The 2008 Meltdown And Where The Blame Falls

Robert Lenzner for Forbes Magazine, 2 June 2012:

Note:  This blog is based on my notes for a speech at the Harvard Class of 1957 55th reunion in Cambridge, Mass. on May 22nd.

Armageddon was threatening the financial system on Wednesday, September 17, 2008. The largest bankruptcy in American history,  that of investment bank Lehman Brothers on Monday, September 15, had roiled global markets, accelerating the stupendous decline in values of every possible investment vehicle—common stocks, corporate bonds, real estate, commodities like oil, copper and gold,  private equity and hedge funds alike. In the midst of the chaos Merrill Lynch, the firm that had brought Wall Street to Main Street, was absorbed in a shotgun marriage by Bank of America BAC +0%.

Only days earlier came the recognition at the New York Federal Reserve Bank and the US Treasury that AIG, the largest insurance company in the world was running out of money. This required an immediate injection of $85 billion in bail-out funds. And later another $100 billion, still not paid back to Uncle Sam.

That day, Sept 17, an even greater crisis was pending. All day long the chairman of General Electric, a company recognized across the globe as a leading industrial giant, was calling the Secretary of the Treasury, Hank Paulson to warn that the next day, Sept. 18,  that GE would no longer be able to roll over its short term debt. The American business system was on the cusp of faltering mightily. The US economy was on the brink of a precipice into the unknown.

Messrs Paulson and Bernanke, at the Fed, knew the nation could not suffer the risk of a total breakdown in industry and finance. So, they decided to instantly guarantee the $600 billion commercial paper market, which is widely used to finance day-to-day operations of all major firms. This guarantee became part of the total cost of bailing out Wall Street, which totaled over $7 trillion—when you added guarantees to loans, investments and outright grants. The bailouts were key to raising the Fed’s balance sheet from $1 trillion to $3 trillion—and to upping the nation’s total amount of debt some $5 trillion to a record $15 trillion.

Conversely, the household wealth of the nation, measured by losses in financial markets and the historic drop in residential real estate—was reduced by a sickenly humungus   $12-$14 trillion at the very bottom of the whole process in March, 2009. You take that money—$12-14 trillion away from the asset side of the ledger and add another $5 trillion in debt—- and you are bound to experience   a decline in the nation’s GDP and a very much slower rate of recovery from such a trauma. A recovery that could take 10 years or more according to Harvard economist Kenneth Rogoff. That brings us to 2018. Need I say more?

How did we reach this very near call on a total systemic breakdown?

Firstly, there were no cops on the beat.  Laissez-faire free market economics was the prevailing public policy. Federal Reserve chairman Alan Greenspan spoke of irrational exuberance but took no steps to cool off markets in the late 1990s. In fact, he was asked by Loews chairman Larry Tisch and former Goldman Sachs co-chairman John Whitehead to raise the margins on trading, and refused, claiming falsely that such a move was up to the SEC—and not the Fed. Not true.

In 1999 the Glass-Steagall Act—which had separated commercial banking from investment banking for 66 years, was overturned—a move that opened the door to more speculative trading on the part of Wall Street firms.

Then, in 2000 Messrs. Greenspan, former Treasury Secretary Rubin and his successor Lawrence Summers pressed to pass a bill that would prohibit the regulation of derivatives—the fastest growing and most complicated and murky new financial product. This was an incredible mistake, as derivative contracts like mortgage backed bonds and credit default swaps mushroomed in across the globe without any oversight, strict capital requirements and on an organized exchange where buying and selling were handled daily.

The result of this vacuum; no one anywhere knew who owed what to whom across the world.  Despite the danger lurking in the rapid depreciation of these contracts,  Bernanke publicly stated the absurd amount of sub-prime mortgages being sold to unsuspecting buyers would not spread to a much wider, deeper crisis. He didn’t know what he was talking about, sadly..

Lastly, in 2004 the major firms convinced the SEC to let them value certain assets on their balance sheet at values they chose—rather than marking them t o market—which would reveal what losses they were carrying. This added another dangerous laxity to financial regulation. The system was falsifying its accounts believing the investments would bounce back.

The entire catastrophe’s underlying theme was summed up later by this admission from former Fed chairman Greenspan . ” I made a mistake,” he admitted in a hearing, “in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms.” And we made this man into the wise parental guardian of American capitalism for 18 years. We journalists, that is.

Pressed again later on, Greenspan admitted to “shocked disbelief, (because his whole) intellectual edifice had collapsed.”  Naive at minimum. At worst, locked into a narrow limited ideological viewpoint that set the stage for the meltdown. Let Goldman Sachs and Citigroup master their own appetite for profits. So much for reining in animals spirits.

Secondly, the banks and investment banks were using reckless amounts of leverage. They borrowed, in many cases, $30 to $40 of debt for every dollar of capital they had. In truth, this was a recipe for disaster, since a decline of only 4% in their capital put them on the road to insolvency.  It was as if you bought a million dollar house, put down a payment of $30,000 and borrowed $970,000. What sense of irrational optimism allowed this mad way of doing business.

By the fall of 2008 the decline in the value just of subprime mortgage backed bonds—which lost up to 80% of their value in the market—meant that Fannie Mae, Freddie Mac, Lehman, Merrill Lynch, Citigroup, Bank of America, Washington Mutual and Wachovia were in a state of peril. The only way to make money in bank stocks was to short them. My favorite day trader told me after it was all over that I should be worth $50 million. With the run on Lehman Bros. both Morgan Stanley and Goldman Sachs were in danger of experiencing a run on their accounts.

Perhaps AIG is the most extreme example of leverage as financial hari-kari. It had sold protection to banks and insurance companies across the globe by issuing $540 billion of credit default swaps, which meant AIG promised to make good on any losses in value of their mortgage holdings.

AIG did not hedge $1.00 of the derivative contracts; in other words it bought no insurance against potential losses. Nor did it have any capital in the holding company that sold these financial insurance policies. It was banking on its Triple A credit rating to protect its holdings. Nor did its top management understand the danger of this gargantuan liability. AIG Financial was 100% leveraged.  And it had written risky business since the managers of this unit were paid 30% of the group’s revenues—not 30% of its profits. A motivation for private profits and public losses.

The AIG mess, then, is the result of denial about the level of risk, arrogance that the triple A credit rating is an absolute safety belt, greed about compensation that leads to reckless behavior and overall, a level of irrationality that approached insanity. No one was watching the store, and the system was threatened with disintegration. Nothing less. Nothing more. A despicable performance.

Lastly come classic instances of rotten character,  a sickening virus of entitlement and careless grandiosity.

Dick Fuld, former Chairman of Lehman is a classic example. He refused to let another Lehman employee ride in his private elevator up the Lehman executive floor. He asked Treasury Secretary Paulson to call the Russian authorities to let him fly his private jet over their airspace to return to the US and face the expanding crisis. Paulson rightly said No.

And Fuld never revealed t o the public,to his shareholders that Lehman hid $50 billion in debt several reporting period in a row so as to make its balance sheet look less leveraged. In fact, to this day Fuld claims he didn’t know about this ruse.  The regulators inside Lehman apparently never wised up to this swapping the debt for a few days and then bringing it back on board. All told—a shabby story.

Then, there’s the Bear Stearns chairman who did not leave his bridge tournament outside New York to attend to t he crisis of potential bankruptcy. Or the Goldman Sachs director who bought more shares of Goldman in the late fall of 2008 though he was also chairman of Goldman’s chief regulator—the New York Federal Reserve Board.

Or the former Goldman partner who was acting as chairman of Wachovia, a failing bank,  and demanded a premium in Goldman shares and the power to succeed Lloyd Blankfein as chairman—though Wachovia was on the verge of filing bankruptcy. Even though the Treasury Secretary had requested Goldman chairman Blankfein to perform a public service by absorbing the broken bank, the antagonized Goldman chairman told the Wachovia executive to get thee to a nunnery. Some Masters of the Universe have such rotten hubris, such selfish, self-aggrandizing drives they act like primitive warriors from a more violent time.

So, where do we stand today?  We left our 315 million citizens the distinct impression that the powers that be in Washington are the handmaidens of finance—coming to the rescue of Wall Street by means of a most costly bailout to avoid Armageddon.  The auto industry in Detroit was stabilized as well with federal funds. A very clear message that Big Business is the priority of the nation for it cannot be alloswed to fail no matter the public largesse required.

The roles of financial institutions too big to fail is multiplying from 6 to 30. Take notice taxpayers of America.

The Dodd-Frank bill to regulate Wall Street is an unholy mess.

There is no centralized regulatory system in the world.

There is no rational solution for dealing with the interrelatedness of the global financial system.

And we have been lately treated to evidence that little has changed in the mores of Wall Street. Shocking is the only possible reaction to the lack of proper risk controls in the Chief Investment Office of JP Morgan Chase, where over $300 billion was being leveraged into huge casino bets on illiquid derivative contracts in Europe I didn’t know about.

Then, there was the utter greed shown in the Facebook in the initial public offering, which imprudently reached for a $100 billion valuation and thus its initial ordinary investors holding shares with an immediate paper loss. Only the insiders, the top execs, the private equity firms that dumped shares, got to sell to the unsuspecting public at $48 a share, when the stock was maybe worth $20-$25 a share.

As the famous British economist John Maynard Keynes said many years ago: “When the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill done.” It is the threat we could face again that makes the 99% view financial markets as a rigged game. Go see the documentary film, “Inside Job,” which won the Academy Award 2 years ago—if you don’t believe me.

Robert Lenzner for Forbes Magazine.