by David Dreman
This story is, of course, total fiction. We all know investment banks and banks don’t own casinos—at least not directly. The details, too, are not literally true. So, as you read on, any similarities you may deduce are simply a matter of coincidence.
Or, then again, are they?
Singing the Bailout Blues
“How could the U.S., the strongest country on earth, put itself into this horrific situation?” I wrote in Forbes shortly after the $700 billion Troubled Asset Relief Program (TARP) was passed by Congress in late 2008. “I wince at the $700 billion bailout,” I continued. “It was a necessary evil, but it doesn’t make me feel good as an investor.” The article went on to describe what we knew back then had caused the worst financial crisis in history.1
The public is still very perturbed about the financial bailout, as well as the high levels of unemployment the financial crisis has caused. Further resentment has been stoked because millions of people have been forced out of their homes. Many Americans are furious that virtually all of the perpetrators of these financial acts are walking off not with prison sentences but with severance payments up to a hundred million dollars. The final and possibly bitterest blow is that the financial executives who almost brought down our economy received seven- and eight-figure bonuses for what they did. The rise of the Tea Party and the sweep of the House of Representatives by Republicans in November 2010 showed quite clearly that voters are unhappy with the slow progress of both constructive change and job creation. Is popular opinion close to the truth on what actually happened, or is it out of whack with the facts?
Three congressional committees (which were surprisingly bipartisan) subpoenaed hundreds of thousands of e-mails and took voluminous testimony. Prior to the hearings, few explanations were forthcoming from the Fed and the Treasury about the banks and investment bankers who received the bailouts. But thanks to the congressional committees’ thorough work, we know much more today.
What we have learned is at times shocking. Bankers were enormously deceitful to the public, and their greed was on a par with almost any in our history. Yes, Congress has taken actions to prevent a recurrence of some of the folly, but all too many questions remain. In order to highlight possible causes of future crises, let’s take a quick look at what we’ve learned.
First we’ll look at the roles played by the Federal Reserve under its current and previous chairman, as well as by senior administration officials through the previous two administrations and the present one. We’ll then move on to the banks, investment banking firms, and other key players. No one group can be singled out for causing the financial crisis or the Great Recession. As most of us know, they were caused by a powerful confluence of factors, almost a perfect storm. What many people don’t know was the degree of incompetence and misguided ideology, as well as the powerful role played by little-known special-interest groups and the intensity of greed displayed by so many, all of which were critical elements.
The solutions to these serious problems are certainly beyond the scope of this book, but an understanding of the insidious effects they inflict should prove helpful to us as investors in understanding the problems we must continue to cope with for some time.
Mr. Chairman
May I introduce you to one of the major economic powers in U.S. history? No, he wasn’t a political figure such as FDR or Ronald Reagan, but he was reverently called “the Oracle” by many thousands for the brilliant economic moves people thought he had made, which they believed had saved not only the U.S. economy but businesses globally. I’m referring, of course, to Dr. Alan Greenspan. He holds a Ph.D. in economics and served as chairman of the Federal Reserve of the United States from 1987 to 2006. For Wall Street, he was the closest thing to a Delphic oracle that investors had ever seen.
During his tenure as Fed chairman, he appears to have been strongly driven by ideology. As many know, Greenspan is a disciple of Ayn Rand, the author of Atlas Shrugged and one of the prime intellectuals from whom libertarianism took its ideas. In his late twenties, Greenspan fell into the Objectivist movement, dominated by Rand, which favored free markets and opposed strong government, and he contributed several essays to her book Capitalism: The Unknown Ideal. He was even a strong advocate of the gold standard and in his earlier years would have denied the power of the Fed to increase or reduce the money supply. Through the years he remained close to Ayn Rand and was a strong believer in deregulation. She and his mother were present as the witnesses when President Reagan swore him in as the chairman of the Federal Reserve in the summer of 1987.
In his prepolitical years, his philosophy was relatively simple: regulation bad, free enterprise good. He went so far as to state on Meet the Press that antitrust laws should be abolished. Not only did he want to cast out the New Deal in its entirety; he even wanted to undo the Republican president Theodore Roosevelt’s trust-busting work in the early twentieth century. His perspective is encapsulated well in this quote from a speech he gave to the American Bankers Association in 1996: “If banks were unregulated, they would take on any amount of risk they wished, and the market would rate their liabilities and price them accordingly.”2 Simple, yes; naive, yes; and to a large degree successful. So successful, in fact, that the deregulation of the banks played a major role in their blowing up both themselves and the economy a little over a decade later. The complexity, scale, and interdependence of modern banks were never considered by the man who led the Fed for twenty years.
Greenspan appears to be an advocate of the much earlier form of free enterprise, the laissez-faire of the 1830s and 1840s. Back then, all the fundamentals he would like to see in the current world were functioning. What his almost zealous idealism seems to overlook was that it was anything but a perfect time. Most people lived in enormous poverty. Fifty to 60 percent of the English population suffered from malnutrition. Child labor was widespread, and most people worked a seven-day week. “Don’t come in Sunday, don’t come in Monday” was a sign industrialists often posted on British factory doors. Debtors’ prisons dotted the country. Several major riots took place in manufacturing cities and London, protesting the terrible conditions, while Wellington, “the Iron Duke,” who won the Battle of Waterloo, was prime minister. Ironically, had Greenspan lived in those halcyon times, his chances of achieving the success he did would have been almost nil, because major positions went to the upper class. At heart he is a man of the early nineteenth century.
Fortunately for him, he was born much later and achieved enormous success. Greenspan at his pinnacle was widely considered to be the most able central banker who ever walked the face of the earth. He was a financial savior, affectionately called “the Prophet” or “the Oracle,” whose understanding of evolving financial and economic problems and his adept handling of them as they arose led, most believed, to a world of peace and prosperity.
Every statement or speech he gave was a news event and was immediately flashed to financial markets globally. No economic forum was considered important if he did not speak or attend. His portrait sold for as much as $150,400,3 and a dinner with him went for $250,000.4 More important, he had the ear of every president of the United States from Ronald Reagan to George W. Bush, as well as most congressmen and senators, whether Democrats or Republicans, almost since his appointment as chairman of the Fed.
Wall Street speculated on what he would say prior to his every major appearance before Congress. His speeches were often televised live, and their content was distributed to the media before the actual delivery of the talk. Greenspan’s speeches and statements were convoluted and difficult to decipher, although every word was studied by tens of thousands.
To me his statements not only were difficult to decode but often seemed to contradict previous ones he had made. When I mentioned this to other money managers I knew or when I wrote about his lack of clarity in my Forbes column, I was told that this was the way a major chairman of the Fed should present himself. Others said that this was the way an oracle sh
ould speak. Greenspan told Bob Woodward, the noted journalist and political author, that he wanted to keep the financial community off balance by doing this so it never fully understood his course of action. He called it “constructive ambiguity.”5
If his speeches were opaque, his actions as Fed chairman for almost twenty years certainly were not. And it was those actions that played an important role in the worst financial crisis in history. What is striking was that although his decisions on key matters were consistent, predictable, and repeated numerous times, few Fed watchers caught on to the pattern.
Greenspan did not want outside regulation by governmental agencies at any level, and he did not want the Fed to carry out many of its assigned responsibilities to regulate banks and other financial institutions or to provide the consumer protection it was mandated to give. He had an unshakable belief that companies, regardless of their size, industry, or circumstances, would, in their own self-interest, regulate themselves well. His belief in self-regulation colored most of his major actions over the almost twenty years he was chairman.
Greenspan was instrumental, along with Treasury Secretary Robert Rubin and Lawrence Summers, a powerful, politically connected Harvard economist, who would later become secretary of the Treasury, in repealing the Glass-Steagall Act under the Bill Clinton administration. The act, which restricted the power of commercial banks to compete with investment banks and significantly curtailed the amount of risk they could take, had by and large worked successfully to that time. The roots of the repeal came out of Greenspan’s Federal Reserve, which in the late 1980s began reinterpreting Glass-Steagall in a series of actions that slowly increased the banks’ abilities to expand into other activities.6
Enormous decisions that affected the welfare and livelihoods of most Americans were made by the ranking Fed and Treasury policy makers and were based on their personal ideologies, which were often far removed from those of the electorate.
Were It That Simple
Greenspan was also the “leading proponent of the deregulation of derivatives.”7 There were an ample number of knowledgeable people who were concerned that this deregulation would cause a serious drop in the safeguards on their use in the last year of the Clinton administration. Among the opponents was the former head of the Commodity Futures Trading Commission (CFTC), Brooksley Born. She attempted to have derivatives regulated, including the extremely complex and lethal credit default swaps, which sank AIG and came close to sinking dozens of other financial institutions and hedge funds. Born was met by enormous opposition from Secretary of the Treasury Robert Rubin, Lawrence Summers, and, oh yes, Alan Greenspan, all of whom, on April 21, 1998, took turns trying to talk her out of her position.8 One account indicates that Summers’s discussion was—to be charitable—very assertive. Born’s stand resulted in her being forced out of the Clinton administration.9
Rubin and Summers, with the strong support of Greenspan, pushed through the Commodity Futures Modernization Act of 2000, which Clinton signed into law in his last month in office. The impact on markets resulting from the nonregulation of these toxic derivatives was enormous. President Clinton told ABC News in April 2009, when asked about the advice he had received from Secretary Rubin and his handpicked successor, Summers, “On derivatives, yeah, I think they were wrong and I think I was wrong to take it.”10
Numerous warnings by highly knowledgeable financial types were given about the destructive power of derivatives years before the meltdown. George Soros, the hedge fund manager who “broke the Bank of England” with his shrewd currency trades, avoids using such contracts, “because we don’t really understand how they work.”11 Felix Rohatyn, who saved New York City from going bankrupt in the 1970s, described derivatives as potential “hydrogen bombs.” Warren Buffett presciently observed, five years before the 2007–2008 crash, that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”12 Those warnings, like so many others, were ignored.
From 1990 and for the next four years, the Fed cut rates sharply. Easier access to credit and rapid advances in financial technology led to explosive growth in the over-the-counter derivatives markets, which reached $25 trillion in notional value by 1995 and increased tenfold to 2005.
Alan Greenspan took an active role in lessening the regulation of derivatives and did not see any cause for alarm, consistent with his unwavering philosophy that the derivatives markets were unregulated and therefore must be good. Even after derivative scandals sent shock waves through the market in the mid-1990s and derivative counterparties lost billions of dollars, Greenspan continued to press for greater deregulation of them. His policy never changed. In 2003, he testified to the Senate Banking Committee, “We think it would be a mistake” to more deeply regulate the contracts.13 During the 2008 crash, in a speech at Georgetown University, Greenspan said that the problem was not the derivatives but the people using them—who got “greedy.”25 He was contradicted by Frank Partnoy, a law professor at the University of San Diego and an expert on derivatives and financial regulation, who said, “Clearly, derivatives are a centerpiece of the crisis.”14
The consistency and obstinacy of Greenspan’s push to deregulation in the face of failure after failure of his policies are remarkable. So, as we run quickly through a number of other major policy decisions that contributed to the magnitude of the financial crisis, an important question we should ask is whether the Fed’s powers ought to be curtailed after the damage it has caused the economy.
As obstinate as Chairman Greenspan was about derivatives, he was even more so about not taking any action to curb the excesses of the housing bubble.
The subprime problems did not begin in 2004–2005. Rather, they go back almost a decade to the passage of the Tax Reform Act of 1986, which allowed the deduction of interest on a primary residence and one other home.15 This made the cost of subprime mortgages cheaper than consumer loans, on which interest could not be deducted. A major new market was opened for people who could not get conventional mortgages because of low credit scores. Credit was now available, but at higher interest rates, and numerous financial companies, aka loan sharks, flocked into what looked like a very profitable new business.
By 1997, questionable accounting, higher-than-projected arrears, and defaults made it apparent that the industry had underpriced its loans and was floundering. Of the top ten originators of new mortgages in 1996, only one remained in 2000. Did the credit-rating agencies, the Federal Reserve, the regulators, and the banks remember this dismal performance? They did not, as we all painfully know. Only a year later, subprime demand roared ahead again and housing prices had turned up sharply. The housing bubble had started.
The Subprime Ball
After the 1996–2000 high-tech bubble collapsed, the Federal Reserve, under Chairman Greenspan, lowered interest rates significantly and a very easy monetary policy was established to cushion the enormous market losses, estimated at over $7 trillion, that investors had taken after the 2000–2002 crash. The Fed feared those losses might severely curtail consumer and to a lesser extent business spending, pushing the nation into a recession. To prevent this outcome, the Fed funds rate was dropped from 61/2 percent in mid-2000 to 1 percent in mid-2003 in thirteen consecutive steps as the high-tech bubble disintegrated. Long-term Treasury rates fell from 7 percent to 41/2 percent.16
After the 2000–2002 high-tech bubble collapsed, people realized that although many had lost heavily in the market, housing, usually accounting for by far the greatest portion of their net worth, was not only intact but moving steadily higher. Beginning in 2002, an enormous housing boom was triggered whose excesses, as we’ll see, were the prime cause of both the near-destruction of the global financial system and the worst economic climate since the 1930s.
Twelve and a half trillion dollars’ worth of new-home originations was completed between 2002 and 2007. Risky subprime originations shot up far more than conventional mortgages, increasing fro
m 6.6 percent of total mortgages in 2002 to a whopping 21.7 percent in 2006.17 The subprime industry had hit a grand slam!
However, as is so often the case in the financial sector, the truth is not found in the glossy pages of a self-congratulatory annual or quarterly report but squirreled away in the footnotes buried deep in the back pages, where, it is hoped, they will never be found.
The Casino Has a Grand New Game
Mortgages were now available for buyers with only the most limited incomes and financial resources, housing prices soared, and buyers were lining up to get a part of the action. The mortgage companies and real estate investment trusts (REITs), along with banks and investment bankers, the major originators of subprime mortgages, were aware that they now had an opportunity that comes maybe once in a generation, and they were quick to exploit it.
Enormous incentives were paid to subprime marketers to encourage sales. Many mortgage bankers (a glorified name for a primarily unscrupulous bunch of mortgage sellers whose ethics make most used-car salesmen appear highly principled) made a million dollars or more a year as well as lavish perks. The merchandise they sold smelled worse than fish left unrefrigerated for days.
The object for the mortgage lenders was to make it easy for borrowers with little or no income or even without jobs to buy homes, by loosening the underwriting standards in the subprimes and Alt A’s*86 enough so that anyone could buy. Quality was of little concern. Everything they bought was immediately packaged with pools of other similar mortgages and sold to hungry clients.
Oh yes, bankers from Citibank, Bank of America, and Wachovia to Goldman Sachs, Morgan Stanley, Lehman Brothers, and Bear Stearns were all major players in the game. They not only bought mortgages from mortgage bankers but aggressively acquired the mortgage banks themselves; vertical integration meant even greater profits.*87