Bailout Nation

by Barry Ritholtz

  Transcripts of Fed meetings from the late 1990s—released years later—showed that Greenspan and his cohorts were concerned about excesses in the financial markets, and determined that raising margin requirements would help deflate the nation’s newfound obsession with day trading dot-com stocks.

  “I recognize there is a stock market bubble problem at this point,” Greenspan said in a September 24, 1996, Fed meeting, and declared that raising margin requirements was a solution. “I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.”1

  But the FOMC chair chose not to do so. After the famous “irrational exuberance” speech in 1996, Greenspan thereafter remained silent about speculative excesses that, by late 1999, were terribly obvious to even casual observers.

  Greenspan later claimed it was impossible to know a financial bubble of immense proportions was under way.

  Actually the Fed—led, of course, by its ubiquitous chairman—did something worse than nothing. Greenspan also gave explicit, intellectual support to the equity bubble by talking enthusiastically about the tech-inspired productivity miracle. The Fed chair applauded the notion that a “new economy” had emerged. It was music to traders’ ears.

  The New Economy

  In September 1998, Greenspan gave a speech titled: “Question: Is There a New Economy?”23

  While nuanced in its entirety, future academics will be shocked by the very idea the chairman of the Federal Reserve would contemplate such a ridiculous notion that technological innovations such as the PC and just-in-time inventories had significantly reduced, if not eliminated, the risks of future recessions.

  “There is, clearly, an element of truth in this proposition,” Greenspan said (reportedly with a straight face). “In the United States, for example, a technologically driven decline is evident in the average lead times on the purchase of new capital equipment that has kept capacity utilization at moderate levels and virtually eliminated most of the goods shortages and bottlenecks that were prevalent in earlier periods of sustained strong economic growth.”

  Furthermore, the Fed chairman “would not deny that there doubtless has been in recent years an underlying improvement in the functioning of America’s markets and in the pace of development of cutting-edge technologies beyond previous expectations.”

  As is often the case, few people focused on the subtleties and caveats of the speech, and the media seized upon Greenspan’s comments supporting the New Economy notion. This optimistic spin fit the zeitgeist of the era. Even the prevailing media coverage played along: Consider the Wall Street Journal capitalizing the proper noun New Economy—as if there was anything proper about it.

  Many separate elements contributed to the boom. Cheap money was a significant factor, but it wasn’t the only one. A broad economic expansion was in its sixth year, with baby boomers in the sweet spot of their earning and spending years. Inflation appeared to be modest. New technologies had captivated the American imagination, creating instant millionaires and more than a few billionaires. Internet message boards (before they were overrun by touts and spammers) helped democratize stock research. Wall Street was flush with cash. CNBC—called “bubble vision” by noted short seller Bill Fleckenstein—was a relentless cheerleader throughout this entire era.

  Credit the Y2K bug for what came next.

  For the prior few years, there was increasing concern over the glitch in the software code that had been given only two digits for dates. What would happen when the calendar rolled over from 1999 to 2000? There were worries that this would wreak havoc on computer systems around the world. Companies spent huge amounts of money replacing much of their tech infrastructures. The worst of the doomsayers were survivalists who seemed to be looking forward to the American version of Mad Max. They advised people stock up on ammo, bottled water, and canned food, along with cash and gold.

  The survivalists were a fringe group, considered paranoid loons by most thinking people. Not many took them seriously, except the Federal Reserve. It did not ignore the Apocalypse Now crowd. It wasn’t that the Fed believed this crowd; the fear was that if enough of these paranoid loners managed to somehow convince the rest of the country that all hell was going to break loose, it could conceivably cause a run on the banks.

  Greenspan’s nightmare scenario was 24/7 news media coverage of long bank lines around the country, as a panicked populace withdrew their money in preparation for the end of the world.

  The mad ravings of maniacs aside, the Fed figured better safe than sorry. To stave off any Y2K-related bank runs, the Federal Reserve held a bigger cash reserve than it ordinarily did. It also created a way for banks that needed any extra cash to borrow some—creating (I kid you not) the “Century Date Change Special Liquidity Facility.”

  But most important, the Federal Reserve injected an extra $50 billion in currency into the banking system. It’s readily visible as a giant spike on a chart of U.S. currency (M1) (see Figure 7.2).

  The effects of all of this extra fuel on an already “bubblicious” environment lit the market’s afterburners. Stocks went from red-hot to white-hot, as all of this money found its way to the most speculatively traded issues. The NASDAQ exploded upward, despite having a P/E that was approaching 200 (a P/E of 15 is considered reasonable). For the calendar year 1999, the index gained 85.6 percent (see Figure 7.3). From the liquidity injection in late October to just six months later, the NASDAQ almost doubled, rising from 2,600 to over 5,100. It was a nearly 100 percent gain in only half a year. There simply was no precedent for anything like this in stock market history.

  Figure 7.2 U.S. Currency (M1)

  SOURCE: Board of Governors of the Federal Reserve, 2008 Federal Reserve Bank of St. Louis, http://research.stlouisfed.org.

  It was the perfect setup what came next.

  The final up leg of a bull market often takes the form of a blow-off top. This occurs when the merely absurd becomes the utterly ridiculous. Blow-off tops happen when stocks (or indexes) make all-time highs, sucking in the last of those spectators who had been sitting idly on the sidelines.

  In 2007, for example, China’s Shanghai Stock Exchange (SSE) index had a blow-off top, rocketing from 1,200 in 2006 up to 6,400 by October 2007. The SSE had gained an unsustainable 100 percent plus year-to-date. A year later, it was back at 1,800, a tumble of 71 percent.

  Figure 7.3 NASDAQ, 1999

  In 2008, crude oil had a similar blow-off top. During the summer, crude peaked at over $147 per barrel. Before year’s end, it had plummeted more than $100 a barrel, falling 69 percent to $46. Such is the nature of speculative tops.

  Y2K came and went. The clocks rolled over on December 31, 1999, to January 1, 2000, virtually without incident.

  Markets pulled in a bit in January—likely tax selling—then made new highs. After some backing and filling, the NASDAQ resumed its record-breaking pace in February. Thus 2000 looked to be yet another good year. From 3,600, the index gained another 35 percent over the next six weeks, breaking over 5,100.

  But there were some residual effects of the Y2K bug that would soon be felt. Corporate America had just completed a massive technology upgrade. Companies had essentially rebuilt their entire information technology (IT) infrastructures over the past year or so. Hence, there was very little need to do much spending on hardware or software. The Y2K upgrades and preparation had pulled much of the year 2000’s tech spending into the 1999 fiscal year.

  Preannouncement season is that period each quarter just before earnings get released. Also called “confessional season,” it is when any company whose profits are below previously given public guidance to the press, investors, and analysts must fess up.

  Preannouncement season was when the wheels started to come off the technology bus.

  The first quarter of 2000 brought a series of warnings from Qualcomm, Intel, Dell, EMC Corporation, and a host of other stalwarts of the so-called New Economy. With stocks up enormously and valuations incredibly rich, it was se
ll first, ask questions later.

  There is an old traders’ expression: Markets eat like a bird, but shit like a bear. Gains accumulated over time can disappear very quickly. Momentum is a double-edged sword, and the excitement that had driven stocks higher over the prior five years quickly reversed to the downside. Barely a month after hitting its all-time peak, the NASDAQ had plummeted 37 percent, to near 3,200.

  Soon after, bargain hunters appeared. The current crop of traders’ only frame of reference was up, up, up! They had known nothing but a rampaging bull market, and their muscle memory had been trained to buy on the dips. This led to a reflexive bounce to 4,000, followed by another sell-off back down to 3,000.

  The “buy the dip” strategy had been a successful moneymaker throughout most of the 1990s. That was good for another bounce back to 4,200 by summer’s end. But the market couldn’t hold on to its gains. Valuations remained too high, and earnings were falling off a cliff.

  By September, stocks were back in sell-off mode again. The NASDAQ finished 2000 near 2,400; it was a brutal way to end the year.

  For the calendar year 2000, the NASDAQ lost 39 percent. From its peak, it was down more than 50 percent. By October 2002, the NASDAQ Composite had traded down to 1,100, shedding 78 percent of its total value (see Figure 7.4). It was the biggest U.S. stock disaster since the 1929 Crash.

  About now, you might be wondering why a book on bailouts has spilled so much ink on the U.S. stock markets. There is a good reason, in fact two good reasons why.

  Figure 7.4 NASDAQ, 1999-2002

  The first is asset prices. The Greenspan Fed had made repeated forays toward protecting asset prices from significant losses. Whether the motivation was to maintain confidence or to protect the economy is not relevant—the end results were the same. The central bankers created enormous moral hazard that resulted in ever more reckless speculation.

  Second, and more important, each subsequent attempt into managing the (kinda) free markets required ever greater intervention. The capital markets are enormous, unruly beasts consisting of hundreds of trillions of dollars in value, traded by millions of people every day. They cannot be tamed or managed for very long. No, not even by a master “market whisperer” like Greenspan.

  As we will soon see, the collapse of NASDAQ equities prodded the Federal Reserve into action. Greenspan began an unprecedented mop-up operation after the bubble popped. He would soon learn that the cleanup was even more expensive than anyone had imagined.

  In January 2001, the Federal Reserve started an extraordinary rate-cutting process, one for which there is no comparison. On January 3, the Fed made an intermeeting cut of a half point, which was followed by another half-point cut on January 31, and then more half-point cuts on March 20, April 18, and May 15. June and August each saw quarter-point cuts. By the end of the summer, rates had been nearly halved, down to 3.5 percent (see Table 7.1).

  All this rate slashing was before September 11. A recession had begun much earlier in the year, with the National Bureau of Economic Research dating its start as of March 2001. It would end shortly after 9/11, in November of that year.

  Table 7.1 2001 Rate Cuts

  There are those who have claimed that this radical rate cutting was in response to 9/11. Others have suggested that the terrorist attacks were what caused the recession. This historical revisionism is factually incorrect. As the record plainly shows, the recession had begun one year after the market peaked, and half a year prior to the terror attacks.

  On September 10, 2001, the NASDAQ was at 1,700. If you for a moment ever doubted that Greenspan specifically targeted the stock market and not the economy, consider his actions after the 9/11 al-Qaeda attack. That Tuesday saw the nation in shock. By the terrorists’ design, the entire event played out live on television. That day, the Fed did . . . nothing, except for releasing a two-sentence statement: “The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs.”

  My firm’s office was headquartered on the 29th floor of 2 World Trade (I was in the Long Island office that day), so I admittedly have little in the way of objectivity about what happened on September 11. But I vividly recall wondering when the Fed was going to do something. The attacks kept markets closed for the rest of the week—the first time the NYSE had been closed since the Kennedy assassination and funeral.

  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.

  When the markets finally reopened, selling pressure was immediate. Prior to the attacks, the NASDAQ had already suffered losses of 66 percent. That week, it would lose another 17 percent. From that deeply oversold condition, a 50 percent snapback rally would have the index kissing 2,100 by January 2002. The gains were merely technical, a reaction to the massively oversold condition the postattack trading created. The downtrend soon reasserted itself.

  By the summer of 2002, the post-9/11 lows of 1,400 were reached, then breached. The NASDAQ would trade down to 1,300 in July, then 1,200. By October, it would reach its ultimate bottom at 1,100.

  The total NASDAQ fall from its peak was 78 percent, with losses measured in the trillions of dollars.

  Greenspan Time Line

  It was in this environment that the Fed continued the most significant rate-cutting cycle in its history. From the precrash high of 6.5 percent, the Fed gradually took rates lower and lower still.

  By the end of 2001, the federal funds rate was at 1.75 percent—a level not seen since John F. Kennedy was president in 1962. During previous recessions in 1954, 1958, and 1960, rates had been below 2 percent—but only for a few weeks or months at a time. Incredibly, the Greenspan Fed maintained a 1.75 percent cap on the fed funds rate from December 2001 to September 2004. That was a total of 33 months at these ultralow levels. To people who have made a career out of watching the Fed, this was inconceivable.

  And it was not quite done yet. A cut in November 2002 took rates down to 1.25 percent; they were kept there for 21 months (November 2002 to August 2004). The coup de grace was one last 25 basis point cut to a 1 percent fed funds rate in June 2003. Incredibly, the Fed left the rate this low for over 12 months, (June 2003 to June 2004). While the fed funds rate had been as low as 1 percent some 46 years earlier, it had never been allowed to stay that low for more than a year!

  At this point, it’s worth asking why the Fed took rates to such ridiculous extremes. The 2001 recession was fairly mild. The consumer barely paused spending. It was primarily a business capital expenditure (capex) recession. Even that was largely a one-off Y2K-related issue. And the September 11 tragedy, while horrific in its human toll, had only a minor impact on the U.S. economy.

  The only plausible explanation for the radical rate cuts was asset prices. Greenspan was hell-bent on bailing out stock investors.

  It is the very first rule of economics: There is no free lunch. If you drop rates down to ultralow levels, there will be significant repercussions. There was a reason these actions had never been done before by any prior Fed chief. There are costs associated with supposedly free money. Rates this low were incredibly inflationary. More than a few economists warned that this would lead to a massive surge in dollar devaluation, inflation, even speculation and other unintended consequences.

  Someone at the Fed should have listened to them.

  Chapter 8

  The Backwards, Rate-Driven Economy

  There are some frauds so well conducted that it would be stupidity not to be deceived by them.

  —Charles Caleb Colton (Lacon, 1825)

  In the mid-2000s, news of the housing boom an
d bust was omnipresent. There was no one in the United States unaware of the huge run-up in home prices during 2002-2006, or of the subsequent bust that followed.

  What most people did not realize, however, was just how disproportionate the role the so-called real estate-industrial complex played during the 2002-2007 economic cycle. Few investors at the time were aware of the impact the housing boom had—not just for the real estate market, but for the stock market as well. Even today, most people do not really comprehend the full impact the real estate market had on the rest of the economy.

  In order to understand how the United States ended up a Bailout Nation, it is crucial to put the extraordinary surge of housing into broader context.

  In most business cycles, it is the economy that drives real estate. Job creation and wage growth are the key drivers of home purchases. Buyers save for a down payment, get approved for a mortgage, and then go shopping to buy a home. While interest rates are an important factor, in the typical cycle it’s the economy that matters most.

  But that’s not how it happened this time.

  The 2002-2007 housing cycle was historically unique. The combination of ultralow rates, new types of exotic mortgages, changes in lending standards, and massive securitization created the perfect storm for a housing boom. Consider for a moment a normal economy, with robust job creation and healthy wage gains. Under those circumstances, high-risk subprime loans and innovative mortgages would have been totally unnecessary. Without the very low rates or the new exotic debt instruments, the biggest growth in housing since World War II would not have occurred. It was that dangerous combination—and not job or income gains—that led to the unprecedented U.S. housing boom.