The Great Deformation (6 page)

Between early 2002 and mid-2005, the Fed had aggressively rolled out the welcome wagon for speculators, driving inflation-adjusted interest rates in the United States to patently absurd levels. During that forty-month span, when the annualized consumer price index (CPI) increase averaged about 2.6 percent, the rate on short-term borrowings was only 1.5 percent. This meant that real interest rates were negative, and not just for a month or two, but for the better part of four years. Likewise, the real rate on the 10 year Treasury bond also descended to historic lows.

In the parlance of the financial markets, the Fed's sustained spree of interest rate repression had reduced “cap rates” to all-time lows, meaning that their inverse, the price of financial assets, had been goosed to all-time highs. The Fed was thus running an out-and-out bubble machine, bloating the American economy with more cheap debt than ever before imagined.

In fact, between 2002 and 2007 total credit market debt (public and private) outstanding grew by a staggering $18 trillion, or five times more than the $3.5 trillion gain in GDP during the same period. It was only a matter of time before the American economy buckled under the load.

CHAPTER 2

 

W
HEN THE GREAT FINANCIAL BUBBLE FINALLY BURST IN SEPTEMBER
2008, AIG's credit default insurance was shockingly exposed as bogus. Given this evidence of utterly reckless and massive speculation, the Fed was handed, as if on a platter, one final chance to restore a semblance of capital market discipline.

By that late hour, however, the Fed was not even remotely interested in financial discipline. The Greenspan Put had now been superseded by the even more insidious Bernanke Put. In defiance of every classic canon of sound money, the new Fed chairman had panicked in the face of the first stock market tremors in August 2007 (see
chapter 23
), and thereafter the S&P 500 had become an active and omnipresent transmission mechanism for the execution of central bank policy. Consequently, after the Lehman event the plummeting stock averages had to be arrested and revived at all hazards. Accordingly, the bailout of AIG was first and foremost an exercise in stabilizing the S&P 500.

The cover story, of course, was the threat that a financial contagion would ripple out from the corpus of AIG, bringing disruption and job losses to the real economy. As has been seen, however, there was nothing at all “contagious” about AIG, so Bernanke and Paulson simply peddled flat-out nonsense in order to secure Capitol Hill acquiescence to their dictates and to douse what they derisively called “populist” agitation; that is, the noisy denunciation of the bailouts arising from an intrepid minority of politicians impertinent enough to stand up for the taxpayer.

But this hardy band of dissenters—ranging from Congressman Ron Paul to Senator Bernie Sanders—was correct. Everyday Americans would not have lost sleep or their jobs, even if AIG's upstairs gambling patrons had been allowed to lose their shirts. Still, the bailsters peddled a legend which has persisted; namely, that in September 2008 the nation's financial
payments system was on the cusp of crashing, and that absent the bailouts American companies would have missed payrolls, ATMs would have gone dark, and general financial disintegration would have ensued. But this is a legend. No evidence has ever been presented to prove it because there isn't any.

Had Washington allowed nature to take its course in the days after the Lehman collapse on September 15, the only Wall Street furniture which would have been broken was the potential bankruptcy of Goldman Sachs and Morgan Stanley, the two remaining investment banks. Needless to say, the utterly myopic investment banker who was running the US government from his Treasury office wasted not a second ascertaining whether the public interest might diverge from Goldman's stock price under the circumstances at hand.

According to his memoirs, Secretary Paulson already “knew” on the very morning Lehman failed that the last two investment banks standing needed to be rescued at all hazards: “Lose Morgan Stanley, and Goldman Sachs would be next in line—if they fell the financial system might vaporize and with it, the economy.”

Tendentious and sophomoric would be a more than generous characterization of that apocalyptic riff. Yet groundless as it was, the fact that Paulson and his posse treated it as truth is deeply revealing. It underscores the extent to which public policy during the bubble years had been taken captive by the satraps and princes seconded to the nation's capital by Wall Street. Such self-serving foolishness would never have been uttered in earlier times, not even by the occasional captain of industry or finance who held high financial office.

Certainly President Eisenhower's treasury secretary and doughty opponent of Big Government, George Humphrey, would never have conflated the future of capitalism with the stock price of two or even two dozen Wall Street firms. Nor would President Kennedy's treasury secretary, Douglas Dillon, have done so, even had his own family's firm been imperiled. President Ford's treasury secretary and fiery apostle of free market capitalism, Bill Simon, would have crushed any bailout proposal in a thunder of denunciation. Even President Reagan's man at the Treasury Department, Don Regan, a Wall Street lifer who had built the modern Merrill Lynch, resisted the 1984 bailout of Continental Illinois until the very end.

Once the Fed plunged into the prosperity management business under Greenspan and Bernanke, however, the subordination of public policy to the pecuniary needs of Wall Street became inexorable. No other outcome was logically possible, given Wall Street's crucial role as a policy transmission
mechanism and the predicate that rising stock prices would generate a wealth effect and thereby levitate the national economy.

Not surprisingly, the Goldman Sachs “occupation” of the US Treasury coincided almost exactly with the Fed's embrace of financialization, leverage, and speculation as crucial tools of monetary management. Its legates in Washington during this era, Robert Rubin and Hank Paulson, never once agonized over violating free market rules. They simply assumed that the good of the nation depended upon keeping the Wall Street game up and running.

Nor did the Goldmanites have even the foggiest appreciation of why the old fashioned guardians of the public purse, like Bill Simon, had been so resolutely anti-bailout. To his great credit, Simon appreciated the insidious effects of bad precedent and rightly feared that once the floodgate was opened crony capitalism would flourish. He also understood that every crisis would be portrayed as a one-time exception and that once officials started chasing market-driven brush fires, the policy process would quickly degenerate into analytics-free, seat-of-the-pants ad hocery and would frequently even border on lawlessness.

In fact, that is exactly what happened in the signature bailout episodes during Goldman's occupation of the Treasury. The $20 billion bailout of the Wall Street banks during the 1994 Mexican peso crisis orchestrated by Secretary Rubin was not only unnecessary, but was done against overwhelming opposition on Capitol Hill. In the end, the American taxpayer was thrown into the breach by Treasury lawyers who tortured an ancient statute governing the Economic Stabilization Fund until it coughed up billions for a bailout of Mexico and its Wall Street lenders. In so doing, Rubin simply thumbed his nose at Congress, implying that the greater good of Wall Street trumped the democratic process.

Likewise, the entire Paulson-led campaign to bail out Wall Street during the September 2008 crisis was an exercise in pushing the limits of existing law to the breaking point. Lehman was not bailed out mainly because Washington officials had not yet found a loophole by the time of its Sunday-night filing. But as the crescendo of panic intensified, the Treasury and Fed miraculously found enough legal daylight by Tuesday to rescue AIG.

Throughout the ordeal Paulson and his posse viewed themselves as glorified investment bankers, empowered to use any expedient of law and any drain on the public purse that might be needed to ensure the survival of the remaining Wall Street firms. Rampaging around the globe and browbeating bankers and governments alike on behalf of their half-baked merger schemes, they defiled the great office of US Treasury Secretary like never before.

GOLDMAN AND MORGAN STANLEY: THE LAST TWO PREDATORS STANDING

This was a blatant miscarriage of governance. As will be seen, at that late stage of the delirious financial bubble which had overtaken America, Goldman Sachs and Morgan Stanley had essentially become economic predators. Their bankruptcy would have resulted in no measureable harm to the Main Street economy, and possibly some gain. It would have also brought the curtains down on a generation of Wall Street speculators, and sent them packing in disgrace and amid massive personal losses—the only possible way to end the current repugnant régime of crony capitalist domination of the nation's central bank.

Goldman and Morgan Stanley helped generate and distribute hundreds of billions in toxic assets—mortgage-backed securities and CDOs based on subprime mortgages—that were now resident on the balance sheets of a wide gamut of Main Street institutions like corporate pension funds and insurance companies, along with institutional investors spread all over the planet. The TARP and Federal Reserve funds that were pumped into Goldman and Morgan Stanley, however, did nothing to ameliorate the huge losses being incurred by these gullible customers.

Instead, the Washington bailouts rescued the perpetrators, not the victims; that is, the bailout benefits were captured almost exclusively by the Wall Street insiders and fund managers who owned the common stock and long-term bonds of these two firms. Yet it was these punters who deserved to take punishing losses. It was they who enabled Goldman and Morgan Stanley—along with Bear Stearns, Lehman, and the investment banks embedded inside Citigroup and JPMorgan—to grow into giant, reckless predators.

As will be seen in
chapter 20
, only twenty-five years earlier these firms had been undercapitalized white-shoe advisory houses with balance sheets which were tiny and benign, but now their designation as “investment banks” reflected an entirely vestigial nomenclature. They had long ago morphed into giant ultra-leveraged hedge funds which happened to have retained relatively small-beer side operations in regulated securities underwriting and M&A advisory services.

The preponderance of their fabled profitability, however, was generated by massive trading operations which scalped spreads from elephantine balance sheets that were not only preposterously leveraged (30 to 1) but also dangerously dependent upon volatile short-term funding to carry their assets. Indeed, perched on a foundation of several hundreds of billions in debt and equity capital, these firms had become voracious consumers of “wholesale” money market funds, mainly short-term “repo”
loans and unsecured commercial paper. From these sources, they had erected trillion-dollar financial towers of hot-money speculation.

On the eve of the financial crisis, Goldman had asset footings of $1.1 trillion and Morgan Stanley had also passed the trillion-dollar mark. Much of their massive wholesale funding, however, had maturities of less than thirty days, and some of that was as short as a week and even overnight. When Bear Stearns hit the wall in March 2008, for example, it was actually rolling over $60 billion of funding every morning—until, suddenly, it couldn't.

It goes without saying that these highly liquid wholesale funding markets were dirt cheap because lenders had no rollover obligation and were often fully secured. It is also obvious that on the other side of their balance sheets, these de facto hedge funds held assets which were generally more illiquid, longer term, and subject to credit and market value risk, and which therefore generated substantially higher average yields.

Due to this “duration” and “credit” mismatch, the profit spread per dollar of assets was considerable, and when harvested a trillion times over, total profits were enormous, reaching $18 billion (pre-tax) at Goldman during the year before the crisis. Since this amounted to a half million dollars of profit per employee (including secretaries and messengers) the potency of carrying a giant balance sheet on the back of cheap wholesale liabilities was self-evident.

Yet here is where the foundation of overvalued debt and equity capital came in. There were limits on the extent to which the assets of these giant “investment banks” could be funded on wholesale money. Even the frothy markets of 2008 would have viewed a balance sheet consisting mainly of slow, illiquid assets funded preponderantly with short-term liabilities as a house of cards. So the investment banks' foundation of permanent capital, in fact, was the vital linchpin beneath the whole Wall Street edifice.

Thus, Goldman's balance sheet at the time of the crisis boasted long-term debt and preferred stock of $220 billion and common stock of $60 billion, even as measured by its depressed share prices that week. Likewise, Morgan Stanley had $190 billion of long-term debt and preferred stock, and $25 billion of common stock at the current market prices of its shares. Taken together then, the last two investment banks standing rested on a half-trillion-dollar base of long-term capital.

During the boom years, this long-term capital had earned handsome returns in the form of interest and dividends, with the common stock, the most junior capital, also experiencing substantial price appreciation. Goldman's share price, for example, had peaked in late 2007 at nearly $250 per share, a level five times its May 1999 IPO price.