Bailout Nation

by Barry Ritholtz

  Pandit’s Coup

  The deal is complex in its structure, but when all is said and done the government is on the hook for about $249 billion in toxic mortgage-backed assets in exchange for $27 billion in Citi preferred stock paying 8 percent. Terms of the $306 billion in loans:14 • The first $29 billion of losses from the portfolio will be absorbed by Citi entirely.

  • The Treasury department will take 90 percent of the next $5 billion of losses, with Citi taking the rest.

  • The FDIC will step in and take 90 percent of the next $10 billion of losses while Citi absorbs the balance.

  • Losses beyond that will be taken by the Federal Reserve in the 90 percent government role.

  In mathematical terms, the $306 billion in guarantees is 306 - 29 = 277 × 0.90 = 249.3 or $249.3 billion.

  Citi took a $350 billion portfolio of assets—some junky, some not—and managed to get you and me to mark it at $306 billion. Never mind that other portfolios had taken 40 percent, 50 percent, even 65 percent haircuts. John Thain dumped some of Merrill Lynch’s assets—financing 75 percent of the sale to Lone Star—for what amounted to 5.47 percent on the dollar. 15

  How did Citi manage to suffer only an 11 percent haircut? Were its holdings that much superior to everyone else’s? Or was the mere idea of a colossus like Citi collapsing that much more threatening to Bernanke and Paulson? Imagine what would have happened to the rest of the banking idiots holding the same crappy paper as Citi if they had to dump all those assets at once. Perhaps it is the Federal Reserve’s desire to maintain confidence that was behind this obscene taxpayer-funded boondoggle.

  Even worse, the Citigroup rescue deal is open-ended. The government has given Citi what is effectively an unlimited line of credit to carry these assets: no fire sales and no panics about marking to market.

  While Citibank was slowly assembled over centuries, Bank of America, at least as we know it today, was a rather hastier creation. We’ll skip its early but interesting history16—its roots go back to surviving the San Francisco earthquake in 1906, and it eventually created Visa—and fast-forward to the 1990s. That’s when the firm began a 20-year acquisition spree that worked out somewhat less than ideally.17

  Recall the original “too big to fail” doctrine that came about when Continental Illinois was rescued by the FDIC. Continental Illinois went into FDIC receivership in 1984, came out of receivership in 1991, and was ironically purchased by Bank of America in 1994.18 Yes, Bank of America’s track record of lousy acquisitions actually goes back decades.

  It was in the 2000s when the management’s acumen for killer acquisitions really shone:• June 2005: Bank of America takes a 9 percent stake in China Construction Bank for $3 billion; China’s market tops out in 2007 and then plummets 72 percent.

  • January 2006: Bank of America acquires MBNA for $35 billion. The world’s largest issuer of credit cards is taken over right before the world’s largest credit crunch occurs, and (whoops) just before the worst postwar recession begins.

  • August 2007: Bank of America invests $2 billion in Countrywide Financial, the nation’s biggest mortgage lender and loan servicer. It is a jumbo loser, dropping 57 percent in a few months’ time.

  • January 2008: Bank of America doubles down and announces a $4.1 billion acquisition of Countrywide. The timing is flawless, and the purchase is announced as the worst housing collapse in modern history is accelerating.

  • September 2008: Bank of America pays $50 billion for Merrill Lynch, including Merrill’s portfolio of toxic assets (along with some previously unannounced trading desk errors).

  On February 20, 2009, Bank of America’s stock hit a low of $2.53. Before the Countrywide acquisition went bust, Bank of America’s stock was at $52 (October 2007).

  As bad as those acquisitions may be, some were even worse than they appear. When Jamie Dimon, CEO of JPMorgan Chase, agreed to take Bear Stearns off the hands of the Federal Reserve, he managed to convince Ben Bernanke to backstop the transaction to the tune of $29 billion. It was a shrewd move, as Bear’s subprime and derivative losses have accumulated not to JPMorgan, but to the Fed. Similarly, Dimon waited for the FDIC to put Washington Mutual through the receivership process before acquiring the thrift in late September 2008.

  Bank of America CEO Ken Lewis was not quite as savvy. He failed to obtain a government guarantee at the time the Countrywide deal was done, and he vastly overpaid for Merrill Lynch’s thundering herd. Without the Fed’s explicit guarantee, he got precisely what a thundering herd of cattle leaves in its trail. He could have waited 24 hours for the firm to fail and then picked up assets for pennies on the dollar, as Barclays did with Lehman’s asset management unit.

  Instead, Lewis bought the firm lock, stock, and barrel—and the barrel was stuffed with nonperforming assets. You didn’t need the benefit of hindsight to see this was a disaster waiting to happen.

  And so September 2008 ended with the stock market in hasty retreat. The already weak stock market plummeted on September 29, 2008, when the House of Representatives rejected the $700 billion bank bailout. The Dow Jones Industrial Average suffered its largest-ever point decline in reaction, falling 777 points, or 7 percent. The S&P 500 took an 8.75 percent hit, its worst decline since the 1987 crash. The NASDAQ lost more than 9 percent, as Google fell below $400 for the first time in two years and Apple tumbled 18 percent. The following week (ending October 10) was the worst in the market’s history. The Dow plummeted 20 percent to break under 8,000. One year earlier, the blue-chip index had been north of 14,000.

  With markets in turmoil, it mattered little how the megabanks had been created—whether carefully assembled over two centuries or haphazardly over two decades. Their past was irrelevant, their present riddled with collapsing subprime derivatives, their future bleak. With too little capital and too much bad debt, management had no idea what to do.

  Out of this maelstrom arose the Troubled Assets Relief Program (TARP): It was Treasury Secretary Hank Paulson’s plan to save the big banks. Inject capital, buy the junk off their balance sheets, spend trillions in taxpayer monies to protect the banks from their own actions. Initial cost was $700 billion. By March 2009, the costs of this plan would rise to $2 trillion.

  Why spend such an enormous amount of money rescuing such reckless, poorly run financial institutions? Perhaps the backgrounds of the men behind the bailouts are instructive.

  The two Treasury secretaries of the bailout era each provide a cautionary tale for future presidents. Hank Paulson came to Treasury from Goldman Sachs. Over the course of three decades, he had risen through the ranks to become Goldie’s CEO. His successor at Treasury is Timothy Geithner, the former president of the New York Federal Reserve Bank (or, as the credit trading desks call him, Turbo Tax Timmy). The New York Fed is a private Delaware corporation, owned in large part by its primary dealers—the 20 or so banks that purchase government Treasuries. 19 (Geithner is also a protégé of another Treasury secretary, Robert Rubin.) Paulson and Geithner are both creatures of the banking world (and both are Dartmouth alums). They didn’t seem to make a smooth transition from being employed by private banks to being employed by the president, working for the public.

  Verily, the danger of the sacred cow is revealed. Rather than pulling out all the stops to save the banking system, the Treasury secretary was flailing desperately to save the banks. All of Paulson’s energies were misplaced. That should come as no surprise, given his (and later, Geithner’s) background. They are bankers, first and foremost. As such, they do what most professionals do when their industry is under assault: protect the institutions. And if it happens to take ungodly amounts of taxpayer money to accomplish, so be it.

  The obvious solution—put the insolvent banks into FDIC receivership, fire management, liquidate holdings, sell the assets off, wipe out shareholders, and pay the bondholders whatever was left over—was simply unthinkable.

  This is reflected in Paulson’s original TARP proposal. It was shockingly short on
details, calling for a tremendous expansion of the Treasury secretary’s powers, with no oversight or liability: 20

  The Secretary will have the discretion, in consultation with the Chairman of the Federal Reserve, to purchase other assets, as deemed necessary to effectively stabilize financial markets. Removing troubled assets will begin to restore the strength of our financial system so it can again finance economic growth. The timing and scale of any purchases will be at the discretion of Treasury and its agents, subject to this total cap.21

  For $700 billion, the country literally got a one-pager: no details, few specifics, and an enormous price tag. Whether it was hubris or something else entirely, it was emblematic of Paulson’s response to the banking disaster. There was no consistency to the decision making, no discernible thought pattern. Every choice seemed to be on the fly, off the cuff, and by the seat of his pants. Hank Paulson’s Treasury department was little more than an “adhocracy.”

  Is this anyway to run a Bailout Nation?

  A modified version of the TARP, sweetened with pork to assure passage, flew though the House and Senate in early October. It was quickly signed into law by President Bush.22 Treasury Secretary Paulson called the government bailout plan “extensive, powerful and transformative.”23

  Shortly after the TARP was passed, Paulson added to its original intent—to use the funds to buy toxic debt from the banks—with a mishmash of programs and schemes, including:• Injection of $250 billion into the nation’s banks.

  • The U.S. government would guarantee new debt issued by banks for three years; this was designed to prompt banks to resume lending to one another and to customers.

  • The FDIC offered unlimited guarantees on bank deposits in accounts that don’t bear interest—usually those of small businesses.

  • The Treasury took preferred equity stakes in the nation’s largest banks (Goldman Sachs, Morgan Stanley, JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Bank of New York Mellon, and State Street).

  Beyond those massive expenditures, Uncle Sam was to “temporarily guarantee $1.5 trillion in new senior debt issued by banks, as well as insure $500 billion in deposits in noninterest-bearing accounts, mainly used by businesses.”24

  All told, the costs of the “bailout package came to $2.25 trillion, triple the size of the original $700 billion rescue package.”25

  Now for the punch line: It was all an elaborate ruse, a coverup of the fact that Citigroup was busted.

  As of October 2008, the other banks, while somewhat worse for wear, neither wanted nor needed the capital injection. None of them were in the same trouble as Citi. Even Bank of America’s problems via Merrill Lynch wouldn’t become acute until December 2008. Washington Mutual, the most troubled on the list, had already been put into FDIC receivership the month before.26 JPMorgan bought WaMu from the FDIC for under $2 billion, and Wachovia was swept up by Wells Fargo for about $15 billion. Thanks to a change in the tax law, Wells Fargo got to shelter $74 billion in profits from taxation. Instead of the FDIC absorbing a few billion in losses from Wachovia’s bad assets, the taxpayers lost 35 times that amount. 27

  At the time of Paulson’s gambit, only Citigroup was in dire straits. Paulson apparently feared what might happen if the rest of the world realized Citi was insolvent at the same moment the markets were cratering. Rather than stigmatize one reckless, poorly managed, overleveraged bank, the Treasury secretary decided to paint the entire banking sector with the same slanderous brush.

  The solvent bankers chafed at the latest TARP plan. Paulson called a meeting of heads of the biggest banks—it was reminiscent of the Long-Term Capital Management meeting at the New York Federal Reserve, with a touch of The Godfather thrown in. The Treasury secretary presented his plan as an offer the banks could not refuse. “It was a take it or take it offer,” said one person who was briefed on the meeting, speaking on condition of anonymity because the discussions were private. “Everyone knew there was only one answer.”28

  What a bizarre twist on the film’s famous horse head scene: “Take this $25 billion or else.”

  As 2008 progressed, the usual snafus and foul-ups of any huge government program followed: The Federal Reserve refused to identify who were the recipients of nearly $2 trillion of emergency loans funded by taxpayers;29 (Bloomberg sued the Fed under the U.S. Freedom of Information Act for a full disclosure) .30 A GAO report criticized the TARP’s internal controls.31

  But the real outrage began once financial institutions began using TARP bailout money to pay executive bonuses. The firms, of course, say it’s different money and bonuses are key to retaining top employees. But if you need to come to the government for a handout, shouldn’t your executives forgo a bonus? Or, as was the case in Europe, shouldn’t the government make canceling bonuses a condition of getting aid?

  Adding to the growing anger were new tax giveaways to bailout recipients. The Treasury department provided a tax break to banks involved in acquisitions that could amount to $140 billion. The Washington Post revealed the IRS quietly made changes to the tax code issued on September 30, while Congress was debating the $700 billion TARP bill.32

  All the while, Citi and Bank of America executives kept returning for more handouts. They may not have been very good at managing risk, but they sure were quick studies. After the first round of TARP money, it became apparent that their capital-raising options were limited. Following the first $25 billion in TARP cash, Citi went back for another $20 billion, and then the big one—$250 billion in full faith and credit from the U.S. government guaranteeing its toxic assets. Bank of America—a.k.a. “Bank owned by America”—also came calling thrice: $25 billion, $20 billion, and then $300 billion in asset guarantees. The winner (and still champ) for multiple trips to handout junction remains AIG; it took four trips to wrangle a total of $173 billion of bailout green.

  Don’t you think they earned their bonuses for that?

  2009 was a new year . . . with a new president, a new Treasury secretary, and a new bailout plan. And as this book was going to press, Treasury Secretary Tim Geithner’s long-awaited successor to TARP was finally out. He chose to extend and replace the TARP with PPIP—a Public-Private Investment Program. Administered by the FDIC, the program’s focus is to move toxic assets—typically CDOs, mortgage-backed securities, and commercial real estate loans—off of the books of troubled banks.

  The PPIP has two unique twists. The first is the private-partnership aspect of it. The FDIC will lend qualified funds up to 7 times leverage to buy bank holdings. These funds need only put up $12 to purchase $84 worth of distressed assets via an auction. The United States is apparently going to use more leverage to work its way out of a situation created by using too much leverage. That seems a bit like trying to drink yourself sober.

  The second twist is the end run on Congress that the PPIP manages. Since it is administered by the FDIC and these are technically secured loans, no congressional approval is required.33

  Treasury has come up with prior clever ways to backdoor Congress. As Felix Salmon wrote on the New York Times Op-Ed page:

  It’s not the first time that Treasury has magicked billions of dollars from some hidden back pocket, just to avoid having to ask Congress for the money. In 1995, with Robert Rubin recently installed as Treasury secretary, Lawrence Summers, the deputy secretary, along with Tim Geithner, a deputy assistant secretary, wanted to bail out Mexico in the face of Congressional opposition. They found something called the Exchange Stabilization Fund, originally intended to stabilize the value of the dollar on world currency markets, and managed to repurpose it for another use entirely.34

  Just what the nation needs—another page from the playbook of Robert Rubin. Meet the new boss . . . same as the old boss.

  Who’s next? Ironically, this part of the chapter has been rewritten six times. Originally, it was about Fannie Mae, but then I had to switch it to Lehman Brothers, then AIG, then General Motors, now Citi.

  That was the last straw, f
or I began to wonder if it wasn’t me who was damning these companies by even thinking about writing them up.

  When the Detroit bailout occurred, I decided to swear off writing anything titled “Who’s Next?” Besides, it was no longer a valid viewpoint. Perhaps a more appropriate title might be “Who’s Left?” Rather than guess who is next, and thereby destroy that poor firm, I’d suggest you turn the page. Let’s see how we got into this jam in the first place.

  INTERMEZZO

  Idiots Fiddle While Rome Burns

  Sometimes I wonder whether the world is being run by smart people who are putting us on, or by imbeciles who really mean it.

  —Mark Twain

  Over the past two years of bailouts, the collection of clueless dolts, political hacks, and—oh, let’s just be blunt and call them what they are—total idiots continues to expand into an ever wider circle.

  While the republic burns due to the unsavory combination of incompetence, radical ideology, and casino capitalism, the clowns seem ever more determined to avoid any and all personal responsibility for the damage they have wrought. Instead, they flail about blindly, blaming everything and everyone—except their own horrific negligence.

  This is financial incompetence writ on a scale far grander than anything seen for centuries.

  As a nation, our institutions have failed us: Under Alan Greenspan, the Federal Reserve slept through the most reckless and irresponsible expansion of bank lending in history for reasons of ideological purity. As recently as March 2009 Greenspan actually contributed a Wall Street Journal op-ed renouncing any blame for the housing bubble.35 In addition to his unprecedented monetary policy, his nonfeasance in failing to perform the Fed’s regulatory role reached the point of criminal negligence long ago. History will be unkind to the Maestro.