by Nomi Prins
Besides off book bank shenanigans and complex securities, forces outside the traditional investment bank world have also aided our financial crisis. Recently, the number of hedge and private equity funds and the pool of money they control in the market have grown substantially. These funds were unregulated and enjoyed special tax advantages, such as paying the IRS at the capital gains rate of 15 percent, instead of at the normal person or corporate rate of 35 percent of the profits they made.27
According to finance historian Niall Ferguson, “there were just 610 hedge and equity funds with $39 billion in assets in 1990. By the end of 2006, there were 9,462 of such funds with $1.5 trillion in assets under management.”28 That’s a lot of money acting with no rules. Plus, those hedge funds can borrow, or leverage, substantially against their assets. In addition, hedge fund head honchos make 20 percent of all returns and charge 20 percent fees simply for the privilege of taking investor money.
I’ve always wanted to know exactly how much leverage is out there, but there’s no good source. The company Hedge Fund Research is considered the authority in the hedge fund field, so I thought it might know. But it turns out that this firm doesn’t. The only leverage information it has is culled directly from a particular fund’s strategy. Hedge Fund Research doesn’t have the information to compile an overall leverage figure for the industry.
In other words, the hedge fund managers don’t even let the experts know how much they borrow, using whatever assets they have as collateral. It’s part of their “strategy.” If they told, maybe all of their customers would know their secret and put their money somewhere else. And the government has never requested this information. So, there we are, with another pocket of borrowing and no transparency.
In 2007, more than $194.5 billion in capital flowed into the unregulated hedge fund business, setting a new record and bringing total assets under management to $1.87 trillion.29 The amount of assets slowed slightly in 2006 but chugged along again the following year.30 The scary part wasn’t even the total assets under management, it was the secret—and still unknown—leverage behind them.
Expensive Failure
By summer of 2009, the price tag for the federal government’s bailout of the banks (including all federal loans, capital injections, and government loan guarantees) stood at approximately $13.3 trillion, roughly dividing into $7.6 trillion from the Fed, $2.5 trillion from the Treasury (not including additional interest payments), $1.5 trillion from the FDIC (including a $1.4 trillion Temporary Liquidity Guarantee program [TLGP] initiated in October 2008 to help banks continue to provide lending to consumers), a $1.4 trillion joint effort and a $300 billion housing bill.31 This number is so huge, it is almost meaningless. But by comparison, $13.3 trillion is more money than the combined costs of every major U.S. war (including the American Revolution, the War of 1812, the Civil War, the Spanish-American War, World War I, World War II, Korea, Vietnam, Iraq, and Afghanistan), whose total price tag, adjusted for inflation, is $7.2 trillion. Plus, according to Olivier Garret, the CEO of Casey Research, who studied this war-versus-bank-bailout comparison, “World War II was financed by savings, the American people’s savings, when Americans bought war bonds. . . . today, families are in debt and the government is in debt.”32 Lots and lots of debt.
Meanwhile, $50 trillion in global wealth was erased between September 2007 and March 2009, including $7 trillion in the U.S. stock market and $6 trillion in the housing market.33 In addition, the total amount of retirement and household wealth trashed was $7.5 trillion in pension plans and household portfolios, $2.0 trillion in lost income in 401(k)s and individual retirement accounts (IRAs), $1.9 trillion in traditional defined-benefit plans, and $3.6 trillion in nonpension assets.34 Job losses, too, have skyrocketed. Between January 2008 and June 2009, the number of unemployed Americans rose from 7.5 to 14.7 million. The unemployment rate shot from 4.8 to 9.5 percent.35 So, reckless banking practices cost the world $65 trillion in losses, plus $13 trillion in various forms of bailout, a total of $78 trillion—and we still have no clue what losses continue to fester in the industry. Stress tests administered by the government and concocted by the industry indicated that ten banks in the United States were short $75 billion in capital, which Treasury Secretary Timothy Geithner declared “reassuring.” I don’t buy that—not the reassuring bit or the fact that with another $75 billion in capital, the industry will be stabilized. You won’t buy it either, after you read this book.
Even while banks were getting bailed out, their bad loans increased. According to a March 2009 report put out jointly by MSNBC.com and the Investigative Reporting Workshop at American University, which followed 8,198 banks over the two year period from the beginning of 2007 through the end of 2008, the total amount of troubled assets rose to $235.3 billion by the end of 2008, from $94.62 billion a year earlier, an increase of 149 percent. Nearly 71 percent of the banks had a higher troubled asset ratio at the end of 2008 than they did in 2007. Only 1,974 banks, or 24 percent, had fewer troubled assets.36 During the first quarter of 2009, the amount of delinquent or defaulting bank loans increased by another 22 percent. Plus six out of ten banks were less prepared to sustain further loan losses than they had been during the end of 2008.
What do all of these disheartening statistics mean? They mean that the bailout is not working. They mean that our government is trying to sustain fundamentally flawed institutions, ignoring a system that is itself fundamentally flawed. Though few of us want to admit it, the failures of the bailout reveal the extent of the problem. We cannot simply patch up the banks with some capital and loans and pretend that everything works fine. We will get out of this mess only if we recognize the incestuous relationship between Wall Street and Washington and see how the economic instability that it manifests affects us all. We need to understand how the addiction to making money in the short term with limited regulation and constraint hinders America’s long term economic stability. We need to stop this pillaging. And we need to totally reconstruct Big Finance in the process, so that it benefits the many, instead of the few.
1
Where’d the Bailout Money Go, Exactly?
Behind every great fortune, there is a crime.
—Honoré de Balzac
Once President George W. Bush took office on January 20, 2001, he appointed a string of his buddies to the treasury secretary position. 1 The first was Paul H. O’Neill, the former chairman and CEO of the aluminum producer Alcoa, who served during the mini recession between 2001 and 2002.2 Then came John Snow, the former chairman and CEO of the transportation company CSX, who served from February 2003 to June 2006.3 These men were rarely seen doing very much of anything.
Treasury Secretary Paul O’Neill basically played the role of the administration’s optimist during a spate of corporate scandals. On February 5, 2002, right smack between the Enron and WorldCom scandals, O’Neill testified before the Senate Finance Committee on how to strengthen the economy. Even as the country was in the midst of a recession, he said, “I believe we always have untapped potential that can be unleashed to spread prosperity throughout the nation. Never has that been more true than right now.”4 O’Neill was later pushed out of his job because he spoke out against Bush’s tax cuts and war policy.
John William Snow spent his time extolling free market virtues and supporting Bush’s tax cuts. He rode into his post on the wave of a unanimous Senate confirmation on February 3, 2003.5 Back then, the economy looked rosy—on its shell. Gross domestic product was bustling again, up 6.1 percent in the last half of 2003, the fastest growth rate in two decades. That’s what war, rising oil prices, and a burgeoning housing-loan bubble will do for you!6 Snow enthused, “This country’s free market system is strong, and the envy of the world.”7
But it takes a banker to make a real difference—to really misuse the country’s money with appropriate flair and deception.
That’s what former Goldman Sachs chairman and CEO Henry (aka Hank) Paulson did. Though politically on
the other side of the aisle from the likes of Robert Rubin, he was part of the same Goldman fraternity and espoused its free market, deregulatory, competitive-to-the-point-of-destruction philosophy. Which goes to show you that money trumps political party affiliation, and Wall Street heritage trumps both.
At Paulson’s confirmation hearing on June 27, 2006, he addressed “some of the steps that could be taken to achieve a stronger and more competitive U.S. economy.” (Note: When Paulson and his ilk use the word competitive, they mean reckless business practices and the absence of cumbersome restrictions on their viability. In reality, competition between financial institutions drives them to make profits out of the most esoteric securities and behaviors, while merging to dangerous levels of concentration.)
In addition to “maintaining and enhancing the flexibility of our capital and labor markets,” Paulson promised to prevent “creeping regulatory expansion from driving jobs and capital overseas.”8 He was good, that Paulson. Regulation equals jobs going overseas. No one wants to lose his or her job. Ergo, no one should want regulation. Good thing he prevented us from losing our flexibility, jobs, and capital.
His actions helped create the economic crisis that began a couple of years later, when deregulated banks leveraged their solid assets, such as citizen deposits, into oblivion, all in the name of competition. But at least his friends on Wall Street were freed from the shackles of regulation.
Paulson Loves Small Government for Big Reasons
Hank Paulson was confirmed for the Treasury post during a three hour Senate hearing love fest, which followed a unanimous Senate Finance Committee voice vote, on June 28, 2006.9 “In the world of finance and international markets there’s simply no equal to Hank,” cooed Senator Charles Schumer (D-NY).10
On July 10, 2006, Paulson was sworn in as treasury secretary.11 It wasn’t his first time in Washington. Paulson had been there before he joined Goldman in 1974.12 After completing Dartmouth College and then Harvard Business School, he went to work in the Nixon administration as Staff Assistant to the Assistant Secretary of Defense at the Pentagon from 1970 to 1972 and was Staff Assistant to John Ehrlichman (the man who masterminded Watergate) from 1972 to 1973.13 The Guardian, for one, was impressed by the young Paulson’s propensity for good timing: “Not only was he well connected enough to get the job, but well connected enough to resign in the thick of the Watergate scandal without ever getting caught up in the fallout.”14 Though Paulson’s initial run in D.C. was brief, it endowed him with a trait that would come in handy later: the ability to make a mess (or at least be a part of one), and not be held responsible.
Walter Minnick, one of Paulson’s closest friends, described Paulson during those years as “a bulldog, very much like a young Dick Cheney. . . . Hank is a salesman’s salesman, and this combination of being tenacious as well as enthusiastic made him very effective.”15 Now if a friend of mine compared me with Dick Cheney, I’d have to find a new friend. But I’m guessing Paulson took it as a compliment.
Even after decades on Wall Street with Goldman Sachs and a successful turn at running the über powerful investment bank, Paulson had reservations about the Treasury post.16 He was concerned about taking a position that wouldn’t have enough of a central policy making role (read: power).17
John Snow, Paulson’s predecessor, never had much sway. Mostly, he just championed the Bush policies that gave a disproportionate tax break to the wealthiest people in the nation and lavished the largest corporate tax breaks in two decades.18 The Senate passed a $70 billion tax cut package, mostly along party lines, which extended tax breaks on capital gains and dividends through 2010, as well as Bush’s 2003 tax cuts.19
Paulson, of course, would have been a private sector advocate of Bush’s dividend tax cut in 2003. With it, he saved about $2 million per year in taxes on the Goldman stock he owned at the time.20 But the best tax coup came from his new job and left every other Wall Street executive’s sign on bonus in the dust. There is a little loophole in the tax code that enables government officers to defer capital gains taxes on assets they had to sell based on divestiture requirements for the post, as long as the money received from the sale of those assets was put directly into U.S. Treasury securities or a list of acceptable mutual funds within sixty days.21 The intent is to prevent the anointed from not taking a public post, for fear of suffering a tax hit.
By leaving Goldman for the Treasury position, Paulson saved himself about $100 million in immediate tax payments, a handsome chunk of change for taking a job that pays only $183,500 per year in salary.22 All that he needed to bank the money was a “certificate of divestiture” from the Office of Government Ethics, which he got just before he sold 3.23 million shares of Goldman stock on June 29, 2006, worth nearly half a billion dollars.23 The sale remains completely tax free until the day the U.S. securities get resold.24
Paulson was surely unaware of what he signed up for regarding the looming economic implosion. In a way, that lack of awareness underscored the disconnect between the moneyed powerful and the rest of the world. Any car assembly workers or schoolteachers or tour guides in the country could have told you they were feeling inordinately pinched (as I found out while researching my previous book, Jacked, from late 2005 through early 2006) and were maxing out on credit cards to pay for essentials like food, medicine, and health care.25 Or perhaps Paulson knew but didn’t want to admit it. Maybe he thought the signs of strain would simply go away. Which is why, as the economy started slipping and banks began to post losses, he insisted that things were fine.
On January 29, 2007, Paulson told a roundtable discussion of big business types what he thought of the U.S. economy: “One of the very pleasant surprises I had coming to government has been the strong economy we have today. I can’t take a lot of credit for it but I’m still very, very pleased about it.”26
Seven months and a Fed rate cut later, on August 21, 2007,27 Paulson had a slight change of heart, in an interview with CNBC, noting that the economy was “stressed”:
We’ve been seeing stress and strains in a—strains in a number of capital markets but this is against the backdrop of a strong global economy, a very healthy U.S. economy, and the reason I start by making this point is that markets ultimately follow the economy. I’ve been through periods of stress, turbulence in the market for over the course of my career, various times, and never in any of those other periods have we had the advantage of a strong economy underpinning the markets.28
His choice of words was a little odd, implying that the economy just needed a good massage and then everything would be fine, but at least he was starting to acknowledge that the capital markets weren’t perfect.
But as we all know, the economy “underpinning the markets” tanked about a year after he made that statement. The reasons were numerous, as we’ve discussed, but they were largely because of practices that took place before Paulson left Wall Street for Washington. We can’t, after all, give him all of the credit for our financial ruin; however, he did encourage raising leverage limits for investment banks to dangerous levels and had a feverish hunger for deregulation at Goldman and later at the Treasury Department.
Paulson Discovers Big Government for Little Friends
As things got worse, Paulson eventually came to terms with the idea that protecting the general economy’s health was kind of, like, his job, and that he should probably do something about it. So, he had some fire drill meetings to discuss the fall of Bear Stearns and how the Federal Reserve would help JPMorgan Chase acquire the fallen investment bank in March 2008, a subject we’ll return to soon enough. But that didn’t halt the economic conflagration, and the autumn of 2008 would bring another set of disasters. On the evening of Friday, September 12, 2008, Paulson, New York Federal Reserve President and CEO Timothy Geithner, and Securities and Exchange Commission chairman Chris Cox held an emergency meeting with a few of the heavy hitters of the financial world: Morgan Stanley CEO John Mack, Merrill Lynch CEO John Thain, JPMorgan Chase CE
O Jamie Dimon, Goldman Sachs CEO Lloyd Blankfein, and Citigroup Inc. CEO Vikram Pandit.29 They were all scared about the market conditions but even more about their own books. None wanted to be seen as weak. None wanted to be the next to fail. Shockingly enough (well, no, not really, I’m just saying that), no official records of their conversations have ever been—or probably ever will be—released.
Notably absent from the meeting was Lehman Brothers CEO Dick Fuld. At that point, there were two potential buyers for Lehman as it tottered on the brink of extinction: Bank of America and London based Barclays. Neither stepped up.
Two days later Fuld was facing the demise of his firm, but his phone calls to Paulson, Geithner, and Cox had met a cold reception.30 As treasurer and designer of the federal bailout program, Paulson had ascended to become the arbiter of who lived and died on Wall Street. Though he had help from Geithner on the Bear Stearns deal and subsequent deals, Paulson wasn’t the kind of guy to play second fiddle. There were no buyers for Lehman and no money from the Fed in return for Lehman’s toxic assets. It was over. Paulson pressed the firm to bite the bullet late Sunday night, September 14. Early Monday morning, Lehman became the biggest corporate bankruptcy in U.S. history. The next day, Barclays came back, and for $250 million in cash, it bought Lehman’s core assets, worth $72 billion, and $68 billion worth of liabilities.31 Barclays didn’t even have to pick up Lehman’s toxic real estate-backed assets.32 By stepping away from the table just days earlier, Barclays ended up with a sweet deal, while the Lehman name was no more.