Bailout Nation

by Barry Ritholtz

  Indeed, one can even imagine a more enlightened set of union representatives who would have been willing to horse-trade much more than they did, giving up pension and health care benefits, in exchange for a significant stake in the companies their union members worked for. Perhaps a more “Silicon Valley stock option” approach might have been the way to go. Employees could give up some health care benefits and pension guarantees, and receive in exchange equity in the form of stock options. I would imagine that this ownership arrangement would have worked miracles on worker productivity, too.

  This would have left the remaining Big Two in a much healthier financial condition going forward.

  The bailout sure didn’t do the auto workers’ union any long-term favors. The UAW’s membership peaked in 1979, with some 1.5 million members. Twenty-seven years later, UAW membership had fallen by two-thirds to 538,448 (2006). And year-over-year totals are still falling by significant amounts. In the last full year of data we have (2006-2007) the union lost another 73,538—a 14 percent annual membership decrease. Membership is now below half a million, and rapidly heading toward 400,000.

  Perhaps that’s not such a coincidence, given what we know about the other implications of this bailout.

  In the event of a Chapter 7 bankruptcy, we don’t know that Chrysler would have disappeared from the face of the Earth. Unlike us mortals, large corporate entities, with valuable physical assets and intellectual property, stand a very real chance of some form of reincarnation. Chrysler owns valuable manufacturing facilities, trademarks, patents, and designs, along with three-quarters of a century of manufacturing know-how. At pennies on the dollar, these assets would have been attractive to a third-party purchaser.

  Had Chrysler been allowed to slip the surly bonds of Earth in 1980, it’s not too difficult to imagine a vulture investor obtaining all of the aforementioned assets, and putting them to good use. Maybe it would have been a group of wealthy auto enthusiasts, or perhaps the budding Korean manufacturers. Whoever it might be, just picture the newly refurbished Chrysler Corporation recapitalized, minus the onerous labor contracts, pension obligations, and health care overhead. Its new owner would have been free to pursue new manufacturing methods, new automobile designs, even new markets—with all the advantages Chrysler itself had, but without the defunct company’s baggage.

  A postbankruptcy Chrysler would have been leaner, meaner, and more cost-efficient, and maybe even a more fuel-efficient machine than the rest of Detroit. Surely it could have been willing to take chances on some new designs that would break free of the stodgy old boring boxes put out by Detroit in the 1970s and 1980s.

  Not only would Chrysler have been much more competitive in the U.S. and world markets, its mere existence would have forced GM and Ford to streamline their own processes and improve their vehicles in terms of attractiveness, mechanical reliability, and fuel efficiency.

  It is quite reasonable to conclude that the bailout of Chrysler in 1980 prevented significant market forces from doing their best to reboot the entire U.S. auto sector.

  The short-term gains of the bailout to save some jobs in the auto industry ended up costing a million more jobs over the ensuing decades.

  Avoiding some immediate pain now seems to invariably lead to much greater pain down the road. This is a pattern we see repeated over and over again.

  INTERMEZZO

  A Pattern Emerges

  As we progressed deeper into the history of bailouts, comparing them to the present, it became increasingly obvious that just about all American bailouts follow a consistent blueprint. This consistency was remarkable from event to event, regardless of the underlying corporate sector, the amount of money involved, or even the decade in which the bailout took place.

  What does the prototypical bailout look like? Something like this:

  Ten-Step Bailout Pattern

  1. Risk event: Typically of the company’s own making, it might be something as general as leverage or as specific as collateralized mortgage-backed securities. Regardless of the particular causes or complexities of these risk events, rest assured that a very significant amount of money is at risk. It is not only the company, but a series of related investments that are also endangered. This means monied parties—usually well connected on Wall Street and in Washington, D.C.—have a vested interest in not allowing the natural course of events to occur.

  2. Preawareness: At first, the risk event is known to only a small coterie of experts such as junior researchers who are easily dismissed, and academics, easily derided as nonpractitioner theorists. The early observers during the precrisis write papers, attend conferences, and discuss industry specifics. More recently, they swapped e-mails and linked to blog posts. Despite the warnings, the industry itself continues with business as usual. Cries of “Chicken Little” and “Cassandra” greet the early warnings.

  3. First reactions: Key employees and industry insiders know something is amiss. But they continue to put on a happy public persona. Those pointing to the warning signs are denigrated with increasingly hostile rhetoric as the entrenched interests hope to scare or shame them into silence.

  4. Bigger reactions: The risk event continues to grow in magnitude. It slowly leaks to the press—industry-specific journals at first, then general-interest media. By that point, it is very slowly beginning to seep into the public’s consciousness. This is a process that typically occurs over months and indeed years.By the time the public has a widespread awareness of the issue, the problem has grown into something understood as significant, but not yet dangerous.

  5. “Interested party” agitation: A group of self-interested parties have taken notice of the situation. Corporate management starts to become increasingly concerned—mostly with their own self-preservation, but with health of the corporate entity as well. There may be a subset of fund managers who perceive the situation as either threat or opportunity, and they seek to protect their assets from damage—or profit from some entities’ demise.Eventually, the regulatory agencies become aware that something is awry, and at that point, it’s a given that the politicians will soon figure out that something big is brewing.

  6. Official concern: By now, some elements of the risk event have impacted the company’s stock price. It is widely perceived as a temporary circumstance—and an opportunity to “buy while the shares are on sale.”Shortly thereafter, the stock price declines even further. Short sellers may be castigated for their nasty rumormongering, and perhaps management blames Wall Street for being too focused on the short-term profits. Regardless, we receive assurances that this is a temporary setback, and the company’s fundamentals are solid.

  Large institutional interests typically have billions of dollars that are put at greater possible loss due to the risk event. Whether they are hedge funds or mutual funds, investment banks or pension funds, the financial sector especially has the ear of the Federal Reserve and the U.S. Treasury secretary. When markets go through their regular cyclical downturns, public officials become increasingly pliable.

  Ironically, it is often those who have built their names and reputations on free-market bona fides who plead and scream for intervention. Creative destruction is a brilliant concept to discuss in grad school, but with real money on the line, it becomes readily dismissed as an abstract academic concept.

  7. Broader worry, deepening panic: The public’s prior hazy understanding is coming into sharper focus: Some company or industry is less than healthy.We now enter the acceleration phase.

  There are more stock price declines, as it becomes apparent this is a very significant issue. As it progresses, the forecast of repercussions expands from worrisome to dire. By now, the mainstream media are covering the issue much more closely. The public is increasingly concerned.

  Those with the most money at stake have become downright frightened. Some have bought the stock or sector the whole way down. Others have been frozen, unable to move, watching the car wreck in slow motion while capital got destroyed. Variou
s options are explored. Alternative plans are discussed. Insiders slowly come to realize that none of these plans can happen fast enough or generate enough capital to resolve the issue.

  The risk event is rapidly approaching the point of no return.

  8. Major intervention/bailout: The political class eventually finds itself unable to resist temptation, and answers the call of some constituency or political campaign donor. We begin to hear phrases like “systemic risk” or “economic catastrophe.” There is a tremendous incentive to overly dramatize the risk event, so as to improve the likelihood of some form of legislation passing.Invariably, some well-meaning politician, columnist, or other observer will warn about the negative consequences that will accompany this intervention. The phrase “moral hazard” will be bandied about. Most often, these arguments are summarily dismissed.

  Sometimes events move so quickly there’s no time for a full and open debate, leaving that discussion to the historians.

  Finally, the bailout plan comes together. It is quickly signed by the president and is perceived as the lesser of two evils, a better alternative than letting Joseph Schumpeter’s creative destruction have its way with the subject of our concern.

  9. Rationalizations and apologies: In a manner bereft of contrition, officials explain why this was absolutely necessary. They warn of the horrors that would have befallen us all if the bailout hadn’t been enacted in haste. Congressional hearings are held, often with the same executives who lobbied for the bailout testifying before the very same members of Congress who approved the package.The executives use phrases like “100-year flood” and “act of God,” and say they “feel terrible for the employees who dedicated their lives to the firm and now have seen their life savings and pensions wiped out by this perfect storm of unforeseeable events.”

  The members of Congress say: “My constituents are outraged!”

  “How could you let this happen on your watch?” “Why were the warning signs ignored?” “You made how much money last year?” “Thanks for the campaign donations.”

  10. Expected results and unintended consequences: The bailout is put into effect sooner rather than later. It usually has some degree of curative properties, as large piles of money often do. We learn of errors and problems fairly quickly, but usually some measure of victory is declared. Minor abuses come to light—a little fraud here, some oversight snafu there. These are par for the course, and mostly ignored.Without fail, the unintended consequences of the bailout begin working their way through the system. The repercussions are felt years and even decades later.

  We have seen this exact pattern with the various industrial bailouts of the 1970s and 1980s, the savings and loan (S&L) crisis of the early 1990s, and the Long Term Capital Management (LTCM) crisis of 1998. More recently, the tech wreck of 2000-2003, the credit crisis, the derivatives disaster, and the housing collapse all went through similar phases.

  Each of these events followed the usual progression. Indeed, all of the current bailouts are repercussions—the step 10—of previous bailouts.

  And we have yet to learn the unintended consequences of the credit crunch bailout, the housing rescue plan, the American International Group (AIG), Citigroup (C), Bank of America (BAC) rescues, the General Motors (GM) loans, or the Fannie and Freddie conservatorship. We seemed to be rushing headlong through steps 1 through 9; step 10 is off in the future.

  But rest assured, we will discover, as we always do, some terrible repercussions down the road. They will be substantive and substantial—and very, very expensive.

  Part II

  THE MODERN ERA OF BAILOUTS

  Source: By permission of John Sherffius and Creators Syndicate, Inc.

  Chapter 5

  Stock Market Bailouts (1987-1995)

  The essential Greenspan legacy . . . is the idea that the Fed will allow nothing to go really wrong.

  —James Grant, publisher of Grant’s Interest Rate Observer1

  So far, we have looked at various interventions—in the economy (1930s); in individual companies (Lockheed, Chrysler); and in entire sectors (banking). The next step on our path to becoming a Bailout Nation was when we went beyond any given company or sector bailout. We moved into uncharted territory when the U.S. Federal Reserve began intervening in the entire stock market.

  Of course, the Federal Reserve has indirectly impacted all markets by performing its ordinary duties: maintaining price stability and maximizing employment. The Fed engages in a variety of targeted actions, such as changing interest rates, adding or subtracting liquidity, buying and selling Treasuries. These all have an impact on the markets, for better or worse. But that impact is incidental to the operations of the Fed’s normal central banking activities. The results are a by-product, not the goal of the central bankers.

  Where investors—and taxpayers—should become concerned is when the Fed goes far beyond ordinary central banking operations and seeks to maintain or support asset prices. This is a slippery slope, and, as we shall see, it leads to consequences that have been utterly disastrous.

  How the Federal Reserve morphed from a lender of last resort to a guarantor of asset prices is a long and tortured tale. We will skip most of the boring history, and instead focus on the era dating from the 1987 crash forward. Traditionally, the Fed’s mandate has been to “foster progress toward price stability” and to “promote sustained real output growth.” For our purposes, let’s call these fighting inflation and smoothing out the excesses of the business cycle.

  Change came to the Fed in the form of a new Federal Open Market Committee (FOMC) chairman. Alan Greenspan took the reins in 1987, and he radically broke away from his predecessors’ philosophies. Under the new chairman, FOMC policy incrementally moved toward supporting asset prices. As so often happens with these things, it began with a major disruption. In Greenspan’s case, it was the 1987 market crash.

  Initially, 1987 was a good year for the markets. By August, the S&P 500 had gained about 40 percent year-to-date. September was a bit rocky, sliding 10 percent from the highs—but that was to be expected. Nothing goes up in a straight line forever, right?

  But then came October. Things took a turn for the worse, as the Dow Jones Industrial Average slid 3.8 percent on Wednesday, October 14. On Friday, October 16, the blue chips lost another 4.6 percent. The crash occurred on Black Monday (October 19)—when the Dow plummeted a harrowing 22.6 percent.

  We can spend many hours going over all of the conditions precedent to the crash, but that is another book entirely (the interested should read Black Monday, by Tim Metz). While there is still academic debate over the causes of the crash, for our purposes, let’s note as sufficient causal elements the combination of portfolio insurance—a derivatives product that utterly failed to work as advertised (let’s hear it for innovation!)—a creaky New York Stock Exchange (NYSE) infrastructure, and Treasury Secretary Baker’s remarks over the weekend implying we were no longer supporting the dollar.

  The actual crash is a fascinating part of stock market history. Those of you who wish to become serious students of the market must familiarize yourself with what occurred. Panics may vary from generation to generation, but we learn that human nature is immutable.

  It is not the crash itself, however, but rather the actions of various parts of the government that are of particular interest to us.

  The response from the Federal Reserve was swift. Before the market’s opening on Tuesday, October 20, the Fed issued the following statement: “The Federal Reserve System, consistent with its responsibilities as the nation’s central bank, affirmed today its readiness to serve as a source of liquidity to support the financial and economic system.”

  Note that the address is to the system, threatened by the large movement downward of asset prices. The central bank then added substantially to reserves through open market operations. Over the next two weeks, the federal funds rate fell to 6.5 percent from 7.5 percent just prior to the crash.

  But the Fed’s ple
dge was not sufficient to halt the sell-off. According to Tim Metz, author of Black Monday (Beard Books, 2003), there was a slight problem prior to the opening of the markets the next day: Most of the NYSE floor specialists were technically insolvent. Not only had they absorbed enormous losses during the crash, but the various bank lines of credit they used each day had disappeared. It looked like the crash was going to continue Tuesday, with the Dow off 6 percent in the morning. It wasn’t until New York Federal Reserve President Gerry Corrigan jawboned banks into restoring credit lines—and somehow turned off futures information between New York and Chicago—that the mother of all Turnaround Tuesdays took place.

  It is a classic example of the authority of the Fed being used to avoid what looked like a full-blown liquidity crisis.

  “. . . the Fed’s responsibilities to serve as lender of last resort was intended to reverse the crisis psychology and to guarantee the safety and soundness of the banking system” was how Robert T. Parry, president of the Federal Reserve Bank of San Francisco, described the Fed’s actions at a University of California at Davis conference 10 years later.2 He affirmed what the Fed saw as its proper role.

  Now, it’s at precisely this point in our narrative that we must stop for a moment to point out something you may not have taken the trouble to consider before. Exactly why did the Fed become in charge of psychology? The central bank was originally established to bring financial order to the early Wild West days of banking. Somehow, resolving fiat currency issues and supervising credit morphed into a far more subjective role. Michael Panzner, author of the prescient doomsday tome Financial Armageddon (Kaplan Business, 2007), calls it “mission creep.”