In point of fact, however, the five born-again investment houses didn’t have much equity capital. Even by 1998, they had posted a combined net worth of only $40 billion, meaning they were levered 28 to 1. There is not a chance that the free market would have tolerated such radical leverage ratios; that is, absent the assurance that the central bank stood behind the distended balance sheets of these firms no one would have done business with them.
Indeed, that assurance was the very essence of the Fed’s reprehensible bailout of Long-Term Capital Management in September 1998. By then the Wall Street house of cards was plainly evident. Notwithstanding all of the post-crisis finger-wagging by the financial establishment against LTCM’s “massively leveraged” trading book, the true facts were damning: LTCM had obtained these massive borrowings from its “prime brokers” whose “investment bank” parent firms were nearly as levered as their now infamous hedge-fund customer.
Contrary to the cover story, therefore, LTCM was not some kind of rogue outlier; it was actually one of “da boyz.” John Meriwether, the firm’s chief, was not doing anything under his own shingle in Greenwich that he had not done at Salomon, and that had not been copied, replicated, and enhanced by the rest of Wall Street.
What the Fed’s LTCM bailout really did was give a green light to the approximate 30 to 1 leverage ratio that already existed all around Wall Street. Indeed, in its misguided belief that the bloated stock averages of September 1998 were the linchpin to national prosperity, the Fed had authorized a cartel of dangerously leveraged gamblers—the rest of Wall Street—to bail out one of their own.
WHEN FIFTEEN GAMBLERS GOT 30X LEVERAGE BLESSED AT THE NEW YORK FED
At the end of the day, the Fed’s craven sponsorship of the LTCM bailout might have been even more lethal than the panic rate cuts of 2001. The former action, in fact, amounted to a vastly upgraded Greenspan Put. As such, it surely paved the way for the final, massive growth of Wall Street balance sheets during the next decade.
As it happened, the head gambler for each of the fifteen major Wall Street banking houses had attended the crucial LTCM bailout meeting convened at the headquarters of the New York Fed. There they had duly noted the fearful perspiration and wobbly knees of officialdom and had concluded, accurately, that the Fed would prop up the casino at all hazards.
After that learning experience, it is not surprising that the five “investment banks” put their balance sheets on financial steroids. In fact, their footings quadrupled between the LTCM warning shot and the thundering meltdown of September 2008. The “financial crisis” thus arose from the vast deformations of the financial system to which the Fed’s interest rate repression and “put” pandering had given rise.
Fed apologists have attempted to deflect culpability by means of a false narrative with respect to the increased leverage limit for broker-dealers. But these SEC rule changes occurred much later and were largely meaningless. When they became effective in 2004, it was long after 30 to 1 leverage was deeply implanted on Wall Street. The five investment houses already had dangerously high leverage ratios in place by 1998 at the “holding company” level where it counted. By contrast, the SEC rule changes applied to the infinitely malleable but irrelevant balance sheets of their “regulated” broker-dealer subsidiaries.
These “broker-dealer” subsidiaries, however, were not observable, operational businesses. They were essentially pro forma accounting boxes whose financial statements could be shoe-horned into compliance with virtually any regulatory standard. Consequently, the 2004 increase in the SEC-permitted leverage ratio was mainly an accounting annoyance and was noticed only by green eyeshades at the time.
What happened to the holding company balance sheets of the five investment houses during the nine years after 1998 is the real story. It amounts to a searing indictment of Fed policy. When the mortgage and credit bubble reached its fevered peak in 2007, the five “investment banks” were posting $140 billion of net worth, meaning they had generated about $100 billion of additional equity since the LTCM crisis. This gain was almost entirely from “retained” earnings, much of which later proved to be dubious accounting gains.
During the same nine-year period, their asset footings grew, too, by the astounding sum of $3.4 trillion, or by thirty-four times more. Needless to say, the distended balance sheets of these five former white-shoe advisory and retail brokerage firms, which now stood at $4.5 trillion, were a screaming affront to the free market. In the absence of the Greenspan and Bernanke Puts and the Fed’s fully telegraphed interest rate pegging policy, it is not possible that such colossal accumulations of assets and leverage could have been assembled.
Had capital and money markets been fully at risk, investors would have lowered the boom on the Salomon “leveraged and long” model well before 1998. Consequently, the $4.5 trillion balance sheet of the “investment banking” houses never could have been assembled. No rational investor, if fully at risk, would have been part of a $4.35 trillion debt pool supported by only the $140 billion pittance of common equity being posted by the Wall Street houses.
In truth, the real equity underpinning the swollen balance sheets of the five investment houses was the Greenspan Put. After the LTCM bailout, the financial markets had been monetizing the maestro’s fear of truly free markets all along.
In the meantime, of course, these bloated balance sheets became a virulent breeding ground for endless varieties of toxic mortgage securitizations and gambling hall derivatives. The reason was straightforward: wholesale money markets had become fearless.
Accordingly, almost anything that trading desks could acquire or concoct could be funded. With short-term repo financing available on almost any class of asset—including junk bonds, equities, and illiquid private loans, as well as mortgages and mortgage-backed securities of nearly any quality—there was virtually no limit on either the size or quality of Wall Street balance sheets.
GARBAGE IN THE BELLY OF THE BEAR
The evidence for this lies in autopsy data from Bear Stearns, among others. From 2000 to 2008, Bear’s balance sheet grew from $90 billion to $400 billion. Yet its funding profile shortly before it collapsed bespoke a financial powder keg. Its fiscal 2007 financial statements showed only $12 billion of shareholder equity and just $55 billion of long-term debt.
This meant that the remainder of its $400 billion of liabilities was comprised primarily of “hot money” loans, including $100 billion of short-term repo, $30 billion of unsecured finance paper, and $75 billion of customer payables. What happened when its balance sheet quality was called into question after big unexpected losses in the second half of 2007 was obviously a run on these hot-money funding sources. Accordingly, repo counterparties refused to roll their paper, unsecured borrowing lines were curtailed or cancelled, and customers demanded payment of their outstanding trade balances.
The evidence of the precariousness of Bear Stearns’s balance sheet lies in its having to roll approximately $60 billion of repo each morning; that is, 15 percent of its balance sheet had a one-day shelf life. As the crisis had intensified, the firm’s secured lenders had continuously choked up on the bat, cutting thirty-day repo to fifteen days, and then five days, and finally just one day.
Worse still, about one-third of this massive daily repo roll was based on mortgage-based collateral that Bear Stearns’s accountants had found necessary to classify as “level III” assets. This meant these securities were so toxic that there was absolutely no outside market for the paper, and also that there was no basis on which to value it other than by make-believe or what was euphemistically called “mark to model.”
So there is no mystery as to why Bearn Stearns’s liquidity literally vanished in its final days. When these overnight lenders began refusing to roll for even one day, what had been $20 billion of available cash on Thursday, March 3, drained down to $12 billion by the next Tuesday and had disappeared entirely two days later.
Accordingly, the firm’s hapless interim CEO, Ala
n Schwartz, had not really misled anyone during his appearance on financial TV the day before Bear’s demise. His predecessors, especially the insufferably swinish Jimmy Cayne, had been pettifogging about the viability of their preposterously leveraged gambling hall for years.
Needless to say, Bear Stearns did not represent a one-off outlier. The events at Lehman and the other Wall Street houses six months later simply replicated the run on these same classes of hot-money funding. Indeed, the sudden collapse at Bear Stearns in March 2008, should have been proof positive to the Fed that its stock market coddling and the implicit “put” under the price of risk assets had led to a vast deformation of Wall Street’s finances.
But this “Defcon 1” warning provoked no reconsideration whatsoever, only a panicked scramble to protect Bear’s lenders and counterparties through what amounted to a sweetheart deal with JPMorgan. In light of the sheer perfidy of Bear Stearns’s financial stewardship, it is evident that officialdom at the Fed and Treasury were willfully blind. The splattered remains of Bear Stearns told anyone who bothered to investigate that there were ticking time bombs all around.
THE MERGER MANIA OF THE MEGA-BANKS
The Greenspan Fed unaccountably believed that the aberrations festering on Wall Street were the fruit of financial innovation and that it was levitating prosperity via the wealth effect of rising asset prices. So it was oblivious to this Wall Street balance sheet explosion, and the fact that the mushrooming footings of the five “investment banking” houses were only a small piece of the threat.
During this same 1998–2007 time frame, the five largest US bank holding companies underwent a similar balance sheet multiplication. In addition to standard deposit banking, all of these holding companies developed significant trading and underwriting operations, and a growing dependence on wholesale funding. Moreover, each was a product of the M&A frenzy unleashed by the Fed’s prosperity management model.
Already by 1998, the predecessors of what would become the five megabanks—JPMorgan, Citigroup, Bank of America, Wells Fargo, and Wachovia—did not bear much resemblance to the staid institutions of the post–New Deal commercial banking market. Each of these giants had been assembled from a breakneck pace of M&A during the first Greenspan decade, a development which was totally alien to the prior fifty-year history of the banking industry.
During that earlier half-century, there had been virtually no mergers of big money center banks or of broadly based retail banking chains. So the abrupt 1990s break from this sedate history might have raised questions about where all the noisily trumpeted “synergies” and consolidation “efficiencies” were suddenly coming from. Entrepreneurs in the regulated deposit banking industry had evidently not discovered any during the prior fifty years. Nor were there any current studies which documented significant economies of scale in commercial banking. There still have been none.
As it happened, empire-building CEOs did not need studies. Operating in the government franchised, supervised, and insured banking industry, they were largely immune from normal free market pressures which always militate toward efficient-scale enterprises rather than sheer size for its own sake.
By contrast, what empire builders like Citigroup’s Sandy Weill and Hugh McColl of Nations Bank actually had going for them was the Greenspan Fed. As it drove PE multiples ever higher during the stock market bubble of the 1990s, it was almost impossible for serial acquirers to dream up a deal that wasn’t “accretive” and therefore a good thing for shareholders.
In still another variation of the M&A racket, the financial consolidators had gotten themselves awarded a high PE multiple based on their alleged potential for strong growth. Such turbocharged stock valuations, in turn, functioned as an “acquisition” currency: a variety of money produced by speculators, not producers and investors.
In a typical bank merger, for example, the acquirer’s 15X multiple made the earnings of an 8X acquisition target accretive to its earnings-per-share. So the acquirer’s market cap rose at the get-go, even after allowance for a significant takeover premium. These post-merger stock price gains, in turn, validated the growth-by-acquisition model of the financial empire builders, thereby encouraging them to repeat the exercise over and over.
Needless to say, serial bank M&A also produced massive “diseconomies of scale” that remained submerged inside these financial behemoths as they steadily became too big to understand or to manage. The sheer chaos that erupted inside these institutions after September 2008 was stunning proof that merger mania had destroyed efficiency, discipline, and value. Yet over the long years of the financial bubble and the bank merger spree it did not seem to matter.
Momentum-chasing fund managers like Bill Miller of Legg Mason kept accumulating the stock of the mega-banks and didn’t need to bother with questions about how all this financial magic was working. Steadily rising stock prices were explanation enough; that is, the “market action” proved that these financial empire builders could do no wrong.
THE BANK SYNERGY SCAM: QUADRUPLE DIPPING
These banking behemoths were built on threadbare theories impervious to evidence. Thus, the financial “supermarkets” notion had been Citigroup’s mantra, yet there was no validation that it had actually generated sustainable “cross-selling” or other incremental revenue gains. Likewise, the mega-banks’ formulaic claims for cost savings from each acquisition were completely implausible, and amounted to double, triple, and quadruple dipping.
The sequential strings of merger upon merger were so long that the serial cost reduction synergies claimed for them were logically impossible. Bank of America, for example, claimed it would squeeze large savings out of FleetBoston following its acquisition in 2004. Yet the predecessor entities had made the same claim when BankBoston merged with Fleet Financial Group in 1999. The latter, in turn, had been a serial acquirer which presumably squeezed out all redundant head counts and operating costs when it merged with Shawmut National bank in 1995.
Even by that point, the potential for synergies was questionable, since Fleet Financial Group had earlier claimed it had picked redundant costs clean when it merged with Bank of New England in 1991; and this large redundancy savings, if it happened at all, had come on top of cost takeouts that Fleet Bank had claimed from its merger with Norstar Bancorp of Albany in 1988. In short, the endless chain of synergies was a delusional racket.
The Bank of America merger chain was only one strand of the M&A “roll-up” wave that hit the banking system between 1992 and 2007. All told, tens of billions in cost synergies were claimed during this tidal wave of M&A, and most of it was in head count and payroll.
Yet there was no proof in the pudding. In fact, Bureau of Labor Statistics monthly payroll data showed that there were 1.76 million jobs in depository banks in 1992 and slightly more—1.82 million—in 2007. The massive head-count reductions claimed in the industrywide merger wave, in fact, were just so much press release eyewash.
Based on the financial agitprop of the bank empire builders, of course, the impression was also easily garnered that these M&A deals were driving a ripping wave of productivity and efficiency throughout the banking system, and that redundant and obsolete bricks-and-mortar branches were being aggressively shuttered. In fact, the nation had been blessed with 115,000 bank branches and offices in 1992 and was nearly doubly blessed with 165,000 of them in 2007.
WHY THE CLAIMS FOR BANK M&A WEREN’T ON THE LEVEL
Gary Cooper would have doubtless found the claims of the banking empire builders in 2005 to be no more “on the level” than he had found the claims of Communism in the 1950s. The actual fact was that giant strides in information technology and inventions like the ATM were sharply reducing the cost of plain old deposit banking during this period.
Yet there was no evidence that these actual productivity breakthroughs depended upon the roll-up of trillion-dollar financial supermarkets, or that the bank merger mania added any independent benefit to these underlying technology-driven gains. I
n fact, some of the most efficient banks in the United States have asset footings of under $50 billion (i.e., 2 percent of Citigroup), yet have not been denied economies of scale with respect to any aspect of the information technology revolution in banking.
The former Hudson City Bancorp, for example, had the lowest operating cost-to-revenue ratio of any publicly traded bank in the United States, but had only $45 billion of assets and 135 branches. In fact, its operating cost ratio was less than half that of its mega-bank competitors such as Chase Bank and Citibank, with which it went head-to-head on its New Jersey turf.
Not surprisingly, Hudson City Bancorp had no trading operations or prop desk, and was strictly in the residential mortgage and community banking business. Unlike the banking behemoths, it did not suffer from “dis-economies of scale” and thereby maintained a pristine loan book. It never wrote a single subprime loan or any other risky “innovative” mortgage, and boasted a mortgage portfolio where the loan-to-value ratio averaged a rock-bottom 60 percent; that is, virtually none of its borrowers were “underwater.”
Accordingly, Hudson City Bancorp was the poster boy for prudent and proficient underwriting: it had only 500 bad loans out of 80,000 in its mortgage book. It also put the lie to the entire “size matters” propaganda that arose from the merger mania. Hudson City Bancorp not only suffered no scale disadvantages but also avoided the underwriting chaos of its Too Big to Manage competitors.
In truth, there are no significant economies of scale in retail banking above $50 billion in assets, period. Consequently, the massive “roll-ups” of retail banking should never have been tolerated by bank supervisors.
Nor was the case any more compelling with respect to corporate lending and securities underwriting. The relevant marketplace for these operations is global, yet that’s exactly why almost every corporate financing of size is widely syndicated. The latter process—often involving dozens of financial institutions presenting widely differing geographies, customer bases, and scales of operations—represents the opposite of the mega-bank principle; the very purpose of syndication is to disaggregate scale, not concentrate it.
The Great Deformation Page 54