The Great Deformation

by David Stockman

  It goes without saying that given the enormous balance sheet girth of these institutions—all of them were greater than $1 trillion in size—the amount of losses could have easily been absorbed without help from the taxpayers. In the case of Goldman, the largest recipient, the taxpayer funds amounted to less than eight months of profit and bonus accruals during the very next year.

  In fact, at the time of the crisis the dozen or so giant international banks that got the AIG bailout money had $20 trillion in assets among them. By contrast, even in a worst-case outcome in which the banks lost twenty cents on the dollar for the mostly AAA paper (i.e., “super-senior”) insured by AIG, their collective exposure to losses amounted to $80 billion at most.

  Washington thus threw stupendous sums of money at AIG in a craven, discombobulated panic, yet these subventions amounted to just 0.5 percent of the elephantine balance sheets of its big global bank customers.

  The September 2008 bailouts thus represented an outbreak of madness at the very top of the political system. The crisis was defined by the Paulson-Bernanke cabal in such Armageddon-like terms that all checks and balances disappeared. Every one of Washington’s lesser players, including the president and the congressional leadership, stood down in the face of an immense urban legend that had materialized, as if out of whole cloth, in a matter of hours after the Lehman bankruptcy filing.

  Panic-stricken Fed and Treasury officials had issued a financial ukase; namely, that an AIG bankruptcy had to be prevented at all hazards because it would bring the entire financial system tumbling down. Never in the inglorious history of Washington’s financial misdeeds has such a large proposition been based on such a threadbare predicate.

  The pretentious young men flitting around Secretary Hank Paulson, who was temperamentally unfit for the job and had by then seemingly come unglued, apparently did not even bother to review AIG’s publicly filed financials. If they had they would have seen that its mammoth balance sheet resembled nothing so much as a clam shell. The lower half of the shell was comprised of dozens of major insurance subsidiaries and was asset rich with the previously mentioned $800 billion of mostly high-quality stocks, bonds, and other investments. They would have also recognized that the liabilities of these insurance subsidiaries were of the slow and sticky variety, consisting mainly of the current and future claims of its life, property, and casualty policyholders.

  Unlike bank deposits, these insurance liabilities could not be subject to a panic “run” by retail policyholders. Instead, they would come due over years, and even decades, as eligible loss claims matured. So if they had done even a modicum of homework, they would have recognized that the balance sheet foundation of AIG was stable and was neither exposed to “contagion” nor a transmitter of it.

  Had they sought out competent legal advice, they would have also discovered that in the event the parent company filed for bankruptcy, the dozens of solvent AIG insurance subsidiaries would have been pounced upon and, if necessary, legally sequestered by their regulators in the states and foreign jurisdictions where they were domiciled. These protective actions, in turn, would have paved the way for policyholders of these quarantined units to satisfy their claims in the normal course or through an orderly judicial process.

  Furthermore, had they consulted knowledgeable Wall Street analysts they would have been quickly disabused of the simple-minded notion that an AIG corporate failure would trigger a global contagion. At the practical operating level, AIG was not remotely the globe-spanning octopus about which Paulson regaled frightened congressmen. Despite Hank Greenberg’s fifty years of empire building, AIG was actually a late bull market concoction, a jerry-built monument to the economically senseless takeover arbitrage which emanated from the stock market bubble the Greenspan Fed had fueled in the late 1990s.

  With a high-flying PE multiple of 35 times earnings, AIG had engineered a flurry of takeovers by swapping its high-value paper for the stock of its targets, which generally sported more earthbound valuations. Accordingly, between 1998 and 2001 AIG had acquired a string of large life and casualty insurers including Western National, SunAmerica, Hartford Steam Boiler, and American General. Just these four takeovers were valued at a combined $45 billion and helped boost AIG’s total assets by $140 billion to nearly $450 billion over this three-year period.

  The giant catch-22 embedded in this spasm of bubble-era financial engineering, however, was entirely lost on the rampaging posse on the third floor of the Treasury Building: namely, that AIG was a glorified insurance industry mutual fund. It had grown to giant size by acquisitions and investments, but it did not have automatic access to the assets sequestered in its far-flung subsidiaries.

  Yes, SunAmerica alone had millions of retirement annuity customers, American General had billions of life insurance outstanding, and Hartford Steam Boiler provided fire and accident protection to a significant share of the industrial facilities in the nation. From AIG’s small New York City headquarters, Greenberg and his successors could control business plans, staffing, executive compensation, underwriting standards, and much else. But they could not extract cash or capital from any of these insurance subsidiaries without complying with state insurance commission rules designed to protect policyholders and ensure solvency.

  Hank Paulson was running around Washington with his hair on fire, but contrary to the message he repeated over and over to purposely petrify congressmen his true mission was not to save middle-American annuitants and retirees; they were already being protected by insurance regulators from Connecticut to California. Instead, this alleged threat to millions of policyholders was a beard—behind which stood the handful of giant financial institutions which had purchased what amounted to wagering insurance from the AIG holding company.

  To be sure, AIG’s giant financial customers like Bank of America or Société Générale had not reached their tremendous girth due to their prowess as legitimate free market enterprises. They were lumbering wards of the state and, as will be seen, products of the cheap debt, moral hazard, and serial speculative bubbles being fostered by the Fed and other central banks. Not surprisingly, therefore, they were now desperately petitioning the treasury secretary for help in collecting their gambling debts from AIG.

  Needless to say, Paulson did not hesitate to throw the weight of the public purse into the arena on behalf of these gamblers, because it resulted in an immediate boost to the stock price of Goldman Sachs and the remnants of Wall Street. Hank Paulson thus desecrated the rules of the free market, and for the most deplorable of reasons: namely, to make Goldman, Deutsche Bank, and the rest of the banking giants whole on gambling claims which had been incurred to carry out an end run around regulatory standards in the first place.

  As previously indicated, all of the CDS gambling debts in question had been incurred at the holding company, which is to say, in the “upstairs” half of the AIG claim shell. The holding company was essentially bereft of liquidity because its assets, while massive, consisted almost entirely of the illiquid private stock of the endless string of insurance subsidiaries AIG had acquired or created over decades. And the not so secret reality was that invariably insurance regulators had imposed protective barriers, or “dividend stoppers,” to protect policyholders from capital depletion by parent-company stockholders.

  This meant that in the event of a bankruptcy there would be no raid on the insurance company assets to satisfy holding company liabilities. It also meant there would be no contagion—that is, the AIG holding company was in no position to engage in a fire sale of insurance subsidiary assets in order to satisfy the margin calls and loss claims against the CDS policies issued by the holding company. The insureds—the giant global banks—would have been flat-out stiffed and have faced severe losses on the value of their CDS contracts. That would have been the end of the matter: an honest resolution under law and the rules of the free market.

  The key to free market justice in this instance was the “dividend stoppers,” and I had learned
the everlasting truth about them during my days doing LBOs at Blackstone in the 1990s. We had come close to buying a state-regulated property and casualty (P&C) insurance company, and our plan for hitting the jackpot was to do, oddly enough, the very thing which proves there was no need to bail out AIG in September 2008. We intended to buy the target P&C insurer through an unregulated (“upstairs”) holding company funded with 80 percent debt, and then strip-mine cash from the insurance subsidiary.

  Stated more politely, the insurance company profits would be “upstreamed” as dividends to pay interest on the holding company debt. After collecting a generous return on the small amount of equity we had invested in the holding company, we would flip the insurance company stock to a new investor—perhaps even an insurance conglomerate like AIG—and thereby close out what promised to be a highly lucrative deal.

  On the way to this easy money, however, Blackstone’s pertinacious cofounder, Steve Schwarzman, became worried that an unfriendly state insurance commission could shaft us by forbidding payment of dividends in the name of “conserving assets” for the benefit of policyholders. That risk became the infamous “dividend stoppers” in our internal deliberations, and after much digging and expert advice to find a way around it, Schwarzman finally threw in the towel, pronouncing that it wasn’t “safe” to plant a leveraged holding company atop a state-regulated insurance company.

  Upon learning of the AIG bailout fifteen years later the salience of that episode was unmistakable. By then Steve Schwarzman was a billionaire LBO king and proven Midas. So if even he hadn’t been able to find a way to get insurance company cash past a “dividend stopper,” then it couldn’t be done at all. In fact, AIG’s holding company was massively leveraged, by way of its margin obligations under the CDS contracts, and it was now bankrupt just as Schwarzman had feared, leaving the punters who bought $400 billion of its worthless CDS insurance contracts high and dry.

  AIG’S WAGERING INSURANCE WAS BOGUS

  The fact that the CDS insurance underwritten by the AIG holding company was bogus embodied its own delicious irony. The big banks that got stiffed were essentially using CDS for an entirely untoward purpose in the first place; that is, it permitted banks to evade the capital requirements of their own regulators. The AIG “insurance” magically transformed high-risk assets such as collateralized debt obligations (CDOs) and other subprime mortgage bond assets into AAA-rated blue chip credits and eliminated any need for capital reserves.

  While the party lasted, therefore, AIG’s big-bank customers got the best of both worlds. They were able to puff up their quarterly income statements by booking fat revenues earned on higher yielding investments while paying comparatively meager amounts to AIG for the CDS insurance premiums. It amounted to found money.

  At the same time, their balance sheets remained pristine because their junk assets were camouflaged as AAA credits. Since no equity capital needed to be set aside for these CDS “wrapped” assets, the banks’ ROE (return on equity) was flattered enormously: it was a magical math equation in which the numerator (income) was maximized while the denominator (invested equity) was minimized.

  In the trade this was known as “regulatory arbitrage,” but in fact it was a giant scam under which the big banks had piled up mountains of CDOs on their balance sheets without needing a single dime of capital. The return on equity was thus infinite. Is it no wonder, then, that the Wall Street banks went into a paroxysm of hysteria—which were quickly transmitted to the third floor of the Treasury building—when the prospect suddenly materialized during the weekend of the Lehman crisis that AIG might fail and that, absent its CDS insurance wrap, their balance sheets would be exposed as buck-naked depositories of financial toxic waste.

  So had AIG been required to meet its maker in bankruptcy court, insurance commissioners at home and abroad would have seized the subsidiaries, conserved the assets, and safeguarded the interests of tens of millions of policyholders. At the end of the day, grandpa’s life insurance policy would have remained in force and the fire insurance on Caterpillar’s factories in Peoria would have remained money good. And contrary to the blatantly misleading canard Paulson had circulated in the corridors of Washington, not one of the millions of retirement annuities written by AIG would have been jeopardized by the bankruptcy of its holding company.

  In short, there was no public interest at stake in preventing AIG’s demise. Indeed, the bailout’s primary effect was to provide a wholly unwarranted private benefit at public expense; namely, the shielding of highly paid bank traders and executives who had exposed their institutions to embarrassing losses from taking the fall that was otherwise warranted.

  Moreover, as unpleasant as it might have been for the executives and shareholders involved, such a market-driven outcome was fully aligned with the public good. The fact is, society can reap the benefits of free market capitalism only if its vital nerve center, the money and capital markets, is kept healthy and balanced by periodic purges of excess and error.

  TOO BIG TO FAIL SUPPLANTS THE FREE MARKET: THE FED’S VISIBLE HAND

  By the time of the September 2008 crisis, however, these long-standing rules of free market capitalism had undergone fateful erosion: traditional rules of market discipline had been steadily superseded by the doctrine of Too Big to Fail (TBTF). The latter arose, in turn, from the notion that the threat of “systemic risk” and a cascading contagion of losses from the failure of any big Wall Street institution would be so calamitous that it warranted an exemption from free market discipline.

  But there was no proof of this novel doctrine whatsoever. It implied that capitalism was actually a self-destroying doomsday machine which would first foster giant institutions with wide-ranging linkages, but would then become vulnerable to catastrophe owing to the one thing that happens to every enterprise on the free market—they eventually fail.

  In fact, if TBTF implied an eventual catastrophe for the system, there was an obvious solution: a “safe” size limit for banks needed to be determined, and then followed by a 1930s-style Glass-Steagall event in which banking institutions exceeding the limit would be required to be broken up or to make conforming divestitures. Yet while the TBTF debate had gone on for the better part of two decades, this obvious “too big to exist” solution was never seriously put on the table, and for a decisive reason: the nation’s central bank during the Greenspan era had become the sponsor and patron of the TBTF doctrine.

  This was an astonishing development because it meant that Alan Greenspan, former Ayn Rand disciple and advocate of pure free market capitalism, had gone native upon ascending to the second most powerful job in Washington. In fact, within five months of Greenspan’s appointment by Ronald Reagan, who had mistakenly thought Greenspan was a hard-money gold standard advocate, the Fed panicked after the stock market crash in October 1987 and flooded Wall Street with money.

  For the first time in its history, therefore, the Fed embraced the level of the S&P 500 as an objective of monetary policy. Worse still, as the massive Greenspan stock market bubble gathered force during the 1990s it had gone even further, embracing the dangerous notion that the central bank could spur economic growth through the “wealth effect” of rising stock prices.

  This should have been a shocking wake-up call to friends of the free market. It implied that the state could create prosperity by tricking the people into thinking they were wealthier, thereby inducing them to borrow and consume more. Indeed, the Greenspan “wealth effects” doctrine was just a gussied-up version of Keynesian stimulus, only targeted at the prosperous classes rather than the government’s client classes. Yet it went largely unheralded because Greenspan claimed to be prudently managing the nation’s monetary system in a manner consistent with the profoundly erroneous floating-rate money doctrines of Milton Friedman.

  Indeed, the Greenspan wealth effects doctrine sounded conservative and reassuring, especially since it was conducted behind a smokescreen of Friedmanite rhetoric about the glories of free m
arkets and the wonders of the 1990s upwelling of new technology and productivity. In fact, Greenspan had made a Faustian bargain: once the Fed got into the stock market–propping and Wall Street–coddling business as tools of monetary policy and took on vast pretensions about its role as the nation’s prosperity manager, it could not let the stock market fall back to free market outcomes.

  The Greenspan Fed during the 1990s thus conducted a subtle assault on free market capitalism. The nation’s level of employment, income, GDP, and general prosperity would no longer be an outcome of the invisible hand; that is, the interaction of millions of producers, consumers, and investors on the free market. Instead, the advance of the American economy now flowed from the visible ministrations of the Federal Reserve, which by the end of the decade had become the omnipotent overlord of daily economic life, influencing every nook and cranny of the nation’s $14 trillion gross domestic product (GDP).

  Under the maestro’s wealth effects gospel, the nation’s central bank orchestrated the financial markets, the stock averages, the Treasury yield curve, bank lending, housing credit, the dollar’s exchange rate, the flow of merchandise trade, the movements of cross-border capital, and much more. Needless to say, this sweeping usurpation of economic power reflected a virulent outbreak of institutional hubris at the Fed and one of the greatest adventures in mission creep ever conducted by a public agency.

  Under the new Greenspan doctrines, the Fed also came to believe that through deft maneuvering it could eliminate all the kinks from the business cycle and unlock virtually every dollar of “potential” GDP. But the Achilles heel to these pretensions could not be gainsaid: the keys to this exceptional macroeconomic performance were sustained financial stability and constantly rising asset prices—conditions which would generate a positive “wealth effect” and a resulting virtuous cycle of higher confidence, consumption, employment, and incomes.