As a conservative, I grew up in the threat of socialism: the nationalization of the tools of production. What no one warned me was that this could be accomplished by way of a unique form of nationalization: the nationalization of insolvency.
We have lived through this process in 2008. The process will continue for several more years.
Insolvency is being transferred from the banking sector to the government sector. How much insolvency? So far in 2008, the government and the Federal Reserve System are on the hook for as much as an additional $7.7 trillion.
Solvency is being retained by the bailed-out banks: the private sector. Insolvency is being transferred to those who depend on Social Security and Medicare, and also to future investors in U.S. government debt.
This is being done with full compliance of Congress, both Administrations, Wall Street, and most voters, who do not understand the nature of the transfer process.
One man does understand it. He shares a common bond with Treasury Secretaries Henry Paulson and Robert Rubin: he served as CEO of Goldman Sachs. His name is John Whitehead. He has watched the financial markets for six decades. On November 12, he offered his assessment. The United States faces a slump deeper than the Great Depression. Unlike the Great Depression, however, this will be accompanied by the downgrading of Treasury debt.
We’re talking about reducing the credit of the United States of America, which is the backbone of the economic system. I see nothing but large increases in the deficit, all of which are serving to decrease the credit standing of America. . . .
The public is not prepared to increase taxes. Both parties were for reducing taxes, reducing income to government, and both parties favored a number of new programs — all very costly and all done by the government.
All this has taken place behind the scenes this year. It has taken place on five Sundays. Then, on five Mondays, the announcement of the transfer of insolvency to the U.S. government has been made by Treasury Secretary Paulson. The public cheers.
It happened again last weekend: another Sunday surprise. The government on Sunday guaranteed the survival of Citigroup, which was about to go bankrupt. Citigroup includes Citibank.
Citigroup in 2006 had a capitalized value of $274 billion. By Thursday afternoon, this was down to $26 billion.
This was not much of a surprise. The stock market had already anticipated it. The Dow rose by almost 500 points late on Friday in expectation of the bailout. It was up another 400 points on Monday.
American investors believe in bailouts. For them, salvation happens on Sunday.
As taxpayers, they shrug it off. “We’ll grow our way out of this.” They really mean, “Our children will grow their way out of this, and will pay us our Social Security and pensions as our government has promised on their behalf.” Think of this as the equivalent of the United Auto Workers’ faith in the pension guarantees made by the Big Three American automakers.
As investors, they cheer. “No more losses!” Think of this as the United Auto Workers’ view of competition in 1965.
To understand the enormous gullibility of investors, let me cite directly from a Citi document that I downloaded this week. Save it before senior management takes it down.
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It goes on like this for two pages. Inspirational!
Investors believe in government bailouts with the same confidence that readers are expected to believe this promotional piece by Citi.
Before I comment on the Citi bailout, let me review the history of recent Sunday deliverances. I call these Sunday surprises.
THE FIRST SURPRISE
The first Sunday surprise took place on March 16. The New York Times described it late that afternoon.
Bear Stearns, pushed to the brink of bankruptcy by what amounted to a run on the bank, agreed late Sunday to sell itself to JPMorgan Chase for a mere $2 a share, narrowly averting a collapse that threatened to cascade through the financial system.
The price represents a startling 93 percent discount to Bear Stearns’ closing stock price on Friday on the New York Stock Exchange.
Bankers and policy makers raced to complete the deal before financial markets in Asia opened on Monday, as fears grew that the financial panic could spread if Bear Stearns failed to find a buyer.
The deal, done at the behest of the Federal Reserve and the Treasury Department, punctuates the stunning downfall of one of Wall Street’s biggest and most storied firms.
Less than a week earlier, the CEO of Bear Stearns, Alan Schwartz, had assured the public that the company was solvent, that there was no problem. A Reuters story was typical of the press’s handling of the story.
Schwartz, in a televised interview on CNBC, also said he is comfortable with the range of analysts’ earnings estimates for the fiscal first quarter ended Feb. 29. Results for the quarter are due next week.
“We don’t see any pressure on our liquidity, let alone a liquidity crisis,” he said.
Bear finished fiscal 2007 with $17 billion of cash sitting at the parent company level as a “liquidity cushion,” he said.
“That cushion has been virtually unchanged. We have $17 billion or so excess cash on the balance sheet,” he said.
Schwartz denied speculation that other brokers were turning down Bear’s credit on trades for fear of counter-party risk.
According to an article published weeks later, this “speculation” was introduced by the CNBC interviewer, who cited an anonymous source that Goldman Sachs had turned down a Bear Stearns trade. Schwartz denied it.
“There’s been a lot of volatility in the market, a lot of disruption. That’s causing some administrative pressure, getting trades settled. We’re in constant dialogue with all the major dealers, and I have not been made aware of anybody not taking our credit,” he said.
The Reuters article went on to describe the state of the markets.
As one of the largest players in mortgage-backed bond markets, investors have assumed Bear’s exposure would lead to crippling losses.
“None of that speculation is true,” Schwartz said. When speculation starts in a market, one that has a lot of emotion in it and people concerned with volatility, “they will sell first and ask questions later,” he said. “That creates its own momentum.”
The critic of this chain of events argues that there never was verifiable evidence that Goldman Sachs or any other firm had turned down Bear Stearns’ business.
The market did not care. This supposed solvency turned out to be irrelevant within hours. Bear Stearns’ stock price continued to fall on Thursday and Friday. By Monday morning, Bear Stearns was no more.
A rumor cannot create this outcome except when fears are rampant and leverage is high. Bear Stearns was the victim of high leverage and bad forecasts. It took a fire sale on Sunday, initiated by the New York Federal Reserve Bank, to keep Bear from going bankrupt on Monday, March 17: St. Patrick’s Day.
To sweeten the deal, the Federal Reserve absorbed the risk for $29 billion of Bear Stearns’ debt.
The public outcry and the threat of a shareholders’ lawsuit against the $2 per share price later led to Morgan upping the price to $10.
As for the $17 billion in liquidity, Morgan must have gotten it as part of the firm’s assets. We never heard any more about it.
Paraphrasing Bunker Hunt’s statement in 1980, as he was going bankrupt, when the FED had to lend him a billion dollars, “Seventeen billion just doesn’t go as far as it used to.”
THE SECOND SURPRISE
On Sunday, September 7, Treasury Secretary Paulson announced that Fannie Mae and Freddie Mac had been taken over by the U.S. government. He issued this press release.
Before I turn to Jim to discuss the action he is taking today, let me make clear that these two institutions are unique. They operate solely in the mortgage market and are therefore more exposed than other financial institutions to the housing correction. Their statutory capital requirements are thin and poorly defined as compared to other institutions. Nothing about our actions today in any way reflects a changed view of the housing correction or of the strength of other U.S. financial institutions.
Note these words: “Nothing about our actions today in any way reflects a changed view of the housing correction or of the strength of other U.S. financial institutions.” A week later, Paulson & Co. were at it again. They tried — and failed — to keep Lehman Brothers Holdings from going bankrupt.
Paulson’s press release then made a statement that will haunt the financial markets for the news two years — maybe three.
I have long said that the housing correction poses the biggest risk to our economy. It is a drag on our economic growth, and at the heart of the turmoil and stress for our financial markets and financial institutions. Our economy and our markets will not recover until the bulk of this housing correction is behind us.
I can think of no more accurate statement from Mr. Paulson during his term of office. The housing correction is in its early phase. As it accelerates, so will the “the turmoil and stress for our financial markets and financial institutions.” Count on it.
This was the nationalization of America’s mortgage industry. By September 2008, Fannie and Freddie were supplying 90% of all residential mortgages in the United States. But Paulson did not use the N-word. He picked another.
I support the Director’s decision as necessary and appropriate and had advised him that conservatorship was the only form in which I would commit taxpayer money to the GSEs.
“Conservatorship.” How reassuring. Nationalization would have seemed so crass, so anti-free market.
Then he admitted what is still true: the mortgage market is at the heart of the U.S. economy. The economy was heading for a cliff.
And let me make clear what today’s actions mean for Americans and their families. Fannie Mae and Freddie Mac are so large and so interwoven in our financial system that a failure of either of them would cause great turmoil in our financial markets here at home and around the globe. This turmoil would directly and negatively impact household wealth: from family budgets, to home values, to savings for college and retirement. A failure would affect the ability of Americans to get home loans, auto loans and other consumer credit and business finance. And a failure would be harmful to economic growth and job creation. That is why we have taken these actions today.
This is the issue of systemic risk, or, as the old spiritual put it, “the knee bone connected to the thigh bone. The thigh bone connected to the. . . .” And so on. Paulson called for government intervention to keep the market from imposing its negative sanctions on bad decisions made by the leaders at Fannie and Freddie.
And policymakers must address the issue of systemic risk. I recognize that there are strong differences of opinion over the role of government in supporting housing, but under any course policymakers choose, there are ways to structure these entities in order to address market stability in the transition and limit systemic risk and conflict of purposes for the long-term. We will make a grave error if we don’t use this time out to permanently address the structural issues presented by the GSEs.
There was no mention of the taxpayers’ price tag on this “conservatorship.” Combined, the two outfits have guaranteed over $5 trillion in mortgages. To this was added the Mortgage-Backed Securities (MBS) that had been sold — and borrowed against — to buy these mortgages. What of these investments?
Because the U.S. Government created these ambiguities, we have a responsibility to both avert and ultimately address the systemic risk now posed by the scale and breadth of the holdings of GSE debt and MBS.
The move was immediately praised by Ben Bernanke. Bond fund manager Bill Gross also praised it.
THE THIRD SURPRISE
A week after the nationalization of the mortgage market, there was another emergency meeting. This time, the survival of the huge investment-banking firm of Lehman Brothers Holdings was at stake. So little known was this 160-year-old institution that knowledgeable commentators still do not know how to pronounce Lehman: “Leeman” or “Layman.” (“Leeman.”)
Another institution facing bankruptcy was Merrill Lynch, the largest and most famous retail brokerage form in the United States.
The result of Sunday’s meeting: Lehman declared bankruptcy on Monday morning and Merrill was bought by Bank of America for $50 billion of BofA stock.
All of this was done behind closed doors over a weekend. That was how desperate the government and the Federal Reserve were to get the deals done by Monday morning. They failed with Lehman. No deal.
Lehman had over $100 billion in bonds outstanding. It reported its debts at $613 billion and its assets at $639 billion.
According to its former CEO, Richard Fuld, he took out $300 million in the eight years prior to the collapse of his company.
By the end of the week, September 21, two other investment banks, Goldman Sachs and Morgan Stanley, filed with the FED for bank holding company status. That was on a Saturday. This switch was immediately granted. This entitled them to the bailout money being offered by the Federal Reserve System and anything Congress might pass. Congress passed a $700 bailout plan, plus $150 billion in pork, by the end of September.
That was the last of the Big Five investment banks. The survivors are minor players that only specialists have heard of, such as Jeffries.
Goldman Sachs’ press release on September 21 is worth considering. It mentioned that it had been founded in 1869. It was a private banking firm open only to “high net worth individuals.” No longer.
“When Goldman Sachs was a private partnership, we made the decision to become a public company, recognizing the need for permanent capital to meet the demands of scale. While accelerated by market sentiment, our decision to be regulated by the Federal Reserve is based on the recognition that such regulation provides its members with full prudential supervision and access to permanent liquidity and funding,” said Lloyd C. Blankfein, Chairman and CEO of Goldman Sachs. “We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution with an exceptionally clean balance sheet and a greater diversity of funding sources.”
That said it all. The rich no longer could survive on their own. From now on, they will need to be “under Federal Reserve supervision.”
We are at the end of an era that stretches back to early nineteenth-century America. The whole nation now looks to fiat money and government bailouts. The era of American entrepreneurship has ended in the financial markets.
THE FOURTH SURPRISE
On the weekend of September 27, FDIC officials met with officials of America’s fourth largest bank, Wachovia, and officials of America’s no-longer largest bank, Citigroup. They hammered out a merger. This was done with no public announcement. The announcement came in a press release on Monday morning, before the stock market opened.
Citigroup Inc. will acquire the banking operations of Wachovia Corporation; Charlotte, North Carolina, in a transaction facilitated by the Federal Deposit Insurance Corporation and concurred with by the Board of Governors of the Federal Reserve and the Secretary of the Treasury in consultation with the President. All depositors are fully protected and there is expected to be no cost to the Deposit Insurance Fund. Wachovia did not fail; rather, it is to be acquired by Citigroup Inc. on an open bank basis with assistance from the FDIC.
It was a sweet deal for Citigroup.
Citigroup Inc. will acquire the bulk of Wachovia’s assets and liabilities, including five depository institutions and assume senior and subordinated debt of Wachovia Corp. Wachovia Corporation will continue to own Wachovia Securities, AG Edwards and Evergreen. The FDIC has entered into a loss sharing arrangement on a pre-identified pool of loans. Under the agreement, Citigroup Inc. will absorb up to $42 billion of losses on a $312 billion pool of loans. The FDIC will absorb losses beyond that. Citigroup has granted the FDIC $12 billion in preferred stock and warrants to compensate the FDIC for bearing this risk.
It was too sweet a deal. Wells Fargo sued Citigroup. Citigroup was offering $2.2 billion for Wachovia. Wells Fargo was offering $15 billion. Wells Fargo eventually triumphed. That move gave Wells Fargo more branches than any other bank, plus deposits equaling Bank of America.
THE FIFTH SURPRISE
Citigroup was the institutional heir of the Rockefeller family, through William, the brother of John D. William’s son James Stillman Rockefeller, who became chairman in 1959.
The bank’s history goes back to the War of 1812. So large was this bank that it was the first contributor to the Federal Reserve Bank of New York in 1914.
On November 4, 2007, its CEO, Chuck Prince, resigned. The next day, I told my Website’s subscribers to get out of stocks and short the S&P 500.
According to a report on Bloomberg, in late 2006, the capitalized value of Citigroup was $274 billion. It was the largest bank in the United States in terms of market value, with Bank of America second. By September 21, 2008, its capitalized value was in the range of $26 billion.
The extent of the bank’s condition was published only after the Sunday bailout. At that point, the government and the Federal Reserve had to come clean. The disaster could no longer be concealed. What had been the largest bank in terms of market value had slipped to #6, and was about to go bust. This is why the government intervened.
The government (you and I) will shield the bank’s shareholders and creditors against most of the losses in its portfolio of toxic loans.
Terms of the asset guarantees mean Citigroup will cover the first $29 billion of pretax losses from the $306 billion pool, in addition to any reserves it already has set aside. After that, the government covers 90 percent of the losses, with Citigroup covering the rest from assets that include leveraged loans and so-called structured investment vehicles.
The government will pay $20 billion for $27 billion of preferred stock, which will pay 8%. (It will pay 8% only because the government will pay off the bad loans.)
The government has already provided $25 billion in the Troubled Asset Relief Program, which is part of the $700 billion bailout bill, passed in late September.
“This is a partial government takeover,” Christopher Whalen of Institutional Risk Analytics, a Torrance, California-based research firm, said in a Bloomberg Radio interview. “We have been telling people for a while that some of the top banks were going to end up controlled by the government next year. It looks like that’s happening sooner than even we expected.”
In a lengthy, detailed article published in the New York Times on November 22 — two years too late — the reporters trace the history of bad decisions made by senior managers at Citi. The article shows that there were red flags, but no one paid any attention. The article also indicates that there may be more bad news to come.
Call it “Citi bailout, phase I.”
America’s biggest banks are going bust or have gone bust. Little banks are toppling each week. There is no end in sight.
The government, which is running a trillion-dollar deficit this fiscal year, is adding ever more debt to save the favored banks. It is buying the banks’ insolvency in the name of future taxpayers.
The buyers of Treasury debt and the Federal Reserve System are funding all of this. They think future taxpayers will pay them back. I don’t. I think there will be a tax revolt: mass inflation.
Meanwhile, every dollar that flows into the Treasury does not flow into the private sector. The nationalization of insolvency continues. The authority to make decisions regarding who will get the shrinking supply of private savings that the banks have not already absorbed to keep their doors open has been transferred to a new generation of capitalists, people who live in fear of government regulators, not depositors.
The year 2008 has seen the end of free market financial capitalism. Forget about efficiency. Forget about stable economic growth. Forget about everything except solvency as defined in fiat money.
Moral hazard is alive and well in the West. Free capital markets are not.
It was nice while it lasted. But it could not last. State capitalism always demands bailouts. It always gets what it asks for.
Senior managers got the gold mine. Taxpayers got the shaft.
November 26, 2008
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