The Great Deformation

by David Stockman

  The fact that the abysmally unqualified Kashkari led the bailout brigade while Bair was systematically excluded from the process speaks volumes as to how completely public policy had fallen into the clutches of Wall Street. Kashkari and his posse had no sense whatsoever about the requisites of sound public finance. So in the fog of Washington’s panic, prevention of private losses quickly and completely supplanted any reasoned consideration of the public good.

  THE BLACKBERRY PANIC OF 2008

  The exclusive diagnostic tool used by the principals during this entire episode was carried in their pockets. This was the BlackBerry Panic of 2008. What was going down hard was not the American economy, just the stock prices of Goldman and the other big banks.

  As the “eye witness” accounts contained in the numerous histories written by financial journalists make clear, the driving force behind every action and each decision was the instantaneous oscillation of stock prices and credit spreads, and the openings and closings of financial markets around the globe. Needless to say, the dancing digits on the hundreds of BlackBerries toted about on the field of battle measured nothing of relevance to the public interest, even as they kept instant score on the price of the stocks and bonds of the financial institutions in play.

  The journalistic histories also make clear the method of persuasion used by Washington officialdom to deliver the keys to the nation’s exchequer to Wall Street and its agents in the Treasury and the Fed. In a word, it was fear—lurid premonitions of cash machines gone dark, payrolls undelivered, air freight grounded, and assembly lines stopped-out.

  In the cold light of day, however, it is abundantly clear that none of these catastrophes would have occurred had TARP never been enacted. Trillions of bank deposits were already well protected by the FDIC’s existing powers to guarantee deposits and take over insolvent banks, along with the Fed’s capacity to make virtually unlimited discount window loans to member institutions on the presentation of standard collateral.

  This fear-based stampede to adopt TARP was made all the easier by the White House’s virtual abdication from the policy process. Indeed, the contrast between these September 2008 acts of perfidy by the Bush administration and the comparable betrayal of conservative principles by a Republican White House in August 1971 is striking.

  Back then, Richard Nixon called his government to Camp David for an entire weekend and personally led the charge for policies—wage and price controls, import protection, and closure of the gold window—which were antithetical to GOP principles. In September 2008, however, George W. Bush simply delegated his raid on the American taxpayers to the Treasury Department and then reverted to his habitual somnolence on matters of economics.

  And not surprisingly. During his brief interval of success in scalping a handsome profit from the Texas Rangers franchise, George W. Bush had apparently learned little about business and virtually nothing about the nation’s now massively debt-ridden economy. So as president in the white heat of crisis, he was easy prey for the fear-mongering of the cabal lead by Treasury Secretary Paulson and Chairman Bernanke.

  At a meeting of the congressional chieftains, the president thus tersely conveyed the entirety of his comprehension of the momentous matter at hand. “This sucker is going down,” he told them, and in a comparative flash the nation’s petrified legislators wrote out a $700 billion blank check.

  And so the TARP bailout was enshrined as a last-resort exercise in breaking the rules to save the system. Ever the master of malapropism, President Bush soon took to proclaiming, “I’ve abandoned free market principles to save the free market system.”

  Ironically, however, the truth was more nearly the opposite. The financial meltdown of 2008 was occurring because sound economic principles had already been abandoned—years earlier, in fact. The right solution was to restore these discarded canons, not to eviscerate them further. That meant promptly dismantling the giant gambling halls which had ushered in the crisis.

  It also meant returning the Fed to its proper role as guardian of the dollar’s value and stern taskmaster of banking system liquidity; that is, to a policy of dispensing discount window loans only at a penalty rate of interest against sound collateral while remanding insolvent institutions to the FDIC for closure. But most importantly, it meant liquidation of the massive pyramids of debt and leveraged speculation that had built up throughout the American economy over more than three decades.

  THE ARROGANCE OF WALL STREET:

  CRONY CAPITALISM, JOHN MACK STYLE

  The urgent imperative for the Fed to revert to these canons of sound money can be illustrated by its opposite: the utterly shameful and gratuitous bailout of Morgan Stanley two weeks after the Lehman bankruptcy. On September 29, 2008, Morgan Stanley was insolvent and belonged in the financial morgue on a slab alongside Lehman.

  Yet that very day it reported to the public that it had “strong capital and liquidity positions.” That statement was utterly misleading, but it never gave rise to an SEC investigation because it could be defended by means of a hair-splitting technicality. A later investigation by the Federal Crisis Inquiry Commission, in fact, showed that Morgan Stanley had $99 billion of liquidity on the date in question. What the investigation also showed, however, was that very same day it had been the recipient of $107 billion in liquidity injections from the Fed’s alphabet soup of bailout programs. It was liquid only because it had become a branch office of the New York Fed!

  Absent the cash being injected by the Fed’s multiple and massive fire hoses, Morgan Stanley would have been deeply illiquid. Its hot-money lenders would have seized tens of billions in collateral, which they would have sold at any loss necessary to retrieve their cash. Lehman’s reputed $40 billion loss at the time of its filing would have paled compared to the losses which would have been ripped from Morgan Stanley’s tottering $1 trillion balance sheet.

  As previously indicated, the survival of Morgan Stanley was of no moment to the American economy. It was a giant leveraged hedge fund being subjected to the mother of all margin calls; that is, its reckless reliance on overnight wholesale money to fund massive amounts of impaired, illiquid, and highly volatile assets was undergoing a flaming crash landing.

  The claim that its vestigial capabilities in the mergers and acquisitions arena and in underwriting stocks and bonds needed to be preserved was ludicrous. Neither of these businesses required meaningful amounts of capital, and there were always dozens of pedigreed Wall Street veterans waiting to hang out a boutique investment banking shingle to pick up the slack.

  Even though no public purpose was served, the details of the Fed’s $107 billion bailout of Morgan Stanley underscore the abject manner in which it had capitulated to the imperatives of crony capitalism. About $61 billion of this amount was obtained from the Fed’s Primary Dealer Credit Facility, and the Crisis Commission’s data show that Morgan Stanley had put up only $66 billion of collateral against this advance. This meant that the “haircut,” or margin of safety, was only 8 percent.

  Yet Morgan Stanley’s collateral pool was a veritable trash bin of broken and impaired securities. Indeed, about $22 billion, or 32 percent, of the total consisted of common stock, for which the implied 8 percent haircut was a joke since the stock market had been moving by that much in a couple of days.

  Likewise, another 10 percent of the collateral pool consisted of junk bonds which at that juncture could not be sold at any price. And another $20 billion, or 30 percent, consisted of assets with an “unknown rating.” In short, prior to the crisis of 2008 not one central banker in a thousand would have accepted this Morgan Stanley trash bin as acceptable collateral for an advance of even a fraction of the $61 billion it actually got.

  In this episode lies proof of the lasting damage wrought by the bailouts of Wall Street. Morgan Stanley’s CEO and chairman, John Mack, was a ruthless gambler and bully who had never hesitated to exploit any available avenue to make a buck, to say nothing of a billion bucks. In the run-up to the crisis
, Morgan Stanley had embraced any and all short sale trades that could potentially yield a profit, including a giant short of the housing market which blew up and ended up costing Morgan Stanley a $9 billion write-off.

  But after Mr. Market dispatched Lehman Brothers and then Merrill Lynch, the short sellers had turned their sights on Morgan Stanley. It was by then apparent that its wholesale funding was rapidly vanishing, and it would be forced to take massive losses on the junk assets which had accumulated on its balance sheet over years and years of bubble prosperity on Wall Street.

  Yet in less than a New York minute, Mack had reversed course and stormed the barricades on Capitol Hill and the White House, demanding an SEC ban on short selling of his stock and that of the other banks and financial institutions. On Tuesday afternoon, September 16, for example, the treasury secretary, according to his memoirs, “got an earful from John Mack … the short sellers were after his bank. His cash reserves were evaporating.”

  Crony capitalism had now reached its apotheosis: one insuperably arrogant prince of Wall Street was commanding his former chief rival, and now occupant of the highest financial policy job of the land, to pull any and all stops to save his firm. From what? The answer was, to save it from its own clients. In fact, prime brokerage customers and trading counter-parties were withdrawing their deposits and margin accounts at a furious pace because they knew full well that, like Lehman and Bear Stearns, Morgan Stanley was a house of cards.

  The idea that the short sellers were draining Morgan Stanley’s cash was a complete canard. Creditors and lenders to Morgan Stanley were fleeing, which would force a fire sale liquidation of impaired assets and thereby render the firm insolvent. Short sellers were furiously attacking the carcass because they knew the firm was finished, brought down by the foolish leverage and hot-money wholesale funding from which it had harvested so much ill-gotten profit in the past.

  What the short sellers hadn’t reckoned with, however, was the final triumph of crony capitalism. Morgan Stanley was spared because Goldman wanted it rescued. In a phone call to Paulson during the heat of the crisis that day, Goldman’s current CEO, Lloyd Blankfein, had left no doubt about the stakes. As the tone-deaf Paulson actually confessed in his own memoirs, he had used the great powers of his office to save Goldman Sachs: “Lloyd was afraid that if something wasn’t done, Morgan Stanley would fail … And even though Goldman had plenty of liquidity and cash, it could be next.”

  So within hours of Mack’s presumptuous tantrum and with virtually no analysis or due process, the US government met his demands. Chris Cox, the former congressman and purported free market true believer who George W. Bush had chosen to head the SEC, issued a truly pitiful announcement. In it he explained to American citizens that for the next fifteen days they would be free to buy financial company stocks, but not to sell them.

  The short-selling ban was the product of naked Wall Street aggression, and in the case of Morgan Stanley there could be no doubt as to the true purpose. The Morgan Stanley stock had dropped from $80 per share to $40 on the eve of the crisis, had fallen to $20 upon the Lehman filing, and by the end of September was at $7 and sinking fast.

  Thus, in the final weeks of September leading to the fateful October 3 approval of TARP, Washington’s action was being driven by an overriding Wall Street imperative; namely, saving the stock price of Morgan Stanley—and those of Goldman, JPMorgan, Bank of America, and Citigroup, too—from the fate of Lehman Brothers, and assuring that the personal wealth of John Mack and the remaining Wall Street titans would remain intact.

  Within a fortnight, of course, the danger had already passed. Armed with gifts that only the sovereign state can bestow—a ban on short selling of its stock and $100 billion of cash based on junk collateral—Morgan Stanley evaded Mr. Market’s wrathful attack and not only remained open for business, but saw its stock price recover smartly. By the end of the year it had tripled, and within twelve months had risen fivefold from the time of its bailouts.

  Nor was Morgan Stanley given special rank in the hierarchy of Washington’s bailout dispensations. From the same liquidity fire hoses which powered cash into Morgan Stanley, nearly the identical amount went to Citigroup at $100 billion, Bank of America at $91 billion, Goldman Sachs at $80 billion, and nearly equal amounts to the leading banks of Europe. All told, the Fed dispensed nearly $700 billion in emergency loans during the last months of 2008, doubling down on the appropriated money provided by TARP.

  At the end of the day, this trillion-dollar infusion of capital and liquidity from the public till had a single overarching effect: it nullified in its entirety the impact of Mr. Market’s withdrawal of a similar magnitude of funding from the wholesale money market. So the very monetary distortion—the availability of cheap overnight funding in massive quantities—upon which the Wall Street financial bubble had been built had now been recreated at the lending windows of the Fed, FDIC, and the US Treasury.

  The opposite path of liquidating the Wall Street bubble was eschewed, of course, not only because it would have meant massive losses to speculators in the stock and bonds of Goldman Sachs, Morgan Stanley, JPMorgan, and the remaining phalanx of the walking wounded. Crony capitalism also triumphed because in muscling the system during the white heat of crisis, Wall Street had plenty of intellectual cover. The fact is, mainstream economists of both parties were trapped in a Keynesian dead end, proclaiming that the solution to the crushing national debt load which had actually triggered the financial crisis was to pile on more of the same.

  Accordingly, banks which were “too big to fail” couldn’t be busted up, since they were allegedly needed to shovel more credit onto already debt-saturated household and business balance sheets. Likewise, speculators who should have suffered epochal losses during the meltdown were resuscitated by Fed-engineered zero interest rates in the money market, thereby quickly reviving the same massively leveraged “carry trades” in commodities, currencies, equities, derivatives, and other risk assets which had brought on the crisis in the first place.

  THE BONFIRE OF IDEOLOGIES

  In a narrow sense, the GOP was responsible for this calamity. Republican administrations had turned the nation’s central bank over to money printers and Wall Street coddlers not only by appointing Greenspan and Bernanke, but also by celebrating the phony prosperity they fostered as evidence of triumphant GOP economics.

  Worse still, the clique of political hacks around Karl Rove who ran the Bush White House were so unlettered in the requisites of sound money and free market economics that, over and over, they caused the nation’s top economic jobs to be filled by statists and Keynesians. Thus, professors Glenn Hubbard, Greg Mankiw, and Ed Lazear had no problem whatsoever advising George Bush that two giant tax cuts and two unfunded wars were entirely copacetic from a fiscal viewpoint. After all, the huge resulting deficits provided a Keynesian pick-me-up to the prosperous classes.

  Bernanke had nosily advertised his partiality to unlimited money printing and monetary central planning long before the Rove crowd in the White House okayed his first appointment to the Fed in 2002. The same political clique that vetted and appointed Bernanke also drummed Paul O’Neill out of his job as secretary of the treasury for having the temerity to suggest that the tax cuts and unfinanced wars were a recipe for fiscal catastrophe. Eventually they came up with Hank Paulson, who had spent a lifetime doing M&A deals, but not studying the great questions of economic governance.

  Even rank-and-file Republicans on Capitol Hill had remained wary of the financial Frankensteins at Fannie Mae and Freddie Mac, but Paulson did not hesitate to bail out their creditors when he had a perfect opportunity to shut them down in September 2008. Likewise, when the US economy began to falter in the spring of 2008 because the Greenspan-Bernanke bubble was finally bursting, this clueless GOP treasury secretary revived the equivalent of Jimmy Carter’s ridiculed $50 per family tax rebate, as if inducing households to buy more Happy Meals and Coach bags on Uncle Sam’s credit card had anythin
g to do with sound financial policy.

  By the time of the Wall Street meltdown, Republicans had long ago succumbed to the hoary notion that “deficits don’t matter,” a posture which permitted the floodgates to the treasury to be opened to TARP. In fact, when the House Republican leader had invited his troops to consume a $700 billion “mud sandwich” and vote for a bill that violated every core principle of a free market economy, they did so because their ancient fears of deficit finance had long since evaporated. Now after massive and blatant intervention in every corner of the financial market, and the wider economy too, there were no remaining boundaries to the state at all.

  In this context, national economic policy became an ad hoc free-for-all. The GOP could not explain why the calamity had happened. After all, their central bank appointees had promised permanent prosperity, but had fostered instead the now dramatically collapsing financial bubble. Likewise, the American economy was suddenly plunging even though the GOP had supposedly supercharged it with multiple doses of the tax-cut tonic. And Republican governments had resolutely dismantled the last remnants of a fraying structure of financial regulation, but now the nation was being assailed by Wall Street’s speculative furies.

  So unable to explain or account for the financial and economic conflagration that descended on the nation in the fall of 2008, they adverted to conjuring a mythical past—an alleged golden age of Reaganomics. As detailed in part II, the GOP’s escapism into the alleged glories of the Reagan era was pure revisionist history. The Reagan Revolution had actually been a progenitor of the calamity now upon the nation, not an alternative régime that needed to be revived.

  At the same time, the Keynesian left channeled FDR and the New Deal to chart a way forward, but it, too, was a lapse into the revisionist past. The New Deal was fundamentally a grab bag of statist experiments which didn’t work, and even FDR abandoned much of it along the way. As detailed in part III, it was no golden era of enlightened economic governance, either, and more often than not resembled a political gong show. The New Deal did not end the Great Depression and was irrelevant to the current crisis. What the left was reviving in the fall of 2008 was nothing more than a revisionist illusion.