The Great Deformation (122 page)

Since yield is the inverse of price, the implicit meaning is that the outstanding pool of junk bonds had lost roughly half of its market value, or a staggering $450 billion. Needless to say, millions of 401-K investors, who had been flushed into junk bond mutual funds by the Fed's “risk-on” promises, were now being carried off the field on their shields.

Yet while Main Street was still licking its wounds, Wall Street greeted the Fed's announcement of quantitative easing in March 2009 as the equivalent of a horn call at a fox hunt. Speculators flocked into the smoldering ruins of the junk bond market and by the end of 2009 had driven the Merrill index yield all the way back down to 10 percent. This meant that the market value of these busted bonds had doubled in nine months, and that fast-money speculators employing leverage had quadrupled their money, or more.

Self-evidently, the debt-laden companies which had issued these junk bonds hadn't recovered miraculously during that thirty-nine-week interval, but Wall Street confidence in the Bernanke Put had. In fact, the $1.1 trillion QE1 bond-buying campaign announced by the Fed in early 2009 was a powerful signal to Wall Street that the Bernanke reflation would aim to drive up bond prices as well as stocks. Accordingly, junk bond prices continued to soar and by mid-2010 the Merrill index yield had fallen to 7 percent, meaning that leveraged speculators had doubled their money again.

This explains how the Bernanke Fed has showered speculators with windfalls again and again in the various risk asset classes, yet the problem is not merely the unfairness of these massive unearned rents and the resulting further skew of societal wealth to the top 1 percent. In truth, the Fed's radical financial repression policies cause vast economic deformations, even as they generate gratuitous upward redistributions of the
wealth. That is because interest rates are the price of money, and the Fed's drastic manipulation of the bond market has caused massive unnatural flows into risky debt—a distortion that has opened even more lucrative post-bubble gambling venues for Wall Street speculators.

Thus, by the end of 2009 Main Street was still struggling to stabilize itself, but junk bonds had been the return champions of the year. So once again, Main Street investors were lured back into the chase for riches. Accordingly, fresh money flowed into high-yield bond funds like never before, totaling a record $35 billion in 2009 at a time when the nation's purported brush with Armageddon was still fresh, and then kept rising to a $100 billion inflow over the four years ending in 2012.

New money needed an outlet, of course, and the result was the greatest boom in junk bond issuance ever recorded. During 2009–2012 approximately $1 trillion of junk bonds were issued, or two times the issuance during the Greenspan reflation of 2003–2006. Even more importantly, about 60 percent of this huge volume was devoted to the refinancing of existing bonds. So this was the mother of all “refi” booms, and it meant that speculators in busted junk bonds were taken out at par or even premiums to book value.

Never before had so much cash been hauled home by speculators—literally hundreds of billions—for so little valued added. Indeed, the junk bond windfall of the past several years has been wanton, but that is not all. It has also facilitated an unprecedented junk bond maturity extension—that is, a can-kicking exercise—that has unleashed, in turn, even greater windfall gains on the more junior preferred stock and common equity securities of these issuers.

Thus, as of December 2010 there were nearly $850 billion of junk bond maturities pending for 2013–2116. This amounted to a so-called maturity cliff that threatened the financial viability of many, if not most, of the “debt zombie” LBOs previously described. Owing to the junk bond refi boom fostered by the Fed, however, by late 2012 the “maturity cliff” had been smashed down to only $375 billion, or by nearly 60 percent.

Accordingly, the day of reckoning has been pushed back toward the end of the current decade. In the meanwhile, however, private equity shops have experienced a massive windfall: the value of their thin slices of equity of these born-again debt zombies have soared, often by 3X and even 10X orders of magnitude. Likewise, a comparable refi boom in commercial real estate has unleashed a similar drastic rebound of what had been underwater equity investments in struggling strip malls and office buildings.

Needless to say, this is bubble finance at work, not sustainable economic recovery. But pending the next financial meltdown it means that the entire
arena of busted leverage—junk bonds, leveraged loans, LBO equity, commercial mortgage-backed securities, underwater mall investments, and much more—has given rise to several trillions of windfall gains to adroit speculators. When coupled with 115 percent recovery in the broad equity markets, and 200–400 percent gains in high-beta equities, it can be well and truly said that the Fed has engineered a fulsome recovery—for the top 1 percent.

HOW THE TOP 1 PERCENT FOUND RICHES IN THE AUTO CRASH

One of the great untruths of the 2012 election campaign was the Obama claim that the auto bailout was a great victory for the people. As has been seen, it was actually just a heist by the aristocracy of organized labor whereby 50,000 auto jobs were shifted from south of the Mason-Dixon Line to its north. But it was also much worse than that. In combination, Washington's fiscal bailouts and the Fed's massive gifts to carry traders generated truly obscene speculator profits in the burned-out districts of the auto belt.

Thus, in the case of the GM bailout the only group that gained beyond GM's 48,000 active UAW members and 400,000 retirees was a few dozen suppliers. Crucially, however, the windfalls even here went to financial speculators. The preponderance of auto parts makers were pulled into bankruptcy, so it was the “distressed” paper of their
Chapter 11
estates that reaped the gains. As it happened, speculators in the various classes of their busted loans and securities harvested spectacular upsides literally within months of the White House–orchestrated quick rinse bankruptcy of GM.

To be sure, these GM suppliers, who were owed about $15 billion for parts and material, were not victims—they were enablers. They had taken a reckless risk in continuing to extend forty-five days of trade credit to GM, even though it was obvious that GM was burning cash so rapidly a crash landing was only a matter of time.

In the White House's simulacrum of a bankruptcy court, however, most suppliers got paid a hundred cents on the dollar. Their unsecured claims did not rank very high in the contractual hierarchy of creditors, but their lobbying ranks on K Street turned out to be nine-tenths of the law. Once again, the free market's disciplinary mechanism, in the case of the regulation of trade credit, was given short shrift.

As previously described, I had been the principal investor when the $4 billion auto supplier I had put together (on too much leverage) had been taken down a few years before the White House gravy train arrived in Detroit. But I had learned the reason why suppliers foolishly extended GM trade credit long after it was objectively bankrupt. Most of them, including
my company, were up to their eyeballs in debt and had no choice except to “extend and pretend” in order to keep enough cash coming in to pay the interest bill.

GM was therefore at the end of a destructive daisy chain of debt that encompassed the entire auto supply base. When the free market's unsparing campaign to clean house was stopped cold on December 12, 2008, the Bush administration struck a more deadly blow at the vitals of free enterprise than simply granting GM a stay of execution until it could be officially bailed out by the statists who had won the election. In fact, a corollary effect of the bailout was the further evisceration of business credit discipline.

While rarely acknowledged, trade credit is the first line of defense against unsound finance in the American business system. At the present time, there is about $2.5 trillion of trade credit outstanding; that is, payables owed to suppliers by their downstream customers. These debts among companies handily exceed the $1.8 trillion of bank loans and commercial paper owed by nonfinancial businesses.

In the general scheme of business credit, suppliers are unsecured lenders while banks rank above them and are secured by liens on fixed and working capital. As a result of this junior status, suppliers ordinarily have powerful incentives to closely monitor the financial health of their customers, and generally do so with far better ground-level knowledge and insight into their customers' circumstances and current industry conditions than do the commercial bankers.

By refusing to ship on forty-five-day credit, suppliers can exert a powerful braking effect on the financial policies of their customers. Indeed, a “run” among trade creditors on a profligate customer like GM can ordinarily be every bit as swift, contagious, and devastating as a proverbial run on a retail bank. This natural mechanism of financial discipline on the free market has been greatly crippled, however, owing to the massive increase in credit market debt during the era of bubble finance.

As previously indicated, nonfinancial business credit grew from $4.5 trillion to $11.5 trillion over the last eighteen years. Accordingly, as suppliers got deeper and deeper in debt to external lenders, their trade creditor's trump card—refusal to ship on forty-five-day terms—lost its efficacy. They could no longer make this threat because they could not afford a disruption in the daily cash flow needed to service their heavy external debt. In a process that was subtle and incremental, therefore, the business credit system became an ever more fragile chain of debtors who could not afford to safeguard their own trade credit exposure.

This breakdown of the business credit chain reached its epitome in the auto supply base that served GM and the other original equipment manufacturers
(OEMs). During the fifteen years before Detroit's crash landing in late 2008, the domestic auto space had become a playpen for Wall Street–based financial engineering, including M&A roll-ups, LBOs, and supplier division spin-offs from the Big Three OEMs. The consistent theme behind all of these maneuvers was to pile the debt higher and higher.

The impact was especially insidious in the case of the huge upstream parts division spin-offs from the OEMs, all of which ended up in bankruptcy. The GM spin-off was called Delphi and its $30 billion in annual sales made it the largest auto supplier in the world.

THE ELLIOT GANG AND PLUNDER OF DELPHI

Delphi was comprised of the former parts divisions—radiators, axles, lighting, interiors—that had been spun out of GM in the late 1990s by investment bankers claiming it would make GM look more “focused” and “manageable.” In truth, Delphi was a dumping ground for $10 billion of GM's debt, pension, and health-care obligations, as well as dozens of hopelessly unprofitable UAW plants and billions more of hidden liabilities such as parts warrantees.

Not surprisingly, Delphi hit the wall early, entering
Chapter 11
in the fall of 2005. That this spin-off company was intended all along to be a financial beast of burden for GM is evident in its reported financials for its prior six years of existence as an independent company. During that period its sales totaled $165 billion, mostly to GM, but it recorded a $6 billion cumulative net loss and generated negative operating free cash flow. Indeed, saddled with $60 per hour UAW labor costs against non-union competition at $15 per hour, it was kept alive only by an intra-industry Ponzi scheme: Delphi floated bad trade credit to GM and GM massively over-paid Delphi for parts.

Needless to say, Delphi was an economic train wreck that had no prospect of honest rehabilitation, but under pressure from GM and the UAW it remained mired in bankruptcy court for the next four years. In the interim it continued to float billions of GM's payables on the strength of its DIP facility, yet was ultimately able to emerge from
Chapter 11
only because the White House auto task force saw fit to pump billions of taxpayer money into its corpse as part of the GM bailout.

The first-order effect of this terrible abuse of state power, of course, was a few more $60 per hour UAW jobs in Saginaw, Michigan, and a few less $15 per hour non-union jobs in Tennessee and Alabama. But the real evil of the bailout lay in its rebuke to free market discipline and the powerful message conveyed by the White House fixers that failure in the market-place
no longer mattered. Even complete zombies like Delphi could be spared, so long as crony capitalism was alive and well in Washington.

The self-evident fact is that Delphi should have been liquidated, with its few viable operations auctioned off and its dozens of uncompetitive and obsolete UAW plants shuttered. The billions of trade credit it had foolishly extended to GM should have been written off, not paid in full by the taxpayers (with GM bailout funds). Yet this capricious assault on the free market was only one of the evils that came from the auto bailouts.

After Delphi was unnecessarily resuscitated with what turned out to be $13 billion of taxpayer money, including $5 billion from TARP and $6 billion from the Pension Benefit Guaranty Corp.'s takeover of Delphi's busted pensions, an even more obnoxious turn of events unfolded. A marauding band of hedge fund speculators were able to scalp an astounding $4 billion profit from a company that under the rules of the free market and bankruptcy law would never have seen the light of day after its original
Chapter 11
filing. Indeed, just one of the investors, a so-called vulture fund named Elliot Capital, appears to have realized a 4,400 percent gain, or $1.3 billion, on its Delphi investment, which was taken public in an IPO in the fall of 2011.