The Great Deformation (9 page)

THE REAL BAILOUT CATALYST: JEFF IMMELT'S THREATENED BONUS

At that particular moment, however, General Electric CEO Jeff Immelt was apparently in no mood for a lesson in price discovery. In fact, he was then learning, along with the rest of Wall Street, an even more painful lesson about the folly of lending long and borrowing short. Notwithstanding that General Electric was one of just a handful of AAA-rated American corporations, it was suddenly discovering that its hugely profitable finance company, General Electric Capital, was actually an unstable house of cards.

GE Capital's financial alchemy rested on a simple but turbocharged formula straight out of the Wall Street playbook. At the time of the crisis, GE Capital boasted $650 billion of financial investments from customized deals in real estate, equipment leasing, working capital finance, and private equity. While these highly proprietary investments yielded generous rates of return, they were also highly illiquid and prone to blow up at higher than normal loss rates, thus bearing an asset profile that called for generous amounts of equity capital funding. In fact, however, GE Capital's massive balance sheet was leveraged nearly 10 to 1 and included upward of $100 billion of short-term commercial paper.

Needless to say, this huge load of commercial paper carried midget interest rates (4.7 percent), which helped fuel impressive profit spreads on GE's assets. But this ultra-cheap CP funding also bore short maturities, meaning that GE Capital had to rollover billions of commercial paper debts day in and day out.

When commercial paper rates suddenly spiked during the Lehman crisis, GE was caught with its proverbial pants down. But rather than manning-up for the financial hit that his company deserved, Jeff Immelt jumped on the phone to Treasury Secretary Paulson and yelled “Fire!”

Within days, the sell-off in the commercial paper was stopped cold by Washington's intervention, sparing GE the inconvenience of having to pay market rates to fund its massive pool of assets. The Republican government essentially nationalized the entire commercial paper market.

Even a cursory look at the data, however, shows that Immelt's SOS call was a self-serving crock. His preposterous message had been that the commercial paper market was seizing up and that GE was on the edge of collapse—a risible proposition. Nevertheless, that assertion quickly became gospel among panic-stricken officialdom, and from there it rapidly spread to Wall Street and the financial press.

Not surprisingly, even two years later when the dust had settled and facts were readily available to refute this horary untruth, Secretary Paulson insisted upon repeating the GE legend in his memoirs. Describing round the clock staff activities on Wednesday, September 17, he noted that “our most pressing issue” had been to “help the asset-backed commercial paper market before it pulled down companies like GE.”

That was garbled nonsense. GE was not even a significant issuer of “asset-backed commercial paper” (ABCP). Those small amounts it did issue ($5 billion) were non-recourse and self-liquidating, meaning that GE Capital would have already passed ownership of the embedded assets to the ABCP conduit and its investors would have taken a hit, not GE.

By the same token, it was a huge issuer of unsecured commercial paper (100 billion), but even that was not remotely capable of felling the mighty GE. The required rollover funding was less than $5 billion per week, which was petty cash for a $200 billion (sales) global corporation with an AAA credit rating.

Although GE was not heading into a black hole, it was facing the need for a painful bout of liquidity generation which would have required either a fire sale of some of its sticky assets or a highly dilutive issuance of long-term equity or debt capital. Both courses were feasible, but each would have resulted in a sharp blow to earnings and top executive bonuses.

Instead of allowing the free market to resolve the matter, however, the taxpayers were thrown into the breach in still another variation of stopping the alleged “run” on Wall Street's cheap wholesale funding. Again, a necessary and healthy market correction was cancelled while the cronies of capitalism were kept in the clover.

WHY THE ATMS WOULD NOT HAVE GONE DARK: THE SECRET OF “GAIN ON SALE” ACCOUNTING

The commercial paper bailout incited by Jeff Immelt was utterly unnecessary. The facts show that the bailsters conjured up still more economic goblins where none actually existed. What the commercial paper bailout mainly did was prop up the banking industry's “gain on sale” profit scam.

The single most salient fact about the $2 trillion commercial paper market was that upward of $1 trillion was accounted for by the aforementioned ABCP, or asset-backed commercial paper segment. This was just another form of securitization, and it amounted to the financial equivalent of a twice-baked potato.

In this instance, Wall Street had gone to the banks and credit card companies and purchased massive volumes of “receivables” representing payments owed on millions of auto loans, credit cards, student loans, and other installment credit. These receivables were then dumped into a “conduit,” which was a legal structure that existed only in cyberspace; the underlying payments on loans and credit cards were processed and collected by their bank and finance company originators.

Nevertheless, the conduits were given a top credit rating by S&P and Moody's because they were over collateralized; that is, they had enough extra assets per dollar of ABCP issued to absorb any likely defaults by the underlying borrowers. Given these AAA ratings, the ABCP conduits were thus enabled to issue billions of commercial paper debt against their “assets,” which were actually, of course, debts of the American consumer.

The crucial point about this $1 trillion ABCP market, however, was that it did not originate new loans; it was merely a mechanism for refinancing debts which already existed. Accordingly, no consumer anywhere in America needed the ABCP market in order to swipe their credit card or get a car loan.

Instead, consumer loans of this type were being advanced, day in and day out, to the public by the likes of JPMorgan, American Express, Bank of America, and hundreds of other banks and finance companies. All of the money passing through cash registers from credit cards and into car purchases from auto loans flowed directly from these banks, not the ABCP market.

While the ABCP conduits accomplished nothing for the consumer, they did permit the banks to enjoy the magic of “gain on sale” accounting. Under the latter dispensation of the accounting profession, banks could immediately book the lifetime profits on these consumer loans the minute they were sold to the securitization conduit, even though such loans were months and even years from maturity.

The profits on a five-year car loan, for example, could be booked practically the day it was made. Likewise, credit card companies essentially had their profits fed intravenously; that is, within virtually the same digital nanosecond that a consumer's credit card was swiped, there also transpired a nonrecourse sale of this credit card receivable to the conduit. Right then and there, by means of advanced technology and accounting magic, the bank issuer of the credit card was able to book the estimated “gain on sale” directly to its profit column.

So when Bernanke and Paulson regaled Capitol Hill about the “collapse” of the commercial paper market, what they neglected to mention was that the main thing collapsing was these quickie “gain on sale” profits at JPMorgan, Citibank, Capital One, and the rest of the issuers. No credit card authorization was ever denied nor was any car loan application ever rejected because the ABCP market melted down in the fall of 2008.

That the commercial paper market meltdown had never been a threat to the Main Street economy is now crystal clear: the amount of ABCP paper outstanding today is 75 percent smaller than in September 2008, but the banks have had no problem whatsoever funding credit card and other consumer loans on their own balance sheets out of their own deposits and other funding sources. In fact, the banking system is now actually so flush with cash that it is lending $1.7 trillion of excess reserves back to the Fed at the hardly measureable interest rate of 0.25 percent annually.

Another $400 billion layer of the $2 trillion commercial paper market had been issued by industrial companies and was used to meet working
capital needs, including payroll. So it did not take the Washington bailsters long to conjure up frightening scenarios about millions of empty pay envelopes at the giant corporations which were heavy commercial paper users.

Had the bright young Treasury staffers racing around behind Hank Paulson's flaming hair come from the loan department of a Main Street bank rather than the M&A wards of Wall Street, however, they would have known better. At the time of the crisis, there was hardly a single industrial company issuer of commercial paper that did not also have a “standby” bank line behind its program.

Indeed, such back up lines were mandatory features of industrial company commercial paper programs. They were designed to assure investors that if issuers could no longer roll over maturing commercial paper, they would make timely repayment by drawing down their standby lines at their bank.

Moreover, industrial company issuers paid an annual fee of 15 to 20 basis points on these standby credit lines, precisely so that banks would have a contractual obligation to fund if requested. In the event, none of the banks violated their legally enforceable loan contracts to fund these CP standby lines. There was never a chance that corporate payrolls would not be met.

CRONY CAPITALIST SLEAZE: HOW THE NONBANK FINANCE COMPANIES RAIDED THE TREASURY

The final $600 billion segment of the commercial paper market provided funding to the so-called nonbank finance companies, and it is here that crony capitalism reached a zenith of corruption. During the bubble years, three big financially overweight delinquents played in this particular Wall Street sandbox: GE Capital, General Motors Acceptance Corporation (GMAC), and CIT. And all three booked massive accounting profits based on a faulty business model.

When a financial company lends long and illiquid and funds itself with short-term hot money, it needs to regularly charge its income statement with a loss reserve for the inevitable, violent moments of financial crisis when short-term money rates spike or funding dries up completely. At that point, a fire sale of assets at deep losses becomes unavoidable in order to scrounge up cash to redeem their hot-money borrowings as they come due daily.

The big three nonbank finance companies had not provided such rainy-day reserves. Consequently, when the commercial paper market seized up, Mr. Market came knocking, intent on rudely clawing back years' worth of
overstated profits. In short order, however, the two largest of these giant finance companies, GE and GMAC, received taxpayer bailouts, proving once again that in the new régime of crony capitalism the kind of muscle which ultimately mattered was political, not financial.

The single most malodorous of the big finance companies was General Motors Acceptance Corporation, which went by the innocent-sounding acronym of GMAC. But it wasn't innocent in the slightest, perhaps hinted at by the fact that its chairman was one Ezra Merkin, whose major line of business had famously been in the operation of multibillion-dollar feeder funds for Bernie Madoff.

GMAC was not only a huge purveyor of some of the worst slime in the subprime auto loan and home mortgage market, but it was also a giant financial train wreck waiting to happen. Leveraged at more than 10 to 1 and funded with massive amounts of short-term commercial paper, it had no ability to absorb even mild losses in its loan book.

GMAC was in the business of accumulating truly rotten loans. Its operating units appear to have scoured subprime America looking for “twofers.” Thus, the notorious Ditech online mortgage operation put millions of financially strapped households in homes they couldn't afford. Then it compounded the favor by putting a new car in their garage via a six-year subprime auto loan that was “upside down” (i.e., greater than the value of the car) nearly from day one.

Many of the “twofer” households lured into unsustainable debt by GMAC's subprime predators defaulted on their auto and mortgage loans when housing prices crashed and the economy buckled. As a consequence, GMAC ended up writing down $25 billion of loans, or more than the cumulative profits it had booked during the previous several years.

By every rule of capitalism, an enterprise as foolish, dangerous, predatory, and insolvent as GMAC should have been completely liquidated by a financial meltdown which was functioning to purge exactly that kind of deformation. Instead, it has remained on federal life support owing to $16 billion in TARP funding and an additional $30 billion in guarantees and subventions from FDIC and the Fed.

Yet there is not a shred of evidence that the Main Street economy has benefited from GMAC's artificial life extension program. There has never been a shortage of solvent banks, thrifts, and finance companies to serve the auto and housing finance needs of the nation's diminished pool of creditworthy borrowers. So when the Washington bailsters stopped the commercial paper meltdown on grounds that the likes of GMAC were imperiled, they snatched defeat from the jaws of victory.

Washington's $30 billion lifeline to AAA-rated General Electric was no less gratuitous. At the time of Immelt's SOS call to Secretary Paulson a day after the Lehman bankruptcy filing, the stock and bond markets were in a state of turbulence and panic. Even under those dire conditions, however, the world's capital markets were still valuing GE's common stock at $200 billion and were trading its $400 billion of term debt at a hundred cents on the dollar. Thus, as measured by the fundamental metric of corporate finance known as “enterprise value” (debt plus equity), the markets were capitalizing General Electric at $600 billion during the very midst of the meltdown.