Bailout Nation

by Barry Ritholtz

  Had the Chrysler bailout not occurred in 1979, it is very likely the Detroit automakers would look quite different than they currently do: The UAW contract, health care and pension provisions, company management, and even the cars they design and sell would likely be very different today. In a bizarre way, we can trace Lockheed’s $250 million bailout to the potential $34 billion (at least) bailout of General Motors, Ford, and Chrysler in 2008 and 2009.

  In Chapter 11, we reviewed how a 2004 exemption to a 1975 rule governing banks’ net capital ratios paved the way for the excessive risk taking at major Wall Street firms. But even that 1975 rule, which ultimately earned an “excellent track record in preserving the securities markets’ financial integrity and protecting customer assets,” contained seeds of future bailouts.4

  The original net capital ratio rule said the value of broker-dealers’ assets should be based on the credit ratings of nationally recognized statistical rating organizations (NRSROs). This ruling imparted tremendous power to firms deemed NRSROs—a designation process controversial to this day—and effectively gave the two largest firms, Moody’s and Standard & Poor’s, a duopoly on the rating of financial securities. (Fitch was also granted NRSRO status in 1975 but has historically played Chrysler to Moody’s GM and S&P’s Ford.)

  As Wall Street’s dependence on the NRSROs grew, so too did the power of the rating agencies. As Pulitzer Prize-winning journalist and author Thomas Friedman famously declared in 1996:

  There are two superpowers in the world today in my opinion. There’s the United States and there’s Moody’s bond rating service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful.5

  Friedman was exaggerating, but only by a little bit. As the power of Moody’s, S&P, and their smaller rival Fitch continued to grow, it attracted the attention of federal regulators.

  As SEC Commissioner Paul Atkins said in a 2008 speech:

  Subsequently, NRSRO ratings were incorporated into additional SEC regulations, gaining momentum with Rule 2a-7, which governs which assets may be held in a money-market mutual fund. Rule 2a-7 was promulgated in the early 1990s when some funds came close to breaking a dollar of net asset value because of declining values of certain riskier securities that they held in their portfolios. The new rule looked to high-rated debt instruments as suitable investments for money-market funds.6 (emphasis added)

  In essence, a ruling that began in 1975 with good intentions (measure and limit the risk taken by investment banks) granted tremendous power to a small number of credit rating agencies. Those firms became the ultimate arbiters of what mutual funds, money market funds, banks, brokers, and a whole host of other investors could or could not own. Not content with their “superpower” status, the rating agencies ultimately sought “super profits.” They were one of the great enablers of the derivatives mania of this decade.

  Although the rating agencies had been feckless in accurately assessing the credit quality of Enron (Aaa until just prior to its bankruptcy), investors around the world deluded themselves into believing all manner of CDOs, CMOs, RMBSs, and other toxic securities were really of triple-A quality because rating agencies said so. These NRSROs had been blessed by the government to have the official word on such matters, so very few people questioned the veracity of the process.

  “You have legitimized these things, leading people into dangerous risk,” an executive with Fortis Investments, a money management firm, wrote in a July 2007 e-mail message to Moody’s.7

  Actions have consequences. Denying reality, falsifying data, gaming the numbers, cooking the books, making believe inflation is more modest than it really is, or pretending toxic assets deserve the highest credit ratings all have real-world consequences, intended and otherwise.

  Chapter 13

  Moral Hazard: Why Bailouts Cause Future Problems

  To be sure, some moral hazard, however slight, may have been created by the Federal Reserve’s involvement. [Such negatives were outweighed by the risk of] serious distortions to market prices had Long-Term [Capital Management] been pushed suddenly into bankruptcy.

  —Alan Greenspan1

  What is moral hazard? During this past year of our bailout, the phrase has been bandied about haphazardly. Let’s define this important term before proceeding further.

  Moral hazard is “the prospect that a party insulated from risk may behave differently from the way they would if they were otherwise fully exposed to that risk. It arises when an individual or institution does not bear the full consequences of its actions, and therefore tends to act less carefully than they otherwise would, leaving a third party to bear the responsibility for the consequences of those actions.”2

  That’s the formal definition. E. S. Browning, writing in the Wall Street Journal, used this less complicated description:

  Moral hazard is an old economic concept with its roots in the insurance business. The idea goes like this: If you protect someone too well against an unwanted outcome, that person may behave recklessly. Someone who buys extensive liability insurance for his car may drive too fast because he feels financially protected.3

  Hence, there is very real concern that the many bailouts of 2008 and 2009 are creating moral hazard, encouraging more reckless behavior in the future.

  Consider the Greenspan quote at the beginning of this chapter; I first came across it in Roger Lowenstein’s When Genius Failed: The Rise and Fall of Long-Term Capital Management. Rest assured that LTCM did not present, as Greenspan claimed after LTCM’s rescue, only “slight” moral hazard. The collapse of that hedge fund in 1998 and its subsequent Fed-orchestrated rescue plan provided one of the greatest—and most terrible—examples of moral hazard ever known.

  As noted in Chapter 6, LTCM used enormous amounts of leverage. The fund’s traders applied complex quantitative strategies, using over $100 billion in borrowed capital to buy thinly traded assets that were hard to value. Overall, the entire operation was highly dependent on global liquidity.

  Gee, that sounds vaguely familiar.

  Leverage, complexity, thin trading, difficult-to-value, liquidity dependent—it’s as if the trading gods are mocking those managers who came after LTCM and managed to lose billions upon billions of dollars anyway. How on earth could the lessons of LTCM be missed? One can imagine the booming voice of the Almighty, both amused by and annoyed at these traders: “You want a sign? How much more of a sign do you idiots need? I never should have taught you primates to wear pants. There are smarter chimpanzees running naked in Africa than you morons.”

  At least, that’s how I imagine it.

  Contrary to what Greenspan claimed, the Federal Reserve’s involvement did not create “slight” moral hazard. Rather, the 1998 Fed-orchestrated rescue was moral hazard writ humongous. Lowenstein presciently wrote the following in 2000:

  If one looks at the Long-Term episode in isolation, one would tend to agree that the Fed was right to intervene, just as, if confronted with a suddenly mentally unstable patient, most doctors would willingly prescribe a tranquilizer. The risks of a breakdown are immediate; those of addiction are long term.

  But the Long-Term Capital case must be seen for what it is: not an isolated instance but the latest in a series in which an agency of the government has come to the rescue of private speculators.... It is true that the Fed’s involvement was limited and that no government money was used. But the banks would not have come together without the enormous power and influence of the Fed behind them, and without a joint effort, Long-Term surely would have collapsed. Presumably, the banks and others would have suffered more severe losses—though not, one thinks, as great as some suggested. Long-Term’s exposure was huge, but, spread over all of Wall Street, it was hardly of apocalyptic proportions....

  Permitting such losses to occur is what deters most other people and institutions from taking imprudent risks. Now especially, after a decade of pr
osperity and buoyant financial markets, a reminder that foolishness carries a price would be no bad thing. Will investors in the next problem-child-to-be, having been lulled by the soft landing engineered for Long-Term, be counting on the Fed, too? On balance, the Fed’s decision to get involved—though understandable given the panicky conditions of September 1998—regrettably squandered a choice opportunity to send the markets a needed dose of discipline.4

  We now know the answers to Lowenstein’s rhetorical question: Yes, they most certainly were counting on the Fed. And, we know precisely what that next problem child was—the many mortgage-backed bonds and credit default swap bets upon them. Further, we have witnessed investors lulled from 2005 to 2007 into what I have described elsewhere as a “stupefying complacency.”

  To be certain, the management of large investment banks missed the obvious lesson here; as soon as they were able to, they willingly leveraged up nearly as much as LTCM had. When one considers the astonishing parallels between that past crisis and the current one, the missed opportunity for a “dose of [market] discipline” is all the more regrettable.

  Had Long-Term Capital Management been allowed to fail, it’s quite possible the worst of the current credit crisis, regulatory fecklessness, and speculator recklessness could have been avoided. Instead, there was a massive, cascading systemwide failure. At every point along the way, from home purchases in Stockton, California, to Iceland’s fiscal demise, things went awry.

  So much for the lessons learned.

  LTCM was not the only missed opportunity to teach a lesson about moral hazard. Other bailouts continue to leave lasting, negative effects on future behaviors, including a lack of discipline across many industries.

  Recall the original 1980 Chrysler bailout. Since then, the Detroit automakers have seen their market share tumble from 74 percent of autos sold in the United States to 47 percent; the UAW has since lost over two-thirds of the 1.5 million members the union had back in 1980. That was with a bailout. Would they really have fared much worse had circumstances been allowed to run their natural course (i.e., without government interference)? Perhaps this is why the first bailout proposal for Detroit automakers was defeated at the behest of Senate Republicans in December 2008.

  The moral hazard of the original Chrysler bailout showed up in subsequent actions by the automakers, as detailed in Chapter 4. The impetus to make more reliable, attractive, fuel-efficient cars seemed to have been forgotten until it was way too late. For many years, innovative designs and automotive technologies were the sole province of Japanese and German auto designers. Making ever less expensive cars became the province of the Koreans.

  Meanwhile, the Big Three spent much of the intervening decades since the bailout—and millions upon millions of dollars—lobbying Congress. Rather than innovate the way other manufacturers did, they fought for exemptions from Corporate Average Fuel Economy (CAFE) standards, or litigated against emission standards from states such as California.

  As a car guy, I can say without hesitation that General Motors hasn’t designed a dashboard that wasn’t ugly as shit since the 1950s (the early 1960s Corvettes were the sole exception, but they were a special project). The biggest automotive accomplishment out of Detroit during recent decades was getting SUVs exempt from various car safety and fuel efficiency rules. Is it any wonder that Toyota has royally kicked GM’s ass since then, bypassing the still-bloated manufacturer for the number one slot in auto sales in the United States? Toyota is now the world’s biggest automaker. I am hard-pressed to name any nonfinancial American company that deserves bankruptcy more than GM.

  There is yet another reason to be wary of broad government interventions : Vast amounts of money up for grabs have a tendency to corrupt anything they come near. The pork attached to the original Troubled Assets Relief Program (TARP) plan was a disgraceful showing. It was an embarrassing spectacle of business as usual from a Congress with the lowest approval rating of any political organ in America. To merely witness it made one rethink the wisdom of poll taxes, and reconsider one’s belief in democracy.

  Once the auto bailout lost in the Senate, the White House said the government was likely to make an emergency loan to GM, Ford, and Chrysler out of TARP. Well, I guess if you think about it, the automakers are “troubled assets”—but that’s hardly what was contemplated by the term when Congress originally approved the $700 billion emergency fund.5

  How typically corrosive and corrupting a big pile of money can be. This is yet another downside of bailouts: It brings the leeches and vultures, mostly in the form of lobbyists, seeking to grab a slice of that sweet pork pie.

  And that’s before we even consider what other, worthwhile programs will be squeezed out by the bailouts’ terrible financial costs.

  How to Pay for National Health Insurance

  Since the government has spent such an inordinate amount of taxpayer money cleaning up after Wall Street’s so-called best and brightest and the mess they made, there is not a whole lot of money left over for other new programs.

  Once such legislative work was national health insurance. Surveys have shown that a significant majority of Americans support it. It was one of the key planks of Barack Obama’s presidential campaign.

  Well, no worries over the lack of funding for health care. There is a simple way to ensure that every man, woman, and child in the United States is covered by health care insurance. Taking a page from the cleverest of Wall Street’s financial engineers, all it takes is a little of that Street magic and derivative-based hocus-pocus in seven steps:1. Set up a large, well-capitalized hedge fund. About $5 billion should do it.

  2. The prospectus of the fund should note its purpose is to “seek out profit opportunities via arbitraging inefficiencies in the markets and health care system of the United States.” Include standard socially conscious fund language with clauses such as “We plan to do well by doing good.”

  3. Launch the fund—and promptly max out your leverage. The credit crisis makes it difficult to go 50 to 1, but 10 or 20 to 1 should not be much of a problem.

  4. Use the money to write credit default swaps with a notional value of $3 trillion. The premiums on these CDSs should be about 10 percent to 15 percent or so.

  5. Roll over the cash premiums—about $350 billion worth—into a national fund. Use it to buy health care insurance for all U.S. citizens!

  6. Send certified letters to your counterparties, declaring that due to the unfortunate current credit conditions, you will be defaulting on these CDSs. Be sure to mention that a significant amount of your CDS paper is held by JPMorgan and Citigroup. Another trillion is held by China and Japan, with other sovereign wealth funds owning the rest.

  7. Send out a press release announcing “systemic risk.” Tell the Treasury secretary and the Federal Reserve chair that your imminent collapse will wreak global havoc. Apply for bailout.

  Congratulations! You have national health care!

  Repeat for any major government program: alternative energy research, school vouchers, Mars mission, global warming, or missile defense shield.

  In the future, this is how all government spending programs will be funded.

  The other danger that moral hazard presents is to allow investors to mistakenly believe a paternal Fed will always be there to bail them out of any jams. Some evidence of this can be seen in the behavior of several well-known funds and famous investors. In 2007 and 2008, they placed a series of large bets in the financial sector. Some purchased investment banks with long, storied histories and pedigreed founders. Others jumped into the mortgage business, buying firms that specialized in underwriting, origination, or securitization. Still others have scooped up bank shares at prices that were perceived to be on the cheap.

  What were originally thought to be bargains turned out instead to be quite pricey. Losses have ranged from the merely enormous to the utterly devastating. Of the approximately $57.3 billion in high-profile investments tallied in Table 13.1, an international group
of presumably savvy investors had suffered a collective loss of about 75 percent as of December 2008.

  Note: These devastating losses are ongoing—and seemingly getting worse all the time.

  Table 13.1 You Call That “Smart Money”?

  SOURCE: Published reports, Yahoo! Finance

  How did otherwise intelligent, experienced investors find themselves on the wrong side of these trades? These were not mere stock-picking foibles of the “win some, lose some” variety. Rather, they were catastrophes that had nothing to do with these investors’ ability to read complex balance sheets, or assess financial leverage, or recognize counterparty risks. These investment losses did not come about based on some unforeseen macroeconomic challenge to a company’s business model.

  No, the problem that these investors encountered was one of misplaced confidence. It’s yet another risk that is run when investors perceive that the government is there to rescue them. These fund managers made the simple mistake of placing their faith in the central bank of the United States of America. Inspired at first by the Federal Reserve, and then subsequently by the Treasury, these formerly savvy traders rushed headlong into the U.S. financial sector, regardless of what proved to be readily apparent risks.