13 Bankers: The Wall Street Takeover and the Next Financial Meltdown (27 page)

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For example, pension funds with long-term liabilities should prefer to invest in long-term assets, so they are getting their money back at the same time that they need to make payouts.

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In a stylized example, an MBS offering might be composed of 85 percent senior MBS and 15 percent junior MBS. If 5 percent of the underlying mortgages default, the junior investors will lose one-third of their money, but the senior investors will lose nothing. The senior investors only lose if over 15 percent of the underlying mortgages default. By contrast, in a pass-through MBS, there are no tranches; if 5 percent of the mortgages default, all investors lose 5 percent of their money.

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There is not universal agreement on terminology. A mortgage-backed security with tranches is sometimes called a CDO. A CDO backed by mortgage-backed securities is sometimes classified as a mortgage-backed security (because ultimately it, too, is backed by mortgages).

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Contrary to popular belief, not all subprime loans are loans to poor people. The classification of a loan depends on the relationship between the borrower, the property, and the size of the loan. Chris Mayer and Karen Pence have found that “subprime mortgages are not only concentrated in the inner cities, where lower-income households are more prevalent, but also on the outskirts of metropolitan areas where new construction was more prominent.”
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In 2005, only eight U.S. companies had AAA bond ratings: AIG, Automatic Data Processing, Berkshire Hathaway, ExxonMobil, General Electric, Johnson & Johnson, Pfizer, and United Parcel Service.

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Preemption is a legal doctrine holding that certain areas regulated by the federal government may not be regulated by the states—even if they wish to enact more stringent requirements than those prescribed by federal regulators.

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The Federal Reserve controls the federal funds rate by buying and selling Treasury securities, which decreases or increases the amount of money available to banks, thereby affecting the rate at which banks lend to each other. The federal funds rate has an important though indirect influence on all interest rates in the economy.

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Average real annual growth has been lower in the 2000s (through 2008) than in any decade since the 1930s; real median household income (in 2008 dollars) has fallen from $52,587 in 1999 to $50,303 in 2008.
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6
TOO BIG TO FAIL

To paraphrase a great wartime leader, never in the field of financial endeavour has so much money been owed by so few to so many. And, one might add, so far with little real reform.

—Mervyn King, governor of the Bank of England, October 20, 2009
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On October 13, 2008, their stock prices in tatters and the short-term viability of their firms in doubt, the heads of nine major banks—Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Merrill Lynch, Morgan Stanley, State Street, and Wells Fargo—arrived at the Treasury Department for a meeting with Treasury Secretary Henry Paulson.
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Each was given a term sheet agreeing to sell shares to the government, and Paulson told them to sign it.
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This might seem like a government takeover of the financial sector—a seizure of ownership interests in nine major banks. And given the stakes—a near-total freeze of credit markets, a plunge in the stock market, the potential collapse of those and yet more banks—that would not have seemed too far-fetched. But the remarkable thing about this meeting was not that the government was stepping in to protect the U.S. financial system and, by extension, the global economy. What was remarkable was something that Vikram Pandit, CEO of Citigroup, noticed instantly: “This is very cheap capital!”
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It was such a good deal that John Mack, CEO of Morgan Stanley, signed the term sheet immediately, even before consulting his board of directors.
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Few people at the time were arguing that the government should sit on its hands and let the financial sector implode. But few also expected Paulson, Federal Reserve chair Ben Bernanke, and Federal Reserve Bank of New York president Tim Geithner to rescue the banks on such generous terms. The October 13 deal was structured as a purchase of preferred shares, which effectively meant that Treasury loaned the banks money, at an initial 5 percent annual interest rate (a rate that was not available in the market), that never had to be repaid.
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(Treasury also received options to buy a small amount of common shares at a predetermined price.) The purchases theoretically meant that the government now owned part of the banks, but Treasury promised that it would not influence the management of the banks and would not vote for members of their boards of directors.
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It was close to free money.

Why was this such a sweet deal? Although banks borrow most of their money, all banks need capital—money that cannot be demanded back by creditors. Capital serves as a buffer that prevents a bank from failing when its assets fall in value. In good times, when capital is readily available, banks prefer to borrow as much as possible in order to maximize their profits, keeping their capital levels low; but in bad times like October 2008, when banks most need additional capital, it is at its most expensive—because who wants to invest in a bank that may fail the next day?

But as Pandit recognized, the government was giving the banks capital cheaply; Warren Buffett, by contrast, had just invested in Goldman Sachs at a 10 percent interest rate. (Buffett also received more options than Treasury, and at a bigger discount to the then current market price.) In short, Paulson, a former CEO of Goldman Sachs, was pushing free money at his former colleagues. Phillip Swagel, then a Treasury assistant secretary, later wrote, “This had to be the opposite of the ‘Sopranos’—not a threat to intimidate banks but instead a deal so attractive that banks would be unwise to refuse it.”
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According to Swagel, the government had to offer attractive terms because it could not force the banks to agree to any investment, and it is true that some bankers claimed that they did not need government capital.
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However, the government did have considerable negotiating leverage, thanks to its regulatory authority, its ability to threaten
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to bail out banks later should they need it, and the fact that banks would be taking a risk by walking away without money that their competitors had. And the government officials involved fully appreciated the strength of their position. During the meeting, Paulson responded to an objection by saying, “Your regulator is sitting right there,” referring to the director of the Office of the Comptroller of the Currency and the chair of the Federal Deposit Insurance Corporation. “And you’re going to get a call tomorrow telling you you’re undercapitalized and that you won’t be able to raise money in the private markets.”
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The government’s largesse was not limited to capital at a bargain basement rate. At the October 13 meeting, officials also revealed that the government would begin guaranteeing debt issued by the banks, allowing them to raise money by selling bonds to private investors who now knew that the government would protect their investments. Together, these two measures constituted an extraordinary gift from the government, on behalf of taxpayers, to the financial sector.

At the time—with Lehman Brothers bankrupt, Bear Stearns and Merrill Lynch sold, and Goldman Sachs and Morgan Stanley fleeing for the safety of bank holding company status (which gave them increased access to emergency lending from the Federal Reserve)—many observers thought the financial crisis signaled the demise of Wall Street. For the onetime “masters of the universe,” being forced to accept government money was a humbling blow. And even with the cushion of a large government subsidy, the banks seemed unlikely to return to the high-flying ways of the boom. America’s leading business newspaper put its name on a book entitled
The Wall Street Journal Guide to the End of Wall Street as We Know It.
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An era, it seemed, was ending.

Today, however, it is clear that Wall Street did not end. While some fabled institutions have vanished, the survivors have emerged larger, more profitable, and even more powerful. The vague expectation that the government would bail out major financial institutions when necessary has become official policy. The connections between Wall Street and Washington have become stronger. A Democratic administration has done everything in its power to restore a private, profitable financial sector. A casual observer would be forgiven for thinking that Washington has behaved like an emerging market government in the 1990s—using public resources to protect a handful of large banks with strong political connections. Whether this was due to political capture or to unbiased economic policymaking, the result was the same: Wall Street only became stronger as a result of the financial crisis.

The story of the financial crisis of 2007–2009 has been told many times.
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Policymakers, economists, and commentators have pointed to many causes and contributing factors, ranging from “oversaving” in China to basic human psychology.
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However, few would deny that a U.S. financial system that inflated an asset bubble with cheap lending, manufactured colossal amounts of complex and potentially toxic securities, levered up with debt to maximize profits, and binged on short-term funding played a central role in bringing on the crisis. Even under the theory (popular among Americans) that a glut of saving in China created a flood of cheap money in the United States, leading to overborrowing and the housing bubble, that money had to flow through the American financial system, which did a phenomenally poor job of allocating it efficiently.

This system was made possible by the rise of the financial sector over the past three decades. Members of the Washington establishment bought into Wall Street’s vision of free-flowing capital and unfettered innovation. Whether they were true believers or cynics out to maximize their campaign contributions or their future earning potential, policymakers helped the major banks by relaxing regulations, declining to enforce existing regulations, or neglecting to regulate new markets. This is why mortgage originators were allowed to make loans that got bigger over time, making them harder to pay off; why those mortgages could be packaged into securities that masked their intrinsic risk; why banks could stash those securities in off-balance-sheet vehicles and pretend they didn’t own them; why they could use fancy risk models that said that nothing could go wrong with those securities; why trillions of dollars of side bets could be placed on those same securities; and ultimately why trillions of dollars of assets ended up precariously perched on top of a bubble of debt.

In 2006, the air began leaking out of that bubble, housing prices began to fall, and borrowers unable to refinance their mortgages started defaulting in sharply rising numbers. In 2007, the mountain of assets based on housing values began to crumble as increasing defaults torpedoed the prices of mortgage-backed securities and collateralized debt obligations (CDOs). In 2008, the resulting avalanche almost brought down the global financial system. Key government policymakers made admirable efforts to save the financial system. But the actions they took ultimately demonstrated the importance of a particular worldview in Washington—the idea that big, risk-loving banks are crucial to our economy and our way of life.

ON THE EDGE OF THE CLIFF

The financial crisis played out in a series of increasingly frightening episodes on Wall Street. Each scare prompted concern in Washington. But the three men who dominated economic policy through the end of the Bush administration—Paulson, Bernanke, and Geithner—hoped to avoid direct government intervention, preferring the approach of cushioning the downturn through increased liquidity and lower interest rates. Only in 2008 did they recognize that they were dealing with the kind of collapsing debt bubble common to emerging market crises in the 1990s—a scenario that required stronger measures.

Problems became widely visible in summer 2007, when Bear Stearns and then BNP Paribas revealed problems with internal hedge funds that had invested heavily in subprime mortgages. The disclosures made investors wonder how many other funds might contain ticking time bombs. The Federal Reserve responded with additional liquidity, lowering the discount rate and the federal funds rate
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in an attempt to encourage lending and head off a credit contraction.

Fear only grew, however, as investors next became concerned about the structured investment vehicles (SIVs) that many banks had spawned in order to profit from structured securities while minimizing their capital requirements. As rumors spread that SIVs would either go bankrupt or infect the balance sheets of their sponsoring banks, the government attempted to engineer a backroom deal involving money from private banks. The theory was that the SIVs only faced a short-term liquidity crisis—given time, their assets would recover their value—and therefore deep-pocketed banks could buy them out safely. In October 2007, at the urging of the Treasury Department, several major banks announced a Master Liquidity Enhancement Conduit (MLEC) that would buy several hundred billion dollars’ worth of securities from troubled SIVs. However, the idea was quietly dropped in December. Most likely the banks realized that using their own money to bail out their own SIVs—or, as some suspected, pooling the money of many banks to bail out Citigroup’s SIVs—did not represent a real solution.