Bailout Nation

by Barry Ritholtz

  Tragically, this was avoidable. Former Fed Governor Edward Gramlich was an expert on subprime lending and became increasingly concerned about predatory lending in the early part of this decade. His 2007 book, Subprime Mortgages: America’s Latest Boom and Bust (Urban Institute Press), presciently warned of the dangers these loans presented to the credit and housing industry, and the economy as a whole.

  In 2007, the Wall Street Journal reported that Gramlich “said he proposed to Mr. Greenspan in or around 2000, when [predatory lending] was a growing concern, that the Fed use its discretionary authority to send examiners into the offices of consumer-finance lenders that were units of Fed-regulated bank holding companies.”16

  “I would have liked the Fed to be a leader” in cracking down, Gramlich, who retired from the Fed in 2005, told the Wall Street Journal shortly before his death in 2007. The Journal noted, “Knowing it would be controversial with Mr. Greenspan, whose deregulatory philosophy is well known, Mr. Gramlich broached it to him personally rather than take it to the full board.”17

  If only Greenspan had heeded Gramlich’s warnings. Instead, he chose to dismiss them. As we have since learned, this turned out to be an enormous error on Greenspan’s part.

  Credit Ben Bernanke for having the good sense to close the barn door after all the horses had escaped. In December 2007, Bernanke reversed his predecessor’s antiregulatory fervor:

  The Federal Reserve, acknowledging that home mortgage lenders aggressively sold deceptive loans to borrowers who had little chance of repaying them, proposed a broad set of restrictions Tuesday on exotic mortgages and high-cost loans for people with weak credit. The new rules would force mortgage companies to show that customers can realistically afford their mortgages. They would also require lenders to disclose the hidden sales fees often rolled into interest payments, and they would prohibit certain types of advertising. Borrowers would be able to sue their lenders if they violated the new rules, though home buyers would be allowed to seek only a limited amount in compensation.18

  Ahhh, a return to lending money only to people who could “realistically afford their mortgages.” What a quaint and charming notion.

  Chapter 12

  Strange Connections, Unintended Consequences

  There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.

  —Frédéric Bastiat1

  One of the great risks of human endeavors is that all actions, however well intended, have unintended consequences. This is especially true when governments are involved.

  History shows that government actions—as well as inaction—have repercussions that are rarely anticipated. This is the case of legislation, tax policy, and most especially of bailouts. Legislative policy pursued at the request of a given company or industry often ends up harming that industry immeasurably. That it was pursued by friend rather than foe makes it only ironic, not untrue.

  For the Bailout Nation, this critical issue is well worth pondering, especially now that we have written some rather enormous checks. Our collective actions and omissions will leave an onerous legacy to future generations, often manifesting themselves in unanticipated ways.

  As examples of how unintended consequences can be felt far in the future, consider two legislative acts wholly unrelated to the current financial crisis.

  The 1996 Telecommunications Reform Act amended the Communications Act of 1934 and eliminated media ownership regulations. This led to an enormous degree of media consolidation, especially in radio. Prior to the 1996 Act, broadcasters could own just 40 stations nationally. After the Act became law, 10,000 radio stations were bought up or merged.

  The biggest of the buyers was Clear Channel Communications, acquiring over 1,200 channels. They fired local talent—DJs, program managers, music directors—and on many of these stations, ran a homogenized playlist feed from a central bunker in Texas. Call it Hamburger Helper for radio. Replace tasty, expensive meat with cheap filler and hope no one notices.

  For a while, it worked. Clear Channel became enormously profitable. It had the costs of a small radio network, but an audience 100 times the size.

  And then, that audience . . . left. They didn’t even change the channel; they simply abandoned radio in droves. Ask a radio executive what broadcasters sell, and most will tell you “Advertising.” That is actually wrong; what radio sells is an audience to advertisers. Once the listeners figured out they were getting filler instead of steak, they went elsewhere. Between satellite radio, iPods, and streaming Internet audio, the terrestrial music business model of radio was thoroughly damaged—mostly, at the request of the industry.

  Clear Channel once had a stock price over $70 and a market cap near $40 billion; now it trades for pennies. What’s left is an outdoor billboard company, with an under $1 billion market cap.

  Next, consider the Securities Litigation Reform Act of 1995. This legislation was supposed to be a way to eliminate class action lawsuits that were the bane of public companies’ existence. Buried in the legislation was a little-noticed clause that eliminated “joint and several liability” for those who contribute to securities fraud. The consequences of the change were significant. It removed liability for fraud from the accountants who audited quarterly statements for public companies.

  What do you think happened once accountants were no longer liable? An explosion of accounting fraud! The accounting scandals of the late 1990s and early 2000s were directly attributable to this small legal change. So too was the collapse of Enron, which led to the corporate death penalty for Arthur Andersen. We can probably pin the subsequent enactment of Sarbanes-Oxley, which is undoubtedly having all sorts of its own unintended consequences, on that same clause. These all trace back to what the industry itself had requested.

  As the saying goes: Be careful what you wish for; you may get it.

  The repercussions of current Treasury Department bailouts and Federal Reserve rescue plans may not be realized for years or even decades. The unintended consequences of these bailouts fester beneath the surface, slowly working their mischief.

  It turns out that many different prior actions contributed to the great unraveling of the U.S. financial system. The old cliche é is “success has many fathers, but failure is an orphan.” Let’s do some DNA testing to see if we can identify the ancestry of the modern financial system collapse.

  One of the oddest connections is the direct line one can draw from the Boskin Commission, a Senate-appointed board charged with reviewing the consumer price index (CPI) in 1995, to the collapse of Bear Stearns in 2008.

  When Alan Greenspan brought interest rates down to such ultralow levels, he did not in all likelihood think he was being reckless. We will deal with the inherent contradiction of a free market economist’s constant intervention in the economy in a later chapter (and perhaps on the couch of Alan’s shrink). The Fed might have been panicked over the state of the economy, but a fair reading of Greenspan’s public testimony shows the Fed chairman was convinced inflation was “contained.” He did what he felt was necessary to revive the economy.

  Yet home prices doubled in a short period of time, crude oil increased ninefold from its 2001 lows of $16 to $147, and food prices skyrocketed. There was also enormous inflation in medical costs, education, insurance, and other services.

  During most of this 2003-2007 run-up in prices, the consumer price index (CPI), the official measure of inflation, hardly budged. Credit the Boskin Commission for contributing to this illusion of low inflation. The Boskin reforms changed not only the basket of goods measured for inflation, but how we measure them. It allowed “hedonic adjustments” for the improvement of quality. Forget what the window sticker says; your new car isn’t really more expensive—it’s better.

  Then there was “substitution”—for example, when the price of steak rises, consumers can re
place it with chicken at the previous low prices. In the topsy-turvy world of Boskin, substituted prices remained the same. In the real world, inflation just drove steak out of your price range.

  Convened by President George Bush Sr. and signed into law by President Bill Clinton, the 1996 report of this Advisory Commission to Study the Consumer Price Index concluded that CPI overstated inflation by 1.1 percent. It was through tricks like substitution, hedonic adjustments, and other intellectually dishonest methods that the Boskin Commission made their disingenuous claims.

  It was as dishonest a study of inflation as has ever been published. The government’s keeper of all things statistical is the Bureau of Labor Statistics (BLS). Some of the absurdities foisted upon the BLS by the Boskin Commission made it clear that accurately measuring inflation was not remotely their concern.

  In reality, the Boskin Commission was formed to lower the reported inflation rate as a backdoor method of reducing the cost of living adjustment (COLA) paid by Social Security and many other government programs, including benefits for veterans and their dependents. These payments are linked to CPI inflation.

  Rather than accurately measuring inflation, the commission’s apparent goal was to avoid bankrupting the U.S. Treasury. Unfunded entitlement programs (Medicaid, Social Security, and now Medicare Prescription Drug Plans) have been the so-called third rail of American politics—and lacking the will or courage to deal with them directly, politicians of both parities simply kicked the can down the road for future policymakers to deal with (or not).

  The Boskin study was an exercise in tortured logic that is itself worthy of another book—try Kevin Phillips’ Bad Money (Viking, 2008). If the CPI was overstated by 1.1 percent annually for 10 years starting in 1996, the Congressional Budget Office estimated the error would add about $148 billion to the federal deficit in 2006 and $691 billion to the national debt.2

  As it turned out, the true cost of the Boskin Commission was immeasurably higher. Since the Boskin Commission’s recommendations were adopted in 1999 by the Bureau of Labor Statistics, the spread between real-world inflation and official CPI the BLS reports has only grown further apart. In the current decade, the BLS has reported only modest inflation increases as actual prices of goods and services have skyrocketed.

  For a while, the Boskin-influenced CPI data convinced many economists that the inflation beast really had been tamed. Soon, however, the official data became laughable. The Fed was insisting inflation was moderate as food and energy prices soared. Even more absurd was the Federal Reserve’s preferred measure of inflation—the core CPI, minus food and energy costs.

  Or as I prefer to call it, inflation ex-inflation.

  What happens when we deny objective reality, purposefully misstate the economic data, and try to hide beneath a series of obfuscations and misdirection? We end up making policy based on a false view of reality. The drumbeat of bad data, and the imprimatur of legitimacy thereof, provided an undeserved credibility for the “low inflation” theme. That created a level of acceptance of elevated inflation that eventually led to several disasters. Rates were left at levels that responsible central bankers, aware of reality and concerned about inflation, would never have allowed.

  The post-Boskin fantasy world made ultralow rates for extreme lengths of time more acceptable. The Boskin Commission’s recommendations turned BLS data reporting into something once removed from actual inflation. Unfortunately, this gave some degree of cover to Alan Greenspan’s dramatic reduction of interest rates from 2001 to 2003 down to 1 percent.

  Without the commission’s changes, it’s hard to imagine Greenspan could have kept rates as low—and for as long—as he did. Those ultralow rates begat the boom in housing, which fed the residential mortgage-backed security (RMBS) business.

  And the single biggest player in RMBSs? Bear Stearns.

  Many factors led to the credit crisis—but we can draw a straight line from the silliness of the Boskin Commission to Greenspan’s 1 percent federal funds rate to a surge in derivatives trading, and on to the collapse of many financial firms. Bear Stearns was the first—but it wouldn’t be the last.

  From Boskin to Bear Stearns on to Lehman: Perhaps the most obvious of our strange connections is the number of repercussions that the Fed-engineered rescue of Bear Stearns had on other investment banks’ managements, most notably Lehman Brothers.

  Larger and better diversified than Bear, the 158-year-old Lehman was the second-biggest player in the RMBS market. Following the Bear bailout in March 2008, Lehman management may have assumed that the Fed and Treasury would come to its rescue if it ran into real trouble.

  That misplaced reliance was a fatal mistake. But it may have begotten the strangest, least-intended consequence of all: Lehman turning down a rescue offer from Warren Buffett’s Berkshire Hathaway. To date, this marks the single biggest missed opportunity of the bailout era.

  After the Bear collapse, Lehman CEO Dick Fuld reached out to a few sources to round up some extra capital. Somewhat surprisingly, Buffett was receptive to taking a stake in Lehman. In 1987, Buffett had successfully rescued Salomon Brothers, but the experience had soured him on Wall Street. It was widely believed that he had sworn off owning any investment banks unless they could be had for a song.

  Fuld must have been singing Buffett’s tune. According to Bloomberg, Berkshire Hathaway offered to buy preferred shares that would pay a dividend of 9 percent and could be converted to common at the then-market price of $40.30.

  Buffett’s money was costlier than other potential investors, but it came with the imprimatur of the world’s best-loved investor. That alone probably would have guaranteed Lehman’s survival.

  Surprisingly, Fuld spurned Buffett’s offer, choosing instead to sell $4 billion in convertible preferred (7.25 percent rate, 32 percent conversion premium) on April Fool’s Day; the buyers of those preferreds turned out to be quite the fools indeed.

  By rebuffing Berkshire and, as Bloomberg described it, “corporate America’s Good Housekeeping seal of approval,” Lehman likely missed its last, best chance for survival. Ironically, Buffett got the chance to make an even tougher deal with Goldman Sachs after Lehman went belly-up—a 10 percent interest rate on a $5 billion investment.

  Lehman’s Fuld also had other chances to raise money before the firm’s bankruptcy filing in mid-September 2008. But the deals were never consummated, most notably negotiations with Korea Development Bank, which reportedly broke down over price.3

  One cannot help but imagine: But for the Bear Stearns bailout, would Lehman CEO Dick Fuld have been as arrogant? One has to think he expected policy makers would give Lehman the same treatment as his smaller rival.

  Enron’s lobbying for an energy derivatives trading exemption ultimately was what led to the Commodity Futures Modernization Act. The CFMA, we now know, created an unregulated shadow insurance industry. This led to all sorts of normally staid firms getting in way over their heads.

  Consider the bond insurers. The Ambacs, MBIAs, and FGICs (formerly a GE/Blackrock company) of the world used to have a nice little business. They were called monolines, because they did only one thing: They wrote insurance on bonds issued by cities, states, and local municipalities. Historically, muni bonds have very low default rates; state and local governments have the power to levy taxes to make principal and interest payments, and hence rarely default. With an additional guarantee on those payments from the monolines, insured munis were granted triple-A ratings, the highest possible. The monolines’ fees were the “vig” on getting those top default risk ratings. The premium more than paid for itself in reduced borrowing costs for state and local governments.

  This was a lovely, low-risk business, with few defaults and a steady revenue stream. At one point in time, Ambac had the highest revenue per employee on the planet.

  That situation was obviously intolerable. So the muni bond insurers brought in the financial engineers, who decided that they should be issuing insurance on credit defau
lt swaps (CDSs)—the premiums were so much bigger than those on boring old munis!

  These firms were used to heavy oversight and supervision in the municipal bond business. In their structured finance division, regulatory oversight was nonexistent; without it, they went off the rails.

  Since 2007, the stock prices of Ambac and MBIA have cratered, losing more than 90 percent. Both firms faced investigations by regulators. How a highly profitable, low-risk business stumbled into the treacherous worlds of exotic derivatives is worthy of a book itself. Tens of billions of dollars would be lost by the monoline (now duoline) insurers, and chaos in the municipal bond market ensued when the credit crunch hit in 2007-2008.

  The absence of bond insurance has made borrowing much more expensive for many state and local municipalities. The increased costs of financing municipal projects—sewers, bridges, roads, schools, hospitals—have put many of these projects on hold for now. The timing couldn’t be worse; the slowdown started shortly before the recession began.

  When the Senate unanimously passed the Commodity Futures Modernization Act, the senators could not have foreseen the impact it would have on municipal bond underwriting and local government activity in just a few short years. That’s to say nothing of the impact unregulated derivatives had on AIG.

  The Lockheed bailout of 1971 led directly to the Chrysler bailout nine years later in 1980. Both took the form of guaranteed loans; both were in sectors and industries deemed to be indispensable.

  What made the Chrysler bailout have such significant repercussions in the future was that it forestalled dealing with a ruinous employment agreement, originally signed by the major automakers and the United Auto Workers (UAW) in the 1950s. It also failed to address rising guaranteed pensions and expensive health care costs. That contract eventually would cost the Big Three hundreds of billions of dollars in both areas. The Chrysler bailout effectively kicked that can further down the road, and by 2008 GM, Chrysler, and Ford were all in shambles. And it allowed Toyota to become the world’s largest automaker, employing over 300,000 people around the globe.