A brief essay on the subprime credit consequences when CEOs fail to lead, directors fail to direct and regulators fail to regulate
It began as a term that few had even heard of barely 18 months ago and most experts dismissed as an insignificant blip in a fundamentally robust economy. But yesterday, George W. Bush signed into law the most extensive -and expensive- free market repair bill since the Great Depression, thanks to what we have come to know as the subprime mortgage meltdown. The legislation marks another ironic milestone for this Republican, MBA-trained apostle of the private enterprise system. In 2002, he put his signature to the Sarbanes-Oxley Act, which, in the wake of Enron and numerous more accounting-related corporate frauds, also brought the power of the federal government closer to the boardroom than at any time since the 1930s.
The Housing and Economic Recovery Act of 2008, which also serves as a bailout for Fannie Mae and Freddie Mac, addresses precisely the flaws and failures which successive business leaders and government officials said would never occur in the modern era. Depression-time failures, runs on banks, and the collapse of huge financial institutions that were typical of the 1930s, they said, were a thing of the past. But just as those events were a product of human shortcomings and unbridled greed, so too is the present day crisis the result of CEOs whose bonus-obsessed lack of vision made them unsuited to lead, directors whose risk-oblivious nature made them incapable of directing and regulators whose focus on the battles of the past made them incapable of regulating. Exhibit One in this regard is the more than $30 million in compensation the CEOs of Fannie Mae and Freddie Mac, the struggling mortgage giants that prompted the recent government bailout, were awarded by the boards of those companies during the past year when the seeds of their horrific losses were being sewn.
Only a few months ago, the priority of the new treasury secretary, Henry M. Paulson Jr., and the Bush administration was to roll back enforcement under Sarbanes-Oxley, which many in the business community claimed was hampering American competitiveness. Blue ribbon committees composed of impressive and accomplished corporate men and women were formed to look at ways of blunting the regulation of business. All the time they were focused on this objective, the time bomb of the subprime credit disaster was ticking away. But the business world, and Wall Street in particular, disposed typically to hearing only the siren song of great bonuses and increased fees, did not heed the tick, tick, tick of impending calamity that was of their own making. No alarm bells sounded, at least on Wall Street, about the overly complex financial instruments that were being created, or the possibility that the ever- faster moving gravy train would meet with an abrupt generational derailment. So much has the landscape shifted that the man from Wall Street who was brought in to loosen the reins of corporate regulation has now become the architect of the most sweeping government intervention since FDR. And his boss, the first MBA graduate in presidential history, will have presided over the most staggering run up of the national debt in U.S. history.
Republicans and other traditional advocates of government restraint have fallen so far from their Milton Friedman, laissez-faire pedestals that they have given Secretary Paulson what amounts to a blank check for unlimited backing of these government-sponsored enterprises whose names sound like something out of a 1920s Gershwin musical. It is a hard swing from earlier days, when Fed chairman Ben S. Bernanke testified before Congress that he didn’t expect the credit crisis would spread to other parts of the economy. Just days before the meltdown at Fannie and Freddie, Henry Paulson was predicting “we are closer to the end of this problem than we are to the beginning.”
Much of the litter prompting the actions of the Bush clean-up crew came about through Wall Street’s obsession with bigger bonuses and more fees, and insufficient attention as to how they were achieved. A good part of the world, though happily we did not count ourselves among this group, really believed for a while that some of these fellows actually deserved and earned their bonuses, which, in many cases, amounted to $40 million, $50 million or even more than $100 million in a single year. We have long contended on the subject of excessive CEO pay that it is well to remember that its recipients are endowed with no superhuman traits.
Unfortunately, too many in the boardroom and on the stock exchange floor seemed to think the more a CEO received, the more he was able to jump over tall buildings in a single bound. But as Merrill Lynch’s Stanley O’Neal and Citigroup’s Charles O. Prince schlepped out of their offices for the last time after presiding over record multi-billion-dollar losses, they seemed remarkably fallible -even with the millions in bonuses and severance they carted away in the process. Also gone with the toppling of CEO after CEO who failed to live up to their Marvel Action Comics billing is the idea that their compensation is the business just of shareholders. Look at the casualties of home ownership and the record foreclosures that are sweeping America, a trend that can be traced to the creation of flimsy investment vehicles designed only for their quick fee and bonus producing content for Wall Street and mortgage lenders, and you see how much Main Street America has at stake in the compensation inducements that crony boards hand out to their country club CEO buddies.
It was a nice party while it lasted. Shareholders did well. Directors commanded ever higher fees for their slumbering counsel in what was an impressive reprise of their roles during the Enron era scandals and long before, during another time of Wall Street excess culminating in the market crash of 1929. Top management became elevated to god-like status with remuneration packages commensurate with that standing.
The shell game continues. Just this week, Merrill Lynch announced that it was selling off $6.7 billion in what many regard as toxic mortgage investments. The problem is, only two weeks ago those assets were valued by the company at $11.1 billion. The company’s write-downs -so far- we are told exceed some $40 billion. But to be honest, whenever numbers climb over the $25 billion mark we generally have to reach for the oxygen mask and lose track of the details in the process. Another problem: Merrill has to loan the buyer most of the money to take over the sludge. It’s a little like the Fed buying up $29 billion in feeble Bear Stearns assets to help out with the JPMorgan Chase deal. Except they called it a loan at the time. Nobody is calling it that now. Thinking about Fannie Mae, one is reminded of the scandal there when government investigators found top management fiddled with the books in order to prop up their bonuses. In 2006, U.S. regulators filed more than 100 civil charges against former CEO Franklin Raines and other officials of the company, accusing them of manipulating earnings to maximize their bonuses. It was among many ethical lapses that will be uncovered during the heady times of recent years.
Now the party is over. And, as they had to in the 1930s, it is the taxpayer who must pick up the tab for the broken furniture and all the other casualties of the splurge of over-indulgence that marked what we have called before the Modern Gilded Era. When incomes in America begin to approach the level of disparity which existed in the 1920s, as they did in the past couple of years, perhaps it is a warning sign that reason and judgment have reached a dangerous state of undersupply in the economy, and in society as well.
With the stroke of a pen this week, America’s debt will have been increased by nearly a trillion dollars; its deficit now the greatest in the country’s history. Many of the owners of the corporations who gambled and lost on these ill-conceived schemes will be bailed out. Some homeowners may benefit from the legislation, and a higher standard of regulation -which should not have required a Titanic-like catastrophe before its need became obvious, will prove beneficial in the future. But the greatest beneficiary is Wall Street, which has consistently held the view that there is no better system than modern free market capitalism, except, of course, modern government enterprise when it shows up with its purse open. For there is no more beautiful sight to the errant Wall Streeter than when Mr. and Mrs. America come to junior’s rescue after he wraps the BMW of self-aggrandizement around the lamppost of ever looming, but never fully contemplated, reality.
The point of all of this is not to disparage capitalism, especially the idea of responsible capitalism -a principle we have long advocated and believe is fundamental to the innovation, creativity and advancement of a free and prosperous society. But it is to further illustrate that capitalism is merely an engine, not an Adam Smith-invented autopilot. How well it operates, what value it creates, what havoc it wreaks are dependent upon the skills, vision and integrity of the men and women to whom it is entrusted.
Many of the wrong people were entrusted with it this time. The price has been steep. The damage to the reputation of this unique economic system has been considerable. The consequences of insatiable greed, and of governance and regulatory systems that failed to check it, have been historic.
It might be hoped that for the hundreds of billions of dollars American taxpayers are shelling out for the economic debacle which in some respects rivals the Great Depression, they also will have paid for the education of future actors on Wall Street, in the boardroom and in the regulatory halls of government, who will have learned something of the vice of unrestrained excess, something of the virtue of a financial system more grounded in both value and values and something of the sacred trust that is bestowed when society loans power and opportunity to those whom it allows to lead, direct and regulate.