Bailout Nation

by Barry Ritholtz

  As a nation, we have a choice to make: Either we place some reasonable regulations upon the banks and investment houses or we allow the vagaries of the free markets to punish those who trade with, or place their assets in, the wrong institutions.

  If the taxpayers are ultimately on the hook for the losses of the financial sector, do they not have the right to insist that the riskiest of behaviors be restricted? If a business model is so inherently flawed that it causes a worldwide economic collapse, shouldn’t the behavior that contributes to that collapse be prevented?

  There is no middle ground; it is an either-or choice. But for God’s sake, we cannot suffer the worst of both worlds—we cannot allow banks the freedom to make horrific but preventable mistakes (i.e., lending money to those who can’t possibly hope to pay it back), but then expect the taxpayers to foot a multitrillion-dollar bill when they fail. It is not the responsibility of the taxpayer to act as guarantor to every counterparty, warrant all hedge funds’ trades, and insure every Wall Street transaction.

  That’s not capitalism, it’s not socialism, it’s not regulation, and it sure as hell isn’t what free markets are. Our language is insufficient to describe this hodgepodge system, this random patchwork of casino capitalism, cronyism, and politics as usual. Ideological idiocy is the only phrase I can muster that has any resonance with the daily insanity.

  We cannot have privatized profits and socialized risks.

  We have entered into a fit of Orwellian madness: American capitalists, long the globe’s leading advocates for free markets, have become socialists. Halfway around the world, Chinese Communists have picked up the baton and are moving rapidly toward a form of capitalism. Ironically, it is the once-Communist nations—China and Russia—that hold most of Fannie’s and Freddie’s damaged paper.

  Hey, comrades, who’s selling the rope to whom?

  Perhaps the government’s rescue of “Phony and Fraudy,” AIG, Bank of America, Citigroup, et al. is not so much a bailout of corporate America as it is a desperate attempt to stay in the good graces of our friendly global bankers. As the world’s largest debtor nation, we have come to depend on the kindness of strangers—be they the Japanese, Europeans, oil-rich Gulf states, or even former Communists.

  Back in the United States, something beyond cognitive dissonance is occurring—a full-blown case of dementia is unfolding in the public sphere. When this era of excess and absurdity is looked back upon in the future, the question I expect to be asked most is not why many of these people weren’t jailed for their financial felonies. Rather, I expect future historians to wonder why so many of these folk weren’t heavily medicated and placed in protective custody, for the only rational explanation for their statements and behaviors is that they have gone so far round the bend as to be completely and totally insane.

  Massively overleveraged companies? Blame short sellers.

  Wildly undercapitalized financial firms? Blame rumors.

  Heinously poor corporate management? Blame the messenger.

  IndyMac goes belly-up, having lost $900 million in 2008 alone. Its shares fell 87 percent in 2007 and then its value dropped (on top of the prior year’s utter collapse) another 95 percent in 2008. The stock was trading on the pink sheets for under a nickel as of mid-December.

  Some estimates of the total bad loans made by IndyMac are in the neighborhood of $30 billion—and the head of the Office of Thrift Supervision (OTS) blames a senator who is investigating how much of the FDIC’s $53 billion fund the rescue is going to eat up! The towering incompetence of OTS is incomprehensible, but it is its colossal gall that is truly stupefying.

  Perhaps someone is running around Washington, D.C., with a ball-peen hammer, whacking senior government officials on their skulls. Blunt head trauma is a better explanation for the absurdities proffered than anything else we have heard. Books will be written about this period of time, and our descendants will wonder in awe as to how this was allowed to happen. Tulip mania’s got nothing on us!

  It’s not just the total dollar value of the losses that has exceeded all other global fits of financial madness combined; rather, it’s how so many warning signs were so blithely ignored by so many and for so long. Future authors and historians will wonder: What was wrong with these people? Did the antibiotics in the food supply drive them mad? Did the high-fructose corn syrup compromise their ability to think? Was it some form of viral plague? ’Roid rage? What else could have created such mass delusion among not just the populace, but their leadership and institutions? Once-proud investment houses have been replaced with casinos. Concepts such as risk management and capital preservation have become passé. Myths pass for wisdom, heuristics for knowledge.

  Adam Smith would not know whether to weep or retch were he alive to see this today.

  Part V

  POST-BAILOUT NATION

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

  Chapter 19

  Casting Blame

  The human mind cannot grasp the causes of phenomena in the

  aggregate. But the need to find these causes is inherent in man’s soul.

  And the human intellect, without investigating the multiplicity and

  complexity of the conditions of phenomena, any one of which taken

  separately may seem to be the cause, snatches at the first, the most

  intelligible approximation to a cause, and says: “This is the cause!”

  —Leo Tolstoy

  War and Peace

  Book IV, Part 2, Chapter 1, first paragraph

  Now we come to what should be the most satisfying part of our exercise: assessing blame and assigning responsibility to all of the ne’er-do-wells who got us into this mess.

  Fans of schadenfreude, brace yourselves: There are so many players responsible for the housing boom and bust, the credit crisis, and the financial collapse that it is difficult to blame any one person—it is a broadly shared culpability.

  There are many who were rooting for the blame to be assessed to a given political party, a particular player, or a specific act of malfeasance. In reality, the situation is far more complex. The responsibility is widespread, and there is plenty of shared blame. Joseph Stiglitz, the Nobel Prize-winning professor of economics at Columbia University, called it a “system failure”—not merely one bad decision, but a cascade of many decisions that produced tragic results.1

  The recklessness and incompetence seemed to be a team effort. With no single villain and so much blame to go around, I fear missing some person or event that significantly contributed to the mess now enveloping the global economy.

  That does not mean we cannot attempt to highlight those whose contributions have disproportionately led to the final catastrophe. After exhaustively reviewing this debacle, I assess responsibility in order of culpability as follows:• Federal Reserve Chairman Alan Greenspan

  • The Federal Reserve (in its role of setting monetary policy)

  • Senator Phil Gramm

  • Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings (rating agencies)

  • The Securities and Exchange Commission (SEC)

  • Mortgage originators and lending banks

  • Congress

  • The Federal Reserve again (in its role as bank regulator)

  • Borrowers and home buyers

  • The five biggest Wall Street firms (Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Goldman Sachs) and their CEOs

  • President George W. Bush

  • Presidents Bill Clinton and Ronald Reagan

  • Treasury Secretary Henry Paulson

  • Treasury Secretaries Robert Rubin and Lawrence Summers

  • FOMC Chief Ben Bernanke

  • Mortgage brokers

  • Appraisers (the dishonest ones)

  • Collateralized debt obligation (CDO) managers (who produced the junk)

  • Institutional investors (pensions, insurance firms, banks, etc.)
for buying the junk

  • Office of the Comptroller of the Currency (OCC); Office of Thrift Supervision (OTS)

  • State regulatory agencies

  • Structured investment vehicles (SIVs)/hedge funds for buying the junk

  Let’s look at the most significant players.

  Many of the monetary and regulatory errors that directly led to the present crisis are attributable to the man they once called the Maestro. Under the guidance of Alan Greenspan, the Federal Reserve abused monetary policy, ignored critical lending issues, and failed to regulate new and irresponsible banking products.

  Several of Greenspan’s policies proved to be wildly misguided: the regular interventions to protect asset prices and bail out investors, the irresponsibly low rates after the post-2000 crash, and his nonfeasance in supervising lending. Most of all, it was his deeply held philosophical conviction that all regulations are bad, and are to be avoided at all cost. We now know what that cost is, and it’s astronomical.

  Alan Greenspan had spent his years at the Fed operating under an enormous philosophical misconception, as the former Fed chairman admitted in testimony before Congress on October 22, 2008: “I made a mistake in presuming that the self-interest of organizations, specifically banks and others, was such as that they were capable of protecting their own shareholders.”2

  Based on Greenspan’s worldview, the events of the present crisis and many others that occurred over the past decade were impossible, given that the so-called wisdom of the free markets would prevent them. Only they did occur. Greenspan’s faith was wildly misplaced, and the taxpayers are that much poorer for it. If we have to put our finger on the single intellectual flaw that underlies the housing collapse, the credit crisis, the economic recession, and the problems with toxic paper, it would be a misplaced belief that markets could self-regulate. One is reminded of the Benjamin Disraeli quote: “He was distinguished for ignorance; for he had only one idea, and that was wrong.”3

  Given how enamored Greenspan was of free markets, it is increasingly difficult to reconcile many of the actions he undertook. The very concept of the champion of free markets repeatedly intervening in their inner workings is a contradiction of enormous proportions. It is a catch-22 worthy of Joseph Heller.

  It is beyond my capacity to decipher how Greenspan justified his internal conflicts, but at least he later admitted that his primary philosophy “had a flaw.” Unfortunately, his flawed economic belief system colored nearly every policy he enacted as Federal Reserve chairman. Most of today’s crises trace their roots in part to his policies.

  In 1836, Mayer Rothschild wrote, “Give me control of a nation’s money, and I care not who makes the laws.” If only that prescient warning had been heeded by the Federal Reserve. It might also serve as an admonition for Ben Bernanke, the current Fed chief.

  The Greenspan era lasted 20 years (1987 to 2006). The Federal Open Market Committee (FOMC) must take responsibility for following him so obsequiously, especially in the latter years of his reign. Exceptions include Edward Gramlich, whose timely warnings about subprime and early concern with predatory lending were on target and ignored. So, too, William Poole deserves credit for his many cautionary warnings about the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. To our chagrin, neither man was paid much heed by Greenspan or the FOMC.

  The single biggest fault found within the Fed is its inability to fulfill its responsibilities as bank regulator. The Fed not only failed to supervise lending institutions, but it also ignored the most significant shift in lending standards in the history of human finance. The results were disastrous.

  The Fed, as an institution, failed the nation. It directly encouraged mass speculation. It failed to supervise innovative new forms of lending. The inflationary spiral that sent oil soaring from $16 in 2001 to $147 per barrel seven years later, along with other commodity and food prices, is attributable to its radical rate-cutting regime.

  The current chairman, Ben Bernanke, deserves partial blame for the Fed’s slumber during this inflationary spike. A renowned student of the Great Depression, it was then Fed Governor Bernanke who raised warning flags about deflation after the tech bubble burst. He provided the framework and intellectual cover for Greenspan’s ultra-easy money circa 2001 to 2003.

  As Fed chair, Bernanke was terribly slow to realize the subprime mortgage crisis was anything but “contained.” By the time he did awaken to the crisis in August 2007, he responded with a series of programs that pushed the envelope of legality, dramatically expanded the Fed’s balance sheet, and put the central bank’s credibility at risk.

  Of all the institutions that played a part in the current crisis, none had a more prominent role than the Federal Reserve.

  The first telegraph message ever sent, “What hath God wrought,” reflected Samuel Morse’s deep concern for the repercussions of his own actions. If only Phil Gramm were so similarly introspective.

  While Congress deserves much blame for the crisis, no one elected official looms larger in our drama than Gramm. He was the senator behind the Commodity Futures Modernization Act of 2000 (CFMA), and spearheaded the repeal of Glass-Steagall. The legislation that overturned it bears his name (Gramm-Leach-Bliley Act). Both legislative acts were WMDs—weapons of monetary destruction. These time bombs eventually led to mass financial destruction.

  Barbara Roper, director of investor protection for the Consumer Federation of America, said: “Since the financial meltdown, people have been asking, ‘Where was Congress? Why didn’t they see this coming? Why didn’t they provide better oversight?’” We now know the answer is that members of Congress were too busy pursuing a radical deregulatory agenda. Instead of protecting investors and defending the overall economic system, their misplaced concern was how to make life easier for Wall Street.

  During the late-1990s era of deregulatory dogma, the GOP controlled the House and Senate, and Gramm was the point man on issues of deregulation. The Texas Republican was aided in his deregulatory quest in part by Senator Chuck Schumer, a New York Democrat. Perhaps Schumer represented the interests of New York’s Wall Street too well.

  To this day, Gramm still claims deregulation had no impact on the housing collapse or the credit crisis. The exempting of derivatives from all regulation—including state insurance supervision, reserve requirements, or clearing information—was not at all related to the eventual problems, according to Gramm. He remains unrepentant as to his impact. Placing any blame on deregulation was simply “an emerging myth,” the retired Texas senator has said. Deregulation “played virtually no role” in the economic turmoil engulfing the globe, Gramm claimed in November 2008.4

  What shameless nonsense. You will not come across a greater example of cognitive dissonance in your lifetime. Gramm’s inability to recognize the results of his legislative handiwork is a function of a flawed mind protecting itself from the harsh reality. The inconsistency of his deeply held philosophy and the results thereof are logically incomprehensible to Gramm’s conflicted brain. If he were ever to admit the truth, he would likely go stark, raving mad.

  I’ll give Alan Greenspan this much credit: At least he has come clean about the “flaw” in his philosophy. Gramm, by contrast, remains committed to his tainted brand of unregulated, free-market absolutism. Of all the players in the tragic drama that has unfolded, he alone remains unrepentant. Gramm is Bailout Nation’s most intellectually bankrupt citizen. Like Greenspan, Gramm had only one idea; unlike Greenspan, he had no comprehension it was wrong.

  F rom Ronald Reagan to George W. Bush, each president of the past 25 years bears some responsibility for contributing to the belief that we can let markets govern themselves.

  Of the four, President George W. Bush has the greatest culpability—not because this crisis happened on his watch, though that should be reason enough. The more significant basis of his culpability is that he shared Greenspan’s and Gramm’s radical belief system—that markets could police themselves,
that all regulation (indeed, most government) was inherently bad. This philosophy colored all of Bush’s appointments to key supervisory positions, as well as his legislative agenda.

  Former Presidents Clinton, George H.W. Bush, and Reagan each have some responsibility, but far less. The first President Bush is the least culpable. Reagan chose not to reappoint Fed Chair Paul Volcker, replacing him with Alan Greenspan. Regardless of other actions, this forever taints the legacy of the Gipper. However, in many ways, Ronald Reagan is the intellectual father to what became the radical deregulatory movement. As the Washington Post noted, “Ronald Reagan’s unwavering belief in free markets—and his distaste for regulation that put hurdles in the way of entrepreneurs—had steadily spread through the government. ‘The United States believes the greatest contribution we can make to world prosperity is the continued advocacy of the magic of the marketplace, “Reagan told a U.N. audience’” in 1986.

  While some partisans have tried to paint the crisis as a purely Republican debacle, history informs us otherwise. Yes, the GOP did control Congress from 1994 to 2006. However, President Clinton, a Democrat, bears a significant responsibility also. He and his Treasury secretaries, Robert Rubin and Lawrence Summers, all bought into the deregulatory mantra. Clinton, Rubin, and Summers are right there with W. in the hierarchy of proximate causes of the debacle.

  Until recently, Rubin has escaped much blame for both supporting Glass-Steagall’s repeal as Treasury secretary and his participation in Citigroup’s failure as a long-standing board member.5 Citibank was one of the main proponents of repealing Glass-Steagall, and Rubin joined the bank’s board shortly after leaving Treasury in 1999—quite an unsavory turn of events.6