Assignment 1
Blackberry Panic Paper
a. Paulson’s Folly
Its public sector teeters on the ragged edge of political dysfunction and fiscal
collapse. At the same time, its private enterprise foundation has morphed into a
speculative casino which swindles the masses and enriches the few. These lamentable
conditions are the Janus-faces of crony capitalism—a mutant régime which now
threatens to cripple the nation’s bedrock institutions of political democracy and the
free market economy. A decisive tipping point in the evolution of American capitalism
and democracy—the triumph of crony capitalism—took place on October 3, 2008.
That was the day of the forced march approval on Capitol Hill of the $700 billion
TARP (Troubled Asset Relief Program) bill to bail out Wall Street. This spasm of
financial market intervention, including multitrilliondollar support lines provided to
the big banks and financial companies by the Federal Reserve, was but the latest brick
in the foundation of a fundamentally anti-capitalist régime known as “Too Big to
Fail” (TBTF). It had been under construction for many decades, but now there was no
turning back. The Wall Street bailouts of 2008 shattered what little remained of the
old-time fiscal rules.
There was no longer any pretense that the free market should determine
winners and losers and that tapping the public treasury requires proof of compelling
societal benefit. Not when AAA-rated General Electric had been given $30 billion in
taxpayer loans and guarantees to avoid taking modest losses on toxic assets it had
foolishly funded with overnight borrowings that suddenly couldn’t be rolled over.
Even more improbably, Goldman Sachs had been handed $10 billion to save itself
from alleged extinction. Yet it then swiveled on a dime and generated a $29 billion
financial surplus—$16 billion in salary and bonuses on top of $13 billion in net
income—for the year that began just three months later.
Even if Goldman didn’t really need the money, as it later claimed, a round trip
from purported rags to evident riches in fifteen months stretched the bounds of
credulity. It was reminiscent of actor Gary Cooper’s immortal 1950s expression of
suspicion about Communism. “From what I have heard about it,” he told a
congressional committee, “it isn’t on the level.” Nor was Washington’s panicked
bailout of Wall Street on the level; it was both unnecessary and targeted at the wrong
problem. The so-called financial meltdown was not the real crisis; it was only the tip
of the iceberg, the leading edge of a more fundamental economic malady. In truth, the
US economy was heading for the wringer because a multi-decade spree of
unsustainable borrowing, speculation, and financialization of the national economy
was coming to an abrupt end.
In the years after 1980, America had undergone the equivalent of a national
leveraged buyout (LBO). It was now saddled with $30 trillion more in combined
public and private debt than would have been the case under the time-tested canons of
financial discipline and prudence which prevailed during the nation’s long economic
ascent. This massive debt burden had fueled a three-decade prosperity party by
mortgaging the nation’s future. Now the bill was coming due and our national
simulacrum of prosperity was over. This rendezvous with the limits of “peak debt,”
however, did not mean that the Main Street economy was in danger of collapse into
an instant depression. That was the specious claim of the bailsters. What did threaten
was a deeper and more enduring adversity. The demise of this thirty-year debt super
cycle actually meant that it was payback time. Instead of swiping growth from the
future, the American economy would now face a long twilight of debt deflation and
struggle to restore household, corporate, and public sector solvency.
This abrupt turn in the road should not have been surprising. America’s
fantastic collective binging on debt, public and private, had no historical precedent.
During the century prior to 1980, for example, total public and private debt on US
balance sheets rarely exceeded 1.6 times GDP. When the national borrowing spree
reached its apogee in 2007, however, the $4 trillion of new debt issued by households,
business, banks, and governments amounted to 6 times that year’s $700 billion gain in
GDP. Plain and simple, what was being recorded as GDP growth was little more than
faux prosperity borrowed from the future. In fact, by the time of the financial crisis
total US debt outstanding was $52 trillion and represented 3.6 times national income
of $14 trillion. Accordingly, there were now two full turns of extra debt weighing on
the nation’s economy.
The embedded mathematics underpinning the situation were nothing short of
daunting and complex, casting a stark light on the drastic departure from historical
norms. To fully appreciate the gravity of the financial landscape in 2008, it is essential
to delve into the specifics of leverage ratios and their implications over time.
Historically, for nearly a century prior to 1980, the United States had maintained a
relatively conservative leverage ratio of approximately 1.6 times the national income.
This ratio, reflecting the relationship between total debt (both public and private) and
the nation’s gross domestic product (GDP), had served as a benchmark for sustainable
financial practices and economic stability.
Had this historical leverage ratio been adhered to, the total combined debt of
the United States—including both public and private obligations—would have been
significantly lower. Specifically, by the end of 2008, the total debt would have
amounted to approximately $22 trillion. This figure stands in stark contrast to the
actual debt levels observed at that time, which were alarmingly higher, signaling a
profound deviation from the previously established norms of fiscal prudence and
economic management.
To understand the implications of this deviation, one must consider the
exponential growth in leverage that occurred in the decades leading up to the financial
crisis. The period post-1980 saw a dramatic increase in borrowing and lending
activities, driven by a variety of factors including deregulation, financial innovation,
and a general shift towards a more credit-intensive economic model. Financial
institutions, corporations, and households alike engaged in borrowing practices that
far exceeded the historical leverage ratio, thereby inflating the overall debt levels to
unprecedented heights.
This burgeoning debt was fueled by the availability of cheap credit and the
proliferation of complex financial instruments that obscured the true risk and extent of
leverage in the system. The resulting leverage ratio far exceeded the historically
sustainable level of 1.6, with total debt ballooning to figures that posed significant
systemic risks. The consequences of this excessive leverage became painfully evident
when the financial system began to unravel in 2007-2008, precipitating a severe
economic crisis that necessitated extraordinary intervention measures.
Furthermore, the implications of such high debt levels were multifaceted,
impacting not only the financial markets but also the broader economy. High leverage
magnified the potential for financial instability, as even minor disruptions could
trigger cascading failures across interconnected sectors. This instability necessitated
massive government interventions, including bailouts and monetary stimulus, to
prevent a complete economic collapse. The disparity between the sustainable debt
level of $22 trillion and the actual debt underscored the extent of overleveraging and
the systemic vulnerabilities that had accrued over years of fiscal imprudence.
In essence, the forbidding mathematics of leverage and debt revealed the
precariousness of the economic structure that had evolved. The historic leverage ratio
of 1.6 times national income represented a bygone era of more measured and cautious
financial practices. The deviation from this ratio highlighted the need for a
reevaluation of financial regulations and the importance of maintaining sustainable
debt levels to ensure long-term economic stability and resilience against future crises.
So the nation’s households, businesses, and taxpayers were now lugging
around the aforementioned $30 trillion in excess debt. This staggering financial
burden dwarfed levels which had historically been proven to be healthy, prudent, and
sustainable. TARP and all its kindred bailouts and the Fed’s ceaseless money printing
could not relieve it. And Washington’s reckless use of Uncle Sam’s credit card to fund
the Obama stimulus actually made it far worse by attempting to revive the false
prosperity of the bubble years. The obvious question remains: Why did this plague of
debt arise? Did the American people suddenly become profligate and greedy through
a mysterious process of moral and social decay?
There is no evidence for the greed disease theory but plenty of reason to
suspect a more foreboding cause. The real reason for the current crisis of debt and
financial disorder is that public policy had veered into the ditch, permitting an
unprecedented aggrandizement of the state and its central banking branch. In the
process, the vital nerve center of capitalism, its money and capital markets, had been
perverted and deformed. Wall Street has become a vast casino where leveraged
speculation and rent seeking have displaced its vital function of price discovery and
capital allocation.
The September 2008 financial crisis, therefore, was about the need to
drastically deflate the Wall Street behemoths—that is, dangerous and unstable
gambling houses—fostered by decades of money printing and market rigging by the
Fed. Yet policy veered in the opposite direction, propping them up and thereby
perpetuating their baleful effects, owing to a predicate that was dead wrong. A handful
of panic-stricken top officials, led by treasury secretary Hank Paulson and Fed
chairman Ben Bernanke, proclaimed that the financial system had been stricken by a
deadly “contagion” that had come out of nowhere and threatened a chain reaction of
financial failures that would end in cataclysm.
That proposition, though entirely baseless and devoid of factual accuracy,
nonetheless catalyzed a chain of events that would have far-reaching and profound
implications. It introduced a critical and, some might argue, perilous mandate—an
injunction that called for the suspension of all conventional rules governing free
market capitalism and fiscal prudence. The principles that had long been upheld as the
bedrock of economic stability and integrity were abruptly deemed irrelevant, cast
aside in the face of what was perceived as an urgent and unparalleled crisis.
In the wake of this proposition, a narrative took shape that suggested the
traditional mechanisms of economic governance and market regulation were
insufficient to address the enormity of the challenges at hand. This narrative argued
that extraordinary times demanded extraordinary measures, and thus, the well-
established doctrines of financial discipline and market self-regulation were
abandoned. The urgency and magnitude of the situation were cited to justify the need
for unprecedented intervention by the government, leading to the allocation of
unlimited public resources toward the rescue efforts.
These resources were directed primarily at Wall Street's floundering
behemoths, the colossal financial institutions whose imprudent practices had
precipitated the crisis. The rationale provided was that the collapse of these entities
would spell disaster not only for the financial sector but for the broader economy as
well. Therefore, it was deemed imperative to shore them up at any cost. What ensued
was a series of bailout packages, government-backed loans, and fiscal stimuli aimed
at stabilizing these institutions and restoring confidence in the financial markets.
However, this approach was not without its critics. Many argued that pouring
vast sums of taxpayer money into rescuing private corporations, particularly those
whose reckless behavior had contributed to the economic turmoil, set a dangerous
precedent. It was seen as a moral hazard, potentially encouraging similar behavior in
the future by demonstrating that losses would ultimately be socialized, even if profits
had been privatized. Moreover, there was concern that such actions undermined the
foundational principles of capitalism, where market forces, rather than government
interventions, were supposed to dictate the success or failure of businesses.
The long-term ramifications of this decision were significant. It fundamentally
altered the relationship between the state and the financial sector, expanding the scope
of government involvement in the economy. It also sparked intense debate over the
role of regulation, the responsibility of financial institutions, and the limits of
government intervention. As policymakers and economists reflected on the crisis and
the response it elicited, the proposition that had initially seemed so unassuming
revealed itself to be a catalyst for a dramatic and contentious transformation in
economic policy and philosophy.
b. Aig was Safe Enough to Fail
As it happened, Washington drew the red line at AIG the day after the Lehman
failure. Yet the relevant facts show that an AIG bankruptcy would not have started a
chain reaction—that there never was a financial doomsday lurking around the corner.
In fact, none of the bailouts were necessary because the meltdown was strictly a
matter confined to the canyons of Wall Street. It would have burned out there on its
own had Washington allowed the free market to have its way with a handful of
insolvent institutions that needed to be taken out: Morgan Stanley, Goldman, and
Citigroup, among others.
In short, the financial “contagion” predicate, which triggered the bailout
madness of the Bush White House and the Bernanke Fed, had no basis in fact. And
the proof starts with AIG, the bailout poster child itself, and the alleged catalyst for
the purported chain reaction. The plain fact of the matter is that AIG was structurally
incapable of starting a contagion. Any modest hit to the balance sheets of a handful of
its huge, global banking customers owing to the collapse of its bogus credit default
insurance (CDS) would have caused a healthy purge of busted assets. At the same
time, its millions of insurance policy holders were never in harms’ way; they were
always a pretext to obfuscate the real purposes of the Washington bailsters.
At the time of the crisis, 90 percent of AIG was solvent and no danger to the
financial system or anyone else. Its $800 billion balance sheet consisted mostly of
high-grade stocks and bonds that were domiciled in a manner which utterly
invalidated the “contagion” theory. Indeed, this giant asset total was a statistical
artifact of AIG’s consolidated financial statements: its massive horde of high-grade
assets was actually parceled out into scores of insurance subsidiaries subject to legal
and regulatory jurisdictions scattered all over the globe. Those lockups both protected
policyholders and ensured that there would be no massive asset-dumping campaign
by AIG, the presumptive catalyst for the contagion.
So the crisis did not implicate AIG’s vast assets. It was actually all about its
hemorrhaging CDS liabilities—which could have been easily ring fenced. They were
domiciled exclusively in AIG’s holding company and accounted for less than 10
percent of its consolidated liabilities. These obligations could have been readily
liquidated in bankruptcy without any disruption to the insurance companies, their
solid assets, or their policyholders. Nevertheless, AIG was handed a massive and
wholly unwarranted taxpayer-funded infusion that ultimately totaled $180 billion.
Hank Paulson, the most destructive unguided missile ever to rain down on the free
market from the third floor of the US Treasury Building, later claimed, “If AIG went
down, we faced real disaster. More than almost any financial firm I could think of,
AIG was entwined in every part of the global system, touching businesses and
consumers alike.”
That was balderdash and subterfuge. A “global” firm by definition has a global
footprint in the same manner as a zebra has stripes. But that obvious factoid doesn’t
prove that free market exchange is a transmitter of communicable economic disease,
which was what Paulson and his fellow bailsters constantly implied. In fact, the
unjustified largesse granted to AIG was not designed to inoculate the masses from
harm, but to save the bacon of a few dozen speculators. The paper trail uncovered by
congressional investigators shows that the $400 billion (notational value) of busted
CDS insurance issued by the AIG holding company was held by a very small number
of the world’s largest financial institutions, and virtually none of it was held by the
banks of Main Street America which were allegedly being shielded from AIG’s
imminent collapse. Moreover, the worst-case loss faced by the dozen or so giant
institutions actually exposed to an AIG bankruptcy would have amounted to no more
than a few months’ bonus accrual.
Yet there is not a shred of evidence that the panic-stricken amateurs
surrounding Paulson ever investigated which institutions held the CDS contracts or
their capacity for absorbing losses. Instead, in one of the most egregious derelictions
of duty every recorded, Paulson and his posse of Goldmanite hotshots hastily and
blindly shielded these behemoths from even a dollar of loss on their AIG insurance
policies. As the congressional investigators later determined, AIG’s big-bank
customers were actually supplied cash from a multitude of bailout spigots that
aggregated to truly stunning magnitudes. This evidence also shows that each and
every recipient institution had the balance sheet capacity to absorb the AIG hit, so the
bailout was all about protecting short-term earnings and current-year executive and
trader bonuses. That is the shocking truth of what the AIG bailout actually
accomplished. Saddling innocent taxpayers with business enterprise losses generated
on the free market is always an inappropriate exercise of state power, but shattering
policy rules and precedent in order to vouchsafe the bonuses of a few thousand
bankers is beyond the pale.
Not surprisingly, Goldman Sachs was the largest beneficiary of taxpayer
largesse and was paid out nearly $19 billion on its various claims against AIG. But
many of the other financial behemoths were not far behind, with a total of $17 billion
going to France’s second largest bank, Société Générale, while $15 billion was
transferred to Deutsche Bank, $14 billion to Bank of America and Merrill Lynch, and
nearly $10 billion to Londonbased Barclays, which also got the corpse of Lehman as a
consolation prize.
It goes without saying that given the enormous balance sheet girth of these
institutions—all of them were greater than $1 trillion in size—the amount of losses
could have easily been absorbed without help from the taxpayers. In the case of
Goldman, the largest recipient, the taxpayer funds amounted to less than eight months
of profit and bonus accruals during the very next year. In fact, at the time of the crisis
the dozen or so giant international banks that got the AIG bailout money had $20
trillion in assets among them. By contrast, even in a worst-case outcome in which the
banks lost twenty cents on the dollar for the mostly AAA paper (i.e., “super-senior”)
insured by AIG, their collective exposure to losses amounted to $80 billion at most.
Washington thus threw stupendous sums of money at AIG in a craven,
discombobulated panic, yet these subventions amounted to just 0.5 percent of the
elephantine balance sheets of its big global bank customers.
The September 2008 bailouts thus represented an outbreak of madness at the
very top of the political system. The crisis was defined by the Paulson-Bernanke cabal
in such Armageddon-like terms that all checks and balances disappeared. Every one
of Washington’s lesser players, including the president and the congressional
leadership, stood down in the face of an immense urban legend that had materialized,
as if out of whole cloth, in a matter of hours after the Lehman bankruptcy filing.
Panic-stricken Fed and Treasury officials had issued a financial ukase; namely, that an
AIG bankruptcy had to be prevented at all hazards because it would bring the entire
financial system tumbling down. Never in the inglorious history of Washington’s
financial misdeeds has such a large proposition been based on such a threadbare
predicate.
The pretentious young men flitting around Secretary Hank Paulson, who was
temperamentally unfit for the job and had by then seemingly come unglued,
apparently did not even bother to review AIG’s publicly filed financials. If they had
they would have seen that its mammoth balance sheet resembled nothing so much as a
clam shell. The lower half of the shell was comprised of dozens of major insurance
subsidiaries and was asset rich with the previously mentioned $800 billion of mostly
high- quality stocks, bonds, and other investments.
They would have also recognized that the liabilities of these insurance
subsidiaries were of the slow and sticky variety, consisting mainly of the current and
future claims of its life, property, and casualty policyholders. Unlike bank deposits,
these insurance liabilities could not be subject to a panic “run” by retail policyholders.
Instead, they would come due over years, and even decades, as eligible loss claims
matured. So if they had done even a modicum of homework, they would have
recognized that the balance sheet foundation of AIG was stable and was neither
exposed to “contagion” nor a transmitter of it.
Had they sought out competent legal advice, they would have also discovered
that in the event the parent company filed for bankruptcy, the dozens of solvent AIG
insurance subsidiaries would have been pounced upon and, if necessary, legally
sequestered by their regulators in the states and foreign jurisdictions where they were
domiciled. These protective actions, in turn, would have paved the way for
policyholders of these quarantined units to satisfy their claims in the normal course or
through an orderly judicial process.
Furthermore, had they consulted knowledgeable Wall Street analysts they
would have been quickly disabused of the simple-minded notion that an AIG
corporate failure would trigger a global contagion. At the practical operating level,
AIG was not remotely the globe-spanning octopus about which Paulson regaled
frightened congressmen. Despite Hank Greenberg’s fifty years of empire building,
AIG was actually a late bull market concoction, a jerry-built monument to the
economically senseless takeover arbitrage which emanated from the stock market
bubble the Greenspan Fed had fueled in the late 1990s.
With a high-flying PE multiple of 35 times earnings, AIG had engineered a
flurry of takeovers by swapping its high-value paper for the stock of its targets, which
generally sported more earthbound valuations. Accordingly, between 1998 and 2001
AIG had acquired a string of large life and casualty insurers including Western
National, SunAmerica, Hartford Steam Boiler, and American General. Just these four
takeovers were valued at a combined $45 billion and helped boost AIG’s total assets
by $140 billion to nearly $450 billion over this three-year period. The giant catch-22
embedded in this spasm of bubble-era financial engineering, however, was entirely
lost on the rampaging posse on the third floor of the Treasury Building: namely, that
AIG was a glorified insurance industry mutual fund. It had grown to giant size by
acquisitions and investments, but it did not have automatic access to the assets
sequestered in its far-flung subsidiaries.
Yes, SunAmerica alone had millions of retirement annuity customers,
American General had billions of life insurance outstanding, and Hartford Steam
Boiler provided fire and accident protection to a significant share of the industrial
facilities in the nation. From AIG’s small New York City headquarters, Greenberg and
his successors could control business plans, staffing, executive compensation,
underwriting standards, and much else. But they could not extract cash or capital from
any of these insurance subsidiaries without complying with state insurance
commission rules designed to protect policyholders and ensure solvency.
Hank Paulson was running around Washington with his hair on fire, but
contrary to the message he repeated over and over to purposely petrify congressmen
his true mission was not to save middle-American annuitants and retirees; they were
already being protected by insurance regulators from Connecticut to California.
Instead, this alleged threat to millions of policyholders was a beard—behind which
stood the handful of giant financial institutions which had purchased what amounted
to wagering insurance from the AIG holding company.
To be sure, AIG’s giant financial customers like Bank of America or Société
Générale had not reached their tremendous girth due to their prowess as legitimate
free market enterprises. They were lumbering wards of the state and, as will be seen,
products of the cheap debt, moral hazard, and serial speculative bubbles being
fostered by the Fed and other central banks. Not surprisingly, therefore, they were
now desperately petitioning the treasury secretary for help in collecting their
gambling debts from AIG. Needless to say, Paulson did not hesitate to throw the
weight of the public purse into the arena on behalf of these gamblers, because it
resulted in an immediate boost to the stock price of Goldman Sachs and the remnants
of Wall Street.
Hank Paulson, during his tenure as Secretary of the Treasury, undertook
actions that fundamentally undermined the established rules and principles of the free
market. This departure from long-standing economic doctrines was not motivated by
considerations of public welfare or economic stability in the broadest sense. Instead, it
was driven by the most deplorable of reasons: the desire to ensure that major financial
institutions, including Goldman Sachs, Deutsche Bank, and other banking giants,
were made whole on their substantial gambling claims.
These claims had arisen from highly speculative and risky financial activities,
which were pursued in a deliberate attempt to circumvent existing regulatory
standards. These banks had engaged in complex and opaque financial maneuvers,
leveraging their positions to extraordinary extents in a bid to maximize profits. They
had taken on massive risks, creating and trading in derivatives and other financial
instruments whose values were often detached from underlying economic realities.
As the financial crisis unfolded, the enormous scale of these institutions'
exposure became apparent. The speculative positions they had taken were rapidly
losing value, threatening not only their solvency but also the stability of the entire
financial system. The interconnected nature of the global financial markets meant that
the collapse of any one of these giants could trigger a domino effect, leading to
widespread economic turmoil.
In this context, Paulson's intervention can be seen as an attempt to prevent an
immediate and catastrophic financial meltdown. However, the methods employed and
the outcomes achieved were deeply problematic. By pouring public resources into
these failing institutions, Paulson effectively desecrated the core tenets of free market
capitalism. He abandoned the principle that markets should be allowed to self-correct,
with poorly managed firms facing the consequences of their actions.
The bailout of these banking giants did more than just stabilize the markets in
the short term; it also set a troubling precedent. It signaled to the financial sector that
reckless behavior and the circumvention of regulatory standards could be rewarded
rather than punished. The implicit message was that certain institutions were "too big
to fail" and that the government would step in to rescue them, no matter how
imprudent their actions had been. This moral hazard encouraged the very behaviors
that had precipitated the crisis in the first place, undermining efforts to restore genuine
market discipline and accountability.
Moreover, the decision to prioritize the interests of large financial institutions
over those of ordinary citizens and smaller businesses exacerbated social and
economic inequalities. As these banking giants were made whole, many individuals
and families faced foreclosure, unemployment, and financial ruin. The resources that
could have been used to support broader economic recovery and to provide relief to
those most affected by the crisis were instead funneled into propping up a sector that
had significantly contributed to the economic instability.
In summary, Hank Paulson's actions during the financial crisis represented a
profound breach of free market principles. His decision to bail out major financial
institutions, motivated by the desire to cover their gambling losses, not only
desecrated the rules of capitalism but also set a dangerous precedent for future
financial conduct. It highlighted the need for robust regulatory frameworks and the
importance of ensuring that financial institutions are held accountable for their actions
to prevent such crises from recurring.
As previously indicated, all of the CDS gambling debts in question had been
incurred at the holding company, which is to say, in the “upstairs” half of the AIG
claim shell. The holding company was essentially bereft of liquidity because its
assets, while massive, consisted almost entirely of the illiquid private stock of the
endless string of insurance subsidiaries AIG had acquired or created over decades.
And the not so secret reality was that invariably insurance regulators had imposed
protective barriers, or “dividend stoppers,” to protect policyholders from capital
depletion by parent- company stockholders. This meant that in the event of a
bankruptcy there would be no raid on the insurance company assets to satisfy holding
company liabilities. It also meant there would be no contagion—that is, the AIG
holding company was in no position to engage in a fire sale of insurance subsidiary
assets in order to satisfy the margin calls and loss claims against the CDS policies
issued by the holding company. The insureds—the giant global banks— would have
been flat-out stiffed and have faced severe losses on the value of their CDS contracts.
That would have been the end of the matter: an honest resolution under law and the
rules of the free market.
The key to free market justice in this instance was the “dividend stoppers,”
and I had learned the everlasting truth about them during my days doing LBOs at
Blackstone in the 1990s. We had come close to buying a state-regulated property and
casualty (P&C) insurance company, and our plan for hitting the jackpot was to do,
oddly enough, the very thing which proves there was no need to bail out AIG in
September 2008. We intended to buy the target P&C insurer through an unregulated
(“upstairs”) holding company funded with 80 percent debt, and then strip-mine cash
from the insurance subsidiary. Stated more politely, the insurance company profits
would be “upstreamed” as dividends to pay interest on the holding company debt.
After collecting a generous return on the small amount of equity we had invested in
the holding company, we would flip the insurance company stock to a new investor—
perhaps even an insurance conglomerate like AIG—and thereby close out what
promised to be a highly lucrative deal.
On the way to this easy money, however, Blackstone’s pertinacious cofounder,
Steve Schwarzman, became worried that an unfriendly state insurance commission
could shaft us by forbidding payment of dividends in the name of “conserving assets”
for the benefit of policyholders. That risk became the infamous “dividend stoppers” in
our internal deliberations, and after much digging and expert advice to find a way
around it, Schwarzman finally threw in the towel, pronouncing that it wasn’t “safe” to
plant a leveraged holding company atop a state-regulated insurance company. Upon
learning of the AIG bailout fifteen years later the salience of that episode was
unmistakable.
By then Steve Schwarzman was a billionaire LBO king and proven Midas. So
if even he hadn’t been able to find a way to get insurance company cash past a
“dividend stopper,” then it couldn’t be done at all. In fact, AIG’s holding company
was massively leveraged, by way of its margin obligations under the CDS contracts,
and it was now bankrupt just as Schwarzman had feared, leaving the punters who
bought $400 billion of its worthless CDS insurance contracts high and dry.
c. False Legends of Dark ATMS and Failing Banks
Given this evidence of utterly reckless and massive speculation, the Fed was
handed, as if on a platter, one final chance to restore a semblance of capital market
discipline. By that late hour, however, the Fed was not even remotely interested in
financial discipline. The Greenspan Put had now been superseded by the even more
insidious Bernanke Put. In defiance of every classic canon of sound money, the new
Fed chairman had panicked in the face of the first stock market tremors in August
2007, and thereafter the S&P 500 had become an active and omnipresent transmission
mechanism for the execution of central bank policy. Consequently, after the Lehman
event the plummeting stock averages had to be arrested and revived at all hazards.
Accordingly, the bailout of AIG was first and foremost an exercise in stabilizing the
S&P 500.
The cover story, of course, was the threat that a financial contagion would
ripple out from the corpus of AIG, bringing disruption and job losses to the real
economy. As has been seen, however, there was nothing at all “contagious” about
AIG, so Bernanke and Paulson simply peddled flat-out nonsense in order to secure
Capitol Hill acquiescence to their dictates and to douse what they derisively called
“populist” agitation; that is, the noisy denunciation of the bailouts arising from an
intrepid minority of politicians impertinent enough to stand up for the taxpayer. But
this hardy band of dissenters—ranging from Congressman Ron Paul to Senator Bernie
Sanders—was correct. Everyday Americans would not have lost sleep or their jobs,
even if AIG’s upstairs gambling patrons had been allowed to lose their shirts. Still, the
bailsters peddled a legend which has persisted; namely, that in September 2008 the
nation’s financial | 19 payments system was on the cusp of crashing, and that absent
the bailouts American companies would have missed payrolls, ATMs would have
gone dark, and general financial disintegration would have ensued. But this is a
legend. No evidence has ever been presented to prove it because there isn’t any.
Had Washington allowed nature to take its course in the days after the Lehman
collapse on September 15, the only Wall Street furniture which would have been
broken was the potential bankruptcy of Goldman Sachs and Morgan Stanley, the two
remaining investment banks. Needless to say, the utterly myopic investment banker
who was running the US government from his Treasury office wasted not a second
ascertaining whether the public interest might diverge from Goldman’s stock price
under the circumstances at hand. According to his memoirs, Secretary Paulson already
“knew” on the very morning Lehman failed that the last two investment banks
standing needed to be rescued at all hazards: “Lose Morgan Stanley, and Goldman
Sachs would be next in line—if they fell the financial system might vaporize and with
it, the economy.”
Tendentious and sophomoric would be a more than generous characterization
of that apocalyptic riff. Yet groundless as it was, the fact that Paulson and his posse
treated it as truth is deeply revealing. It underscores the extent to which public policy
during the bubble years had been taken captive by the satraps and princes seconded to
the nation’s capital by Wall Street. Such self-serving foolishness would never have
been uttered in earlier times, not even by the occasional captain of industry or finance
who held high financial office. Certainly President Eisenhower’s treasury secretary
and doughty opponent of Big Government, George Humphrey, would never have
conflated the future of capitalism with the stock price of two or even two dozen Wall
Street firms. Nor would President Kennedy’s treasury secretary, Douglas Dillon, have
done so, even had his own family’s firm been imperiled. President Ford’s treasury
secretary and fiery apostle of free market capitalism, Bill Simon, would have crushed
any bailout proposal in a thunder of denunciation. Even President Reagan’s man at the
Treasury Department, Don Regan, a Wall Street lifer who had built the modern
Merrill Lynch, resisted the 1984 bailout of Continental Illinois until the very end.
Once the Fed plunged into the prosperity management business under
Greenspan and Bernanke, however, the subordination of public policy to the
pecuniary needs of Wall Street became inexorable. No other outcome was logically
possible, given Wall Street’s crucial role as a policy transmission mechanism and the
predicate that rising stock prices would generate a wealth effect and thereby levitate
the national economy. Not surprisingly, the Goldman Sachs “occupation” of the US
Treasury coincided almost exactly with the Fed’s embrace of financialization,
leverage, and speculation as crucial tools of monetary management.
Its legates in Washington during this tumultuous era, Robert Rubin and Hank
Paulson, who served as high-ranking officials in the U.S. Treasury, displayed a
remarkable and unwavering commitment to the preservation and perpetuation of the
Wall Street financial apparatus. Their tenure was marked by a conspicuous lack of
concern for the potential repercussions of violating the established tenets and
principles of free market capitalism. Neither Rubin nor Paulson appeared to
experience any significant moral or ethical dilemmas about their actions, which often
involved bending or outright breaking the traditional rules that had long governed
economic and financial practices.
Robert Rubin, who served as Treasury Secretary during the Clinton
administration, and Hank Paulson, who held the same position during the George W.
Bush administration, operated under the steadfast belief that the prosperity and
stability of the nation were inextricably linked to the health and vitality of Wall Street.
This conviction led them to make decisions that prioritized the interests of the
financial sector, often at the expense of broader economic principles and the well-
being of the average American citizen.
For Rubin, the philosophy of deregulation and the promotion of financial
innovation were paramount. He championed policies that reduced regulatory
oversight and allowed financial institutions to engage in increasingly complex and
speculative activities. This approach was predicated on the assumption that an
unfettered financial sector would drive economic growth and innovation, ultimately
benefiting the entire nation. However, this deregulation also paved the way for the
risky behaviors that would later contribute to the financial crisis.
Paulson, who succeeded Rubin, faced the full brunt of the financial meltdown.
His response was characterized by aggressive intervention in the markets, including
the orchestration of massive bailouts for failing financial institutions. Paulson's
actions reflected a deep-seated belief that the collapse of these institutions would
precipitate a broader economic catastrophe. Therefore, he deemed it essential to use
all available resources to keep these entities afloat, believing that their survival was
synonymous with national economic stability.
Throughout their respective tenures, neither Rubin nor Paulson seemed to
agonize over the implications of their decisions on the sanctity of free market
principles. They did not dwell on the fact that their policies and interventions often
involved significant departures from the ideals of market self-regulation, risk
accountability, and fiscal prudence. Instead, they operated under a paradigm that
equated the good of the nation with the unimpeded functioning of Wall Street.
This paradigm was rooted in the notion that a robust financial sector was
crucial for funding innovation, facilitating trade, and driving overall economic
growth. Consequently, any measures necessary to ensure the continuity of Wall
Street's operations were justified, regardless of their impact on market integrity or the
potential creation of moral hazards. Rubin and Paulson's actions thus underscored a
broader governmental and institutional shift towards prioritizing financial stability
over market discipline, a shift that had profound and lasting implications for the U.S.
economy.
In retrospect, the legacy of Rubin and Paulson's era in Washington is a
contentious one. While their policies and interventions may have averted immediate
economic disaster, they also set the stage for future crises by reinforcing the notion
that large financial institutions could rely on government support in times of trouble.
This approach contributed to a cycle of risk-taking and bailouts that continues to
challenge the principles of free market capitalism and raises questions about the
proper role of government in regulating and supporting the financial sector.
Nor did the Goldmanites have even the foggiest appreciation of why the old
fashioned guardians of the public purse, like Bill Simon, had been so resolutely anti-
bailout. To his great credit, Simon appreciated the insidious effects of bad precedent
and rightly feared that once the floodgate was opened crony capitalism would
flourish. He also understood that every crisis would be portrayed as a one-time
exception and that once officials started chasing market-driven brush fires, the policy
process would quickly degenerate into analytics-free, seat-of-the-pants ad hocery and
would frequently even border on lawlessness. In fact, that is exactly what happened in
the signature bailout episodes during Goldman’s occupation of the Treasury.
The $20 billion bailout of the Wall Street banks during the 1994 Mexican peso
crisis orchestrated by Secretary Rubin was not only unnecessary, but was done against
overwhelming opposition on Capitol Hill. In the end, the American taxpayer was
thrown into the breach by Treasury lawyers who tortured an ancient statute governing
the Economic Stabilization Fund until it coughed up billions for a bailout of Mexico
and its Wall Street lenders. In so doing, Rubin simply thumbed his nose at Congress,
implying that the greater good of Wall Street trumped the democratic process.
Likewise, the entire Paulson-led campaign to bail out Wall Street during the
September 2008 crisis was an exercise in pushing the limits of existing law to the
breaking point. Lehman was not bailed out mainly because Washington officials had
not yet found a loophole by the time of its Sunday-night filing. But as the crescendo
of panic intensified, the Treasury and Fed miraculously found enough legal daylight
by Tuesday to rescue AIG. Throughout the ordeal Paulson and his posse viewed
themselves as glorified investment bankers, empowered to use any expedient of law
and any drain on the public purse that might be needed to ensure the survival of the
remaining Wall Street firms.
Rampaging around the globe with an air of unassailable authority, Robert
Rubin and Hank Paulson aggressively pursued their agendas, often browbeating
bankers, government officials, and international financial leaders alike. Their missions
were frequently undertaken on behalf of ambitious and half-baked merger schemes
and other high-stakes financial maneuvers that, while promising short-term gains,
often ignored long-term consequences and systemic risks. In their relentless pursuit of
these objectives, they defiled the great office of the U.S. Treasury Secretary in ways
that had never been witnessed before.
The U.S. Treasury Secretary, historically a position of immense responsibility
and ethical stewardship, was transformed under their tenure into a role that seemed
more akin to that of a corporate enforcer than a guardian of public fiscal policy. Rubin
and Paulson used their substantial influence to push through deals that aligned with
their Wall Street backgrounds and priorities. Their actions were marked by a distinct
willingness to override objections, whether from skeptical lawmakers, concerned
international partners, or cautious financial regulators.
Rubin, during his time, was a leading advocate for the repeal of the Glass-
Steagall Act, a cornerstone of financial regulation that had maintained a clear
separation between commercial and investment banking. His lobbying efforts were
instrumental in dismantling this critical barrier, leading to an era of financial
conglomerates whose size and complexity would later pose severe risks to the global
economy. Rubin's tenure was characterized by an unwavering commitment to
financial deregulation, which, while catalyzing short-term market exuberance, also set
the stage for future financial instability.
Paulson, following in Rubin's footsteps, continued this legacy but took it to
even greater heights during the financial crisis of 2008. His approach was one of
direct intervention and forceful persuasion, often strong-arming other financial leaders
and government officials to accept his plans. Paulson's infamous TARP (Troubled
Asset Relief Program) initiative involved the government purchasing troubled assets
from financial institutions to stabilize the banking system. This program, while
arguably necessary to prevent a total economic collapse, was executed in a manner
that many perceived as favoring Wall Street over Main Street.
Under their leadership, the Treasury was seen as an extension of Wall Street's
interests rather than a defender of the public good. Their aggressive tactics and single-
minded focus on ensuring the prosperity of large financial institutions led to
widespread criticism and a sense of betrayal among those who believed that the office
of the Treasury Secretary should prioritize national and global economic stability over
the fortunes of a few powerful banks.
d. Goldman and Morgan Stanley: The Last Two Predators Standing
This was a blatant miscarriage of governance. As will be seen, at that late
stage of the delirious financial bubble which had overtaken America, Goldman Sachs
and Morgan Stanley had essentially become economic predators. Their bankruptcy
would have resulted in no measureable harm to the Main Street economy, and
possibly some gain. It would have also brought the curtains down on a generation of
Wall Street speculators, and sent them packing in disgrace and amid massive personal
losses—the only possible way to end the current repugnant régime of crony capitalist
domination of the nation’s central bank.
Goldman and Morgan Stanley helped generate and distribute hundreds of
billions in toxic assets—mortgage-backed securities and CDOs based on subprime
mortgages—that were now resident on the balance sheets of a wide gamut of Main
Street institutions like corporate pension funds and insurance companies, along with
institutional investors spread all over the planet. The TARP and Federal Reserve funds
that were pumped into Goldman and Morgan Stanley, however, did nothing to
ameliorate the huge losses being incurred by these gullible customers.
Instead, the Washington bailouts rescued the perpetrators, not the victims; that
is, the bailout benefits were captured almost exclusively by the Wall Street insiders
and fund managers who owned the common stock and long-term bonds of these two
firms. Yet it was these punters who deserved to take punishing losses. It was they who
enabled Goldman and Morgan Stanley—along with Bear Stearns, Lehman, and the
investment banks embedded inside Citigroup and JPMorgan—to grow into giant,
reckless predators. Only twenty-five years earlier these firms had been
undercapitalized white-shoe advisory houses with balance sheets which were tiny and
benign, but now their designation as “investment banks” reflected an entirely vestigial
nomenclature. They had long ago morphed into giant ultra-leveraged hedge funds
which happened to have retained relatively small-beer side operations in regulated
securities underwriting and M&A advisory services.
The preponderance of their fabled profitability, however, was generated by
massive trading operations which scalped spreads from elephantine balance sheets
that were not only preposterously leveraged (30 to 1) but also dangerously dependent
upon volatile short-term funding to carry their assets. Indeed, perched on a foundation
of several hundreds of billions in debt and equity capital, these firms had become
voracious consumers of “wholesale” money market funds, mainly short-term “repo”
loans and unsecured commercial paper. From these sources, they had erected trillion-
dollar financial towers of hot-money speculation. On the eve of the financial crisis,
Goldman had asset footings of $1.1 trillion and Morgan Stanley had also passed the
trillion-dollar mark. Much of their massive wholesale funding, however, had
maturities of less than thirty days, and some of that was as short as a week and even
overnight. When Bear Stearns hit the wall in March 2008, for example, it was actually
rolling over $60 billion of funding every morning—until, suddenly, it couldn’t.
It goes without saying that these highly liquid wholesale funding markets were
dirt cheap because lenders had no rollover obligation and were often fully secured. It
is also obvious that on the other side of their balance sheets, these de facto hedge
funds held assets which were generally more illiquid, longer term, and subject to
credit and market value risk, and which therefore generated substantially higher
average yields. Due to this “duration” and “credit” mismatch, the profit spread per
dollar of assets was considerable, and when harvested a trillion times over, total
profits were enormous, reaching $18 billion (pre-tax) at Goldman during the year
before the crisis. Since this amounted to a half million dollars of profit per employee
(including secretaries and messengers) the potency of carrying a giant balance sheet
on the back of cheap wholesale liabilities was self-evident.
Yet here is where the foundation of overvalued debt and equity capital came
in. There were limits on the extent to which the assets of these giant “investment
banks” could be funded on wholesale money. Even the frothy markets of 2008 would
have viewed a balance sheet consisting mainly of slow, illiquid assets funded
preponderantly with short-term liabilities as a house of cards. So the investment
banks’ foundation of permanent capital, in fact, was the vital linchpin beneath the
whole Wall Street edifice. Thus, Goldman’s balance sheet at the time of the crisis
boasted longterm debt and preferred stock of $220 billion and common stock of $60
billion, even as measured by its depressed share prices that week. Likewise, Morgan
Stanley had $190 billion of long-term debt and preferred stock, and $25 billion of
common stock at the current market prices of its shares. Taken together then, the last
two investment banks standing rested on a half-trillion-dollar base of long-term
capital.
During the boom years, this long-term capital had earned handsome returns in
the form of interest and dividends, with the common stock, the most junior capital,
also experiencing substantial price appreciation. Goldman’s share price, for example,
had peaked in late 2007 at nearly $250 per share, a level five times its May 1999 IPO
price.
Yet in the matter of investments, as in the opera, it’s not over until the fat lady
sings. The crucial economic purpose of each firm’s capital was to function as a
financial shock absorber. During times of heavy economic weather, therefore, senior
wholesale lenders would be spared from any losses incurred on impaired asset
accounts; losses would be absorbed by the firms’ more junior, permanent capital—the
common equity first and ultimately the long-term debt as well. As events unfolded in
the fall of 2008, these shock absorbers were brought into play.
In a remarkably brief span of time, Robert Rubin and Hank Paulson's approach
to financial governance and crisis management was put to a severe test, and they were
found to be gravely deficient. The collapse of Lehman Brothers and the near-demise
of Merrill Lynch highlighted the profound weaknesses in their strategies and the
overall fragility of the financial system they oversaw. When Lehman Brothers filed
for bankruptcy on September 15, 2008, it sent shockwaves through the global
financial markets. Lehman's failure was a direct consequence of its inability to sustain
itself through an unprecedented liquidity crunch and the massive devaluation of its
assets. The firm's permanent capital reserves were woefully inadequate to absorb the
staggering losses from its risky mortgage-backed securities and other speculative
investments. This inadequacy left Lehman utterly exposed, unable to meet its
financial obligations, and ultimately insolvent.
As the dust from Lehman's collapse was still settling, Merrill Lynch, another
titan of Wall Street, found itself teetering on the edge of financial ruin. The once-
mighty investment bank, burdened by its own toxic assets and declining market
confidence, could no longer sustain its operations independently. Merrill Lynch's
permanent capital base was similarly insufficient to cover the extensive losses it had
incurred, rendering it vulnerable to insolvency. In a desperate bid to avert a total
collapse, Merrill Lynch was hastily acquired by Bank of America in a deal that
resembled an emergency medical evacuation more than a strategic merger. The
acquisition was orchestrated at breakneck speed, effectively carting Merrill Lynch off
to Bank of America on a financial stretcher, in a move designed to prevent the already
dire financial crisis from worsening.
This rapid sequence of events exposed the profound miscalculations and
shortcomings in Rubin and Paulson's stewardship. Their policies, which had heavily
favored deregulation and the expansion of financial institutions without adequate
oversight, had left the system perilously unprepared for such shocks. The reliance on
complex financial instruments and excessive leverage, combined with insufficient
capital buffers, proved to be a fatal flaw for both Lehman and Merrill Lynch. These
firms, emblematic of Wall Street's excesses, were unable to withstand the severe
market downturn and the ensuing liquidity crisis.
Rubin and Paulson had underestimated the systemic risks posed by the
excessive interconnectivity and interdependence of major financial institutions. Their
faith in the self-regulating nature of the markets and the sufficiency of existing capital
requirements was misplaced. The collapse of Lehman and the emergency sale of
Merrill Lynch underscored the critical need for robust regulatory frameworks and the
importance of maintaining substantial capital reserves to mitigate the impact of
financial downturns.
The failures of these institutions also had broader implications for the global
economy. The collapse of Lehman Brothers, in particular, triggered a cascade of
financial instability, leading to severe credit freezes, plummeting stock markets, and
widespread economic distress. The inadequacies in the permanent capital of these
firms not only rendered them insolvent but also highlighted the systemic
vulnerabilities that could jeopardize the entire financial system.
In retrospect, the rapid unraveling of Lehman Brothers and Merrill Lynch
stands as a stark reminder of the perils of inadequate financial oversight and the
dangers of excessive leverage. The events called into question the efficacy of the
regulatory frameworks of the time and highlighted the urgent need for comprehensive
reforms. Rubin and Paulson's tenures, marked by a profound misjudgment of the risks
inherent in the financial system, serve as a cautionary tale for policymakers and
financial leaders. The lessons learned from these failures have since informed efforts
to strengthen financial regulation, increase capital requirements, and enhance the
resilience of the global financial system to prevent such catastrophic failures in the
future.
In the days after September 15, the shock absorbers of the last two investment
banks left standing, Goldman and Morgan Stanley, also failed the test. Their most
illiquid asset classes—such as securitized mortgages, CDOs, commercial real estate
securities, and corporate junk bonds— declined in market value by between 20
percent and 50 percent during the meltdown. Even when blended with holdings of
low-risk government bonds and blue chip corporate securities, the blow to capital was
devastating, and they would not have survived the ordeal on their own.
e. Days of Crony Capitalist Plunder
On the eve of the crisis about $650 billion, or one-third of prime fund assets,
were invested in commercial paper, making these funds the largest single investor
class in the $2 trillion commercial paper market. Consequently, when the wave of
money moved from prime funds to governmentonly funds which could not own
commercial paper, open market rates on the A2/P2 grade of thirty-day commercial
paper spiked sharply.
In the months leading up to the financial meltdown of September 2008, the
yield on various types of loan paper, including mortgage-backed securities and other
debt instruments, had remained relatively stable and low. Prior to the spring of 2008,
these financial instruments were yielding a modest return of around 1 percent. This
low yield reflected the broader environment of easy credit and abundant liquidity,
where investors were willing to accept minimal returns in exchange for perceived
safety and stability. The financial markets were characterized by a sense of
complacency, with few anticipating the magnitude of the impending crisis.
However, as the first signs of trouble began to emerge in the early part of
2008, investor sentiment started to shift. Concerns about the subprime mortgage
market, rising default rates, and the overall health of major financial institutions began
to grow. Despite these early warning signs, the true extent of the financial system's
vulnerabilities was not fully appreciated until the dramatic events of September 2008.
As the crisis reached its peak, the confidence that had once underpinned the
financial markets evaporated almost overnight. The collapse of Lehman Brothers and
the near-failures of other major financial institutions sent shockwaves through the
global economy. In this climate of panic and uncertainty, the risk premiums demanded
by investors soared. The yield on loan paper, which had been a meager 1 percent just
a few months earlier, suddenly skyrocketed to over 6 percent. This dramatic increase
was driven by a flight to safety, as investors demanded significantly higher returns to
compensate for the heightened risk and uncertainty.
The soaring yields reflected the broader turmoil in the financial markets.
Institutions and investors were frantically reassessing the riskiness of their portfolios,
leading to a massive sell-off of previously low-yielding loan paper. The sharp increase
in yields was not merely a reflection of changing interest rates but an indicator of the
severe credit crunch and the lack of confidence in the financial system's stability. As
yields rose, the value of the underlying loan paper plummeted, exacerbating the
balance sheet problems for many financial institutions that held large quantities of
these assets.
This sudden spike in yields had far-reaching consequences. For financial
institutions, the increased cost of borrowing and the devaluation of their assets led to
further liquidity pressures and solvency concerns. Many institutions found themselves
unable to roll over their short-term debt or secure new funding, intensifying the crisis.
For borrowers, the higher yields translated into increased borrowing costs, further
straining households and businesses already grappling with the economic downturn.
In essence, the transition from a 1 percent yield to over 6 percent within such a
short period highlighted the fragility and interconnectedness of the financial system. It
underscored how quickly market conditions could deteriorate and how investor
sentiment could shift from complacency to panic. The dramatic rise in yields on loan
paper was both a symptom and a driver of the broader financial crisis, reflecting the
deep-seated fears and the systemic weaknesses that had been building up over the
preceding years.
The aftermath of this yield spike saw unprecedented interventions by central
banks and governments worldwide, who sought to restore confidence and stabilize the
financial system. Measures included massive liquidity injections, interest rate cuts,
and the implementation of various bailout programs designed to shore up failing
institutions and revive credit markets. These interventions were crucial in preventing a
complete collapse of the financial system and laid the groundwork for the subsequent
recovery efforts.
In summary, the abrupt and severe increase in yields on loan paper from 1
percent to over 6 percent during the September 2008 crisis was a stark illustration of
the financial turmoil of that period. It highlighted the rapid erosion of confidence and
the intense pressures facing both financial institutions and borrowers. This period
remains a critical case study in the dynamics of financial crises and the importance of
maintaining robust risk management practices and regulatory oversight to safeguard
the stability of the financial system.
Any garden variety economist might have suggested that commercial paper
had been seriously overvalued. The flight from prime funds was living proof that the
market had been artificially buoyed by big chunks of demand from what were
inherently risk-intolerant prime fund investors. Now, the commercial paper market
was in a violent rebalancing mode, causing borrowers to experience the joys of “price
discovery” as interest rates sought a higher, market-clearing level.
f. 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.
