Washington’ s takeover of Fannie Mae and Freddie Mac gained the quick support of Wall Street, who never meets a bailout it doesn’t like, and the thanks of Beijing, whose playbook it seems to be borrowing.
Months after U.S. Treasury Secretary Henry M. Paulson, Jr. reassured the world ‘s markets that “We are closer to the end of this problem than we are to the beginning,” the Bush administration this week seized mortgage giants Fannie Mae and Freddie Mac. With that single act, the United States -long-reputed bastion of free enterprise, and led by the first MBA-trained president ever- undertook the largest nationalization of private enterprise in modern history. It was by far the most striking culmination, at least to date, of the folly, hubris and Titanic misjudgment that has seen Wall Street, boards and regulators take a holiday from risk and reality that can now be measured in trillions of dollars in write-downs, lost shareholder value and the worst economic crisis since the Great Depression.
Like the government-sponsored Bear Stearns rescue that preceded it, this, too, is a bailout that has the fingerprints of Wall Street all over it. Morgan Stanley played a pivotal role in advising Mr. Paulson on how the deal would be orchestrated. In fact, all of the government’s recent interventions have been done in consultation with Wall Street’s biggest firms.
With the stroke of a pen, the decision to place the strangely named pair into a “conservatorship” removes key private sector competitors from the mortgage business that was so lucrative to Wall Street’s top banks and institutions, while at the same time ensuring a steady flow of mortgage funds into the market. Wall Street got what it wanted again, and showed its gratitude by the Dow soaring more than 300 points in the first few minutes of trading after the decision was announced. And the U.S. government is now the biggest mortgage backer in the world.
Reasonable men and women will differ as to whether the bailout of these institutions was wise or not. What cannot be disputed is that it was the result of one of the most costly governance and oversight failures ever.
What brought the U.S government to this remarkable place in the history of its free enterprise system? How was it possible that these two firms were permitted to play such a pivotal role in the economy that their stake in the mortgage market was actually measured in the trillions? How could regulators and boards of directors have failed to such an extent that this mother of all bailouts became necessary?
I doubt that there will be much of an appetite to pursue these questions, which is exactly why, in a culture where accountability and good governance always took second place to short-term greed and self-interest -and that was on a good day- such a calamity happened in the first place.
Over time, investors, investment bankers and executives became incredibly wealthy from Fannie and Freddie. The two CEOs of these firms made more than $30 million last year alone. The financial rewards from these institutions were viewed as the legitimate fruits of a fabled market-driven free enterprise system which, it is claimed, operates best when government stays out of the picture. Naturally, these rewards were privatized. Now that the jig is up, it is claimed by many, including a deafening chorus on Wall Street just fresh from its long running show where it was clamoring for ever lower interest rates from the Fed, that government cash is necessary to clean up the mess and stabilize the market. The losses, which already are counted in the billions, will be socialized. And thanks for thinking about Adam Smith.
The earth did not exactly shake from the howls of outrage heard among defenders of free market capitalism when the takeovers were announced, or from the College of Wall Street cardinals where the vice of hypocrisy rarely evokes the specter of shame. And it is the idea that Wall Street winds up making money from either success or failure, that free enterprise or government bailout is just fine with this crowd as long as the money keeps rolling in, that is the most galling.
It is always a measure of the fundamental strengths of any system of government or economics that the spires of its principles are able to withstand the gales of expediency. Looking at how happily the market embraced this latest government intervention, which occurred on a draconian scale heretofore typically associated with South American dictatorships, the toppled ruins on Wall Street, and in those other places where principles are expected to matter, are not a pretty sight.
The Alice in Wonderland world into which U.S. capitalism has descended, where profits were based on flaky business models, indecipherable investment vehicles and assets held together by thin air, has long had its antecedents in a similarly dysfunctional system of CEO pay. This, too, is a world diverged from reality and common sense, where monster-size bonuses often had nothing whatever to do with performance or outcomes and where fortunes were regularly awarded by boards on the basis of shoddy results, if not outright failure. Is it at all surprising that it was this same system that tempted CEOs to misjudge the prospects of risk and to take actions that were based on how next year’s bonuses would be affected rather than what was in the long-term interests of investors. It is not that far a stretch from a boardroom culture where bonuses were routinely awarded even for poor performance to one that would see a pandemic creation of investment vehicles that proved to be empty in terms of value and risk consideration.
Criminal fraud at the level of Hollinger or Enron, or misfeasance such as was found at Fannie Mae when previous management cooked the books in order to push up their own pay, may not abound throughout corporate America. But the seeds of the folly that is at the center of CEO pay and the disaster it so often heralds may well be viewed by history as having been synonymous with the disconnection of value, values and meaningful governance/oversight that has brought the economy and the American business system to this perilous point in time.
And the price tag for all of the government’s actions over the past year -the Bear Stearns rescue scam (as noted on these pages before, the Fed never really took on the $29 billon loan; it bought the collateral outright), its apparently never closing and endlessly accommodating discount window, and now this latest Wall Street bailout? Nobody seems to know. And few appear to be asking even during a presidential election year. The costs seem likely just to be pushed off in one form or other, whether in the guise of soaring inflation, galloping deficits, higher interest rates or a weaker dollar, to a future generation. The rewards of the government’s latest intrusive efforts will be privatized once more. Their risks and the costs that lie ahead will be socialized again.
One more point of interest: the Fannie and Freddie move was met with approval by countries which hold substantial instruments of U.S. debt, including significant amounts of paper obligations on the part of these financial institutions. China, a totalitarian state that professes communism but increasingly practices capitalism, especially praised the move by the United States, a land which trumpets capitalism but increasingly seems to practice the fine art of socialism.
In the distorted, upside down world that America’s leaders, financial wizards, regulators and directors have created, what pleases Beijing most seems only fitting.
We have cast a skeptical eye in recent months on the Fed’s response to the subprime meltdown, and its handling of the Bear Stearns bailout. In The Wall Street Journal today, Greg Ip writes: (subscription required)
Since the credit crisis began last August, the Fed has expanded the volume and types of loans it is willing to make to banks and securities dealers — loans that are backed by a wide variety of collateral from subprime mortgages to student loans. It has so far not directly purchased such debt. It did, however, make an unprecedented loan of $29 billion to facilitate the sale of Bear Stearns Cos. to J.P. Morgan Chase & Co.
Actually, the Fed did not make a traditional $29 billion loan to JPMorgan Chase, as its official statements would have us believe. It was more of a wink-and-a-nudge deal to take on the poorer assets without going through the formality (and the barrage of questions that would follow) of actually purchasing them. How do we arrive at that conclusion?
When you take out a loan and provide collateral, the lender does not usually get to sell your collateral with the hope of making a profit. But that is precisely what Fed chairman Ben S. Bernanke plans to do, if you believe his testimony before the Senate Banking Committee last month.
If we sell these assets over time -and we have allowed ourselves up to 10 years- although we can sell these anytime we like and therefore avoid the need to sell into a distressed market- that we will recover the full amount and that, in addition, if we are fortunate, we may turn a profit…
He repeated versions of the same statement, reiterating the plan to dispose of these assets, throughout his testimony. We have previously noted the cozy relationship that many of Wall Street’s top players have with the Federal Reserve System.
This is part of what former Fed chairman Paul Volcker has described as pushing the legal limits of the central bank’s mandate. The Fed also refuses to disclose details about the Bear Stearns collateral it holds, prompting many to conclude that these assets are not entirely marketable in the first place and that only the Fed could afford to sell them off at fire sale prices over ten years. The whole process behind the bailout lacked even rudimentary transparency.
There are more details disclosed on the label of a jar of Jif peanut butter about the contents of that $2.90 product than the Fed has revealed about the contents of the Bear Stearns collateral it “bought” for $29 billion and the circumstances surrounding that transaction.
For a Fed that is likely to play a much larger role in the regulation of financial institutions, its standards of openness and candor require added scrutiny. If its own conduct in the Bear Stearns bailout is any clue to the approach it will take in the regulation of others, there is little that inspires confidence.
With yet more losses and its recent credit downgrade to junk status following stunning statements by Bank of America regarding Countrywide’s debt, the question is how many icebergs will this Titanic of subprime lending need to hit before the inevitable occurs?
In a posting on Tuesday this week, we suggested that Countrywide’s sinking financial state might be a worrisome signal to Bank of America, and that the sudden 990 percent increase in bad loan provisions ($158 million for Q1 2007 vs. $1.5 billion for Q1 2008) might be something of an unanticipated iceberg for the deal. More and more, Countrywide is beginning to resemble the Titanic of modern subprime lenders: an enterprise that was based on flawed principles, that had become too large for its own good and was steered by overpaid egos who never contemplated the prospect of disaster. The question is: Will it meet a similar fate?
The record is not encouraging. Somehow Countrywide managed to strike another iceberg in a matter of days. On Friday, Standard and Poor’s cut Countrywide’s credit rating to junk status. It based its downgrade on a filing by Bank of America on May 1st that discloses it might not be taking on some $38 billion in Countywide debt. As a statement from the rating agency noted:
Until this filing it was our understanding that [B of A] would acquire all of Countrywide as stated in the January 2008 merger agreement. This new filing raises the possibility that this assumption is no longer true.
The downgrade could trigger a host of draconian actions on the part of lenders and insurers of Countrywide’s obligations that will prove very costly to that company and much more expensive and complicated for Bank of America to complete the transaction.
We have previously conjectured that in its acquisition of Countrywide, Bank of America may be trying to follow the JP Morgan Chase model for the Bear Stearns takeover. In that case, JPMorgan was able to get rid of nearly $30 billion in riskier Bear securities through a Fed-led bailout. B of A’s announcement this week that it might not be backing such a huge chunk of Countrywide’s bonds and notes was considered something of a surprise among analysts. We have been predicting for some time that the element of surprise will be Countrywide’s constant companion. So far, we’re batting 1000. The biggest surprise, however, will be if this deal actually goes through before the Countrywide ship has gone down and top managers and directors have decided to jump into the lifeboats.
A couple of weeks ago, I was interviewed by Barron’s on B of A’s plans for Countrywide. I suppose my comments were too trenchant for the folks at that magazine, since they did not run them. What I said, however, seems to have been fairly close to the mark, given recent events. Here’s part of the interview:
Bank of America may not be as smart in seeing the potential downside of this acquisition as it claims. What is at the heart of many fears about the deal is a concern that we may be witnessing the creation of another Frankenstein-like Bear Stearns monster that just causes a whole new set of problems for everybody. You have to wonder if Bank of America has a plan to get some of the poorer Countrywide assets off its books, as JPMorgan Chase did with Bear Stearns, leaving others on the hook.
Stay tuned for more surprises.
Investigations by Congress in 1912, 1932 and 2002 revealed weaknesses and abuses in both the regulatory regime and in the governance of corporations that yielded major reforms. A comparable effort is needed now in the face of the worst credit crisis since the Great Depression.
A trio of former SEC chairmen and a solo performance on the part of a former high-ranking Fed official are making for some interesting music and a much-needed counterpoint to the current chorus of conventional thinking. In a recent Op-Ed piece in The New York Times, William Donaldson, Arthur Levitt, Jr. and David Ruder write: “In 1987, a presidential task force was established to investigate the Black Monday crash. Today, we need a similar exhaustive, bipartisan and impartial examination to explore a series of possible business and regulatory failures”. The former securities regulators invite an examination of:
…apparent conflicts of interest on the part of the credit ratings agencies; the failure of banks and other lenders to adopt sound lending practices; the failure of investment banks to disclose that they had significant portfolios of securities backed by subprime mortgages; the sale of high-risk securities to investors for whom they were unsuited; the breakdown (or absence) of adequate risk management systems among the top financial services firms; and the failure of regulators to recognize and take early action to deal with the problems that have grown to today’s magnitude.
We would add to that list for investigation the alarming failure of too many boards to effectively oversee risk and the role that excessive compensation played in rewarding CEOs for taking on levels of risk that would run up the price of shares and boost their pay in the short term but which ultimately proved to be unmanageable over the longer run. As we predicted some years ago, Titanic-sized CEO compensation has proven to be the most corrosive force in the modern American boardroom. It will continue to be associated with mishaps, scandals and failures in the future, as it has been in the past, unless it is checked by a healthy injection of common sense and sound judgment around the director’s table.
Valuable as a review of the SEC’s role would be, we have expressed the view that a more comprehensive inquiry regarding the actions of all the players in the subprime ordeal, and what changes are necessary both in the regulatory system and in corporate governance practices, is more appropriate. Back in January, in Time for Tough Questions About Subprime Solutions -and Their Potential Dangers, we suggested that Congress needed to get to the bottom of what was happening and why. We concluded by noting:
The issues of subprime bailouts, foreign investment and the failures that brought American capitalism to this troubling state are far too important to be permitted to escape scrutiny or unfold by stealth or default, which is the current mode of operation. Those actors have too often entered the room when no one was paying attention and waltzed out with most of the silverware in their pockets.
Vincent Reinhart, who was director of monetary affairs at the Fed until last year, has called the Bear Stearns bailout “the worst policy mistake in a generation.” We, too, have had our reservations about that rescue and the lack of transparency associated with it. As we said shortly after the deal was announced:
Americans cannot permit free enterprise to reign just when CEOs and companies are making piles of money only to have it replaced by socialism when they are teetering on disaster.
In a later posting we noted:
More and more, the picture is emerging that this was a bailout of Wall Street, prompted by Wall Street, over problems caused by Wall Street, with terms dictated by Wall Street. The Fed’s agreement constitutes the single most significant market intervention in generations. Such a decision…places substantial taxpayer dollars on the line and the concept of moral hazard in jeopardy.
The causes of the worst crisis in America’s capital markets since the Great Depression, and the unprecedented decisions of the Fed in dealing with it, along with the role other public and corporate actors have played in this saga, call out for serious analysis and national discussion. Congress has acted before in the face of momentous challenges to the stability of the market and public confidence in its functioning. A special subcommittee of the United States House of Representatives was formed in 1912 under the legendary chairmanship of Louisiana Congressman Arsène Pujo to examine the influence of the “money trust” and the growing power of Wall Street titans like J.P. Morgan.
In 1932, in the wake of the Crash of 1929 and the ensuing economic depression, the United States Senate Committee on Banking and Currency (as it was called then) began to consider the need for reforms. Its landmark work, spearheaded by committee counsel Ferdinand Pecora, produced the first securities laws of 1933 and 1934 and created the SEC.
More recently, as a result of a series of accounting scandals and widespread failures in corporate governance, efforts by Congress under Senator Paul Sarbanes and Representative Mike Oxley led to the creation of omnibus boardroom reforms known as the Sarbanes-Oxley Act of 2002.
A wide-ranging inquiry into the causes and lessons of the subprime credit implosion, similar in scope and heft to the Pujo, Pecora and Sarbanes-Oxley hearings, needs to be conducted, and soon. We also think it is important to include in that review the governance of the Federal Reserve System and the reforms that are needed to bring it into line with 21st century levels of public confidence, independence and accountability. We pointed out earlier, for instance, that at the New York Federal Reserve, which played the leading role in the Bear Stearns bailout, Jamie Dimon of JPMorgan Chase, the Fed-assisted purchaser of Bear Stearns, was a director. Richard Fuld and Jeffrey Immelt, CEOs of Lehman Brothers and GE, both big players in the capital markets, were elected by the New York Fed directors to represent “the public.” That, we find to be a bit of a stretch. It’s a throw back to the cronyism of the New York Stock Exchange before it was faced with a wave of demands for reform after the pay scandal involving former CEO Richard Grasso. It is simply not possible for any player in the Fed system to maintain credibility regarding its important public mandate while at the same time maintaining what is an essentially privately structured, club-like governance system. It is time for a serious rethinking about to whom and for what the Federal Reserve System is accountable, and how its governance practices need to be more aligned with its public mission.
Comprehensive investigations by Congress in 1912, 1932 and 2002 (and these were not one- or two-day affairs, as recent hearings on some aspects of the subprime debacle have been) revealed weaknesses and abuses in both the regulatory regime and in the governance of corporations that yielded major reforms. Their enactment paved the way for a restoration of public confidence and enabled significant periods of growth and expansion.
It is important that the opportunity to understand more completely the causes of the subprime crisis, and the vulnerabilities that led to it, not be lost. Only then will the full spectrum of necessary reforms both in the boardroom and in the regulatory arena become clear. In that respect, basic logic if not sound public policy principles counsel that the package of regulatory changes proposed recently by the Bush Administration was premature. More needs to be known about the specifics of the failures at all levels that created the current problem before the correct solution can be adopted. Uppermost in any such legislative review is the question: How exactly was one company, Bear Stearns, allowed to become so critical to the functioning of the market that only by preventing its failure through a massive intervention of the federal government could the collapse of the entire financial system be narrowly averted, as U.S. officials have asserted in testimony before Congress.
Not even in the unfettered era of J.P. Morgan’s trusts, or at the height of the rail-riding Great Depression, was the American public presented with the frightfulness of that prospect.
Conventional wisdom holds that the best time to buy a ticket on a ship -or the whole ship, for that matter- is when it is not sinking. But it is not entirely clear that Bank of America, which apparently still plans to acquire the losing Countrywide Financial, understands this principle of both physics and economics. Countrywide today reported write-downs of $3.5 billion for the first quarter of this year, along with a net loss of $893 million, more than double its net loss for the fourth quarter of 2007. It was the company’s third consecutive quarterly loss.
When CEO Angelo Mozilo boasted that Countrywide would soon return to profitability following its first-ever loss in October of last year, we expressed some doubt. Evidently, it was stringing its shareholders along with the same kind of lines that got so many of its subprime customers into the mess they are in.
The numbers are large, but the biggest eye-popper was below the surface, which, as all informed followers of the Titanic saga will know, is often where the greatest danger lurks. The company set aside $1.5 billion for bad loans compared with $158 million in the comparable quarter last year -a staggering increase of 990 percent. That thud you heard might just be the iceberg.
What more surprises await next quarter? If Bank of America is still to go through with the transaction, it will likely be on the basis of the Fed’s swap-your-junk spring deal whereby weak collateral can be exchanged for Fed happy bucks, or some other form of hokus pokus, to make the mess at Countrywide easier to swallow. One has to wonder if Congress is really on top of what’s going on here, or if the Countrywide deal is another Bear Stearns in the making under a sleeping Rip Van Bernanke?
UPDATE (April 30, 2008):Perhaps we won’t have to wait for the next quarter to see if there are more suprises. The Wall Street Journal Reports today:
A federal probe of Countrywide, the nation’s largest mortgage lender, is turning up evidence that sales executives at the company deliberately overlooked inflated income figures for many borrowers, people with knowledge of the investigation say.
The absence of any discussion concerning all the roles held by these important Wall Street figures, including in the governance of the Fed itself, does a disservice to the stakeholders who are entitled to all the facts.
It is widely held, even by Fed Chairman Ben S. Bernanke, that the Federal Reserve System helped to bail out Wall Street when it agreed to “loan” $29 billion to facilitate JPMorgan’s purchase of distressed investment bank Bear Stearns. We will have more on the subject of that so-called loan in an upcoming posting. What has gone unnoticed and uncommented upon by the press, analysts and members of the U.S. Senate banking committee during its hearing last week, however, is the fact that key Wall Street figures, including Jamie Dimon, chairman and CEO of JPMorgan Chase, Richard S. Fuld, Jr., chairman and CEO of Lehman Brothers and Jeffery R. Immelt, chairman and CEO of GE, are directors of the Federal Reserve Bank of New York, the institution that is putting up the money.
Mr. Dimon is a “Class A” director of the New York Fed, elected by member banks to represent member banks (i.e., Wall Street). Mr. Fuld and Mr. Immelt are elected by member banks to represent the public. One might take the view that foxes are generally elected to guard the henhouse, too. The New York Fed’s governance brings to mind the crony-stocked, self-serving boardroom of the New York Stock Exchange under Richard Grasso before it was forced to make major changes to ensure higher standards of independence and accountability. It is clearly time to look at to whom and how the New York Federal Reserve is held accountable.
We know that JPMorgan benefited handsomely from the Fed’s dramatic measures. Lehman Brothers, widely rumored a few weeks ago as the next possible Bear Stearns, got a boost from the Fed’s market soothing actions. And GE, who just today jolted the market by announcing a 5.8 per cent decline in first quarter net income, was also having problems with its financial services division. Mr. Immelt told CNBC (a unit of GE) that he began to be aware in March of a weakening company outlook. (In an interview earlier that month, he indicated the company was still on target to meet its previous positive guidance.) A less volatile capital market temperament was no doubt helpful to him as well.
More and more, the picture is emerging that this was a bailout of Wall Street, prompted by Wall Street, over problems caused by Wall Street, with terms dictated by Wall Street. The Fed’s agreement constitutes the single most significant market intervention in generations. Such a decision, which places substantial taxpayer dollars on the line and the concept of moral hazard in jeopardy, should be arrived at in a manner that is beyond reproach not only in fact but also in appearance.
The absence of any discussion by the media, the Federal Reserve or legislators concerning all the roles held by these important Wall Street figures, including in the governance of the Fed itself, does a disservice to the stakeholders who are entitled to all the facts in order to properly hold government and its agencies to account. It is our call for the Outrage of the Week.
