This was the part of AIG that was nothing more than a giant structured finance hedge fund. Despite the fact this hedge fund had no credit rating, no supervision or regulatory oversight, and no reserves, it somehow managed to trade off of the good name—and triple-A rating—of the regulated half. Counterparties treated it as if it were triple-A, regulated and guaranteed by the government.
AIG “exploited a huge gap in regulatory oversight” to operate a hedge fund on top of its core insurance business,” as Fed Chairman Ben Bernanke testified before Congress on March 3, 2009.
This was nothing more than a giant fraud, perpetrated by the people who were running AIG’s structured products division. This side of the firm was exempt from any form of regulation or supervision, thanks to the Commodity Futures Modernization Act.
As you might have guessed by now, this portion of AIG is the insolvent half. As taxpayers, you should be asking yourself: Why have we paid $173 billion to bail out the speculation and derivative bets?
Of all the many horrific decisions that Hank Paulson made as Treasury secretary, the $143 billion to AIG may likely be his worst. And his successor at Treasury, Tim Geithner, is not too far behind, having already doled out $30 billion to AIG.
It’s highly unlikely we’re getting the money back. The main reason for the cash infusions so far seems to be bailing out AIG’s counterparties, the firms for which AIG provided so-called insurance on collateralized debt obligations and other derivative instruments. Given that few of these CDOs are ever going to get back to par and that some of the policies have 30-year durations, we’ve only just begun the process of bailing out AIG and its policyholders, who have claims that some estimate run into the $450 billion range.
What should have been done? When AIG was nationalized, it should have immediately spun out the good, solvent life insurance company, which is a highly viable stand-alone entity. The hedge fund should have been wound down in an orderly fashion. Match up the offsetting trades; wind down the rest. End of story.
The credit default swap gamblers had no reasonable expectation that anyone other than the firm they placed their bet with was going to make it good. If they happened to place a bet with a firm run by incompetent management, well, then, that becomes their problem, not the government’s. If they selected as a counterparty another hedge fund that did not reserve for the losses and was unable to make payments, well, that was a choice they made. It certainly is not the obligation of the taxpayer to assume the risk. As of March 2009, the bill for AIG is $173 billion—every last penny of which has been a needless waste.
At least as far as the taxpayers are concerned it’s a waste. To the various counterparties, it was manna from heaven:
“AIG, under pressure from lawmakers to show how its bailout cash was spent, disclosed on March 15 that $105 billion flowed to states and banks, led by Goldman Sachs Group Inc., Société Générale SA and Deutsche Bank AG,” Bloomberg reported.
“Banks that bought credit-default swaps or traded securities with AIG got $22.4 billion in collateral, $27.1 billion in payments from a U.S. entity to retire the derivatives and $43.7 billion tied to the securities-lending program, AIG said. States, including California and Virginia, got $12.1 billion tied to guaranteed investment contracts.”5
Among those that have partaken of Uncle Sam’s munificence were Goldman Sachs, Merrill Lynch, Morgan Stanley, Wachovia, and Bank of America. You might be surprised to learn that the rest of the charity recipients were overseas banks: Germany’s Deutsche Bank and French bank Société Générale, as well as Calyon/Crédit Agricole (France), Danske (Denmark), HSBC (UK), Royal Bank of Scotland, Banco Santander (Spain), Lloyds Banking Group (UK), Barclay (UK), and Rabobank (Netherlands).
Not only are U.S. taxpayers subsidizing the bad decisions made by executives in the United States, but we are also bailing out the poor judgment of the rest of the world.
Adding injury to insult, “some of the billions of dollars that the U.S. government paid to bail out [AIG] stand to benefit hedge funds that bet on a falling housing market,” the Wall Street Journal reported.6
In short, what looks like a government backdoor bailout of major financial institutions with AIG serving as the middleman is, in part, actually a bailout of private speculators. Hedge funds don’t bear the responsibility for the collapse of our financial system, as some contend, but do they really deserve to double-dip on the real estate bust at taxpayers’ expense?
Hence, the call for nationalization is not a move toward socialism, but an attempt to prevent casino capitalism from bankrupting the country. (See Figures 22.1 to 22.5.)
Real capitalists nationalize; faux capitalists look for the free lunch.
Figure 22.1
Source: Strip’s classic designs © 2008 Stereohell/JCC
Figure 22.2
Source: Strip’s classic designs © 2008 Stereohell/JCC
Figure 22.3
Source: Strip’s classic designs © 2008 Stereohell/JCC
Figure 22.4
Source: Strip’s classic designs © 2008 Stereohell/JCC
Figure 22.5
Source: Strip’s classic designs © 2008 Stereohell/JCC
Postscript
Advice to a New President
There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
—John Kenneth Galbraith
I‘ve detailed many of my own thoughts throughout the book, but I have two additional ideas. The first is simple: We need to start teaching basic financial literacy in public schools. That so many people willingly signed on the dotted lines for mortgages they could not possibly afford points to the terrible lack of basic financial knowledge.
Second, quantitative methods have become extremely important on Wall Street. Their ability to identify aberrational patterns and find trading opportunities is one of the biggest growth areas in finance today. It is a technique that could be easily adapted by the Securities and Exchange Commission for indentifying fraud. Perhaps the SEC could impanel practitioners, academics, mathematicians, and quants to develop a plan to use the tools of quantitative analysis to ferret out Ponzi schemes such as Bernie Madoff ’s before they cause billions in losses and ruin lives.
These past 300 or so pages have criticized, castigated, and even castrated many of the worst citizens of Bailout Nation. For this last chapter, let’s employ a different approach.
One of the terrific things about working on Wall Street is that you meet many astute, creative, intelligent people. Contrary to recent events, not everyone who works on the street of dreams is a reckless speculator, overcompensated executive, or Ponzi-schemist. Indeed, the vast majority of Wall Streeters are hardworking souls who are deeply upset about the way their industry has been hijacked and what that has done to our nation. They have many insights about the credit crisis, housing collapse, costly bailouts, and the ugliest recession of our lifetimes. And as you will see, they are not at all shy about expressing their views on how to fix the current mess, either.
Rather than ending our survey of malicious incompetence on a downbeat note, I would like to use this opportunity to present smart ideas from some of the best and brightest I know, offering constructive advice to a new president.
Their suggestions fall into a few broad categories: resolving the housing and credit mess, fixing the economy, improving monetary policy, energy innovations, and (for lack of a better phrase) presidential leadership.
Doug Kass manages a short hedge fund. (His optimism is such that he recently opened a long-only fund, too!) Doug warned early on that leverage, derivatives, and overvalued stocks were a dangerous combination. Now that his worst-case scenario has come true, he has an intriguing idea. Given that the problem in the housing market is one of excess supply relative to limited demand—too many ho
uses, too few buyers—why not bring in more home buyers?
Doug writes: “For a long time the United States has had a policy of issuing green cards rapidly to foreigners willing to invest in a business here. If the U.S. had a new policy to issue rapid green cards (with all the usual security checks) to immigrants willing to buy a house or apartment for $200,000 or more and to eliminate overseas earnings from tax for 15 years, we could get a flood of good immigrants, with skills and assets, providing an immediate catalyst in soaking up the surplus of unsold housing inventory. These policies would cost the United States very little, and would bring in directed capital for housing and employment. U.S. residency/citizenship (sans the iniquitous foreign earnings tax policy) would be highly prized and desired among foreigners anxious to live in a stable society with opportunity, compared to the growing instability over much of the world.”
Ed Easterling, president of Crestmont Research, explains why this might work: “The most significant intermediate economic issue is the excess supply of housing—currently more homes than qualified home buyers. Since we can’t impact the supply of homes in the short run, we need to increase the availability of qualified homeowners. One solution would be to introduce a 10-year work visa program for foreigners who either have college degrees or agree to start a business (and can show that they have the capital to fund it). Both of those groups would be qualified to purchase a full range of excess housing stock and to contribute significantly to the economy.”
And Michael Covel, producer of the documentary film Broke: The New American Dream, adds: “Increasing the population somehow or another is the only thing that can fix this mess. We need more people. Give tax breaks and dual passports immediately to those folks who pass an economic means test. Open the borders to money.”
Newsletter writer John Mauldin concurs: “Bring in one million fairly affluent, legal immigrants, and you put a floor (and maybe some bounce) in the housing markets at all levels. They will figure out how to work and pay taxes (which we need). Many will start new businesses that will create jobs. With excess housing inventory gone, home building can start again, as well as a lot of related durable goods purchased to furnish those homes. And that is with just one million new immigrants. What if the number were two or three million?”
CNBC host Dylan Ratigan has a novel idea: He wants to update the GI Bill. Ratigan calls for a $50,000 housing tax credit provided to all veterans of the Iraq/Afghanistan wars and to every active member of the U.S. military. The idea is to help both the housing market and the veterans. And he advises, make it tradable. If they don’t want to buy a home, they can sell the credit to someone who does. It’s more than an effort to prop up the housing market—it’s a benefit for the servicemen and servicewomen in the armed forces.
Asset manager Jim Welsh advises preventing a repeat of mortgage securitization problems. In the future, any institution that originates a loan that will be securitized should be (1) required to keep 10 percent (or some significant percentage) of any loan that is securitized and (2) absorb the first X dollars of loss, rather than the loss going to the investors who purchased the securitized loan. Lenders will be far more attentive to maintaining good lending standards if they are at true risk of loss.
Jim further notes that we have a size problem. The credit crisis has resulted in a major consolidation among our largest financial institutions, with more than half of all nonfinancial debt (debt held by households, nonfinancial companies, and government) held by the top 15 institutions. The SEC, with the aid of Congress and the Federal Deposit Insurance Corporation (FDIC), should mandate that the 20 largest financial institutions be broken up into smaller firms within 10 years. Getting rid of these behemoth firms would go a long way toward preventing another financial meltdown.
Scott Frew runs Rockingham Capital Partners, a long/short hedge fund. He, too, foresaw a credit crisis before most economists and policy makers recognized it. His solution? “Bite the bullet. Recognize the insolvency of these banks, forcing them into receivership at the hands of the FDIC (a much more palatable framing than nationalizing them). Let’s start dealing with the consequences sooner rather than later (as Japan did).”
The consequences from this action would be substantial: wiping out equity, preferred shareholders, and the subordinated debt. This action would have major ripple effects—including additional bankruptcies.
However, Scott argues that it is a necessary evil: “Pushing the big banks (and AIG needs to go there as well) into fully nationalized mode doesn’t solve our problems by any means; it is merely the first step—but a step without which we can’t make much progress—along a very difficult road. The extent of the deleveraging that we have to undergo, not simply among the banks, but by households and nonfinancial corporations as well, will take years to happen under the best of circumstances. My goal is putting banks in a position from which they are again able to lend.”
On a related note, Robert Lenzner of Forbes suggests: “Get together a FASB-like institution for the SEC; populate it with wise men and lions with no axes to grind, such as Paul Volcker, Felix Rohatyn, and John Whitehead; and decide how to handle the treatment of the bank losses.”
Stock Trader Almanac editor Jeffrey Hirsch suggests a Manhattan Project for energy technology. We have seen only incremental improvements in technologies, such as battery storage, solar energy conversion, and internal combustion efficiency. What we need is a breakthrough on a fundamental physics level—the sort of thing that only government can fund over long periods of time.
Silicon Valley executive Jeff Weitzman (Yahoo!, Coupons.com) adds, “With the billions that we dumped into AIG alone we could, for example, transform the solar industry: Subsidizing solar panel installations would at once pump money directly into the economy in the short term, significantly reduce our reliance on imported energy in the medium term, and push solar over the line of grid parity cost-effectiveness, creating a domestic industry that will export energy-producing equipment and create jobs in research, engineering, manufacturing, and more. We have to spend enough to send these industries into overdrive, setting ourselves on a course to transform our economy in a relatively short period of time.”
Brian Gongol is a sales engineer, small-business owner, and radio talk show host. He thinks we can jump-start the nation’s innovative energy entrepreneurs via inducement prizes. He wants the government (or a wealthy private benefactor) to offer $1 billion cash prizes for each of these energy innovations:• Mass-produced solar roof shingles at a comparable cost to conventional shingles.
• Automobile engine modification that increases fuel efficiency by 10 miles per gallon for less than $1,000.
• Wallpaper-like insulation that increases the heating/cooling efficiency in homes.
• Reduction of transmission losses from power plants by 10 percent for less than the cost of the recovered power.
For a billion dollars each, it’s virtually certain that someone or some organization would enthusiastically start seeking answers to each of these questions. The results would concentrate the diffuse social benefits of positive discoveries.
The simplest idea comes from James Altucher, managing partner, Formula Capital. James suggests: “No income taxes for one year. It’s the most immediate way to make people feel wealthier and give them more confidence in the economy. The result will be new businesses started, a return of the multiplier effect in the economy, and over time much greater tax revenues.”
Ned Davis (of Ned Davis Research) notes, “If President Obama wants to follow through on his pledge of fundamental change and trickle-up economic theory, I would have the government increase fixed investment in proven technologies with visible multipliers, and work with other countries to improve trade and financial stability, instead of providing bailouts. By putting out the prospect of new jobs, the government will help the future look more hopeful.”
A few of Ned’s ideas are:• Installing modern equipment and software to make government more efficie
nt, including the Pentagon.
• Improving transportation infrastructure, including bridges, roads, and mass transit to help Americans commute more safely, efficiently, and quickly.
• Developing nuclear, solar, wind, and other alternative energy facilities to cut our foreign energy dependence, which may reduce energy price volatility and help lower energy costs down the road. Upgrading the transmission grid.
• Improving water infrastructure, including drinking water, wastewater, dams, and ports.
Ned’s bottom line is that a very strong correlation exists between gross domestic investment and nominal gross domestic product (GDP) (see Figure PS.1). If we need more stimulus, let it be directed toward needed investment, not bailouts.
Figure PS.1 Investment and Nominal Changes (Five-Year Percent Changes)
SOURCE: Courtesy of Ned Davis Research
An overlooked economic fix would be to help the cash-starved state and local governments. That idea comes from David Rosenberg, the North American economist for Merrill Lynch. In a recent missive to Merrill’s clients, David noted that “the economy is in dire need of a major positive exogenous shock.” His idea: “The White House should instruct Congress to dole out a $1 trillion zero percent long-term loan to the beleaguered state and local governments that are being forced to cut back services and raise taxes at the worst possible time. What is not open for debate is the state of the economy, and we can no longer just label this a recession after the latest string of shockingly negative employment reports. The government has to declare war right now . . . against this modern-day depression.”
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