Part I – The Blackberry Panic of 2008

Introduction

  • The title of the book is a play on Ben Bernanke’s 2004 speech in which he announced a new age of great moderation now that central banks have mastered the use of monetary policy to smooth the ups and downs of the business cycle.

Chapter 1 – Paulson’s Folly (The Needless Rescue of AIG and Wall Street)

  • Massive TARP bailouts of 2008 circumvented a much needed shearing of the Wall Street behemoths.  This firms (Goldman et. al.) had been gambling in financial markets but the Fed stepped in to cover their losses.
  • Goldman Sachs got $10 billion to stabilize itself but then reported $16 billion in salary and bonuses alone the very next year.
  • The main thesis put forward by Hank Paulson was the risk of contagion in AIG was allowed to fail.
  • AIG was the firm that insured the various gambling debts of the big banks through credit default swaps (CDS).  By buying this insurance from AIG, banks transformed high risk CDOs, subprime mortgages and the like into AAA holdings with no requirement for capital reserve.  This allows financial firms to massively inflate and leverage their balance sheet without the need to offset risk with any actual capital.  AIG, in theory, eliminated all risk for the firms.
  • AIG was structurally incapable of starting contagion.  90% of AIGs assets where high quality assets segregated into various insurance subsidiaries subject to various legal and regulatory jurisdictions.  This represented AIGs traditional, and solvent, insurance business.  The remaining 10% of AIG consisted of the CDS liabilities held in AIG’s holding company.
  • In the event of failure, the holding company would have gone bankrupt and forced the financial institutions holding AIG CDSs to have to face the massive loss.  This may have caused the failure of some of the large firms on Wall Street who had gambled beyond their means.  In short, it would have caused a healthy correction and brought down the TBTF.
  • In the event of failure the 90% of AIG’s traditional assets would not have been at risk.  The insurance subsidiaries would have been legally sequestered by the regulators in the jurisdiction they were located.  Despite the doomsday prophecy of Paulson, the failure of AIG’s CDS business would not have impacted the 90% of its traditional business.  AIG nor its creditors could legally raid these assets.

In short, there was no public interest at stake in preventing AIG’s demise.  Indeed, the bailout’s primary effect was to provide a wholly unwarranted private benefit at public expense; namely, the shielding of highly paid bank traders and executives who had exposed their institutions to embarrassing losses from taking the fall that was otherwise warranted

  • Too Big To Fail (TBTF). idea that the threat of systemic risk and contagion from the failure of any big Wall Street institution was so great that those institutions were exempted from the free market.
  • Obviously solution to TBTF is to force breakups of the banks to whatever size is deemed safe.  Allowing TBTF institutions to simply continue is essentially the taxpayer underwriting the risk for all bets the bank takes – classic moral hazard.
  • Wealth Effect.  The belief that the central bank can create prosperity by easy monetary policy.  A higher stock market, lower cost of borrowing get people to feel wealthier and borrow/consume more.
  • The regular corrections to the stock market undermine the wealth effect and thus run contrary to Fed policy.  By preventing these natural corrections stock market bubbles form.  By keeping interest rates low, housing bubbles form (and other debt based bubbles).
  • Long-Term Capital Management (LTCM) was a Greenwich based financial gambling shop of only a few hundred employees.  LTCM was leveraged over 30 to 1 on an array of speculative bets.  It was probably the most reckless of the Wall Street firms.
  • A debt default by Russia caused a 20% stock market correction in 1998.  LTCM’s highly leveraged model caught up with it and it became insolvent.
  • Instead of allowing LTCM to fail (it posed no systemic risk to the system) the Fed executed a burst of money printing and dropped interest rates.  Together with a $3 billion collection organized by the Fed from other Wall Street firms, LTCM was saved.
  • The message was clear: If even the most speculative investment house would be bailed out if they got in trouble, there was no incentive for firms not to increase leverage and take larger risks.  Any profits realized would be private, any loses could be pushed onto the taxpayer through the Fed.

Chapter 2 – False Legends of Dark ATMs and Failing Banks

  • Majority of bail-out funds went to exactly the Wall Street insiders and fund managers who were responsible for the crisis.
  • The large Wall Street firms based their enormous profits on 30 to 1 leverage and a mismatch of their funding and assets.
    • These banks funded themselves with short-term wholesale money market funds consisting mainly of short term “repo” loans and unsecured commercial paper.  These loans were cheap since the lenders were under no obligation to roll over these short duration loans.
    • The banks then used these wholesale funds to hold assets which were more illiquid, longer term, and subject to risk and therefore earned a higher yield.  It was this duration and liquidity mismatch that allowed large profits to be realized.
  • Once the wholesale market lenders lost confidence in Goldman and Morgan Stanley, they did not roll over their loans.  This caused a run on the institutions which were forced to liquidate assets at fire sale loses to remain solvent and meet their commitments to the wholesale lenders demanding their money back.
  • The TARP program and other liquidity initiatives stopped the wholesale bank run by simply replacing the wholesale market as a source of funding for the Wall Street goliaths.  This prevent the necessary purging of toxic assets and corrupt financial firms.
  • Despite the apocalyptic panic of the Greenspan and Paulson, the crisis would have been confined to Wall Street.  The $12 trillion Main Street commercial banking system and there larger economy were never in any danger.
  • A key reason is that for the preceding years the Wall Street financial firms bought up all the toxic assets from the community banks to be packaged, and repackaged, into CDOs and other derivates.  The left the commercial banks with assets consisting mainly of U.S. treasuries, government-guaranteed mortgage securities and whole loans to home owners, businesses and developers.
  • In Q4 2008 at the peak of the meltdown, total commercial banking assets were $11.6 trillion and yet only $200 billion (1.7%) were the toxic mortgage backed securities.
  • In addition, the assets of the commercial banks at this time included:
    • $1 trillion in Fannie Mae and Freddie Mac mortgage backed securities (fully insured by the U.S. government).
    • $2 trillion in mortgages and home equity lines of credit that overwhelmingly of prime credit and stayed on the books as whole loans, not securitized.
    • $1.6 trillion low-risk, revolving commercial and industry loans.
    • $1.7 trillion whole loans to commercial real estate (office buildings, strip malls, etc.).
    • $1 trillion credit card, auto and other consumer loans well secured with collateral and deep loss reserves.
    • $1 trillion U.S. securities and investment grade corporate bonds.
  • Any crisis in the commercial banking system would have unfolded over many years given the illiquid and secure nature of their balance sheets.  The commercial banks were never at risk of the run infecting Wall Street’s derivatives.

…the nation’s hinterland banks had played a pretty good hand of mortgage finance poker.  First, they had sold off most of their subprime originations to the Wall Street securitization machine.  Next, the largely avoided reinvesting in the garbage securities Wall Street crafted from these subprime loan pools.  And finally, they backfilled their investment accounts by buying mortgage securities wrapped with Uncle Sam’s money-good insurance via the Freddie and Fannie guarantees, not the bogus kind sold to Wall Street and the European banks by AIG.

  • Bernanke and Paulson also fanned the flames after Congress voted down the first TARP bill by claiming that the ATM and payroll systems were at risk of going dark.  They claimed the $3.8 trillion of short term deposits in the money market mutual fund sector were at risk of a run.  Half of this money market was U.S. treasuries and the other half was commercial paper (which had a higher yield).
  • During the weeks following the Lehman collapse, about $430 billion (or 25%) of deposits fled the commercial half of the money market.  Bernanke and Paulson seized on this convince Congress to pass the second TARP fund.
  • What they didn’t tell Congress, even though they knew it at the time, was that $370 billion (or 75%) of this money had simply migrated from the commercial to government halves of the money market funds.  In fact, only 2% of total assets had actually left the money market fund industry in the three weeks prior to the final TARP vote on October 3rd.  There was never a real run and never an danger of it.  The Fed and Treasury heads knew it but still mislead Congress in order to get TARP through.

Chapter 3 – Days of Crony Capitalist Plunder

  • GE Capital is GE’s financial company.  Played same trick of funding from the short-term paper market while holding long term, illiquid assets.  Gained profit from the yield spread of these two investment classes (leveraged 10 to 1).
  • GE was never in any danger given the required rollover was only about $5 billion per week.  GE could easily have issued additional stocks or bonds or sold some of its assets at fire sale prices.  They didn’t want to do this because it would have realized the lose and hurt the share price and earnings (and thus undermined executive stock options and bonuses).
  • Asset Backed Commercial Paper (ABCP).  Form of securitized debt (a derivative).  Comprised half of the $2 trillion commercial paper market.  Packages of consumer debt (auto loans, student loans, credit card debt, etc.) purchased by Wall Street from banks and credit card companies and dumped into a ‘conduit’.
  • These conduits had enough extra assets per dollar of ABCP (i.e. over-collateralized) to absorb any likely defaults and thus got AAA ratings.

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.

  • Another $400 billion of the $2 trillion commercial paper market was issued by industrial companies used to meet working capital needs including payroll.
  • This is were the fear-mongering about payroll systems going dark came from.
  • But this was nonsense.  By law industrial companies were required to keep backup lines of credit at a “standby” bank.  This was precisely to ensure that if the company could not rollover its debt for whatever reason, they could draw down the line of credit at their backup bank.
  • The final $600 billion of the $2 trillion commercial paper market came from nonbank finance companies e.g. GE Capital, General Motors Acceptance Corporation (GMAC), CIT.
  • All three of these major players funded from the short-term paper market while holding long term, illiquid assets.  And all three did not have the proper reserves to deal with any problems rolling over the short term funding.
  • In all three cases, the bailouts snatched defeat from the jaws of victory and prevented the necessary liquidation of these speculative gambling firms.

…Ever the master of malapropism, President Bush soon took to proclaiming:, “I’ve abandoned free market principles to save the free market system.”

Ironically, however, the truth was more nearly the opposite.  The financial meltdown of 2008 was occurring because sound economic principals had already been abandoned-years earlier, in fact.  The right solution was to restore these discarded canons, not eviscerate them further.  That meant promptly dismantling the giant gambling halls which had ushered in the crisis.

  • By late September Morgan Stanley was insolvent and should have gone down.  Instead the Fed provided it with over $100 billion in funding to stay afloat.
  • According to Paulson, Goldman Sachs was pushing for the bailout of Morgan Stanley worried that if Morgan fell, Goldman would be next.

…All told, the Fed dispensed nearly $700 billion in emergency loans during the last months of 2008, doubling down on the appropriated money provided by TARP.

At the end of the day, this trillion-dollar infusion of capital and liquidity from the public till had a single overarching effect: it nullified in its entirety the impact of Mr. Market’s withdrawal of a similar magnitude of funding from the wholesale money market.  So the very monetary distortion – the availability of cheap overnight funding in massive quantities – upon which the Wall Street financial bubble had been built had now been recreated at the lending windows of the Fed, FDIC, and the US treasury.

  • In the aftermath the GOP looked back to the Reagan policies as the model but this was through a revisionist lens.
  • The left looked longingly to FDRs new deal (again with a revisionist lens).
  • In both cases they missed the true cause, and solution:

But the common thread was the proposition that modern industrial capitalism was unstable and prone to chronic cyclical fluctuations and shortfalls that could be ameliorated by the interventions and corrective actions of the state, and most especially its central banking branch.  That was upside down.  The far greater imperfections and threat to the people’s welfare were embedded in the state itself, and in its vulnerability to capture by special interests – the vast expanse of K Street lobbies and campaign-money-dispensing PACs.  Trying to improve capitalism, modern economic policy had thus fatally overloaded the state with missions and mandates far beyond its capacity to fulfill.  The result is crony capitalism – a freakish deformation that fatally corrupts free markets and democracy.

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