Bailout Nation

by Barry Ritholtz

  Glass-Steagall may have set the table, but the Commodity Futures Modernization Act was the poison in the wine.

  The CFMA removed derivatives and credit default swaps from any and all state and federal regulatory oversight. There were no reserve requirements, as were required in insurance policies. There were no audit mandates, so parties were not assured that their counterparties could make payment when a CDS was supposed to pay off. And there was no central clearing firm, so nobody knew precisely how many CDSs there were or who owned them. Until recently, even the dollar value these derivatives totaled was unknown.

  Since the crisis has broken into the open, we now have a few reasonable, if imprecise, estimates on the value of derivatives contracts at various bailout banks. 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. To put this in context, that’s four times the size of the annual gross domestic product (GDP) of the United States.

  Alan Greenspan had “fiercely objected whenever derivatives have come under scrutiny”1 in either Congress or on Wall Street. In 2003, Greenspan told the Senate Banking Committee:

  What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so. We think it would be a mistake to more deeply regulate the contracts.2

  Critics had been warning about derivatives for years, but they made no headway against Greenspan. In 2008, Peter Goodman took a hard new look at the Greenspan legacy. Writing in the New York Times, he observed, “Time and again, Mr. Greenspan—a revered figure affectionately nicknamed the Oracle—proclaimed that risks could be handled by the markets themselves.”3 Former Federal Reserve board member and Princeton economist Alan S. Blinder was less generous. “I think of him as consistently cheerleading on derivatives.”4

  Why was Greenie so opposed to any oversight of derivatives trading? Former SEC chair Arthur Levitt said it was a fundamental disdain for government. It was part of an ideological shift away from government—from Reagan to Greenspan to Clinton to Bush—and toward markets.

  Kenny Boy and the Gramms

  The Commodity Futures Modernization Act is one of the most egregious examples of private enterprise dictating public policy via a combination of sophisticated lobbying and old-fashioned nepotism. The bill was introduced on December 15, 2000, the last day before the Christmas recess. The bill was never debated in either the House or the Senate and was discreetly attached as a rider to the 11,000-page-long omnibus budget bill signed into law by (then) lame-duck President Bill Clinton on December 21, 2000.

  But that’s just the half of it.

  Among the over-the-counter derivatives freed from any federal jurisdiction by the CFMA were energy futures. The bill also included “language advocated by Enron that largely exempted the company from regulation of its energy trading on electronic commodity markets, like its once-popular Enron Online.”5

  This became known as the “Enron loophole” and was designed to help the Houston-based firm pursue its goal of becoming the dominant player in the trading of energy futures, which it saw as having much more profit potential than actually producing energy had.

  A key sponsor of the CFMA was Texas Senator Phil Gramm, whose wife, Dr. Wendy Gramm, was a member of Enron’s board, which she joined in 1992 after providing the company with some regulatory relief in her prior role as chair of the Commodity Futures Trading Commission.

  According to Public Citizen, a national, nonprofit consumer advocacy organization:6 • Enron paid Dr. Gramm between $915,000 and $1.85 million in salary, attendance fees, stock option sales, and dividends from 1993 to 2001. The value of Wendy Gramm’s Enron stock options swelled from no more than $15,000 in 1995 to as much as $500,000 by 2000.

  • 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.

  • Enron spent $3.45 million in lobbying expenses in 1999 and 2000 to deregulate the trading of energy futures, among other issues.

  In 2002, internal Enron documents revealed the company helped write the Commodity Futures Modernization Act. Senator Gramm later claimed he was not responsible for inserting the “Enron loophole” into the legislation. “But once the Commodity Futures Modernization measure—with this provision included—reached the Senate floor, Mr. Gramm led the debate, urging his fellow senators to pass it into law,” the New York Times reported.7

  After failed efforts in 2002, 2003, and 2006, Congress finally closed the “Enron loophole” in 2008 with the passage of the Farm Bill that included an amendment to have the energy futures contracts regulated by the CFTC “with the same key standards (‘core principles’) that apply to futures exchanges, like NYMEX, to prevent price manipulation and excessive speculation.”8

  Enron’s scam had long since come unraveled by 2008, but it still had powerful friends in Washington: Congress had to override President Bush’s veto to get the bill passed and the loophole closed.

  Immediately after the CFMA legislation was passed, a few observers raised concerns. Frank Partnoy, a former derivatives trader at Morgan Stanley (now a law professor at the University of San Diego), is the author of F.I.A.S.C.O.: Blood in the Water on Wall Street, a 1997 book warning about the danger of derivatives. In 2000, referring to CFMA, he noted:

  The new bill’s second impact, in the swaps market, is less direct but still worrisome. The act ends an argument about whether swaps qualify for regulation by making it clear that they are not regulated if a participating company or individual has $10 million in assets. That means that the swaps activities of most companies and mutual funds are not regulated. Yet few investors know what swaps are. And there’s almost no publicly available information about specific trades in this market, now bigger than many stock or bond markets. By contrast, futures trading takes place on exchanges; an investor can find closing quotes for futures in a newspaper’s financial section.9

  Even Partnoy’s prescient fears failed to anticipate exactly how devastating the results of the legislation would be. The potential for financial Armageddon was unconscionably enormous (see Figure 11.1). The CFMA allowed unregulated, unsupervised, unreserved derivatives trades that were ultimately responsible for the biggest bankruptcies in American history. It created the monster that brought down several important companies.

  Figure 11.1 Outstanding Value of Credit Default Swaps

  SOURCE: International Swaps and Derivatives Association

  First came Bear Stearns, which collapsed in March 2008. Bear’s total derivatives holdings were estimated at $9 trillion; JPMorgan Chase was believed to have had about 40 percent of Bear’s exposure, leading numerous wags to surmise that was why JPMorgan bought Bear.

  Lehman Brothers also had a decent-sized derivatives book, estimated at between $2 trillion and $4 trillion when it collapsed into bankruptcy in September 2008. The Lehman failure triggered waves of disruption in the CDS market.

  Shortly after Lehman fell, AIG, the world’s largest insurance company, followed. AIG was nationalized by Treasury and the Fed (in exchange for 79.9 percent of its stock) in October 2008. The $68 billion bailout was only the first of four U.S. government bailouts totaling over $175 billion as of March 2009.

  Then there were the monoline insurers—Ambac, Financial Guaranty Insurance Company (FGIC), and MBIA Insurance Corporation. These were once highly profitable, low-risk, municipal bond insurance firms. Their businesses were demolished once they started dabbling in derivative products. Ambac lost 99 percent of its market cap. MBIA is marginally better, but still trading far below its former $25 billion peak valuation. Private bond insurer FGIC, once partly owned by General Electric and Blackstone, has long since given up any hopes of going public.

&n
bsp; The thought process behind the CFMA—really more of a religious belief—was that self-interested, rational market participants would not endanger themselves or their firms. No one, went the thinking, would knowingly engage in self-destructive, reckless behavior. Markets are perfectly efficient, humans are rational (not emotional), and financial firms and markets can self-regulate. In theory, Adam Smith’s invisible hand keeps the worst impulses of bad players in check.

  In the real world, however, things operated quite differently. Perfectly rational humans and perfectly efficient markets exist only in economics textbooks. In reality, this belief system is sheer, unadulterated nonsense. Compensation systems can get out of alignment with shareholder interests. Short-term profits often trump longer-term sustainability. Complexity is often ignored; risk is poorly understood.

  What the deregulatory zealots have failed to understand is that we don’t regulate markets; what we do is regulate the behaviors of the human beings who work in those markets. And humans need to know what is acceptable and allowable behavior. Without rules and guidelines, people misbehave—and even more so when large sums of money are involved.

  The way markets manage to self-regulate companies that make bad decisions is by annihilating them. The theory that self-regulating markets would prevent these poor decisions from occurring in the first place is wrong; the market instead brutally punishes those who made bad risk management decisions. But prevention? Humans simply aren’t that clever.

  The belief that markets self-regulate reads like a bad joke: Two economists are walking across campus. The younger one points out a $20 bill on the ground. “Nonsense,” says the senior, tenured professor. “If there was $20 on the ground, someone would have picked it up.”

  Self-regulating markets differ from our two economists in one major way: Bad jokes don’t destroy economies.

  The last six months have made it abundantly clear that voluntary regulation does not work.

  —Christopher Cox, former chairman of the Securities and Exchange Commission, September 26, 2008

  Not only are market participants not always rational, they often act inadvertently against their own best interests.

  My favorite example: To ensure that Wall Street firms maintained adequate capital levels, the Securities and Exchange Commission employed what became known as the “net capital rule.” From 1975 to 2004, this was the primary tool used to prevent investment banks from taking on too much leverage. The rule limited their ratio of debt to net capital to 12 to 1; in other words, $12 was the maximum they could borrow for every $1 in capital.

  For the most part, it worked fine. Firms maintained sufficient liquidity to meet their needs; banking disasters were few and far between. But bankers were agitating for a less restrictive leverage rule. They were complaining to the SEC that this excessive regulation was costly. To them, the rules were limiting their return on equity. Loosening the net cap rules would let them leverage their capital further, and therefore earn greater profits. Sure, it would increase their risks—significantly so—but “Hey, we’re a bunch of smart guys—we can handle it.”

  Or so the investment banks argued.

  In 2004, the five biggest investment banks—Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley—got their wish. Led by Goldman Sachs CEO Hank Paulson—the future Treasury Secretary/bailout king—the SEC acquiesced to grant them (and only them) a special exemption. At the time, it was (ironically) called “the Bear Stearns rule.” The firms with a market capitalization over $5 billion would no longer be governed by 12-to-1 net cap rules.

  As soon as this exemption was passed, the collection of brainiacs that ran the five big firms promptly levered up 30, 35, even 40 to 1. You read that right—after 30 years of effective risk management, at the first opportunity they whacked up the leverage as far as they could.

  Thus we learn that the tragic financial events of 2008 and 2009 are not an unfortunate accident. Rather, they are the results of a conscious SEC decision to allow these firms to legally violate net capital rules that had existed for decades, limiting broker-dealers’ debt-to-net-capital ratio to 12-to-1. You couldn’t make this stuff up if you tried.

  Writing in the American Banker, Lee A. Pickard, former director of SEC’s trading and markets division and an author of the original net capital rule in 1975, declared:

  The SEC’s basic net capital rule, one of the prominent successes in federal financial regulatory oversight, had an excellent track record in preserving the securities markets’ financial integrity and protecting customer assets. There have been very few liquidations of broker-dealers and virtually no customer or interdealer losses due to broker-dealer insolvency during the past 33 years.

  Under an alternative approach adopted by the SEC in 2004, broker-dealers with, in practice, at least $5 billion of capital (such as Bear Stearns) were permitted to avoid the haircuts on securities positions and the limitations on indebtedness contained in the basic net capital rule. Instead, the alternative net capital program relies heavily on a risk management control system, mathematical models to price positions, value-at-risk models, and close SEC oversight.10

  In Latin, we call that Res ipsa loquitur—“the thing speaks for itself.” All five exempt brokers no longer exist in their prior forms. As a result of the Bear Stearns rule, Bear Stearns was the first to go belly-up. Lehman became the largest bankruptcy in American history, and Merrill Lynch, on the verge of blowing up, scrambled to sell itself on the cheap to Bank of America. Morgan Stanley and Goldman Sachs received capital injections from the Feds, and had to change their status to commercial banks—to make it easier to obtain even more government bailout money.

  Relying on the self-interest of individuals and firms to prevent egregiously reckless and irresponsible behavior only served to enrich senior management at the expense of shareholders, taxpayers, and employees.

  So much for that idea.

  The newfangled lend-to-securitize mortgage originators discussed previously were covered by a patchwork of state regulations. They should also have been supervised by the Federal Reserve.

  Only they weren’t.

  At the Fed, Chairman Alan Greenspan purposefully chose not to supervise these new mortgage makers. This was yet another example of Greenspan’s free-market beliefs blinding him to the simple realities of the real world. One of the duties of the Federal Reserve is to supervise banking and lending. However, the Fed chief did not believe these lenders needed any supervision. Remember, he believed that market forces would make these lenders police themselves.

  Not only did the Fed do nothing about these changes in lending standards, they were actually praised by Greenspan. Here is what he said in 2005:

  Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. . .. With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers.... Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending . . . fostering constructive innovation that is both responsive to market demand and beneficial to consumers.11

  There was a reason why some people in the past had been denied credit: They simply could not afford the homes they tried to purchase. Any mortgage structure that ignores the borrower’s ability to service the loan is destined for failure.

  Greenspan’s encouraging remarks about the benefits of ARMs in February 2004 are another tale of woe (and woeful misjudgment).

  “American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage,” Greenspan said in a speech before the Credit Union National Association. “To the degree that households are driven by fears of payment shocks but are willing to
manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.”12

  Meanwhile, at the Office of Thrift Supervision, former chief James Gilleran took a chainsaw to a stack of regulations to symbolize how his agency was going to “cut red tape” for thrifts (aka S&Ls), which are heavily involved in mortgage lending. “Our goal is to allow thrifts to operate with a wide breadth of freedom from regulatory intrusion,” Gilleran said in a 2004 speech.13

  This wasn’t malfeasance by Greenspan and Gilleran; rather, it was nonfeasance, the intentional failure to perform a required legal duty or obligation. Even the FBI got into the deregulatory act: In 2004, the FBI warned that “fraud in the mortgage industry has increased so sharply that an ‘epidemic’ of financial crimes could become ‘the next S&L crisis.’” Subsequently, the FBI(!) made a “strategic alliance” in 2007 with the Mortgage Bankers Association (MBA), the trade association for (then) major industry players like IndyMac and Countrywide Financial. 14

  Truly, the foxes were guarding the henhouse.

  When we look into the details of these lenders, we see they were especially enamored of risk. In a fatal twist on traditional banking, their employees got paid on the volume, not the quality, of their loans. Besides, they didn’t need to find a buyer who was a good risk for 30 years—they only needed to find someone who wouldn’t default before the securitization process was complete, as detailed in Chapter 10.

  This was an unbelievably enormous change in lending standards. So what did federal bank regulators have to say about this paradigm shift? Various government agencies did nothing about this shift, even though the FBI warned of an “epidemic” of mortgage fraud in 2004.15

  Not surprisingly, the abdication of lending standards—and the trillions in subsequent resets—resulted in skyrocketing mortgage default rates. As of December 2008, a record 10 percent of all homeowners with mortgages were behind in their payments, up from 7.3 percent in 2007. According to the MBA, among subprime borrowers, the rate was 33 percent. (In the United States, 70 percent of homes carry a mortgage.)