Instead, the Washington bailouts rescued the perpetrators, not the victims; that is, the bailout benefits were captured almost exclusively by the Wall Street insiders and fund managers who owned the common stock and long-term bonds of these two firms. Yet it was these punters who deserved to take punishing losses. It was they who enabled Goldman and Morgan Stanley—along with Bear Stearns, Lehman, and the investment banks embedded inside Citigroup and JPMorgan—to grow into giant, reckless predators.
As will be seen in chapter 20, only twenty-five years earlier these firms had been undercapitalized white-shoe advisory houses with balance sheets which were tiny and benign, but now their designation as “investment banks” reflected an entirely vestigial nomenclature. They had long ago morphed into giant ultra-leveraged hedge funds which happened to have retained relatively small-beer side operations in regulated securities underwriting and M&A advisory services.
The preponderance of their fabled profitability, however, was generated by massive trading operations which scalped spreads from elephantine balance sheets that were not only preposterously leveraged (30 to 1) but also dangerously dependent upon volatile short-term funding to carry their assets. Indeed, perched on a foundation of several hundreds of billions in debt and equity capital, these firms had become voracious consumers of “wholesale” money market funds, mainly short-term “repo” loans and unsecured commercial paper. From these sources, they had erected trillion-dollar financial towers of hot-money speculation.
On the eve of the financial crisis, Goldman had asset footings of $1.1 trillion and Morgan Stanley had also passed the trillion-dollar mark. Much of their massive wholesale funding, however, had maturities of less than thirty days, and some of that was as short as a week and even overnight. When Bear Stearns hit the wall in March 2008, for example, it was actually rolling over $60 billion of funding every morning—until, suddenly, it couldn’t.
It goes without saying that these highly liquid wholesale funding markets were dirt cheap because lenders had no rollover obligation and were often fully secured. It is also obvious that on the other side of their balance sheets, these de facto hedge funds held assets which were generally more illiquid, longer term, and subject to credit and market value risk, and which therefore generated substantially higher average yields.
Due to this “duration” and “credit” mismatch, the profit spread per dollar of assets was considerable, and when harvested a trillion times over, total profits were enormous, reaching $18 billion (pre-tax) at Goldman during the year before the crisis. Since this amounted to a half million dollars of profit per employee (including secretaries and messengers) the potency of carrying a giant balance sheet on the back of cheap wholesale liabilities was self-evident.
Yet here is where the foundation of overvalued debt and equity capital came in. There were limits on the extent to which the assets of these giant “investment banks” could be funded on wholesale money. Even the frothy markets of 2008 would have viewed a balance sheet consisting mainly of slow, illiquid assets funded preponderantly with short-term liabilities as a house of cards. So the investment banks’ foundation of permanent capital, in fact, was the vital linchpin beneath the whole Wall Street edifice.
Thus, Goldman’s balance sheet at the time of the crisis boasted long-term debt and preferred stock of $220 billion and common stock of $60 billion, even as measured by its depressed share prices that week. Likewise, Morgan Stanley had $190 billion of long-term debt and preferred stock, and $25 billion of common stock at the current market prices of its shares. Taken together then, the last two investment banks standing rested on a half-trillion-dollar base of long-term capital.
During the boom years, this long-term capital had earned handsome returns in the form of interest and dividends, with the common stock, the most junior capital, also experiencing substantial price appreciation. Goldman’s share price, for example, had peaked in late 2007 at nearly $250 per share, a level five times its May 1999 IPO price.
Yet in the matter of investments, as in the opera, it’s not over until the fat lady sings. The crucial economic purpose of each firm’s capital was to function as a financial shock absorber. During times of heavy economic weather, therefore, senior wholesale lenders would be spared from any losses incurred on impaired asset accounts; losses would be absorbed by the firms’ more junior, permanent capital—the common equity first and ultimately the long-term debt as well.
As events unfolded in the fall of 2008, these shock absorbers were brought into play. In very short order, they had proved wanting when Lehman filed for bankruptcy and Merrill Lynch was carted-off to Bank of America on a financial stretcher. Both firms had failed because their permanent capital had been inadequate to shield the losses, thereby rendering them insolvent.
In the days after September 15, the shock absorbers of the last two investment banks left standing, Goldman and Morgan Stanley, also failed the test. Their most illiquid asset classes—such as securitized mortgages, CDOs, commercial real estate securities, and corporate junk bonds—declined in market value by between 20 percent and 50 percent during the meltdown. Even when blended with holdings of low-risk government bonds and blue chip corporate securities, the blow to capital was devastating, and they would not have survived the ordeal on their own.
THE HEALTHY RUN ON THE WHOLESALE MONEY MARKET—INTERRUPTED
In fact, as the financial meltdown gathered momentum after Lehman failed on September 15, Goldman, and especially Morgan Stanley, became the victims of a violent “run on the bank” by wholesale lenders, which in classic fashion lost confidence in the value of their collateral. Yet that “run,” so much deplored by Washington officialdom, was actually a good thing—the market’s mechanism for flushing out the bad assets that had piled up on Wall Street balance sheets.
Under the circumstances, these firms had no choice but to rapidly liquidate assets, even at fire sale losses, in order to generate cash to redeem the short-term funding which was coming due in a great tidal wave. Such was their just desert for engaging in the age-old folly of borrowing short and hot, and investing long and illiquid.
Had economic nature been allowed to take its course, the resulting massive destruction of capital value at the two remaining investment banks would have been profoundly therapeutic. It would have demonstrated conclusively that the combined $500 billion of long-term debt and equity capital which had been issued by Goldman and Morgan Stanley over the previous decades had been vastly overvalued and was far more vulnerable to catastrophic loss than the trend-following money managers who owned it had understood.
While the financial party fueled by the Fed’s interest rate repression and “put” under risk assets roared, the Wall Street business model thrived: issuance of overvalued debt and equity enabled it to scalp gargantuan profits from balance sheets bloated with cheap wholesale money. The speculative mania on Wall Street was thus well and truly fostered in the misguided conference rooms of the Fed’s Eccles Building.
When the crash came, however, the inflated prices of the Goldman and Morgan Stanley equity and bonds had come under withering attack. The fund managers who owned them should have suffered massive losses, been fired by their firms, and become an example for an entire generation of money managers, steeling them for years to come against another Wall Street swindle of such hazardous aspect.
But Paulson and Bernanke body-checked the free market before the grim reaper could complete its appointed rounds. So doing, they gave credence to the lame whining of Wall Street executives who claimed they were victims of nefarious short-sellers. But that was pettifoggery. They were actually the victims of just plain sellers: investors and traders who had belatedly recognized that the capital securities of these giant hedge funds would be soon swamped in a tidal wave of losses.
Absent Washington’s bailout interventions, Goldman’s stock price would likely have proven to be worth far less than its $60 book value, if anything at all. Certainly it would not have been worth even close
to the ballyhooed “bargain price” of $115 per share paid by Warren Buffet (only after Uncle Sam pitched a safety net under the market) or the $250 per share it had reached during the bubble peak.
As it turned out, Washington’s intervention with TARP and the Fed alphabet soup of liquidity programs stopped the wholesale bank run in its tracks. It accomplished this by the very simple expedient of replacing the hundreds of billions of private wholesale funding—short-term commercial paper and overnight repo funding—which had gone into hiding with freshly minted Federal Reserve credit. And it was this instant, cheap funding do-over which was the ultimate evil of the bailouts.
In truth, the “run” in the wholesale funding market was the market’s homemade remedy for purging the speculative fevers which had overtaken Wall Street. At the time of the meltdown, the evaporation of wholesale funding was a curative agent, forcing Goldman, Morgan Stanley, and other leveraged hedge funds, including those such as Lehman and Merrill Lynch which had already been rendered insolvent, to liquidate their vast inventories of toxic assets at prices far below book value.
Moreover, this liquidation process exhibited an exceedingly precise focus that was completely inconsistent with Washington’s spasmodic arm waving about “contagion.” Specifically, the asset fire sales were not coming from the old-fashioned “whole loan” books (loans made to homeowners but never securitized by Wall Street) of the nation’s eight thousand commercial banks and thrifts. This was because the response of conventional deposit banks to deteriorating mortgage performance was to boost loan loss reserves, not dump mortgage paper on the open market.
By contrast, the housing and real estate–based assets held by the Wall Street “investment banks” consisted preponderantly of securitized mortgages and related synthetic and derivative instruments. The book value of these “assets” had been artificially inflated from the get-go, based on implausibly optimistic default assumptions with respect to the underlying mortgage pools.
Moreover, these pools had also been drained of value time and again by the fee extractions taken at each step along the route to securitization and sale. This sequence of fee scalping included mortgage origination, packaging of these loans into mortgage-backed securities, repackaging of MBSs into CDOs, and even further repackaging of CDOs into CDOs squared.
As a consequence of the “run” in the wholesale funding market, however, this whole misbegotten edifice was being rectified. The toxic securitized mortgages and derivatives were being marked down to realistic value. Likewise, the wholesale funding market was being taught a harsh lesson on the consequences of the type of reckless lending which had permitted tiny investment banks to grow into trillion-dollar giants.
At the same time, the prices of investment bank capital securities were experiencing shocking declines, as illustrated by Goldman’s stock price dive from $200 per share to less than $50 in a matter of months. In short, the dangerous business model on which these ultra-leveraged hedge funds were based was being purged from the financial system. Indeed, Lehman and Merrill were already down, and Goldman and Morgan Stanley were on the ropes.
Mr. Market was thus on the cusp of being four-for-four in eliminating these dangerous ultra-leveraged gambling operations. Unfortunately, Chairman Bernanke and Secretary Paulson drastically misconstrued this healthy run in the wholesale banking sector. Not only did they view it as a threat to the Fed’s wealth effects model of monetary central planning, but they also saw it as a replay of the Great Depression–era bank runs.
As will be seen in chapter 8, however, it was nothing of the kind. Contrary to Chairman Bernanke’s faulty and self-serving scholarship, the famous bank runs of 1930–1933 were not the result of monetary policy mistakes by the Fed after 1929. Instead, they were the ineluctable consequence of the wartime and postwar debt booms from 1914 to 1929 and the vast crop of insolvent borrowers which they fostered.
Likewise, Washington’s massive intervention in September 2008 could not thwart a Great Depression 2.0 because the collapse of Wall Street could not have caused one. There had been no economic Armageddon looming, only a long cycle of debt liquidation, shrinking living standards, and austerity—or exactly the outcome we have experienced anyway.
The contemporary situation was nothing like the early 1930s because the United States was now a massive international debtor and importer. That condition was the opposite of the American economy’s posture in 1929 when it had been the era’s massive creditor, exporter, and industrial producer; that is, the US back then had played the role belonging now to the red capitalists of China.
At the end of the day, the 2008 financial panic had originated in the canyons of Wall Street; it had actually been contained there during the peak weeks of the crisis, as toxic assets were liquated and wholesale funding was withdrawn; and it would have burnt itself out there had Washington allowed the markets to have their way with errant speculators. Instead, a handful of panicked officials led by Bernanke and Paulson drove Washington into a momentary hysteria, causing it to throw the American taxpayer and the Fed’s printing press into the wrong breach. So doing, they stopped a bank run that was needed and perpetuated two giant financial predators which were not.
THE MAIN STREET BANKS WERE NEVER IN DANGER
There was no logical or factual basis for the incessantly repeated claim of Washington high officials that Wall Street’s losses would spill over into the nation’s $12 trillion commercial banking system and from there ripple outward to infect the vitals of the Main Street economy. Owing to the composition of its asset base, the Main Street banking system was never remotely at risk, and it had no need for capital infusions from TARP.
The actual evidence shows the “run” on the wholesale money market was almost entirely confined to the canyons of Wall Street. During the heat of the fall 2008 crisis, there were no runs on the nation’s eight thousand commercial banks and thrifts, save for a handful of clearly insolvent higher fliers like Indy Mac and Washington Mutual. Nor would there have been one in the absence of TARP and the Fed’s aggressive Wall Street bailout actions.
The carnage on Wall Street in no way weakened the deposit guarantees of the Federal Deposit Insurance Corporation (FDIC) which reassured mom and pop that they did not need to get in line at their local bank branch. The vast bulk of assets held by the commercial banking system were either invested in safe US Treasury debt and government-guaranteed mortgage securities or whole loans to home owners, businesses, and developers which were carried on their “banking books” rather than in “trading” accounts.
There was no reason to fear a contagion of fire sale liquidations of these types of assets or a resulting flight of retail depositors. Even if the national economy plunged into recession, the commercial banking system would experience rising loan loss reserve provisions and weakened profitability. Yet this impact would play out over quarters and years, not in immediate, huge, headline-making loss events which would catalyze public fears about the safety and soundness of their local banks.
There was actually a striking note of irony in the contrast between the relatively safe commercial banking system and the bonfires on Wall Street. As it happened, the mortgage securitization machine had functioned like a giant financial vacuum cleaner, sucking the worst of the subprime and exotic mortgages off the balance sheets of local community lending institutions and into the billion dollar securitization pools assembled on Wall Street.
The main channel for this process, the nonbank mortgage broker industry, was a Wall Street instrumentality of cheap money. By the time of the final housing boom in 2003–2006, in fact, the mortgage broker channel was originating 75 percent of all mortgages. When the financial crisis came, Main Street banks were sound because, ironically, they had been driven out of the high-risk mortgage business by Wall Street and its mortgage broker agents.
When the Greenspan Fed drove short-term funding costs in the wholesale money markets down to 1 percent by the spring of 2003, it enabled Wall Street to finance massive
“warehouse credit lines” to local mortgage brokers and bankers. Stocked up with Wall Street money, the latter did not need retail deposits or capital and, instead, operated as fee-based agents and were therefore free to issue risky loans. They worked out of makeshift offices and did not need vaults, tellers, or drive-through windows. With no skin in the game, they were driven entirely by mortgage production volume (see chapters 18 and 19). When the great Wall Street investment houses—including Bear Stearns, Lehman, Goldman, and Morgan Stanley along with the wholesale banking departments of JPMorgan, Citigroup, and Deutsche Bank—became aggressively involved in financing the local mortgage bankers, brokers, and boiler rooms, the planking for the subprime mortgage fiasco was laid. The Wall Street houses were able to access nearly unlimited amounts of low-cost wholesale funding by means of the commercial paper and repo markets and recycle it through their “warehouse lines” to local mortgage bankers and brokers. Unfortunately, the sudden availability of these multibillion-dollar warehouse lines proved to be a financial poison in the world of home finance, not the socially beneficent “innovation” claimed by investment bankers.
Needless to say, the new army of mortgage brokers put into business by these Wall Street credit lines had not spent decades building up a franchise in local home mortgage markets, thereby acquiring the skills in prudent underwriting and borrower selection on which long-term survival in the home mortgage business inherently depends. But they did know how to organize turbo-charged boiler-rooms which cranked out prodigious numbers of new mortgages.
These new mortgage brokers also had the capacity to grow by leaps and bounds. They had quickly discovered that salesmen currently pitching Amway products, aluminum siding, and used cars could become fully functioning mortgage bankers in a matter of days and weeks. This was especially the case after the government-sponsored enterprises Fannie Mae and Freddie Mac and the big Wall Street banks introduced online computerized underwriting.
The Great Deformation Page 5