Bailout Nation

by Barry Ritholtz

  These turned out to be exquisitely expensive mistakes.

  Indeed, one of the more fascinating aspects of the Fed’s intervention in the financial markets has been the impact it has had on the psyches of some of its largest players.

  This is another consequence of moral hazard. By creating a perceived readiness to bail out markets and speculators, central banks run the risk that they can perversely end up encouraging even more risk taking by other market participants. The bravado and false confidence the Fed’s intervention engendered led quite a few funds down the wrong path. This rise in false confidence among those who should otherwise know better is merely another aspect of moral hazard.

  It can be argued that these misguided rescue operations made the financial system more unstable by encouraging greater recklessness and additional risk taking (see Figure 13.1). All the while, the speculators’ profits remain their own, while the risks are born by the taxpayers.

  The smart money was proven in 2008 to be not so smart after all. The very expensive costs were summed up by an anonymous trader who e-mailed a colleague: “This has been even worse than my first divorce. I’ve lost half my net worth but I still have my wife.”

  Wall Street gallows humor being what it is, the e-mail circulated far and wide among trading desks. But that’s a wholly different kind of moral hazard.

  Figure 13.1 The Anatomy of a Collapse

  Part IV

  BAILOUT NATION

  “I have found a flaw.” - Alan Greenspan

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

  Chapter 14

  2008: Suicide by Democracy

  Remember, democracy never lasts long. It soon wastes, exhausts, and murders itself. There never was a democracy yet that did not commit suicide.

  —John Adams

  How did the once proudly independent United States become a Bailout Nation? The first modest government interventions and legislative fixes soon changed to far more insidious corporate welfare. What once was unthinkable slowly morphed into something merely undesirable on its way to becoming the least bad option facing policy makers. The cumulative effect has been a creeping paternalism, rife with moral hazard.

  During the debates about earlier bailouts, be they Lockheed in 1971 or Chrysler in 1980, the language and philosophy were very different from the 2008 Troubled Assets Relief Program (TARP) debate. Historically, there was a legitimate battle between ideologies as to whether any bailout should be enacted in a market-based economy. Concern about the negative future ramifications of these bailouts was paramount. The bailout discussion circa 2008 was long on fearmongering and short on substantive issues. Lawmakers were presented with a “Trust me” document, then hardly given a chance to read it. “Vote for this or suffer horrific consequences to the entire financial system” was the administration’s approach.

  How did this philosophical shift take place? Philosophically, the politics, economics, and financial analysis of bailouts have shifted dramatically since the 1970s. What makes this so ironic is the rightward political shift of the same era. Since Ronald Reagan was elected president in 1980, Republicans have ascended to power at the federal and state levels. The GOP won the White House in five of the seven elections from 1980 to 2008. The Republicans controlled Congress from 1994 to 2006. One might imagine that a conservative president and a rightward-leaning Congress would boldly object to bailout after bailout.

  One would be disappointed: The TARP plan, the various 2008 bailouts of Bear Stearns, Fannie Mae/Freddie Mac, Citibank, Merrill Lynch, Bank of America, American International Group (AIG), and others all took place during a purportedly conservative Republican administration.

  Maybe it was less a matter of political ideology than it was governing style. For most of the Bush administration’s two terms, the GOP adhered tightly—perhaps too tightly—to Karl Rove’s discipline. The Rove approach helped President Bush govern, but it stifled debate on major issues. Too much party-line groupthink and too little independent thought is the likely reason why social conservatives became conservative socialists.

  Just as there are no atheists in foxholes, there were no free market capitalists in the face of a financial system collapse.

  When Bear Stearns, the nation’s fifth-largest investment bank, ran into trouble, the assumption among many Fed watchers was that it wasn’t deemed “too big to fail.” It was almost an article of faith that the marketplace would be allowed to operate unimpeded. As the crisis at Bear heated up, though, both the Federal Reserve (headed by an academic expert on the Great Depression) and Treasury (headed by a former Goldman Sachs CEO) seemed increasingly uncomfortable with the prospect of so much creative destruction.

  Maybe panicked is a better word than discomfort for how Ben Bernanke and Henry Paulson reacted.

  In March 2008, Bear was “liquidated in an orderly fashion” (rescued is far too kind a word). With Treasury Secretary Paulson concerned with moral hazard, Bear was originally sold for $2 per share. Shareholders balked, and ultimately Bear went to JPMorgan Chase for $10 per share. The bondholders were made whole, with the Federal Reserve and the U.S. Treasury backstopping $29 billion in losses for the deal to get done.

  The issue of whether “too big to fail” played a role in the Bear saga is still the operative question. Bear had extensive ties with JPMorgan Chase, including a rumored 40 percent exposure by JPM to Bear Stearns’ $9 trillion derivatives book. A bankrupt Bear would have significantly damaged JPM, which by all accounts was considered too big to fail. The best explanation I’ve seen as to why Bear was rescued in the first place was to prevent its derivatives mess from dragging down JPMorgan Chase with it.

  Thus began a 12-month period that would see bailout after bailout, all funded by the American taxpayer.

  Then there were the government-sponsored enterprises (GSEs): It’s hard to say why Fannie and Freddie were bailed out on September 7, 2008. Certainly the reason wasn’t insolvency, for as former St. Louis Federal Reserve President William Poole had said in July 2008, they had been technically insolvent for years.1 And it wasn’t cash flow, as the GSEs had enough operating capital to keep going for another 8 to 12 months. Politics during an election year? Saving the next president from making a tough decision? Influencing mortgage rates? These were some of the reasons given, and they are all questionable.

  Then came Lehman Brothers. It wasn’t deemed too big to fail, but its September 14, 2008, bankruptcy helped force the thundering herd of Merrill Lynch into the waiting arms of Bank of America. Curiously, we’ll never find out if Merrill was too big to fail. More important, Lehman’s demise impacted lots of the credit default swaps (CDSs) written in the shadow banking system, including hundreds of billion of dollars’ worth insured by AIG. The same factors that caused Lehman’s bankruptcy also triggered AIG’s crash and contributed to the Reserve Primary Fund “breaking the buck.”

  Soon Uncle Sam was scrambling for his checkbook again.

  Size and interconnections were no longer the sole factors that mattered; side bets—such as the credit default swaps placed on Lehman’s debt—became a key factor, also.

  Bear wasn’t allowed to fail for fear of damaging JPM; Lehman was allowed to fail, but no one considered letting AIG fend for itself. Rather than wait for Citigroup to fail, Treasury acted preemptively, rescuing the giant money center bank before it was on the verge of collapse.

  Discern any pattern here? Me neither.

  Bailing out banks one at time wasn’t working, so on October 14, 2008, the U.S. Treasury injected $125 billion of capital into the nine largest banks and another $125 billion into other, smaller banks. Were the bailout architects using these other banks as cover—a smokescreen to conceal an attempt to shore up Citigroup? Perhaps Citi was closer to collapse than previously realized. Using the authority granted to him by Congress when it passed the controversial $700 billion TARP package (in another of Congress’s finest moments, the original bill was defeated in the House but then a
pproved after Wall Street freaked out and $150 billion in pork was added), Paulson literally made the banks an offer they couldn’t refuse. Any fan of The Godfather or The Sopranos knows the term for someone who forces you to take money you don’t want and might not need.

  On top of the $25 billion Citigroup got in October, regulators decided the firm needed more money and protection from its own bad trades. Outrageous though it seems, the U.S. government gave Citi another $20 billion on November 24, 2008. And that wasn’t all. Uncle Sam guaranteed $306 billion of troubled home loans, commercial mortgages, subprime bonds, and low-grade corporate loans the firm had made.

  Why was there more than $300 billion for Citigroup, but General Motors and Chrysler had to beg and plead for $13.4 billion to stave off their imminent collapse in late 2008? Damned if I know why.

  There is a pattern here, but it’s one of randomness, not predictability. There seem to be no operative governing rules. Every event is a one-off; the response to each company was not part of any well-planned strategy or grand overview. James Montier of Société Générale called it an adhocracy. There has been no broad strategy and apparently no architects to the trillions in bailout dollars so far.

  Battles are won with tactics, but in war victory is achieved via strategy.

  The bailout decision-making process has been dominated by two very different minds and disparate personalities. At the Fed, there is Chairman Ben Bernanke. An academic, he has proven to be a quick study of the ways of Wall Street. His crosstown compatriot at the Treasury, Hank Paulson, was the former deal-making CEO of Goldman Sachs. They are intelligent men of very differing styles and approaches. The government’s initial response to the crisis seems to be a hybrid of their two different approaches. We have yet to see if the dynamic will be any different with President Obama’s Treasury secretary, Tim Geithner, who had a hand in many of the 2008 bailouts as president of the New York Federal Reserve Bank.

  Saving the U.S. financial system bound Paulson and Bernanke together in common purpose. That neither man saw it coming further ties them together. There is a third factor they had in common: They each saw a leadership void as things progressed into crisis.

  Indeed, about now you should be asking yourself why a cabinet department and a central bank were running the greatest government rescue operation in history. And you may be wondering, “Where is the man at the top of the organization chart?” It is a fair question. Why did George Bush go AWOL during this crisis period?

  Indeed, during the second half of 2008, one got the sense that the Bush White House had no stomach for the entire affair. The bailouts were a repudiation of everything the president believed in; perhaps he simply couldn’t bear to take the lead on something he found so philosophically distasteful. Bush’s approval ratings were at record lows, his legacy and reputation in tatters. In the latter half of 2008, the sense was that the Bush White House was running out the clock. As Bush’s last term was ending, the wheels came off the bus. Then the bus caught fire, rolled down a ravine, and ended up at the bottom of the sea. Running out the clock may have seemed easier than the alternative.

  During the interregnum between the November 4th election day and the January 20th inauguration, the void became even more pronounced. Democratic Congressman Barney Frank criticized president-elect Barack Obama for not being more “assertive” during the crisis. “Part of the problem now is that this presidential transition has come at the very worst possible time,” Frank told 60 Minutes. “You know, Senator Obama has said, ‘We only have one president at a time.’ Well, that overstates the number of presidents we have at this time.”2

  Bernanke and Paulson soldiered on. To be fair to our D.C. twosome, this has been the crisis that keeps on changing. It started out as a real estate boom and bust, driven by ultralow interest rates and a bubble in credit and lending. That alone would have been difficult to resolve. It then slowly morphed into a full-blown credit crunch, where commercial lending ceased. Then it changed into a Wall Street crash as stocks crumbled globally and yields dramatically fell. Ultimately, it became a U.S., then global, economic recession, with deflation driving the prices of most commodities into the ground.

  This has been an unprecedented period in American history.

  All the while, the government’s response has always been at least one step—and one crisis—behind the curve.

  As the government dithered, flailed blindly, and generally meandered aimlessly, casting about for a suitable response to these many crises, the tally grew.

  And grew.

  And grew.

  Until the total commitment hit an astronomical figure: $15 trillion. That is how much Uncle Sam has spent, promised, lent, guaranteed, or assumed in liabilities thus far on its way to becoming Bailout Nation’s government in residence. (See Table 14.1.)

  The year 2008 has long since passed any other year—indeed, any other century—in terms of government expenditures directed toward rescuing damaged companies. As this book went to print, the total outlay of government monies and credit from the Treasury Department, the Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve was nearing $9.5 trillion. Add in the $5.5 trillion in Fannie Mae/Freddie Mac mortgage portfolios that the U.S. taxpayer assumed responsibility for when the GSEs were placed into conservatorship, and you get an astonishing total.

  Table 14.1 Bailout Tally

  The good news is the final bill should be considerably smaller than $15 trillion. Many of the loans will be repaid, and the vast majority of the Fannie/Freddie portfolio is sound. My best guess is the final costs for the cleanup of Wall Street’s worst excesses bill should total somewhere between 10 and 20 percent of that number. But that is merely an operating assumption. It is certainly conceivable that circumstances, and the final bill, may change.

  But even so, that is a lot of money.

  Trying to explain a trillion dollars to most humans is difficult. Indeed, a trillion is a lot of anything. It is a nearly impossible number to conceive of, and it is much larger than most people’s conception of time and space. Consider these comparables. The average lifetime is a little longer than two billion seconds (72 years = 2,270,592,000 seconds). One trillion seconds is 31,546 years. In astronomical terms, the universe is believed to be 15 billion years old—that is just shy of 5.5 trillion days old (5,475,000,000,000 days). Suffice to say a trillion is a big number.

  The only event in American history that even comes close to matching the cost of the credit crisis is World War II: In 1940 dollars, it cost the Treasury $288 billion. Adjust that for inflation, and it is $3.6 trillion.

  That’s a fair guess as to what the net cost of the 2008 bailouts will be to the taxpayers in terms of actual expenditures; $15 trillion is the gross cost. Perhaps the United States will show a profit, or maybe the monetary cost will be much greater than that of World War II. Your guess is as good as mine. No one knows.

  Let’s take a closer look at all of the bailouts from March 2008 to March 2009 in the next chapters. Perhaps we might discern if there is some method to the madness.

  Chapter 15

  The Fall of Bear Stearns

  Buying a house is not the same as buying a house on fire.

  —Jamie Dimon, CEO of JPMorgan Chase, on his $2-per-share offer for Bear Stearns

  When Bear Stearns fell apart, few suspected a cascading collapse across the entire financial firmament. Yet that is precisely what occurred as the house of cards built atop residential mortgages wavered, then crumbled.

  The first signs of the mess to come burst into view in the early summer of 2007. That was when Bear Stearns reported heavy losses at two of its internal hedge funds. The announcement would prove to be the tip of the iceberg for the coming global financial crisis and the beginning of the end for the firm that had survived the Great Depression, two world wars, the 1987 crash, the Long-Term Capital Management implosion, and the 2000 dot-com tech wreck.

  The culture at Bear was unique. The firm was heavily focused on fi
xed-income trading and institutional clients, as opposed to equity trading and retail clients. It was considerably smaller than rivals such as Merrill Lynch and Morgan Stanley. The firm had a history of hiring traders with street smarts, rather than the best pedigrees. This was a polite way to say Bear Stearns didn’t hire only WASPs when that was the de rigueur on Wall Street. You could be Jewish with a degree from Brooklyn College, or (later) from India or Pakistan, but it didn’t matter as long as your trading made money for the firm.

  Bear was different from most other Wall Street firms in one other crucial way as well: It was the only primary dealer of Treasury securities that refused to participate in the 1998 bailout of Long-Term Capital Management. This, despite the fact that Bear was LTCM’s prime broker. It was an act of selfish defiance that many on Wall Street never forgot—or, apparently, forgave.

  Oh, and one last thing: Bear was the biggest underwriter and trader of mortgage-backed bonds.

  The firm’s 14,000 employees and its many shareholders were victims of Bear Stearns’ management. Bonuses included stock and options, so many of Bear’s employees were stung twice when the firm failed and the stock crashed. Management allowed (and indeed encouraged) the investment bank to become overexposed to mortgage-backed securities. This alone was a significant factor in its demise. When the firm didn’t seek additional liquidity when it was available, its fate was sealed.

  JPMorgan-Bear Finalized Deal

  • JPMorgan Chase agreed to pay $10 per share in stock and to purchase an additional 92 million shares for an immediate stake of 39 percent.

  • JPMorgan Chase assumed the risk of the first billion dollars of the $30 billion of Bear Stearns’ most risky assets. The Federal Reserve Bank of New York guaranteed the remaining $29 billion but will reap any gains on the portfolio. (As of October 2008, the Federal Reserve stated it had suffered a $2.7 billion paper loss on the $29 billion portfolio of toxic assets.)