by Nomi Prins
Geithner’s No Friend to Homeowners, Either
After working on the bank bailout with Paulson from his post in the New York Federal Reserve (where his boss, former chairman Stephen Friedman, had once been Chairman of Goldman Sachs), forty seven year old Timothy Geithner was confirmed as President Barack Obama’s treasury secretary on January 26, 2009.99
Geithner was touted as having experience. After all, he had been president of the New York Fed, the branch of the Fed that had always enjoyed the closest relationship to Wall Street, so close that before he resigned in May 2009, Stephen Freidman sat on Goldman’s board of directors.100 In fact, five of Geithner’s mentors were or are Goldman Sachs executives. Besides Friedman, they include former NY Federal Reserve chief Gerald Corrigan (who’s now a managing director at Goldman Sachs), John Thain, and Hank Paulson himself.101 Corrigan described his relationship with Geithner as “close,” while John Thain told Portfolio magazine in May 2008 that he sometimes talked to Geithner “multiple times a day.”102
Geithner’s network also included his immediate predecessor at the New York Fed, William McDonough, his fifth mentor.103 No stranger to bailouts himself, McDonough was one of the key architects of the 1998 Long Term Capital Management bailout, which fortunately didn’t rely on public money.104 From the Fed post, McDonough went on to become a vice chairman at Merrill Lynch, which might explain why Geithner was so keen on getting on the bandwagon to shove Merrill up Bank of America’s backside.105
McDonough brought a history of strong ties with Robert Rubin and Larry Summers, who ran the Treasury during the Clinton administration. Summers was appointed as President Obama’s director of the National Economic Council on November 24, 2008.106
Geithner was also no stranger to the Treasury Department. He had served there in some capacity since 1988, for three different administrations, including as Rubin’s and Summers’s undersecretary for international affairs from 1999 to 2001.107 Still, that Geithner and Summers were given powerful economic roles—not to mention Peter R. Orszag’s appointment as Obama’s budget director—showed a lineage not only to Clinton, but to Robert Rubin. They are both Rubin protégés. Geithner, I hasten to add, is careful not to shortchange Summers’s formative role as well; he is so close to Summers, he told the New York Times, that “we can finish each other’s sentences.”108 Touching, isn’t it?
At Geithner’s confirmation hearing on January 21, 2009, he offered vague promises about addressing the economy’s problems.109 Perhaps unsurprisingly, they sounded pretty much like the promises Paulson had made. In his address, Geithner said, “First, we must act quickly to provide substantial support for economic recovery and to get credit flowing again.”
“Second, as we move quickly to get our economy back on track and to repair the financial system, we must make investments that lay the foundation for a stronger economic future.”
“Third, our program to restore economic growth has to be accompanied—and I want to emphasize this—has to be accompanied by a clear strategy to get us back as quickly as possible to a sustainable fiscal position and to unwind the extraordinary interventions taken to stabilize the financial system.”110 He neglected to mention homeowners.
Like Paulson, Geithner pretty much did the banks’ bidding, even when it was the wrong thing to do. The Citigroup debacle was a huge case in point. Then again, Geithner had a history of getting it wrong on Citigroup. In December 2006, he worked with the Federal Reserve to lift a reporting requirement for Citigroup that had been in place ever since the NY Fed discovered that Citigroup had helped Enron set up its off book entities, and the Fed made the firm file quarterly reports about risk management improvements.111 The Fed ended that requirement about the time that Citigroup started bulking up on its own off book hiding spots, called structured investment vehicles (SIVs).112
Citigroup’s fall two years later was spectacular. In January 2009, Citigroup had to sell majority ownership in its Smith Barney retail brokerage unit to Morgan Stanley. Robert Rubin also announced his resignation after nearly a decade with the firm.113
When asked about Citigroup’s woes at his confirmation hearing, Geithner did (sort of) take some responsibility for its demise, saying, “Citigroup’s supervisors, including the Federal Reserve, failed to identify a number of their risk management shortcomings and to induce appropriate changes in behavior.”114
Meanwhile, Obama’s Treasury took up the toxic-asset problem where Bush’s left off and for a brief interlude seemed to be considering the idea of creating some sort of government entity to scoop up the bad assets or having the government guarantee their value, instead of simply injecting capital by buying stock. In the absence of full knowledge about their potential losses, though, doing either would have been like throwing money into a big dark hole. Instead, the Treasury decided to first convert preferred shares in Citigroup to common ones, which would effectively dump more capital into the firm. Second, it developed a private public partnership, in which private investors would be asked to use public funds to purchase toxic assets.
One of the first things you learn as a trader is buy the rumor, sell the news. Geithner missed that lesson. His signature blindfolded, shoot-a dart, save-a bank move came on Friday, February 27, 2009. After leaking the Citigroup stock idea for a few days (giving spec traders time to scoop up shares to later dump), Geithner then announced that the Treasury would convert its preferred shares in Citigroup to common stock. This after nearly $388 billion in capital injections, and debt and loan guarantees failed to do the trick.
So, Citigroup agreed to convert the first $25 billion of its preferred stock investment (which, recall, Paulson overpaid for to begin with) to common stock, increasing the Treasury ownership stake in the flailing bank from 8 percent to 36 percent.
This pushed Citigroup’s stock price down below $1 a share on March 5, 2009, and its market value, which had once been as high as $277 billion, was down to about $5 billion.115
The faster Citigroup’s stock dove, the faster the media rushed to offer explanations, which were as painful as the stock’s dive itself. The business press said that shareholders were concerned about the dilution effect on their own shares: this meant that if new shares were issued to the government, existing shareholders would own proportionately less of the new total amount. So shareholders dumped them, contributing to the huge dip. Which wasn’t the main problem. It’s that shareholders still didn’t know what other pitfalls lurked on Citigroup’s books. The progressive press called the government’s buy-in another step toward nationalization. Which it really wasn’t. Purchasing stock in a black hole of a risk cesspool of a financial institution is not nationalization. It’s simply bad investing strategy. And the conservative press considered it a step toward the destruction of capitalism. Again, it really wasn’t. After all, capitalism thrives on raising funds for assets that have no value.
My interpretation is that the savvier traders did the same thing they’ve been doing unrestrainedly throughout this crisis: they dumped or shorted Citigroup shares because they knew the government remained oblivious to the root cause of the decimation of the banking industry and wasn’t asking the right questions to quantify the potential downside still out there. Without full disclosure, the market assumes the worst. In solidarity, Bank of America’s stock dropped a mere 30 percent. Wells Fargo was down 16 percent. Traders trade down. Banks don’t trust one another. And credit remains in a coffin. Throwing money at this situation reminds me of the bottomless pit scene in the old Flintstones cartoon.
And you’d think that someone in Washington might suggest a moratorium on shorting bank stocks, particularly when the federal government’s buying them with public money. I mean, the move to restrict short selling would come under the allowable emergency procedures of the SEC. And yet the SEC banned the short selling of bank stocks only briefly during the Second Great Bank Depression, from September 19 to October 2, 2008.116
At this point, Geithner had the option of coming up with a
different plan to stabilize the banking system, rather than purchasing shares in its unwieldy firms. It could have been perfect. He could have taken the mantra of change that Obama rode into the White House on and turned the banking industry inside out, beating it into submission in return for helping it survive. So, did he? No. He went back to Paulson’s original plan of buying up toxic assets, with a twist. Under Geithner’s public private partnership plan, we the people wouldn’t buy the assets directly and hope that they have value someday. We would be asked to loan money to private firms to buy them for us—up to $1 trillion worth.117 If the assets have value later, those private firms will make most of the profit on them. And if they don’t? Well, then we’re out another trillion or so.
2
This Was Never about the Little Guy
If you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.
—John Paul Getty1
The Second Great Bank Depression has spawned so many lies, it’s hard to keep track of which is the biggest. Possibly the most irksome class of lies, usually spouted by Wall Street hacks and conservative pundits, is that we’re all victims to a bunch of poor people who bought McMansions, or at least homes they had no business living in. If that was really what this crisis was all about, we could have solved it much more cheaply in a couple of days in late 2008, by simply providing borrowers with additional capital to reduce their loan principals. It would have cost about 3 percent of what the entire bailout wound up costing, with comparatively similar risk.
Just as great oaks from little acorns grow, so, too, can a Second Great Bank Depression from a tiny loan grow.2 But so you know, it wasn’t the tiny loan’s fault. It was everyone and everything that piled on top. That’s how a small loan in Stockton, California, can be linked to a worldwide economic collapse all the way to Iceland, through a plethora of shady financial techniques and overzealous sales pitches.3
Here are some numbers for you. There were approximately $1.4 trillion worth of subprime loans outstanding in the United States by the end of 2007.4 By May 2009, there were foreclosure filings against approximately 5.1 million properties.5 If it was only the subprime market’s fault, $1.4 trillion would have covered the entire problem, right?
Yet the Federal Reserve, the Treasury, and the FDIC forked out more than $13 trillion to fix the “housing correction,” as Hank Paulson steadfastly referred to the Second Great Bank Depression as late as November 20, 2008, while he was treasury secretary.6 With that money, the government could have bought up every residential mortgage in the country—there were about $11.9 trillion worth at the end of December 2008—and still have had a trillion left over to buy homes for every single American who couldn’t afford them, and pay their health care to boot.7
But there was much more to it than that: Wall Street was engaged in a very dangerous practice called leverage. Leverage is when you borrow a lot of money in order to place a big bet. It makes the pay-off that much bigger. You may not be able to cover the bet if you’re wrong—you may even have to put down a bit of collateral in order to place that bet—but that doesn’t matter when you’re sure you’re going to win. It is a high risk, high-reward way to make money, as long as you’re not wrong. Or as long as you make the rules. Or as long as the government has your back.
Let’s say you have a hot tip that the Lakers are going to throw their game against the Knicks tonight. You call your bookie and tell him to put down $30,000 on the Knicks, even though you don’t have anything close to that much on hand. You really have about a grand. You’re a longtime client of the bookie, so he doesn’t ask you to front more than that. You don’t worry about how you’ll pay him back because, hey, you can’t lose. If you win, you win bigger than you could have only using your own money. If you lose, the bookie breaks your kneecaps. Then again, if you’re Citigroup, you get $388 billion of government subsidies and your extremities remain intact.
The Second Great Bank Depression wouldn’t have been as tragic without a thirty to one leverage ratio for investment banks, and, according to the New York Times, a ratio that ranged from eleven to one to fifteen-to-one for the major commercial banks. Actually, it’s unclear what kind of leverage the commercial banks really had, because so many of their products were off book, or not evaluated according to what the market would pay for them.8 Banks would have taken a hit on their mortgage and consumer credit portfolios, but the systemic credit crisis and the bailout bonanza would have been avoided. Leverage included, we’re looking at a possible $140 trillion problem. That’s right—$140 trillion! Imagine if the financial firms all over the globe actually exposed their piece of that leverage.
But for $1.4 trillion in subprime loans to become $140 trillion in potential losses, you need two steps in between. The most significant is a healthy dose of leverage, but leverage would not have had a platform without the help of a wondrous financial feat called securitization. Financial firms run economic models that select and package loans into new securities according to criteria such as geographic diversity, the size of the loans, and the length of the mortgages. A bunch of loans are then repackaged into an asset backed security (ABS). This new security is backed, or collateralized, by a small number of original home loans related to the size of the security. Some securities, for example, might be 10 percent real loans and 90 percent bonds backed by those loans. Some might be 5 percent real loans. Whatever the proportion, the money the mortgage holders pay to lenders on their loans is used to make payments on new assets or securities. Those securities, in turn, pay out to their investors.
During the lead up to the Second Great Bank Depression, the securities themselves were a much bigger problem than the loans. Between 2002 and 2007, banks in the United States created nearly 80 percent of the approximately $14 trillion worth of total global ABSs, collateralized debt obligations (CDOs), and other alphabetic concoctions or “structured” assets. Structured assets were created at triple what the rate had been from 1998 to 2002. Bankers from the rest of the world created, or “issued,” the other 20 percent, around $3 trillion worth. Everyone was paid handsomely.9 In total, issuers raked in a combined $300 billion in fees. Fees can be made for all types of securitized assets, but the more convoluted they are, the riskier and more lucrative they become. Fees ranged from 0.1 percent to 0.5 percent on standard ABS deals and up to 0.3 percent for mortgage-backed securities (MBSs) and whole business securitization (WBS) deals.10 Fees were better for CDOs—between 1.5 and 1.75 percent for each deal, and higher for the riskier slices.11 All told, the $2 trillion CDO market alone netted Wall Street around $30 billion before CDO values headed south.12 Because U.S. investment banks were making huge profits from packaging churning loans and leveraging them, mortgage and asset-backed security volume skyrocketed.
Investment banks, hedge funds, and other financial firms could use the $14 trillion of new securities as collateral against which to borrow money and incur more debt (leverage them). There is no way of knowing exactly how much was leveraged, because the players operated in an opaque system—that is, a system without proper regulatory oversight or enforcement to detect or curtail leverage. But a conservative estimate of the average amount of leverage is about ten to one, considering the roughly eleven to one leverage of the major commercial banks and the thirty to one leverage of investment banks. So, we’re talking about a system that ultimately took on $140 trillion in debt on the back of $1.4 trillion of subprime loans. How insane is that? And, it happened so fast.
In 2005, the mortgage on some little home in Stockton provided the capital for two or three ill advised loans that soon disappeared into an ABS. But it was the global banks, the insurance companies, and the pension funds—particularly in Europe—that purchased the related ABSs. Like their U.S. counterparts, European financiers bought boat-loads of ABSs with borrowed money.13 They also shoved them off book into structured investment vehicles (SIVs) that required no capital charge and little reporting.
By
the fall of 2008 those ABSs, CDOs, and all their permutations would be known as “toxic assets.” They were considered by many to be the major cause of Big Finance’s failures and losses. The push for TARP centered on ridding banks of these poisonous creatures. But make no mistake: toxic assets are not the same as defaulted subprime mortgage loans; loans are merely one of the ingredients that make up the assets. All the subprime loans in existence could have defaulted and the homes attached to them could have been devalued to zero (which didn’t happen), but without the feat of securitization, the banks wouldn’t have become nearly insolvent. Toxic assets became devoid of value, not because all the subprime loans stuffed inside them tanked, but because there was no longer demand from investors. If no one wants your Aunt Mary’s antique gold plated, diamond-encrusted starfish, for all intents and purposes, it has no monetary value at the moment. This basic supply and demand concept is something our government apparently didn’t understand when it offered to take the toxic assets off the banks’ books. And the Fed, as we’ll see, doesn’t seem to care that it took on trillions of dollars’ worth of these assets.