Oh, and this entire series of events took place at a time when the dominant political philosophy was that it was impossible for this to go wrong—the self-regulating markets, you understand, would see to that.
What bad could possibly come of that?
Plenty, as you might imagine. The teetering insurance giant lost $13 billion in the first half of 2008, but the real trouble was about to hit. It wouldn’t be long before AIG would need a lifeline from Uncle Sam—or, as it turned out, Uncle Ben.
When Lehman went down, there was all manner of bad mortgages on its books. Dick Fuld, Lehman’s CEO, had already given these assets a substantial haircut. Lehman was carrying its subprime mortgage securities on its books at 34 cents on the dollar, and its Alt-A holdings at 39 cents. Lehman had written down about two-thirds of their value.
AIG had not had its come-to-Jesus moment yet—not when it came to its housing derivatives, anyway. It had over $20 billion of subprime mortgages marked at 69 cents on the dollar and more than $24 billion in Alt-A securities valued at 67 cents on the dollar. 12
Forget “mark to market.” AIG was carrying these assets at values that were double what Lehman was. You can call that bookkeeping “mark to make-believe.”
The Lehman bankruptcy occurred on September 15, 2008. Two days later, the Federal Reserve stepped in. AIG was effectively nationalized on September 17, 2008, with Uncle Sam picking up 79.9 percent of the former Dow component.
To anyone who believed in the doctrine of “too big to fail,” AIG was a must save: almost a century old, with tentacles reaching everywhere. When the world’s largest insurer collapses, it is every Fed chairman’s nightmare. Hence, the massive effort policy makers have engaged in to keep the firm quasi-solvent as it is wound down. As of March 2009, more than a $173 billion in loans, lines of credit, direct capital injections, and purchases of stock have been made by the government to AIG. No private capital was willing to step up to 70 Pine Street in lower Manhattan.
Some cockeyed optimists believe this will be a profitable transaction for taxpayers, but I find that hard to believe. Not because AIG doesn’t own some fine assets. Rather, because of the extent of the damage done by the structured finance half of the firm. At the end of Q1 2009, AIG announced a staggering $61.6 billion fourth-quarter loss. Even more AIG-related risk was moved to the Federal Reserve (a private institution), and to the Treasury—which is to say you and me.
Understanding how AIG went rogue and what happened since is critical, not only because it’s one of the biggest single bailout beneficiaries, but because AIG encompasses all the elements that led us to the brink of financial catastrophe. These include:• Massive use of leverage.
• Excessive risk taking.
• Abuse of lax regulation.
• Off-balance-sheet accounting.
• Inept risk management.
• Shortsighted (and greedy) incentives.
• Interconnectedness and complexity that screams “systemic risk” to any policy maker within earshot.
Once you can wrap your head around AIG, the mess that is Bailout Nation becomes much clearer. AIG was a fearsome combination of too many bad factors converging together. As is so often the case, these risk elements came together at precisely the wrong time.
“It’s a terrible situation, but we’re not doing this to bail out AIG or their shareholders,” Bernanke declared. “We’re doing this to protect our financial system and to avoid a much more severe crisis in our global economy.”13
Bernanke’s comments about AIG were eerily similar to what former Treasury Secretary Paulson said on September 7, 2008, about Fannie Mae and Freddie Mac: “Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe.”14
As with Bernanke’s statement about AIG, Paulson statement was accurate, concise—and wholly irrelevant. Neither man specified the real reason AIG, Fannie, and Freddie were nationalized: to protect their counterparties and debt holders, including major financial firms and foreign institutions, such as Japan’s central bank, China’s sovereign wealth fund, and Saudi Arabia’s holdings, among others.
Why? The short answer is that foreigners have been funding the profligate ways of the American consumer for decades. Once you begin to depend on the kindness of strangers, it’s best not to make those strangers too angry. We in the United States have lived beyond our means for many years. We consume far more in goods and services than we produce, and that net deficit has to be funded somehow. The global economy has come to depend on the excessive consumerism of the United States. In return, we finance our massive deficit via the constant flow of capital from foreigners. As of June 30, 2008, that capital flow was $1.65 billion per day, every day.
How much kindness would these strangers offer if we allowed our paper that they held to default? Think about the $2 trillion in Treasury securities expected to be issued in 2009—who would be the takers?15 How about any appetite for holding the $4.25 trillion of U.S. government and agency debt already owned by foreigners as of Q3 2008?
Forget going nuclear: These foreign treasury holders could all but destroy the U.S. economy by selling this debt on the open market at once. The only thing that prevents them is the same doctrine that precluded nuclear war during the Cold War: mutually assured destruction (MAD). They’d destroy themselves as well as us.
Why bail out overseas counterparties and debt holders? One gets the sense Uncle Sam had little choice in the matter.
Chapter 18
The Year of the Bailout, Part II: Too Big to Succeed?
No private enterprise should be allowed to think of itself as “too big to fail.” No taxpayer bailouts should allow executives or stockholders to relax.
—William Safire1
The month of September 2008 finished the way it began, with a dire combination of volatility and panic. From Bear Stearns to Lehman to AIG, once the dominos began falling, there was no easy way to halt the progression. As traders sensed this, markets began accelerating to the downside; they got worse every week.
Into this cavalcade of collapse tripped the next major domino: Citigroup, the nation’s biggest bank. Of the many players in our morality tale, the sprawling mess known as Citi was the oldest. It took two centuries of cautious risk management and careful growth to become the biggest and wealthiest of banks; it took less than five years for Citigroup to virtually collapse.
City Bank of New York was founded in 1812. A century later in 1919 it became the first U.S. bank with $1 billion in assets. Just as the stock market was topping before the 1929 crash, the National City Bank of New York (as it was known then) had become the largest commercial bank in the world.2 This was a position the bank that would become Citigroup would frequently occupy for the rest of the twentieth century.
As a banking institution, National City introduced many firsts: traveler’s checks, compound interest on savings accounts, unsecured personal loans to its depositors, negotiable certificates of deposit, consumer checking accounts with no minimum balance requirement, even the idea of a “Personal Loan Department” all originated with Citi. These innovations, combined with intelligent risk management, led to slow but steady growth.
When John Reed became CEO in 1984, he accelerated Citibank’s growth-by-acquisition strategy. Under Reed, Citibank became the largest bank in the United States, the largest credit card issuer, and the largest charge card servicer in the world.3 The bank eventually grew to 275,000 employees, with 200 million customer accounts in more than 100 countries.4
From antitrust laws to Glass-Steagall, Citi began running up against legal limits as to how much further it could bulk up. The law of big numbers caught up with Citi, and its growth strategy lost steam.
That was the case until 1998, the year of the $140 billion megamerger between Citicorp and Travelers Group. The deal was seen as a crowning moment for Citi Chairman and CEO Sandy Weil, widely r
egarded as the architect of the firm’s “financial supermarket” strategy. When we trace where things really began to go awry for Citi, this is the tipping point. It marks the moment when Citi went from being a very large bank to becoming an unmanageable Goliath.
Ever since Continental Illinois had to be rescued by the Federal Deposit Insurance Corporation (FDIC) in the 1980s, the operative phrase concerning bailouts has been whether something is “too big to fail.”5 Following the Citi-Travelers merger, the question became whether Citigroup was too big to succeed. As we shall soon see, the answer was a resounding yes.
Among its peers, Citigroup was a unique banking creature. Not just because of its history and size; Citi was exceptional in that it had more to do with the repeal of the Glass-Steagall Act—the 1933 Depression-era legislation separating commercial and investment banks—than any other financial institution. Let’s flash back for a moment to 1989 when Citi took what the New York Times called “another step in the battle to unshackle the banking industry from the restraints of the Glass-Steagall Act”:
In a securities deal announced last week, Citicorp, the bank holding company, said it was issuing $47 million of mortgage-backed securities through its Citibank Delaware Inc. subsidiary. The move was aimed at avoiding—some say circumventing—a Federal court order that would have blocked the New York-based Citibank from issuing securities backed by residential mortgages originated by the bank.6
In 1995, then Treasury secretary—and future Citigroup board member—Robert E. Rubin testified before the House Committee on Banking and Financial Services. He recommended that Congress should reform or repeal Glass-Steagall. This was an ongoing project for Rubin, and shortly after he retired as Treasury secretary, he would finally achieve victory. In late 1999, the Gramm-Leach-Bliley Act—or, as it was known in some circles, the “Citigroup Authorization Act”—repealed Glass-Steagall. 7
The rules prohibiting bank holding companies from owning other financial firms were finally gone. “Today Congress voted to update the rules that have governed financial services since the Great Depression and replace them with a system for the 21st century,” said then secretary of the Treasury and Rubin protégé Lawrence H. Summers. “This historic legislation will better enable American companies to compete in the new economy.”8
Um, not exactly. While the repeal of Glass-Steagall was arguably not the primary cause of the 2008 credit crisis, it certainly made the outcome far worse. Had Glass-Steagall still been the law of the land, much of the damage banks like Citigroup are now suffering would have been minimized. They simply would not have been able to buy as many toxic assets as they did. Taxpayers are now spending trillions of dollars trying to get this toxic junk off the banks’ balance sheets. Despite his involvement in the debacle, Summers is now director of the National Economic Council for President Barack Obama. Talk about failing upward.
As to Rubin, the repeal of the 1933 Glass-Steagall Act was his “crowning achievement.”9 He stepped down as Treasury secretary in July 1999, and before the year was over, announced his new gig: chairman of Citi’s executive committee. Annual compensation was $40 million.
Nice work if you can get it.
With the repeal of Glass-Steagall, the government pretty much repeated the same error it had made less than 20 years before. The cleanup for the savings and loan crisis—less a bailout than an insurance payout via the Federal Savings and Loan Insurance Corporation (FSLIC) guarantee to depositors—was about $200 billion.10 The costs the next time would be far greater.
Citigroup was now a monster, bigger than any other Wall Street firm. A giant commercial bank, it also had bought investment bank Smith Barney and had added Salomon Brothers, the bond house Warren Buffett had rescued years earlier.
In the early 2000s, the men at the helm of Citi began urging a new and riskier strategy. Citigroup CEO Sandy Weil and influential director and senior adviser Robert Rubin sent the firm charging headlong into the booming housing market. The firm took up an even riskier expansion into derivatives, especially the issuance of collateralized debt obligations (CDOs). Citigroup was the seventh-ranked issuer by value of CDOs in 2000, cranking out $4 billion worth out of a world total of $68 billion. By 2007, Citi was the largest issuer of CDOs, responsible for more than 10 percent of all CDOs that year. It produced over $49 billion worth when the world’s total production was $442 billion.11
The problem was not just what was done, but how. Citi charged recklessly into derivatives issuance. It did so in a slapdash and irresponsible way, with little oversight and even less risk management.
Citigroup CEO Chuck Prince—a lawyer who had been given the reins in 2003 by Sandy Weil in the wake of Eliot Spitzer’s investigations into misconduct by the firm’s sell-side research analysts—summed up the firm’s attitude: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
With that attitude from senior management, the day of reckoning was all but inevitable for the nation’s biggest bank.
Writing in the New York Times, Eric Dash and Julie Creswell detailed how Citi was tripped up—by itself:
For a time, Citigroup’s megabank model paid off handsomely, as it rang up billions in earnings each quarter from credit cards, mortgages, merger advice and trading. But when Citigroup’s trading machine began churning out billions of dollars in mortgage-related securities, it courted disaster. As it built up that business, it used accounting maneuvers to move billions of dollars of the troubled assets off its books, freeing capital so the bank could grow even larger. Because of pending accounting changes, Citigroup and other banks have been bringing those assets back in-house, raising concerns about a new round of potential losses. 12
For most companies and corporate executives, Enron was a cautionary tale of what not to do. Citi learned the exact opposite lesson: It took its higher-risk assets and hid them away off its balance sheet in Enron-like side pockets. These are the now-infamous structured investment vehicles (SIVs) that Citi pioneered. The SIV market allowed firms to keep assets off their balance sheets as long as short-term credit was available to roll over the funds.
At their heart, the SIVs were a simple spread play. Citi made profits by selling short-term debt and using the proceeds to purchase much higher-yielding assets like bank debt, CDOs, and mortgage-backed securities.
And while this might be obvious, it bears repeating: There is no free lunch. Assets with higher yields are much riskier. Think of the yield as an inducement; all other things being equal, you can get people to purchase riskier assets only by bribing them with more money—or, in the case of these instruments, higher yield.
As any casino croupier will tell you, the longer shots usually lose. That is precisely what occurred with the Citi SIVs. As all that higher risk began to come up snake eyes, the entire model fell apart once credit markets froze and the value of the long-term debt began careening lower.
That was a major miscalculation by the SIV designers. As long as credit was readily available, the SIVs did the job of keeping the junky assets off balance sheets. What was apparently not contemplated was a simple cascade effect: The very same factors making these assets increasingly toxic would also impact credit availability. By 2007, house prices had fallen enough that foreclosures were increasing. In some regions of the country, mortgage delinquencies were spiking higher. Once short-term financing dried up, the company had no choice but to take the SIVs back in-house. As these billions in losing assets made their way back to Citi’s balance sheet, its downward spiral began in earnest. By December 2007, Citi assumed $58 billion of debt to “rescue” $49 billion in assets. 13
From July 2007 on, Citigroup’s SIVs were festooned with $87 billion in toxic assets, mortgage-related CDOs, and other long-term paper. By the end of 2008, this had been pared down to $17.4 billion. It would take a monstrous government bailout to help Citi write down most of its SIVs.
In just a
bout every imaginable way, Citigroup’s wounds were self-inflicted. From the gargantuan company that was assembled, to the push for repeal of key regulations, to the way it ran daily operations—Citi was a classic case of “Be careful what you wish for.”
As Citi was teetering at the height of the crisis, a joke was pinging across Wall Street trading desks: “I went to a Citibank ATM this morning, and it said ‘insufficient funds.’ I left wondering if it was them or me.”
That was no joke for Ben Bernanke and Hank Paulson. The thought of the nation’s biggest and best-known bank taking a face-plant gave nightmares to the country’s top finance officials. There was simply no telling what sort of ripple effect that would have—on the economy, on investor confidence, on the markets. Let Citigroup suffer the fate of its own misjudgment? Who wanted to be the guy who let America’s biggest bank go down on his watch? That’s hardly a legacy to be proud of. It was time for some preemptive action. Shore up Citi, send a message, get ahead of the curve—for a change.
One might assume the government would cut a hard bargain with the biggest, stupidest, most irresponsible bank in the country, especially considering how self-inflicted Citibank’s wounds were. Instead, the Treasury essentially handed over the keys to the kingdom for a mere song. For reasons still unknown, the banking behemoth got a helluva good deal.
Credit new CEO Vikram Pandit for scoring such a sweet deal. First, he sold his hedge fund, Old Lane, at an absurd price to the suckers running Citigroup. Then as Citi CEO, he pulled a coup, getting the government to absorb a huge slug of the bank’s liabilities. The net liabilities for a full decade of terrible decision making were transferred from Citi’s bond/shareholders to the taxpayers—a terrible deal for Uncle Sam, but a fantastic score for Citi.
Bailout Nation Page 20