The Great Deformation (75 page)

By the end of 2007, the five investment banking houses plus five mega-banks posted a combined balance sheet of $11.4 trillion. They were now 300 percent of the size they had been in 1998, notwithstanding that the real economy had grown by only 29 percent during the decade.

So once again bubble finance generated a vast deformation. During the course of just eight years, these monuments to runaway M&A and the wholesale-market money shuffle expanded their balance sheets by the staggering sum of $8 trillion. Needless to say, this kind of insensible growth could only occur in a wholly financialized economy driven by a central bank that had rigged interest rates at absurdly low levels.

On the free market, by contrast, the endless hypothecation and rehypothecation of collateral which underpinned the massive balance sheets of these giant banks would have been stopped dead in its tracks. The reason stems from nothing more mysterious than the law of supply and demand.

In a wholesale money market with a freely functioning pricing mechanism—that is, one not contaminated by central bank interest rate repression—the explosion of Wall Street demand for repo and other short-term funding would have caused interest rates to rocket skyward. The effect would have been similar to what occurred in the pre-1914 call money market when the supply and demand for excess savings got out of whack; namely, money market rates would have soared into double digits.

Double-digit money market rates, in turn, would have quashed the demand for wholesale funding because the carry trades, which are the fundamental source of repo demand, would have been deeply negative. Stated differently, carry trades don't work when the interest cost on borrowings is higher than the yield on the pledged mortgages, corporates, governments, or even junk bonds.

Furthermore, the elimination or even shrinkage of repo credit, which was mostly manufactured out of thin air by lenders who sold the collateral short, would have forced the mega-banks to seek plain old deposit funding. Needless to say, a scramble for deposits on the free market would have been a further potent antidote to expansion of Wall Street balance sheets.

Genuine Main Street savers would have demanded far higher interest rates to forego additional amounts of their now beloved consumption. Indeed, to get consumers to throttle back on consumption would have required drastically higher inducements than those which prevailed under the Fed's price-controlled money markets. The magic profits of balance sheet arbitrage would have thus been largely eliminated on the free market.

Absent the money market carry trades enabled by the Fed, therefore, the $8 trillion expansion of Wall Street balance sheets would never have happened. And this means, in turn, that Wall Street's financial meth labs, which manufactured trillions of subprime mortgages, CDOs, and other toxic securities, could not have opened for business. Without repo and other wholesale money markets, there would have been no place to fund the garbage.

By the time the final Greenspan-Bernanke housing and stock market bubble reached its peak in late 2007, however, any institutional memory of free markets in money—that is, the pre-Fed call money market—had long since vanished. Wall Street and policy makers alike had come to embrace as the “new normal” a rigged money market that was pinned down by midget-sized, Fed-administered interest rates.

Not surprisingly, therefore, policy makers did not recognize these bloated balance sheets as the freakish financial aberrations they actually were. Nor did they apprehend that these balance sheets were loaded with impaired and illiquid assets that had been recklessly accumulated by bonus-driven trading desks. In short, the Fed did not see the train wreck that was thundering toward it at full speed.

WHEN $1 TRILLION OF MARKET CAP VANISHED IN THE CANYONS OF WALL STREET

At the end of the day, the vast financial deformation embodied in these ten Wall Street mega-banks had been fueled by the lunatic overvaluation of
bank stocks engineered by the Fed. The incentive for empire builders to assemble train wrecks like Citibank and Bank of America, and for bankers to invent financial tommyrot like CDOs-squared, is evident in the parabolic rise of bank market caps after 1987. The vast riches it bestowed on bank managements through stock options and stock-based cash bonuses had never before been seen in the financial system.

Thus, the implicit market cap of the ancestors of these ten mega-banks had been perhaps $40 billion prior to Black Monday in October 1987. By the end of the first Greenspan stock market bubble in late 2000, their combined market cap had reached $500 billion. Then, after the Fed launched its 2001–2003 rate-cutting spree, the market cap of the ten Wall Street banks literally shot the moon, reaching $1.25 trillion by mid-2007.

In short, ten sprawling financial behemoths which provided almost no value added to the Main Street economy had experienced a thirtyfold gain in market cap in less than two decades. Yet not long after bank executives garnered hundreds of billions in cash bonuses and stock option cash-outs based on these preposterous valuations, the full extent of the bank stock bubble became evident.

By March 2009, after the Wall Street meltdown had taken its toll, four of the ten mega-banks were gone and the market cap of the survivors had shrunk to $250 billion. And so it happened that $1 trillion of market cap disappeared from the canyons of Wall Street in a financial market minute.

The monetary central planners did not give a moment's thought to the implications of this violent collapse of what was a trillion-dollar bubble. And it wasn't just another bubble of the type that had become standard fare under the Greenspan Fed; that is, the home builder, telecom, dot-com, and high-tech stock bubbles which had gone before. In this instance, the very financial transmission system, the primary dealer network that the Fed relied on to implement its policies, had lost 80 percent of its market cap.

These ten institutions constituted the overwhelming bulk of the primary dealer market through which all of the Fed's interest rate pegging, debt monetization, and risk asset pumping operations were conducted. In any reasonable world, the shocking revelation that this crucial policy transmission mechanism had been run by reckless gamblers, and that their balance sheets consisted of a heaving mass of financial assets rented by the day, would have been conclusive.

By the time of the September 2008 financial crisis, the ten mega-banks posed an existential threat to the entire prosperity management model on which the Fed operated. Not surprisingly, the nation's panic-stricken monetary politburo chose to bail out the misbegotten behemoths rather than reconsider its own ill-conceived model.

CHAPTER 19

 

T
HE LONG CYCLE OF MONETARY DEFORMATION TRIGGERED BY THE
events of August 1971 stood at the heart of the home mortgage crash in 2007–2008. Needless to say, it took time and numerous twists and turns to get there.

First came the brutal margin squeeze on traditional bank and thrift mortgage lenders during the Great Inflation of the 1970s. In Old Testament fashion, that breakdown begat the misguided deregulation and crash landing of the savings and loan industry in the 1980s. The demise of these traditional bricks-and-mortar Main Street lenders, in turn, begat the explosive growth of broker-based mortgage finance by Freddie and Fannie in the 1990s.

In due course, the spread of mortgage boiler rooms from coast to coast enabled the rise of Wall Street–based subprime finance after the turn of the century. All the while, the Fed's interest repression policies fostered massive overinvestment in mortgage finance and housing, thereby aggravating these deformations still further.

THE GREAT INFLATION'S LEGACY: BUSTED MORTGAGE LENDERS THE FREE MARKET COULDN'T FIX

The repudiation of sound money at Camp David and the subsequent monetary depredations of Arthur Burns led to the Great Inflation and its assault on the balance sheets of traditional mortgage lenders. Yet, even after double-digit inflation was crushed by Paul Volcker in 1980–1982, its long shadow weighed heavily on the future of home finance.

In fact, Volcker's signal success came too late. By then the traditional home mortgage finance industry had been essentially bankrupted by the negative spread between soaring interest rates on deposit liabilities and the
low fixed rates embedded in legacy mortgage portfolios. Self-evidently, the resulting hemorrhage of losses among bank and thrift mortgage lenders was an artifact of failed monetary policy, not a product of the free market.

The free market could not be expected, therefore, to solve a problem it hadn't created, meaning that deregulation of the savings and loans (S&Ls) was a profoundly misguided cure for the ill effects of bad money. The only real solution was wholesale liquidation of thousands of insolvent banks and thrifts.

Needless to say, not even the Reagan administration had the political stomach for the correct free market answer. So its well-intended alternative, liberalization of S&L lending charters, actually made matters worse.

Deregulation, as we will see below, encouraged traditional bricks-and-mortar bankers, who knew everything about home mortgage lending, to flee into commercial real estate and junk bond investment, about which they knew nothing. In this wholly discombobulated setting, the housing finance industry clung for dear life to the only lifeline available; namely, the government-sponsored mortgage guarantee programs at Freddie Mac and Fannie Mae.

CRUSHED BY THE GSES

Not surprisingly, high on the Reagan administration's free market agenda was the elimination of the GSEs and their taxpayer-subsidized channel of housing finance. As director of the Office of Management and Budget, I championed a plan to eliminate the GSEs through a slow financial euthanasia.

The mechanism was a federal “guarantee fee” designed to raise the cost of Freddie and Fannie financing to private market–clearing levels. It would have permitted the taxpayers to capture the spread between the private market rate and the Treasury's lower cost of financing.

Needless to say, if the GSEs had been required to pay market rates for their capital and funding, there is no reason to believe they would have survived competition from the traditional “originate and hold” model of depository institutions. For that reason, the guarantee fee catalyzed the forces of crony capitalism like rarely before in the history of federal housing programs. Home builders and suppliers of lumber, hardware, HVAC, and electrical products joined real estate agents, mortgage bankers and brokers, title lawyers, and dozens more in a mighty coalition to keep private enterprise humming on cheap, socialized credit.

As Ralph Nadar observed years later, “Fannie Mae and Freddie Mac are fast learners … [they] have swiftly and skillfully managed to pick up the
roughshod tactics of the private corporate world … [and] cling tightly to one of the Federal government's deepest and most lucrative welfare troughs.”

The danger of government subsidization and control of housing finance would eventually be painfully evident. But in 1981, when the GSEs were still in their relative infancy and there was an honest chance to smother them in the cradle, Republicans on Capitol Hill led the charge to kill the OMB-proposed guarantee fee. The American housing industry, they averred, was too important to be left to the whims of the free market.

Four decades after its accidental birth in New Deal–era filing cabinets, therefore, Fannie Mae was adopted by Republican foster parents. Now it would morph into a destructive monster with no legislative check on its growth. Thus, during the first Reagan term, the combined guarantees and direct mortgage holdings of the GSEs doubled from $200 billion to $400 billion and then doubled again by 1988.

When George H. W. Bush left office in 1992, the footings of the GSEs totaled $1.5 trillion. During twelve years of Republican rule, the balance sheets of Freddie and Fannie (and Ginnie Mae) had not simply grown rapidly; they had, in fact, metastasized, reaching a size that was seven times greater than when they had been furtively challenged by the Reagan Revolution.

VOODOO ECONOMICS STRIKES BACK

So the era of Republican rule did not roll back Big Government in the nation's largest industry; that is, housing construction and finance. Even worse, in one of his final acts as president, George H. W. Bush signed the calamitous Housing and Community Development Act of 1992.

This abomination gave new meaning to the term “voodoo economics,” the very epithet Bush had thrown at Ronald Reagan in the 1980 primary campaign. Yet in his final act as president it was Bush who turned out to be the greater practitioner of economic folly.

One major title of the bill, for example, made a mockery of its own bold-print heading. Under the rubric “financial safety and soundness,” Freddie and Fannie were permitted to leverage their balance sheets 200 to 1 in the case of guaranteed mortgage pools, and by more than 100 to 1 overall.

The Bush White House's woolly-minded rationalizations for this madness surely delighted the crony capitalists who crowded the signing ceremony. Embracing the bill as the second coming of motherhood, Bush averred that it would “target assistance where it is needed most, expand homeownership opportunities, ensure fiscal integrity and empower recipients of Federal housing assistance.”

What the bill actually did was set in motion a pervasive, relentless degradation of underwriting standards that was pure financial poison. The so-called affordable housing goals initially required that 30 percent of GSE volume consist of low- and moderate-income borrowers (later raised administratively in steps to 56 percent). It further provided that underwriting standards could be drastically weakened to achieve these targets, including authorization for the GSEs to virtually scuttle the historic requirement that borrowers have “skin in the game” in the form of a meaningful cash down payment.