dollar with taxpayer cash. But while there was no consistency, there were some discernible patterns. Foremost among them: It’s good to be Goldman Sachs.

  Government Sachs

  Before the Fall, American International Group (AIG) was a AAA-rated monolith with $1 trillion in assets, boasting 76 million customers around the globe. But it became the symbol of the reckless exuberance of the mortgage bubble. Among its many products, AIG’s soon-to-be notorious Financial Products subsidiary peddled insurance policies for exotic financial instruments that fueled the explosion of subprime lending. The insurance policies, known as credit default swaps or CDS, underwrote much of the wheeling and dealing of firms like Goldman Sachs. By late 2008 AIG was on the hook for more than $2.7 trillion worth of swap contracts. The swaps were such sure things, the company boasted, that its computers predicted that the odds of never having to pay out any money on the credit swaps was 99.85 percent.4 AIG’s Financial Products unit believed that the CDS were so ironclad that the entire economy would have to descend into a full-scale meltdown before the company would have to pay out a penny to cover the defaulting bonds. As it turned out, billions of dollars in those swaps were held by Goldman Sachs.

  Even in an era of crony capitalism, Goldman Sachs stands out. “Goldman, more than any other company,” wrote journalist Timothy P. Carney, “pulls the levers of government.”5

  Both the Bush and Obama administrations were packed with Goldman Sachs alumni; and the revolving door between government and the firm became so well established that Goldman won the moniker “Government Sachs.” So incestuous was the relationship between Goldman’s insiders and the government that the firm was able to orchestrate the Great Bailout to its maximum advantage. At key moments, the interlocking interests blurred distinctions between what was good for Goldman and what was good for everyone else.

  For years, Goldman had packaged and marketed subprime mortgages to its clients, but more recently it had reversed its position, actively betting against the housing market by buying credit default swaps that would pay off if the housing bubble burst. Goldman was counting on AIG to pay it billions of dollars if, as it expected, the housing market began to implode. In any case, AIG and its sure-thing credit swaps were crucial for Goldman’s bottom line. As The New York Times later noted, “Without the insurer to provide credit insurance, the investment bank could not have generated some of its enormous profits betting against the mortgage market. And when that market went south, AIG became its biggest casualty—and Goldman became one of its biggest beneficiaries.”6

  At every step of the AIG bailout, Goldman was at the table. Actually all around the table. A New York magazine article captured a key behind-the-scenes moment from 2008:

  At the meeting, it was hard to discern where concerns over AIG’s collapse ended and concern for Goldman Sachs began: Among the 40 or so people in attendance, Goldman Sachs was on every side of the large conference table, with “triple” the number of representatives as other banks, says another person who was there.…

  On the government side, Goldman was also well represented: [Then New York Fed President Timothy] Geithner himself had never worked for Goldman, but he was an acolyte of former Goldman co-chairman and Clinton Treasury secretary Robert Rubin. Former Goldman vice-president Dan Jester served as [Treasury Secretary Henry] Paulson’s representative from the Treasury. And though Paulson himself wasn’t present, he didn’t need to be: He was intimately aware of Goldman’s historical relationship with AIG, since the original AIG swaps were acquired on his watch at Goldman.7

  The meeting was ostensibly to determine whether a private or a combination private-public solution could be found to save the insurance giant, which had insured many of the dicier financial instruments of the housing bubble era. But under the watchful eyes of Goldman, those alternatives collapsed, and days later Paulson announced plans for a complete government bailout—$85 billion in taxpayer money to buy a majority share of the company. As the Congressional Oversight Committee later found: “In previous rescue efforts, the federal government had placed a high priority on avoiding direct taxpayer liability for the rescue of private businesses.… With AIG, the Federal Reserve and Treasury broke new ground. They put U.S. taxpayers on the line for the full cost and the full risk of rescuing a failing company.”8

  Most of that cash went to pay AIG’s “counterparties,” the largest of whom turned out to be Goldman Sachs itself, which pocketed $13 billion.

  That $13 billion represented 100 percent—every last nickel—of what it was owed by AIG. This was extraordinary, noted Joe Hagan in New York magazine: Other banks, including Merrill Lynch, had taken much harsher haircuts. “Over time, it would appear to many that Goldman Sachs had received a backdoor bailout from a Treasury Department run by the firm’s former CEO.”9

  Goldman later insisted that it was fully protected from any losses from AIG, but the argument is implausible, considering the dire effect that AIG’s collapse would have had on Goldman’s liquidity and stock price. This, however, raises an intriguing question: “So why did Goldman, supposedly brilliant, expose itself so much to AIG?” asks Timothy Carney. “It’s reasonable, given the company’s closeness to government to conclude Goldman was counting on a bailout if things went badly.”10 As it turned out, that was a very good bet.

  If You’re Goldman Sachs, You’re Fine. If You’re Not, You’re %$*&^#

  As congressional investigators reconstructed the frenzied bailout process, they were frankly stunned by what they found: the shoddy logic behind the defenses for the raid on the Treasury; the flagrant conflicts of interest; the damage to the marketplace caused by the bailouts; and the sleight of hand used to protect Goldman Sachs. Increasingly it became obvious that the concern behind the bailouts was not to save the system, but rather to rescue certain banks, certain politically well-connected banks. Most egregious of all was the fact that the Goldman-dominated Treasury Department appeared to reject any options for bailing out AIG that did not involve paying the banks 100 cents on the dollar. As The New York Times later noted: “All of this was quite different from the tack the government took in the Chrysl
er bailout. In that matter, the government told banks they could take losses on their loans or simply own a bankrupt company; the banks took their losses.”11 Goldman Sachs was insulated from deep losses, in part because of the extraordinarily cozy relationship with the regulators.

  Documents released later by congressional investigators portray officials of the New York Fed truckling to bankers at the very time they were rescuing them from the consequences of their own blunders. “While Wall Street deal-making is famously hard-nosed with participants fighting for every penny,” noted The New York Times, “during the AIG bailout regulators negotiated in an almost conciliatory fashion.”12 (Emphasis added.)

  Congressional investigators were struck by the outrageousness of the conflicts of interest that led to the transfer of billions of dollars from the taxpayers to Goldman Sachs. As the Congressional Oversight Committee later wrote:

  Throughout its rescue of AIG, the government failed to address perceived conflicts of interest. People from the same small group of law firms, investment banks, and regulators appeared in the AIG saga in many roles, sometimes representing conflicting interests. The lawyers who represented banks trying to put together a rescue package for AIG became the lawyers to the Federal Reserve, shifting sides within a matter of minutes. Those same banks appeared first as advisors, then potential rescuers, then as counterparties to several different kinds of agreements with AIG, and ultimately as the direct and indirect beneficiaries of the government rescue. The composition of this tightly intertwined group meant that everyone involved in AIG’s rescue had the perspective of either a banker or a banking regulator. These entanglements created the perception that the government was quietly helping banking insiders at the expense of accountability and transparency.13

  In other words, the elite negotiated with the elite, for the benefit of the elite and at the expense of the rest of us. Forget the welfare queens of yore; no one can mooch with quite the élan or grasping of the rich and powerful.

  For example: Treasury’s “point man” on the AIG bailout, Daniel Jester, was a former Goldman executive who still owned Goldman stock, even as he was negotiating the terms of the bailout. Reported the Times: “According to the documents, Mr. Jester opposed bailout structures that required the banks to return cash to A.I.G. Nothing in the documents indicates that Mr. Jester advocated forcing Goldman and the other banks to accept a discount on the deals.”14 As oversight committee member J. Mark McWatters later observed:

  It is ironic that although the bailout of AIG may have also rescued many of its counterparties, none of these institutions were willing to share the pain of the bailout with the taxpayers and accept a discount to par upon the termination of their contractual arrangements with AIG. Instead, they left the American taxpayers with the full burden of the bailout. It is likewise intriguing that these too-big-to-fail financial institutions (leading members of the “global financial system”) were paid at par—that is, 100 cents on the dollar—at the same time the average American’s 401(k) and IRA accounts were in free-fall, unemployment rates were sky-rocketing and home values were plummeting.15

  The Fed documents suggest that Fed officials were sensitive to this disparity and nervous that making firms like Goldman completely whole would look like a “gift.” In November 2008, staffers advised keeping that aspect of the deal secret. For more than a year, the Fed successfully blacked out the scope of its concessions to the lucky bankers.

  One of the greatest mooches of all time was orchestrated behind closed doors, without transparency, by insiders who were more interested in scratching one another’s backs than protecting either the taxpayers or the integrity of the financial system they were supposedly saving.

  How Awful?

  The rationalizations for the bailout have not stood up well under scrutiny. The Congressional Oversight Committee rejected arguments that the Fed faced a choice of either letting AIG collapse or bailing it out completely with taxpayer funds. The government could have made more efforts to obtain private backing, the committee argued, but instead undertook a deeply flawed effort to put the private rescue in the hands of just two banks, J. P. Morgan and Goldman Sachs, “institutions that had severe conflicts of interest as they would have been among the largest beneficiaries of a taxpayer rescue.” When that effort predictably failed, “the Federal Reserve decided not to press major lenders to participate in a private deal or to propose a rescue that combined public and private funds. In short, the government chose not to exercise its substantial negotiating leverage to protect taxpayers or to maintain basic market discipline.”16

  At the heart of AIG’s collapse was the usual toxic stew of irresponsible betting, excessive leveraging, incompetent risk management, incentives that encouraged recklessness, and creative accounting. By bailing out AIG, congressional investigators found, the government distorted the marketplace “by transforming highly risky derivative bets into fully guaranteed payment obligations.”

  Concluded the Congressional Oversight Committee:

  In the ordinary course of business, the costs of AIG’s inability to meet its derivative obligations would have been borne entirely by AIG’s shareholders and creditors under the well-established rules of bankruptcy. But rather than sharing the pain among AIG’s creditors—an outcome that would have maintained the market discipline associated with credit risks—the government instead shifted those costs in full onto taxpayers out of a belief that demanding sacrifice from creditors would have destabilized the markets. The result was that the government backed up the entire derivatives market, as if these trades deserved the same taxpayer backstop as savings deposits and checking accounts.17

  As a result, the banks who were owed money on their risky bets got “a complete rescue at taxpayer expense,” as did “sophisticated investors who had profited handsomely from playing a risky game and who had no reason to expect that they would be paid in full in the event of AIG’s failure.”18

  The political fallout has been dramatic and apparently surprising for the various ruling classes. But the backlash should not have been unexpected either in its intensity or scope; both major parties were complicit in the orgy of bailouts and the mooching of potentially trillions of dollars from taxpayers. The unprecedented transfer of wealth from those who played by the rules to those who screwed up exposed a permanent bipartisan governing class of insiders and elites: Republican Henry Paulson, followed by Democrat Timothy Geithner, the hapless New York Fed president, who was rewarded for his role in the rescue of improvident billionaire corporations by being named Treasury secretary by President Obama, despite his failure to pay income taxes usually required of the little people whose money he was now charged with managing and whose own taxes he would henceforth be collecting. Bush appointee Ben Bernanke, who orchestrated the bailouts, was similarly reappointed by Obama to head the Federal Reserve, where he continued to conjure dollars from thin air and his own imagination. This perhaps explains why the Tea Party seemed to rise up against insiders in both parties and seemed so intolerant of any hint that it was time to return to business as usual.

  Epilogue

  On July 15, 2009, The New York Times reported that, flush with bailout cash, Goldman Sachs was once more enjoying eye-popping profits:

  Goldman posted the richest quarterly profit in its 140-year history and, to the envy of its rivals, announced that it had earmarked $11.4 billion so far this year to compensate its workers.

  At that rate, Goldman employees could, on average, earn roughly $770,000 each this year—or nearly what they did at the height of the boom.19

  Chapter 12

  * * *

  WALK AWAY FROM YOUR MORTGAGE!

  * * *

  If Moocher Nation had the equivalent of a prom king and queen, they could well be a couple named Alex Pemberton and Susan Reboyras. Thanks to The New York Times, they became the public face of a new phenomenon known as strategic default, in which homeowners choose to walk away from their mortgages.*

  Far fro
m being seen as a failure, the Times reported, Pemberton and Reboyras were among the growing number of defaulters who had embraced foreclosure as “a way of life.”1

  While policymakers and banks wrestled with bailouts and other forms of mortgage relief, reported the Times, Pemberton and Reboyras fashioned “a sort of homemade mortgage modification, one that brings their payments all the way down to zero.” Their “mortgage modification” involved simply ceasing to make the $1,837-a-month payment on their mortgage. (Their “plan” is reminiscent of the old Steve Martin joke about how to make a million dollars and pay no taxes. First you make a million dollars, and then pay no taxes. And when the IRS agent comes to your door, you explain, “I forgot.”)