Window in home of unemployed steelworker in Ambridge, Pennsylvania
Ilargi: A lot of words are written these days about which corporations are -perceived as being- too big too fail, which are not, and what the consequences of that are for society.
In case you wonder how the dividing line is drawn in the sand, between too big and not big enough, the answer turns out to be so simple, you can't possibly be blamed for missing it.
You see, there are two groups of people who decide on the issue, and no-one will blame you for not seeing the difference between them, either.
The first group: politicians. Their decision between who's too big and needs to be resuscitated at all cost on one side, and who is sufficiently small to be poisoned, smothered or drawn and quartered on the other, depends on one single and eerily familiar consideration: what have you done for me lately?
And since the biggest companies hand out the biggest campaign donations, we are face to face with a self-feeding process. Of course, it’s not as easy as just direct donations from firms, that might attract attention; they have many friends and employees who can be coaxed into one political campaign gift or another.
The way the system works is clear, though, I'm sure, isn't it? If you can pay enough, you're big enough. If you pay that little bit more, you're too big. To fail.
That takes us to the second group. The bankers and captains of industry. The guys who make a brazillion dollars in ivory Manhattan towers and are then briefly sent through the revolving Washington doors to make sure that their campaign donations are well spent. So to speak. Public service. So to speak.
But even then, as ludicrous as it may be to have private companies that get so big that they threaten the entire public economy of a nation, that is in the end not the main and underlying problem.
It's complete nonsense for a government like the one in Washington right now to decide which bank -or carmaker- is too big to fail. That's just the pot and the kettle, what the junkie and the joker said to the thief. For more reasons than just the revolving doors mentioned before, it's the government itself that really is too big to fail.
And therefore needs to fail, needs to be cut down to size, just like the banks whose donations voted it into power, or the welfare of the entire nation is put at mortal risk.
I think most everyone can intuitively understand that, and comprehend why it is. There is one thing you need to realize, though. The too big too fail crowd has all the power, and right now you have none.
The true division of power is not between the two parties in the capital, it's between the capital and the people. And the only way, ultimately, to solve that issue, is to make sure the people find their common ground and stand firm on it.
And by doing that themselves become too big to fail.
As is their right and theirs only.
I for one am not holding my breath.
"There must be some way out of here" said the joker to the thief
"There's too much confusion", I can't get no relief
Businessmen, they drink my wine, plowmen dig my earth
None of them along the line know what any of it is worth.
Young, jobless, broke: today's lost generation
Back in the carefree days of the Noughties boom, Britain's youngsters were swept along by the buy-now-pay-later culture embraced by consumers up and down the country. During a decade of near-full employment, many skipped nimbly from one job - and one credit card - to another, and rainy days were such a distant memory that they hardly seemed worth saving for. But with the supply of cheap credit drying up and a generation of school and university leavers about to flood the recession-hit job market, thousands of young people with no memory of the early 1990s recession are shocked into the realisation that the world of 2009 is very different.
Katie Orme, 19, who lives in Birmingham, says she has decided never to get a credit card after seeing the problems that her parents and 22-year-old sister have had with debt - just one of the hard lessons that she has had to learn. Orme finished her A-levels a year ago, and has been searching for a job - and living at home with her parents - ever since. She has had to sign on to support herself and is now on a 12-week internship at the Prince's Trust to improve her CV. The trust says that the number of calls from anxious people such as Orme has shot up by 50% over six months.
"It's so hard to get a job at the moment," she says, "it's better to go and get more qualifications so when more jobs are available you will be better suited." She is far from alone in trimming her expectations to fit a credit-crunched world: many youngsters who have seen nothing like the current turmoil have been shocked into changing their outlook. A recent survey by Post Office financial services found that most 16- to 24-year-olds believe that it will take a decade for their living standards to return to pre-crisis levels - and almost half have been jolted into cutting back their use of credit cards.
The number of under-25s out of work and claiming jobseeker's allowance has increased by more than 200,000, to 456,000, over the past year, according to the latest government figures, released last week. On the wider labour market survey measure, an alarming 18.3% of 16- to 25-year-olds are unemployed. Brendan Barber, the TUC general secretary, says: "Youth unemployment is at its highest rate for 15 years. Unemployment leaves a permanent scar on young people's lives and the government must do all it can to stop joblessness blighting another generation."
David Blanchflower, the labour market expert who recently stepped down from the Bank of England's monetary policy committee, says that even short periods of unemployment can have a long-term "scarring" effect, affecting people's job prospects for many years. "It's a bit like male metalworkers from Sheffield in the 1980s - it continues for ever," he says. He believes unemployment among the young has become a "national crisis" and has lobbied Gordon Brown to act. "This is going to be the biggest issue in the next election. The danger is that we have a lost generation."
And, unlike the many thousands of manufacturing lay-offs during the 1980s recessions, he says, a wide swathe of social groups will be hit this time, from working-class school leavers to middle-class students. "It's a call to arms for their parents and their grandparents," he says. "We need to get all parties together and say, what are we going to do about this?" David Willetts, the Conservative shadow skills secretary, is demanding public funding for young people chucked off apprenticeships by cash-strapped firms, and extra places at further education and in postgraduate training, to ease the "pressure points" caused by the recession. "The risk is that young people find themselves on the dole for months, if not years, and in the long run, their life-time earnings are depressed," he says.
Joe Phillips, who is 24, followed in the footsteps of tens of thousands of other graduates and spent time travelling abroad. "I didn't see it as a frantic rush to get on the career path," he says. However, when he moved to London in September 2008 to try to find a job in the media, he regretted his decision not to enter the jobs market as soon as he had graduated. "I struggled to find any paid work," he says. "I wanted to do communications for a charity but ended up doing a free internship and then a low-paid job." During this period, he had to sleep on friends' sofas and at his sister's flat to make ends meet. At one point, things were so bad he had to move back to the West Midlands to live with his parents.
He has now returned to London, filling a temporary job at the Parkinson's Disease Society which he hopes will be made permanent - but he is acutely aware that nothing is certain in the current climate. Gerwyn Davies, public policy adviser at the Chartered Institute of Personnel and Development (CIPD), believes that the job situation facing today's young people is worse than any generation has seen for decades.
"It's a very difficult pill for young people to swallow," he says. "We already have a situation where one in six young people are unemployed. Unfortunately, this situation is going to worsen." He points out that they will have to compete against a growing pool of more experienced workers who have lost their jobs: "They will have qualifications, but won't have the same work experience as other people coming on to the claimant count."
A recent report by the CIPD revealed that nearly half of the employers it surveyed were not planning to recruit school leavers or graduates this summer. For many young adults hit by the downturn, who are relying on the generosity of parents or claiming state benefits, the normal process of growing up has been delayed: 35 is the new 25. While many who came of age in the 1990s were able to buy a home with a 95% or 100% mortgage and reap the windfall as it tripled in value - or, for the luckiest, stroll into a job in the City and join the ranks of the super-rich - today the concerns of many are the more prosaic ones of finding work and earning enough to pay the bills.
Phillips says there is a big difference between young people 10 years ago and his contemporaries: "We have different priorities. I'm just trying to pin down a permanent job and pay the rent. Buying a house and starting a family seems like a distant thing." Wes Streeting, president of the National Union of Students, fears that graduates emerging from university this year will fare even worse than Philips and his cohorts. He calls the Class of 2009 "generation crunch". "They're the first to pay top-up tuition fees of £3,000 a year, and are graduating into the worst labour market for a very long time," he says.
Labour has already announced a number of measures to help: Alistair Darling promised in the budget that young people would be guaranteed a job or training place. However, with cash tight, this promise only applies to those who have already been searching for work for 12 months and Streeting says that's far too long to wait. "The government needs to look again at the situation facing graduates and what they can do proactively to ensure they are not sitting around becoming depressed and disgruntled because they're unable to get a job," he says.
When top-up tuition fees of up to £3,000 a year were introduced, ministers cited the hefty increase in earning power that a degree brings, but Streeting says that argument looks much weaker in a tough economic climate. The NUS has just launched a campaign to replace the fees by a tax, which would be levied as a percentage of graduates' earnings, hitting the highly-paid hardest. "The current economic climate shows the futility of our funding system for higher education," he adds.
With jobs hard to find, young people are increasingly putting their lives on hold. The National Association of Estate Agents said last week that almost seven out of 10 would-be first-time buyers have now given up hope of ever owning their own home. Instead of branching out on their own, a growing number of youngsters are sharing rental properties. A recent report by flatshare website SpareRoom.co.uk showed that there were 143,000 more people living in a flat or house share in the UK in May 2009 than in autumn 2007, when the credit crunch first began to make itself felt. The UK population of flatsharers has swelled to 2.8 million as renters abandon living alone to save money during the crisis.
For many, the "bank of mum and dad" is the only one whose doors are still open. In the Post Office survey, almost 60% of 18- to 24-year-olds polled said they were living rent free with their parents. Paul Mullins, chief executive of National Debtline, says: "Young people face various unique challenges that do not affect other age groups in the same way. Often they have a large amount of student debt and are often looking to move out of home for the first time. Quite often young people are on a low income, they are at the start of their careers so their earning power is not as high as older age groups."
And it's not just spending habits that have changed: Orme says that the credit crunch has forced her to put other key life decisions on hold as well. "I can't hold down a relationship or look after a child with no money," she says. "There's no point in bringing a child into the world if you haven't got the money to look after it." Even for those who have managed to find a job, recession has made things more tricky. "Unless something changes dramatically, I can't see myself doing all three," Joanna Williams, who is 25, says of buying a house, getting married and having a baby. "I know people who have chosen to have a baby and not get married because it's too expensive to do both."
She believes that she will never be able to get a foot on the property ladder: "I remember when I was leaving school I was told I wouldn't own a house because they were too expensive, and now I think that it will never happen because of mortgages. If you want a house by 30, it would be something that you would have to sacrifice everything else for."." She believes that the tradition of parents helping their children financially with weddings and buying houses is becoming less common as recession bites. "A lot of us would be reluctant to ask our parents for help because we don't know how stable their finances are."
Williams has been working as a PA for a broadcasting company for a year and would like to move on, but the recession has made her fear taking risks to pursue her dream career. "One of the things is that my job is stable and it's a continuing contract, but because of the way things are it makes me reluctant to move on because I am lucky to have a job. I don't want to take any risks."
There have been some tentative signs of green shoots in the UK over recent weeks and some economists have bravely begun to suggest that we may be at the end of the beginning. But even if they are right, the impact of this 21st-century recession will last for many years. Just as the hardship of postwar rationing taught a generation of Britons to waste not, want not, grow their own and make ends meet, today's youngsters are learning tough lessons that will last a lifetime.
If It’s Too Big to Fail, Is It Too Big to Exist?
Nearly a century ago, the jurist Louis Brandeis railed against what he called the “curse of bigness.” He warned that banks, railroads and steel companies had grown so huge that they were lording it over the nation’s economic and political life. “Size, we are told, is not a crime,” Brandeis wrote. “But size may, at least, become noxious by reason of the means through which it is attained or the uses to which it is put.”
Today, amid the wreckage of the gravest financial crisis since the Great Depression, bigness is one of our biggest problems. Major banks, the Detroit automakers, the financial basket case that is the American International Group — the only reason these giant, sclerotic companies are still standing is that they have been deemed “too big to fail.” Or, more precisely, too big to be allowed to fail. Policy makers fear companies like these are so enormous and so intertwined in the fabric of the economy that their collapse would be catastrophic. Hence, all those multibillion-dollar, taxpayer-financed bailouts.
In its overhaul of financial regulation last week, the Obama administration proposed several measures to try to contain the biggest of America’s big banks. But it stopped far short of calling for the dismantling of those institutions. A few Jeremiahs within the administration wanted more. They contended that the biggest banks must be streamlined, and that, in the future, banks should not be allowed to grow to the point where they pose a threat to the financial system.
But they are losing a battle to other officials and banking executives who argue that such radical steps would be impracticable and deal yet another blow to the nation’s damaged financial industry. Washington, the argument goes, let banks grow into behemoths in the first place. Now, all of us must live with the consequences. But if a company is too big to fail, should it be considered too big to exist? Brandeis worried that the corporate giants of his day would imperil democracy through concentrated economic power.
His essays, collected in book form and published in 1914 under the title, “Other People’s Money — and How the Bankers Use It,” helped drum up support for the creation of the Federal Reserve System, antitrust laws and trust busting. One dissenter within the administration — Sheila C. Bair, the chairwoman of the Federal Deposit Insurance Corporation — says the government must stamp out the notion that Washington will ride to the rescue if big banks run into trouble. Investors must understand that they will lose money even if the government has to step in, she says. “The reality is there are investors and creditors out there that have relied on ‘too big to fail’ to make investment decisions,” Ms. Bair said. “We have to take this security blanket away.”
That is easy to say, but not so easy to do. “You have to be flexible,” said Andrew Williams, a Treasury Department spokesman. “You have to be clear that there is not a presumption of too big to fail. But you can’t give it up entirely because to do so may not allow you to avoid, in extremis, a major meltdown.” Lawrence H. Summers, the White House economic adviser, says there is no going back to the days of small banks. The financial world has moved on. “I don’t think you can completely turn back the clock,” he said.
Policy makers argue that shackling some of the very biggest banks with new rules will keep the behemoths from getting into trouble. The overhaul of financial regulation proposed last week by the Obama administration would provide so-called resolution powers that would allow big, complex financial institutions to, in fact, fail and let regulators take them over. The government could then wind down giant financial companies over time, as it does with smaller ones.
The administration also wants greater regulatory scrutiny and higher capital requirements for financial companies that pose so-called “systemic” threats. Details about these proposals are sparse, but the thinking is that investors would press companies to curb their risks and streamline their operations if bigness had some drawbacks. That is not enough for some. Paul Volcker, the former Federal Reserve chairman and current White House adviser, for instance, has suggested that the government limit how much money big institutions can wager trading. The way things are now, banks reap profits if their trades pan out, but taxpayers can be stuck picking up the tab if their big bets sink the company.
Ms. Bair and others argue that the government should impose fees on giant banks to encourage them to operate more carefully and offset some of the costs of rescuing big institutions. The administration’s plan imposes such a charge only after a government rescue occurs. Bigness has always been a powerful American theme. But in business, where many executives live by the creed of “Grow or Die,” it is dogma. Devotees of economic Darwinism insist that corporate size, and its accompanying economies of scale, brings progress and benefits to consumers.
But how big is too big to fail? And how would you measure it anyway? In the case of banks and giants like A.I.G. and Fannie Mae, policy makers argue that the interconnectedness of modern finance, as much as the size of the players, is the real issue. The collapse of one big financial company could cascade through the industry. In the case of General Motors and Chrysler, a failure could mean that thousands of jobs — not only at those companies, but at their suppliers as well — could evaporate.
The too-big-to-fail doctrine, sometimes called T.B.T.F., goes back at least as far as Brandeis’ time, when, in 1914, the Treasury stepped in to provide financial aid to New York City. In the 1980s, when the government rescued Continental Illinois Bank, Stewart B. McKinney, a Connecticut Congressman, declared that the government had created a new class of banks, those too big to fail. The phrase returned and stuck.
Ben S. Bernanke, the chairman of the Federal Reserve, often uses a wonkish euphemism. He refers to Brobdingnagian banks as “systemically critical” institutions. The Obama administration rolled out another description last week: “Tier 1 Financial Holding Companies.” What is remarkable is that, even now, the T.B.T.F. club and some of its members are actually growing, not shrinking. A decade-long run of mergers in the banking industry has concentrated power in fewer hands. Last autumn, when the financial crisis was at its height, policy makers pushed some banks to buy weaker ones to head off failures. (See Merrill Lynch, acquisition of, among others.)
Frederic S. Mishkin, a former Federal Reserve governor from 2006 to 2008, for one, said there could be no turning back on too big to fail. “You can’t put that genie in the bottle again,” he said. “We are going to have to deal with it.”
Too Big to Fail, or Too Big to Handle?
“No one should assume that the government will step in to bail them out if their firm fails.” That’s Timothy F. Geithner, the Treasury secretary, talking tough with lawmakers last week as he promoted the government’s remake of the financial regulatory framework. Talk is cheap, however. And the notion that the plan shows a new aversion to bailouts is not at all supported by its chapter and verse. In fact, there’s precious little in the 88-page document about how the government will eliminate systemic risks posed by financial firms that aren’t allowed to fail because they’re simply too big or to interconnected to other important economic players here and abroad.
Rather than propose ways to shrink these companies and the risks they pose, the Geithner plan argues instead for enhanced regulatory oversight of the behemoths. This suggests the taxpayer safety net will be larger after our national financial train wreck, not smaller. More than two years after the crisis began, “too big to fail” remains “too problematic to address” with anything other than more souped-up regulation. Given that earlier efforts at policing these entities failed so miserably, why should anyone think that a new-and-improved regulatory approach will fare better?
“The sudden failures of large U.S.-based investment banks and of American International Group were among the most destabilizing events of the financial crisis,” the Geithner proposal said. “These companies were large, highly leveraged, and had significant financial connections to the other major players in our financial system, yet they were ineffectively supervised and regulated.” All true, of course, with Citigroup — a bank that Mr. Geithner himself regulated — being Exhibit A. But the solution the document proposed is “a new, more robust supervisory regime for any firm whose combination of size, leverage, and interconnectedness could pose a threat to financial stability if it failed.”
Hmmm. Sort of an enhanced status quo, just with a bigger safety net. That this taxpayer-supported net will be larger and more encompassing when this mess finally ends comes as no surprise to some people. Last August, Edward J. Kane, a finance professor at Boston College, wrote about just this likelihood in a paper titled “Ethical Failures in Regulating and Supervising the Pursuit of Safety-Net Subsidies.”
In the paper, Professor Kane described why the policy responses to financial crises historically had involved expanding the universe of companies eligible for taxpayer support if another mess arose. “When a substantial portion of the financial sector appears to be at risk, it is far easier to patch up the weaknesses in the system with ad hoc loans and guarantees than to negotiate genuine reform,” he wrote.
Professor Kane’s paper certainly is prescient. For top regulators to be able to push through larger bailouts, he argued, two conditions must hold. “First they must be able to control the flow of information,” he wrote, “so as to keep taxpayers and the press from convincingly assessing either the magnitude of the implicit capital transfer or the anti-egalitarian character of the subsidization scheme.”
Sound familiar? Recall the months of secrecy surrounding the bailout of A.I.G.’s counterparties and the refusal of the Federal Reserve Board to disclose how it chose BlackRock to oversee three of its rescue programs and what it was paying the firm to do so? Then there is Professor Kane’s second condition: Regulators’ commitment to these bailout policies “must be continually nourished by praise and other forms of tribute from the bankers, borrowers and investors whose losses are being shifted to less-influential parties.”
We’ve heard a lot of this, of course, in recent weeks. Here is Timothy Ryan, president of the securities industry lobbying group, responding to the Treasury plan on the group’s Web site. “This is an important step forward,” he said. “We have a once-in-a-generation opportunity to rebuild our regulatory structure so that our financial system is more stable, more resilient and better underpins a dynamic U.S. economy.”
To be sure, the Treasury proposal does hope to curb the growth of large, systemically scary companies by raising their costs of doing business. But entrusting greater responsibilities to the same supervisors who missed the risks at the institutions they oversaw during the mania doesn’t inspire confidence. And with the exception of merging the Office of Thrift Supervision into the Office of the Comptroller of the Currency, the plan doesn’t suggest how the regulators who failed will be held accountable for their mistakes.
According to some experts who study systemic risks posed by huge and complex companies, installing a “more robust supervisory regime” isn’t enough. “I do not think that intensification of traditional supervision and regulation of large financial firms will effectively address the too-big-to-fail problem,” Gary H. Stern, president of the Federal Reserve Bank of Minneapolis and an authority on resolving big and troubled institutions, said last month in Congressional testimony.
Mr. Stern declined to comment last week on the Treasury proposal, citing Fed rules against its officials speaking publicly in the days surrounding meetings of its Federal Open Market Committee. But he told Congress that the key to tackling problems posed by financial behemoths is to convince uninsured creditors of these companies that they will not be bailed out by the government. (Rescuing uninsured creditors is exactly what the government did a great deal of in 2008; think Bear Stearns and A.I.G.)
To protect other companies from also becoming unnecessary casualties when a troubled institution founders, regulators must have a quick-response plan in hand, Mr. Stern advised. Reforms that do not materially reduce spillover effects, he warned in his testimony, shouldn’t be relied upon. There isn’t much in the Treasury plan about such spillovers. Nevertheless, it is candid about the failings of regulatory efforts during the recent credit boom. “It is clear now that the government could have done more to prevent many of these problems from growing out of control and threatening the stability of our financial system,” it says.
It’s beyond disappointing that the Treasury plan offers no way to measure regulators’ effectiveness or hold them accountable for their failures. Neither is there a discussion of mechanisms that could be used to signal regulatory failings well before they put the entire system at peril. True financial reform should reward efficient regulation and supervision, Professor Kane said in his paper. “Regulators should be made accountable not just for producing a stable financial economy, but for providing this stability fairly and at minimum long-run cost to society,” he wrote. This means creating incentives that encourage regulators to perform in the taxpayers’ interests.
“The public policy problem,” Professor Kane concluded, “is to design employment contracts that would make it in supervisors’ self-interest to invoke ‘market mimicking’ disciplines when and as a country’s important institutions weaken.” It may be naïve to expect the nation’s top regulators to devise ways to ensure that their dismal performance of late will not occur again. But it’s certainly worth hoping for.
How the bailout bashed the banks
Washington's most dramatic foray into the nation's financial sector since the Great Depression began on Oct. 13 with a misnamed acronym, an unwitting tribe of CEOs, and a confused staff of Treasury officials. It was a foreshadowing of the misadventure to come. "I don't even know who the 9 companies are. Do you?" Michele Davis, assistant secretary for public affairs, wrote in an e-mail sent at 7:15 a.m. on that history-making Monday. "No clue," Treasury chief of staff Jim Wilkinson responded. "Let me get the list."
The list held the names of nine companies that Hank Paulson and Tim Geithner, at the time the Treasury secretary and the New York Federal Reserve president, planned to draft as the leaders of a parade of banks to get capital injections as protection against the financial panic. Paulson had spent Sunday evening calling the CEOs of the firms with a next-day summons to Washington. But by Monday morning, top Treasury staff and the arriving executives remained in the dark about the 3 p.m. meeting Paulson had insisted they attend.
In one e-mail out of a series obtained through the Freedom of Information Act by the conservative group Judicial Watch, Citigroup CEO Vikram Pandit's deputies suggested sending someone else in his place. "If this is a briefing of industry group, I don't think VP can go back to DC. If it is something else we need to know," wrote Citi vice chairman Lewis Kaden. But the Treasury wanted to maintain the element of surprise, saying in a midday news release only that the executives were there to "work out details" of the $700 billion bank rescue plan Congress had passed days earlier.
By then, everyone knew the rescue plan by the acronym TARP, for Troubled Asset Relief Program, and its passage through Congress had been a tormented affair, with the stock market collapsing after an initial thumbs-down by the House. When TARP finally passed, it was supposed to jump-start the lifeless credit markets by deploying taxpayer money to help banks shed toxic assets that were crushing their balance sheets.
The government, however, changed its mind. At this dramatic Monday meeting, TARP morphed into something altogether different -- a more direct program in which the Treasury would pump fresh capital into the system by buying preferred shares of individual banks. And in the months that followed, TARP would morph again and again, especially in terms of political perceptions that became a perplexing new hazard for the more than 500 banks, thrifts, and other financial institutions that had signed up for the deal.
Pandit, among the last to arrive, was joined that afternoon by eight other titans of the shaken world of American finance, including J.P. Morgan Chase CEO Jamie Dimon, Bank of America CEO Ken Lewis, Wells Fargo chairman Richard Kovacevich, and Morgan Stanley CEO John Mack. As the men checked in at the Treasury entrance, department staff scrambled to figure out how to keep the media at bay, but by that point the whole financial world was watching. "There are cameras at the gate," headlined an e-mail that was quickly followed by a decision to corral the media into Lafayette Park across the street, from which they would snap pictures of the bankers emerging with $125 billion more than they had when they went in.
Inside Treasury, some of the bankers initially balked at Paulson's offer, but he wasn't taking "no thanks" for an answer. "We don't believe it is tenable to opt out because doing so would leave you vulnerable and exposed," he said, according to his talking points. At 4:01 p.m., just one hour after the meeting started, Wilkinson e-mailed an update to the White House: "We are there except for one. This deal will get done." Treasury staffers had set up individual offices for the bankers so that they could call their boards and other colleagues without leaving the building. By 6:25, all nine executives had scrawled their signatures on single white sheets of Treasury paper, inserting the amount, in tens of billions, that they had been told to accept.
"We now have 9 out of 9," wrote Wilkinson. The next day the Treasury issued a press release declaring, "These healthy institutions have voluntarily agreed to participate." Was the rescue program necessary? We can probably assume that those signatures helped stave off a far more damaging economic collapse. Some banks, notably Citigroup, wouldn't be alive in their current form without TARP funding. But for those that had a choice (or think they did), accepting taxpayer dollars was a decision that came with costs to their reputation as well as damage to their view of Washington politicians, most notably Congress.
Eight months into a program designed as a three-year capital infusion, the banks allowed to leave TARP are doing so. On June 17, 10 large U.S. banks, including five of the original nine, announced that they had repaid a total of $68 billion in bailout funds, following $2 billion in repayments by smaller banks. The rush to the exit door by relatively healthy banks means that TARP is on the way to becoming what Treasury has always insisted it wasn't: government welfare, a taxpayer-funded propping-up of failed institutions.
While taxpayers can't be expected to be sympathetic to complaints from a sector that vaporized hundreds of billions of dollars, it's worth understanding their motivations as they bail out of the bailout or chafe within its strictures. This is a story exploring the point of view of the often vilified parties on the receiving end of a historic experiment in government intervention, one of many that will play out in the coming years. Banking executives say this is what they've learned:
- A signed deal with Treasury is not a done deal. If taxpayer dollars are on the line, Congress will have something to say, and that something holds the force of law.
- Populism isn't good for business -- but it's the overriding sentiment in Congress today, fueled by a 24/7 news cycle that feeds on outrage. The House actually passed a 90% tax on bonuses, which died only when the headlines had moved on.
- Good intentions don't control the message. The Treasury website still insists the TARP capital-injection program is "not a bailout." But amid a backlash against Wall Street, TARP transformed from a seal of approval to what J.P. Morgan's Dimon called "a scarlet letter."
- The strings attached are not always obvious in the heat of crisis but emerge as major disadvantages in a normal competitive environment.
- What starts out as all-for-one breaks down as participants pursue their self-interest. Treasury boasted that the first nine banks moved "quickly and collectively." It didn't last.
The experience has reminded business leaders why the government is considered a rescuer of last resort. As they repay TARP money, executives at stable institutions are vowing they will never again be tethered to a fickle Washington and a vindictive Congress. In normal times, that would merely be a sign of the free market's healthy skepticism toward government. But these aren't normal times -- the Obama administration needs the private sector to pitch in: healthy banks to lend more than they might otherwise; prospective investors to buy the illiquid assets weighing down lenders. And what happens if "there's another crisis and the private sector doesn't trust the government. What will we do?" asks a former top bank regulator. The bad blood runs deep.
Four months after signing Paulson's term sheets, CEOs from the same nine banks were hauled before a House committee to be derided by one lawmaker as "captains of the universe" and told by another that "no one trusts you anymore." Within days financial institutions that were encouraged to accept taxpayer money under one set of rules issued by the Treasury would be subjected to a new set of rules issued by Congress. They were shamed into canceling corporate events -- "employee recognition" outings in their minds but "lavish junkets" in the language of posturing politicians. (Who got hurt the most? Probably workers in the travel and hotel industries.) Customers called their bankers, angry that the institutions had been "bailed out" and demanding their own bailout from burdensome mortgages and credit cards. "There was this belief that this was free money," says Wells Fargo CEO John Stumpf. "But it was not a bailout, and we never asked for it."
Executives now refer to the "reputational risk" of participating in government-funded programs, while Treasury Secretary Geithner worries that the "stigma" associated with TARP funds is preventing needed capital from getting into the lending pipeline. According to a study by the investment bank Piper Jaffray, shares of those banks that accepted TARP funds suffered compared with those that did not. "Public, investor, and government perception toward recipients has turned negative," the study concluded. Among stable banks there is a "recognition that participating in a government program with a subsidy is not necessarily a good choice," says former Sen. John Sununu, a member of the congressional panel overseeing TARP.
In the TARP saga, executives list a range of complaints: Dimon, whose J.P. Morgan Chase has a global workforce of nearly 225,000, has called the restrictions on hiring foreigners "a complete and utter disgrace." Every executive interviewed complained that Congress's pay limits were driving away top talent. But mostly they complain about the unpredictability that Congress injected into their operations. "Whoever gets TARP will be punished after the fact," Kovacevich told Fortune. "Is this good policy? Does any of this make any sense?" Further down the size spectrum, CEO Tom Geisel of New Jersey-based Sun Bancorp (SNBC) (assets: $3.6 billion) says he wasn't prepared for the changing terms of the deal. "When we signed the contract, the biggest risk was the fact that we didn't know what we didn't know," says Geisel, whose bank stayed out of the subprime business. "The government was a partner that could do whatever it wanted. That's not a partnership. I've never signed a document like that before in my life, and I'll never sign one again."
The Treasury, which is legally authorized to change TARP terms at will, was not the primary source of the problem: It was Congress. From issuing new rules on compensation to high-level talk of nationalizing the banks, the turmoil in Washington stirred an uncertainty in the financial sector that can't have helped recovery efforts. Says former Treasury chief of staff Wilkinson: "Institutions need to know the rules, and the rules keep changing." TARP began as a three-page document that Hank Paulson rushed to Congress in September, during the worst week of the financial crisis. The next month, after critics urged that the toxic-asset plan should be replaced with a capital-injection campaign similar to Britain's approach, Paulson came around to the new idea. Once embraced, Treasury was determined to make it happen.
"We would rather have erred on the side of getting too much capital into the system than too little," Neel Kashkari, the Treasury official who ran the program until May, told Fortune. From the outset, it was billed as an effort to shore up the financial system, not individual banks. Recalls Stumpf: "There was a sense that we were in this together." However, the results of this spring's stress tests suggest that at least some of those big banks did need the government's cash after all. Wells Fargo and Bank of America were among 10 banks told to raise more private capital, as was Citigroup, which is turning over a one-third ownership stake to the government, making it a virtual ward of the state.
While the original nine were told they had no choice but to accept, others did have a choice -- yet soon lined up at the door, having faced mounting losses and worries about financing. Nonbanks American Express and CIT Group converted into depository institutions to qualify for TARP. Community banks mounted a lobbying campaign to be included. "I guess my invitation got lost in the mail," Camden Fine, CEO of the Independent Community Bankers Association, joked to a Treasury official on learning of the Oct. 13 meeting. By January hundreds of banks, thrifts, and other financial institutions were in the system, encouraged by Treasury, which sent out the message that only healthy banks need apply. Treasury was approving applications at a rapid clip, despite a cost to the banks of the 5% annual preferred stock dividend, which would rise to 9% if not paid in five years.
Even though taxpayers stood to profit under those terms, lawmakers from both parties were nursing their own frustrations -- over constituents unable to get loans, over Paulson's sudden shift in direction, over the torrent of federal rescue money Treasury was unleashing with minimal congressional input before the fact. "It was like a fire hose," recalls Rep. Scott Garrett (R-N.J.). "They were being totally dismissive" of alternatives. The event that set off the populist tsunami -- and forever changed the public view of TARP banks -- came days after the inauguration of a new President, one who had campaigned against the "greed" of Wall Street. On Jan. 29, New York state comptroller Thomas DiNapoli issued his annual report on Wall Street compensation, which concluded that bonuses in 2008 had fallen 44% over the previous year.
But what caught everyone's attention is that they still totaled $18.4 billion, even at a time when the companies were collapsing from their bad bets. New President Obama condemned the bonuses as "shameful" and "irresponsible." Lawmakers picked up on the theme, generating headlines and passing an amendment to the 2009 stimulus bill to impose new compensation rules on executives whose banks had signed on to TARP. Lawmakers mined it for good theater. CEOs from each of the nine banks that had signed the initial deal were summoned Feb. 11 before the House Financial Services Committee, where lawmakers demanded an accounting of the taxpayer money they had accepted.
Arrayed across the dais as cameras rolled, the nine men were lashed with scolding and sarcastic gibes like the one by Rep. Michael Capuano (D-Mass.): "Basically you come to us today on your bicycles after buying Girl Scout cookies and helping out Mother Teresa, telling us, 'We're sorry, we didn't mean it, we won't do it again, trust us.' " Of course, some bankers haven't done themselves any favors by continuing to enjoy perks like the use of company jets for personal trips while accepting TARP money, as the Wall Street Journal reported.
Participation in TARP by healthy banks began to decline as banks began to witness the political costs. That dropoff accelerated a few weeks later, after it was disclosed that bailed-out AIG was planning to give its executives $165 million in retention payments and the House responded with its confiscatory 90% tax on bonuses. "The media goaded Congress," recalled Rep. Melissa Bean (D-Ill.), an influential member of the House Financial Services Committee and one of six Democrats who resisted the goading. "That created fears."
Eighty banks withdrew their TARP applications or declined the funds after being approved. Others, like Geisel's Sun Bancorp, began returning their money in March and April. "What began as a positive partnership between business and government to get the economy back on track quickly became politicized," he says. In Geisel's case, he was initially encouraged by regulators to acquire weaker banks, but Congress, steeped in a big-is-bad sentiment, was threatening to amend the program again to add a series of hurdles to acquisitions.
By then the collective spirit was unraveling, and the big banks wanted out too. When top bankers met in March with Obama in the White House, J.P. Morgan's Dimon reportedly presented Geithner with a fake check for $25 billion, the amount of his bank's TARP investment. Geithner didn't accept the souvenir, and Obama didn't accept their protests either. "Be careful how you make those statements, gentlemen. The public isn't buying that," Politico reported Obama saying. "The anger, gentlemen, is real."
No wonder the White House was concerned. The stigma attached to TARP was beginning to affect other relief efforts the administration was trying to get off the ground. Analysts blame the initial lackluster performance of the Term Asset-Backed Securities Loan Facility -- designed to bolster student, auto, and credit card loans -- in part on political fears. Another program still hasn't gotten off the ground, one that was the original intent of the TARP bill: The Public-Private Investment Program to lift toxic assets (now redubbed "legacy" loans and securities) from the banks' balance sheets has had trouble attracting investors. Pricing assets is one obstacle, but investors are also reticent about making money off a government program. "Who wants their employees subjected to death threats and their homes picketed?" asked a hedge fund executive in a pointed reference to the AIG bonus debacle.
The lesson for Wall Street is hard to miss: Profiting off a government-subsidized program is a recipe for a political nightmare. Prospective investors "correctly believe that if they were to make a profit, Congress would come along and claw them back," says Peter Wallison, co-director of financial policy studies at the conservative American Enterprise Institute. So has TARP done its job? "It was one of the largest government appropriations in history," says Thomas Chen, CEO of the investment bank Piper Jaffray. "And a mere seven months later we're letting capital be returned on the basis that the problem is fixed.
So you have to ask: (1) Has it all been fixed?, or (2) Was it necessary in the first place?" Chen believes the program had a short-term calming effect on the economy -- more than a financial effect. Says Thomas Nides, Morgan Stanley's chief administrative officer: "The original concept was to accomplish one thing: to stop us from going off the cliff, to send a clear message that the government was not going to let the system collapse. For that I give them an A+."
Paulson's team has acknowledged that Treasury officials should have communicated better with Congress as the program expanded, bringing lawmakers onboard with the message that was communicated to the nine CEOs on that Monday afternoon: We're all in this together. "We were trying to get the political will to prevent the financial system from collapsing," says Kashkari. "But our political system is better at cleaning up after a mess than reaching consensus to prevent one."
Our political system is also fraught with turmoil and unpredictability. Capitalism, however, thrives on contractual certainty. The Obama White House has drawn many lessons from the Great Depression -- insisting, for example, that the crisis demonstrated the need for early, bold, and large-scale government intervention. But that era also holds lessons about the costly unpredictability of government rules. In her 2007 history of the Great Depression, The Forgotten Man, which became a hot book this spring among conservatives, author Amity Shlaes argues that the economy took longer than it should have to recover in the 1930s and contends that F.D.R.'s stated strategy of "bold, persistent experimentation" spawned fear of commitment in the markets.
That is the theme that TARP veterans return to time and again -- sanctity of contracts, the importance of certainty in market rules. This is American business culture, one that is at odds with the vicissitudes of American political culture. Right now Congress thinks it knows better. But too much bold, persistent experimentation just might undercut the recovery lawmakers say they want.
Obama Defends Proposed New Agency
President Obama defended his proposed Consumer Financial Protection Agency in his weekly radio address yesterday, saying it would tamp down the kind of deceptive lending practices and complicated contracts he said often hurt consumers. Obama proposed the agency as part of his administration's rewrite of rules governing the financial sector.
The proposals are now before Congress, and industry lobbyists are pushing back against the proposed agency. They say it would create overlapping layers of regulation and put government in the middle of legitimate business decisions. Speaking in his weekly radio and Internet address, Obama said new regulations are needed to prevent the type of abuses that contributed to the recent financial meltdown. "It's no coincidence that the lack of strong consumer protections led to abuses against consumers," he said. "The lack of rules to stop deceptive lending practices led to abuses against borrowers."
With the creation of the agency, Obama said "those ridiculous contracts -- pages of fine print that no one can figure out" would be banned at banks and other financial institutions. "Some argue that these changes -- and many others we called for -- go too far," Obama said. "And I welcome a debate about how we can make sure our regulations work for businesses and consumers. But what I will not accept, and I will vigorously oppose, are those who do not argue in good faith. Those who would defend the status quo at any cost."
Obama’s Make-or-Break Summer
That first 100 Days hoopla seems like a century ago. The countless report cards it engendered are already obsolete. The real story begins now. With Iran, universal health care, energy reform and the economic recovery all on the line, the still-new, still-popular president’s true tests are about to come.
Here’s one thing Barack Obama does not have to worry about: the opposition. Approval ratings for Republicans hit an all-time low last week in both the New York Times/CBS News and Wall Street Journal/NBC News polls. That’s what happens when a party’s most creative innovations are novel twists on old-fashioned sex scandals. Just when you thought the G.O.P. could never match the high bar set by Larry Craig’s men’s room toe-tapping, along came Senator John Ensign of Nevada, an ostentatiously pious born-again Christian whose ecumenical outreach drove him to engineer political jobs for his mistress, her cuckolded husband and the couple’s son.
At least it can no longer be said that the Republicans have no plan for putting Americans back to work. But as ever, the lack of an adversary with gravitas is a double-edged sword for Obama. It tempts him to be cocky and to coast. That’s a rare flaw in a president whose temperament, smarts and judgment remain impressive. Yet it is not insignificant. Though we don’t know how Obama will fare on all the challenges he faces this summer, last week’s big rollout of his financial reform package was a big punt, an accommodation to the status quo.
Given that the economy remains the country’s paramount concern — and that all new polling finds that most Americans still think it’s dire — this timid response was a lost opportunity. It violated the Rahm Emanuel dictum that “you never want a serious crisis to go to waste” and could yet prompt a serious political backlash. A tip-off to what was coming appeared in a Washington Post op-ed article that the administration’s two financial gurus, Lawrence Summers and Timothy Geithner, wrote to preview their plan. “Some people will say that this is not the time to debate the future of financial regulation, that this debate should wait until the crisis is fully behind us,” they wrote by way of congratulating themselves on taking charge.
Who exactly are these “some people” who want to delay debate on the future of regulation? Not anyone you or I know. Most Americans were desperate for action and wondered why it was taking so long. The only people who Summers and Geithner could possibly be talking about are the bankers in their cohort who helped usher us into this disaster in the first place. Both men are protégés of one of them, Robert Rubin, the former wise man of Citigroup.
There are some worthwhile protections in the Summers-Geithner legislation, especially for consumers, but there’s little that will disturb these unnamed “people” too much. I’ll leave it to financial analysts to detail why the small-bore tinkering in the administration blueprint won’t prevent another perfect storm of arcane derivatives, unchecked (and risk-rewarding) executive compensation and too-big-to-fail banks like Citi. Suffice it to say that the Obama team has not resuscitated the Glass-Steagall Act, the New Deal reform that Summers helped dismantle in the Clinton years and that would have prevented the creation of banking behemoths that held the economy hostage.
A particularly dramatic example of how the old Wall Street order remains intact can be seen by looking at the fate of credit-rating agencies like Moody’s, which gave triple-A grades to some of the cancerous derivatives at the heart of the economic meltdown. As Gretchen Morgenson of The Times reported last year, Moody’s sins during the subprime frenzy included upgrading its rating of securities underwritten by Countrywide Financial, the largest mortgage lender, after Countrywide complained that the ratings were too tough.
Since then, more details have emerged in this unsavory narrative. When the Securities and Exchange Commission charged Countrywide’s former chief executive, Angelo Mozilo, with securities fraud and insider trading this month, it produced e-mails from 2006 in which Mozilo referred to his company’s subprime loan products as “toxic” and “poison.” Mozilo wrote that “we have no way, with any reasonable certainty, to assess the real risk of holding these loans on our balance sheet.”
Yet Moody’s didn’t warn the public by downgrading Countrywide’s securities until the summer of 2007. Meanwhile, this supposed watchdog for investors, which, like other credit-rating agencies, is paid by the very companies it monitors, took its own tranche of the bubble. Moody’s profit margins even surpassed Exxon’s. And how have it and its peers in the credit-ratings game fared in the Obama regulation crackdown? Incredibly enough, they can still collect fees from the companies they grade. “It is as if Hollywood studios paid movie critics to review their would-be blockbusters,” wrote Eric Dash in The Times.
Non-Wall Street Americans who signed on to Countrywide’s toxic loans are doing far less well. The White House stood by passively this spring as banking lobbyists mobilized to castrate the administration’s Helping Families Save Their Homes Act. The final version eliminated the key provision that would have allowed judges to lower the principal for mortgage holders whose homes are worth less than their loans. Dick Durbin, the Democratic senator from Illinois, correctly observed in April that the banks are “still the most powerful lobby” in Congress and that “they frankly own the place.”
The banks’ influence at the other end of Pennsylvania Avenue is also conspicuous. The revolving door between the government and Wall Street is as greasy as ever in this White House. It’s all too depressing that the administration enforced its no-lobbyists policy to shun a human-rights advocate, Tom Malinowski, a lobbyist for genocide victims in places like Darfur, but granted Geithner a waiver to appoint a former Goldman Sachs lobbyist, Mark Patterson, as his chief of staff.
Obama is very eloquent in speaking of the “culture of irresponsibility” that led us to the meltdown, but that culture isn’t changing so much as frantically rebranding. A.I.G. is now named A.I.U., and has employed no fewer than four public relations firms, including one whose bipartisan roster of shills ranges from the former Hillary Clinton campaign strategist Mark Penn to the former Bush White House press secretary Dana Perino.
Taxpayers are paying for that P.R., having poured $170 billion-plus into A.I.G. But we still don’t have a transparent, detailed accounting of what was going down last fall when A.I.G. and its trading partners, including Goldman, snared that gargantuan cash transfusion. Perhaps if there had been a thorough post-crash investigative commission emulating the Senate investigation led by Ferdinand Pecora after the crash of 1929, we would now have reforms as thorough as F.D.R.’s. It was because of the Pecora revelations that Glass-Steagall was put in place.
If you watch CNBC, of course, the recovery is already here, and the new regulations will somehow stifle it. The market is up, sort of. Even some bank stocks are back. Unemployment, as Obama reminds us, is a lagging indicator. And so, presumably, are all the other indicators that affect most Americans. One in eight mortgages is now either in foreclosure or delinquent, with the share of new mortgages going into foreclosure reaching a record high in the first quarter of 2009. Credit card debt delinquencies are up 11 percent from last year in that same quarter.
The test for Obama is simple enough. If the fortunes in American households rise along with Wall Street’s, he is home free — even if his porous regulatory fixes permit a new economic meltdown decades hence. But if, in the shorter term, the economic quality of life for most Americans remains unchanged as the financial sector resumes living large, he’ll face anger from voters of all political persuasions. When the Fox News fulminator Glenn Beck says “let the banks lose their tails, they need to,” he illustrates precisely where right-wing populism meets that on the left.
It’s still not too late for course correction. Before rolling out his financial package, Obama illustrated exactly what’s lacking when he told John Harwood on CNBC: “We want to do it right. We want to do it carefully. But we don’t want to tilt at windmills.” Maybe not at windmills, but sometimes you do want to do battle with fierce and unrelenting adversaries, starting with the banking lobby. While the restraint that the president has applied to the Iran crisis may prove productive, domestic politics are not necessarily so delicate.
F.D.R. had to betray his own class to foment the reforms of the New Deal. Lyndon Johnson had to crack heads on Capitol Hill to advance the health-care revolution that was Medicare. So will Obama for his own health-care crusade, which is already faltering in the Senate courtesy of truants in his own party, not just the irrelevant Republicans.
Though television talking heads can’t let go of the cliché that the president is trying to do too much, the latest Wall Street Journal/NBC News poll says that only 37 percent of Americans agree. The majority knows the country is in a crisis and wants help. The issue has never been whether Obama is doing too much but whether he will do the big things well enough to move us forward. Now that the hope phase of his presidency is giving way to the promised main event — change — we will soon find out.
Goldman to make record bonus payout
Staff at Goldman Sachs staff can look forward to the biggest bonus payouts in the firm's 140-year history after a spectacular first half of the year, sparking concern that the big investment banks which survived the credit crunch will derail financial regulation reforms. A lack of competition and a surge in revenues from trading foreign currency, bonds and fixed-income products has sent profits at Goldman Sachs soaring, according to insiders at the firm.
Staff in London were briefed last week on the banking and securities company's prospects and told they could look forward to bumper bonuses if, as predicted, it completed its most profitable year ever. Figures next month detailing the firm's second-quarter earnings are expected to show a further jump in profits. Warren Buffett, who bought $5bn of the company's shares in January, has already made a $1bn gain on his investment. Goldman is expected to be the biggest winner in the race for revenues that, in 2006, reached £186bn across the entire industry. While this figure is expected to fall to £160bn in 2009, it will be split among a smaller number of firms.
Barclays Capital, Credit Suisse and Deutsche Bank are among the European firms expected to register bumper profits, along with US banks JP Morgan and Morgan Stanley following the near collapse and government rescue of major trading houses including Citigroup, Merrill Lynch, UBS and Royal Bank of Scotland. In April, Goldman said it would set aside half of its £1.2bn first-quarter profit to reward staff, much of it in bonuses. It is believed to have paid 973 bankers $1m or more last year, while this year's payouts are on track to be the highest for most of the bank's 28,000 staff, including about 5,400 in London.
Critics of the bonus culture in the City said the dominance of a few risk-taking investment banks is undermining the efforts of regulators to stabilise the financial system. Vince Cable, the Liberal Democrat treasury spokesman, said: "The investment banks more than any other institutions created the culture of excessive leverage, excessive risk and excessive bonuses that led to the downfall of the financial system. Now they are cashing in and the same bonus culture has returned. The result must be that we are being pushed to the edge of another crash."
Goldman Sachs said it reviewed its bonus scheme last year and switched from a system of guaranteed rewards that were paid over three years to variable payments that tied staff to the firm. It told employees last year that profit-related bonuses would be delayed by 12 months. Until the release of its first quarter profits in April, it seemed inconceivable that a firm owing the US government $10bn would be looking to break all-time records in 2009. David Williams, an investment banking analyst at Fox Pitt Kelton, said: "This year is shaping up to be the best year ever for investment banks, or at least those that have emerged relatively unscathed from the credit crisis.
"These banks are intermediaries in the bond markets where governments and companies are raising billions of pounds of new money. There is also a lack of competition that means they can charge huge sums for doing business." Last week, the firm predicted that President Barack Obama's government could issue $3.25tn of debt before September, almost four times last year's sum. Goldman, a prime broker of US government bonds, is expected to make hundreds of millions of dollars in profits from selling and dealing in the bonds.
Soup kitchen queues grow as US teeters on brink of new downturn
One of America's largest food companies, Kellogg's, is asking for donations from the public to help fight hunger - not in the developing world, but in the heart of the US, where handouts from "food banks" are catering for a growing number of families struggling to make ends meet. The charity, Feeding America, says demand at its 63,000 soup kitchens and food pantries is 30% higher than at the end of 2008, as spiralling unemployment and repossessions increase the demand for extra help for Americans who would otherwise go hungry. Kellogg's is offering breakfast cereal coupons to consumers who donate money to Feeding America.
The spectre of growing queues at soup kitchens evokes the hardship of the Great Depression, and underlines fears that the credit crunch is exacting a painful toll on American society. While there have been tentative signs in recent weeks that the economy is starting to strengthen, there are also growing concerns that the US could be on the brink of a "double dip," into a new downturn.
With the housing market still plunging, long-term mortgage rates have risen in response to rising bond yields on the financial markets. The Federal Reserve will meet this week to discuss monetary policy, and Ben Bernanke, its chairman, is under pressure to take action to bring mortgage rates back down. John Richards, of RBS, said next week's meeting would be "exceptionally interesting", adding: "changing the policy rate is not the issue; instead, the meeting will be the first chance for the Fed to officially consider what, if anything, it wants to do about the danger posed by rising Treasury yields to the recovery."
With rates already at zero, and the Fed buying back billions of dollars of government bonds, few options are available, but Bernanke is thought to be considering making a public commitment to keep rates low for a long time, in the hope of influencing investors and bringing long-term rates back down. Graham Turner, of GFC Economics, said unless the Fed could reverse the rise in rates, there was a risk that the economy would slide into freefall.
"There is absolutely no floor to the housing market, and the unemployment problem is not going to get better quickly," he said. With foreclosures still increasing, Turner added that a growing number of desperate or disheartened borrowers were simply walking away from their near-worthless properties, risking "a complete breakdown of the social contract between banks and homeowners."
As the treasury secretary, Tim Geithner, struggles to sell Washington's plan for re-regulating the banking sector to a sceptical Congress, a New York Times opinion poll last week showed the American public are less confident in Obama's handling of the economy than his wider record, during his first few months in the White House. While 63% approved of the way he is handling his job as president, more than half said he should focus on reducing the deficit, instead of spending money to kick-start the economy.
Treasury’s Got Bill Gross on Speed Dial
Every day, Bill Gross, the world’s most successful bond fund manager, withdraws into a conference room at lunchtime with his lieutenants to discuss his firm’s investments. The blinds are drawn to keep out the sunshine, and he forbids any fiddling with BlackBerrys or cellphones. He wants everyone disconnected from the outside world and focused on what matters most to him: mining riches for his clients at Pimco, the swiftly growing money management firm.
Mr. Gross, 65, has long been celebrated for his eccentricities. He learned some of his lucrative investing strategies by gambling in Las Vegas. Many of his most inspired ideas arrived while he was standing on his head doing yoga. He knows he has to be well dressed for client meetings or television — but instead of keeping his Hermès ties neatly knotted, he drapes them around his neck like scarves so he can labor with his collar open.
And with the collapse of Wall Street, Mr. Gross has emerged as one of the nation’s most influential financiers. His frequent appearances on CNBC draw buzz, as do his wickedly humorous monthly investing columns on the Pimco Web site. Treasury secretaries call him for advice. Warren E. Buffett, the Berkshire Hathaway chairman, and Alan Greenspan, the former Federal Reserve chairman, sing his praises.
“He’s a very individualistic person. He doesn’t come at analysis or investment judgment in the words, terminology or ambience that I have been used to over the decades,” Mr. Greenspan says. “That may be the secret of his success. There is no doubt there is an extraordinary intellect there.” Mr. Greenspan, it should be noted, now works for Pimco as a consultant. Amid all of this, Mr. Gross and his firm are trying to shape the government’s response to the economic crisis. He is one of the most fervent supporters of the Obama administration’s plan to enlist private investors to help bail out the nation’s ailing banks and try to revive the economy.
That effort, known as the Public-Private Investment Program, or P.P.I.P., has gained little traction so far. But Mr. Gross has energetically defended its architect, Treasury Secretary Timothy F. Geithner, against critics like the New York University economics professor Nouriel Roubini and the New York Times columnist Paul Krugman — both of whom argue that the strategy is flawed and that it would be best for the government to temporarily nationalize so-called zombie banks to prevent a repeat of the Great Depression.
Such nationalization, Mr. Gross insists, would be an unmitigated disaster. “There are two grand plans,” he said this spring at a meeting of his firm’s investment committee. “One is the Krugman-Roubini plan. They think the banks have so much garbage they are beyond hope. The other side is the administration’s side. That’s the one we’re on. If the other side should ever gain credence, then we’ll have something to worry about.”
Mr. Gross is hardly a disinterested observer. Pimco, owned by the German insurer Allianz, is jockeying to be picked by Mr. Geithner to relieve the likes of Bank of America, Citigroup and other banks of an estimated $1 trillion in soured mortgage debt so they can start lending freely again. Mr. Gross calls the plan a “win-win-win” for the banks, taxpayers and Pimco investors. The government is planning to announce soon which money managers will participate. A spokesman for the Treasury Department would not say whether Pimco would be one of them.
In many ways, it is perfectly logical for the White House to turn to someone like Mr. Gross at such a time. Few investors understand the mortgage market better. As co-chief investment officer, he personally manages Pimco’s flagship, the Total Return fund, which has $158 billion in assets. As of the end of May, he had invested 61 percent of the fund’s money in mortgage bonds. Mr. Gross has always been partial to mortgage bonds. And why not? He has done fabulously well with them. In an October 2005 letter to investors, he made one of the most prescient calls of the last decade, warning of the looming subprime mortgage crisis. Almost everybody ignored him. Today, they wish they hadn’t.
When the housing bubble burst and the financial markets fell apart, investors lost billions of dollars. Not Mr. Gross’s clients. Class A shares of the Total Return fund, for individual investors, were up 4.3 percent in 2008, or nine percentage points ahead of comparable bond funds, according to Morningstar; this year through Thursday, the shares were up 5.4 percent. In the midst of an economic crisis, those numbers are impressive. So is the longer-term record: In the 10 years through Thursday, the fund had an annualized return of 6.42 percent, beating its benchmark by 0.54 percentage points, according to Morningstar.
That’s one of the reasons the government has courted him closely. Last fall, the Federal Reserve Bank of New York, run at the time by Mr. Geithner, hired Pimco — along with BlackRock, Goldman Sachs and Wellington Management — to buy up to $1.25 trillion in mortgage bonds in an effort to keep interest rates from skyrocketing. Last December, when it was pressing Bank of America to complete its ill-fated acquisition of Merrill Lynch, the Federal Reserve also looked to Pimco for advice. According to recently released messages that Fed staff members sent one another that month, Pimco evaluated the two banks and concluded that Merrill wouldn’t survive without a capital infusion or additional government aid.
Today, Mr. Gross is eager to buy the same subprime loans he once refused to touch, as part of the Treasury’s distressed-asset initiative. After all, the thinking goes, if anybody can figure out how much all this debt is worth, it’s Pimco. But Pimco’s involvement in so many aspects of the bailout has made many other financiers and analysts uncomfortable. They say its proximity to the Treasury Department and the Fed may allow it to reap billions of easy dollars through federal contracts and preferential investment opportunities.
A frequent complaint is this: Why is the Federal Reserve paying Pimco to buy mortgage securities on its behalf, when the firm is already a huge buyer and seller of the same bonds? “That’s the equivalent of a no-bid contract in Iraq,” fumes Barry Ritholtz, who runs an equity research firm in New York and writes The Big Picture, a popular and well-regarded economics blog. “It’s a license to steal.”
No one, of course, has actually accused Pimco of theft. But there is a larger question: Whose interests is the firm looking out for in the bailout? Money managers, after all, have a legal obligation — a fiduciary responsibility — to put the interest of their investors before anyone else. Even Mr. Gross acknowledges that Pimco’s interests won’t always be aligned with those of the government. Mr. Gross points out that he has never even met Mr. Geithner. For its part, the Treasury Department plays down Pimco’s influence. “We speak with a number of market participants and believe seeking out a diversity of perspectives is critical to our efforts,” says Andrew Williams, a spokesman for the department. He says the Treasury takes conflicts of interests “very seriously in all cases.”
Mr. Gross is well aware of the criticism that has been directed at Pimco. During an interview at its headquarters in Newport Beach, Calif., sitting at his horseshoe-shaped desk on its 4,200-square-foot trading floor overlooking the Pacific Ocean, he brings up the topic of perceived conflicts of interest himself. He almost never personally buys and sells bonds. Pimco has dozens of traders who do this for him here. “There’s the mortgage desk over there,” he says, pointing to a group of well-scrubbed young people hunched over computers. “We’ve been buying some mortgages this morning. That’s our baby, so to speak. That’s our bag.”
He immediately adds that this mortgage trading operation is completely separate from the one on the floor below, where traders are working on behalf of the Fed. He says he can’t even visit that floor himself anymore without a company lawyer at his side. The last time he did was in December, when he wished the traders happy holidays. “I said, ‘Merry Christmas,’ ” Mr. Gross recalls. “The lawyer said, ‘Mr. Gross says Merry Christmas.’ Right then and there, I knew that communications were basically severed. That’s the way the Fed wants it.”
He says he assumes that Pimco traders working on behalf of the government don’t talk to their peers trading for Pimco’s own accounts. Then again, he said he doesn’t know for sure what happens after hours. “I don’t drink beer with these guys; I have no idea what happens in the privacy of their own homes,” he says. He says that when he encounters traders working for the Fed outside the office, he doesn’t talk to them. “I pass some of them on the way to the lunch shop,” he says. “I just sort of wave. I don’t know what to do.”
Mr. Gross is fond of saying he is the antithesis of a Wall Street “alpha male.” He is every bit the Southern Californian, with longish hair and a laid-back attitude. Most Wall Street executives won’t talk to a reporter without a public relations person hovering nearby. Even then, they can be disappointingly bland. No one would ever say such a thing about Mr. Gross. He approaches an interview is almost like a therapy session; it is a chance for him to make confessions. “I’ll tell you an interesting story,” he says at one point. “I shouldn’t, but I will. It’s like I’m taking truth serum every time I do this.”
The tale is about “a very childish and immature” e-mail message that he sent Don Phillips, a managing director of Morningstar, the mutual fund research company, when Morningstar didn’t select him as its fixed-income fund manager of the year in 2008. It is an intriguing story. But it’s nowhere near as interesting as what he has to say about Pimco’s role in the bailout. He sounds genuinely pained by the economic collapse. “There was always a big part of me that thought the Depression was just something from my old American Heritage history books,” he says. “I thought: ‘This stuff can’t happen really. I mean, this is just for the economic philosophers and the paranoid worriers.’ Then, in the last 6 to 12 months, you go, ‘God, this just might happen!’ ”
With the fate of the largest banks still uncertain, a heated debate continues about how to fix the problem. Mr. Geithner wants to enlist money managers like Pimco to buy distressed bank assets with financial backing from the government. That way, his supporters argue, they can offer such generous prices that banks can disgorge the assets without too painful a hit. But proponents of bank nationalization say the Treasury’s plan won’t work because some banks can’t afford to take any losses on asset sales. This camp believes nationalization is the best path because it will let the government clean up banks’ balance sheets and restore their health.
Mr. Gross argues that this would completely destabilize the financial markets. “If you thought Lehman Brothers was a mistake, just stand by and see what nationalizing Citi or B.of A. would do,” he argued in one of his monthly letters to Pimco investors. His mood brightens when he talks about how much money Pimco could reap by participating in the Geithner plan. No wonder: the terms are deliciously favorable for participants selected as fund managers. Money managers like Pimco would be expected to raise at least $500 million from their clients. The Treasury would match that with taxpayer dollars. Then Pimco and the Treasury would create a jointly owned fund of at least $1 billion that would buy distressed mortgage bonds.
Government largess doesn’t stop there. The fund will be eligible for low-interest financing from both the Treasury and the Fed that analysts at Credit Suisse First Boston estimate could be as high as four times the total equity in the fund. So if Pimco ponied up $500 million, the fund that it manages could borrow $4 billion. Pimco would then negotiate with banks to buy their wobbly mortgage-backed securities. Mr. Gross says that some of these securities pay an interest rate as high as 14 percent and that even if default rates were 70 percent, Pimco and the government would still make a 5 percent return after covering their negligible borrowing costs. That means the government-Pimco partnership could make at least $250 million in a year on a $5 billion investment fund. Of that amount, Pimco would get $125 million — a 25 percent return on its original investment.
But here’s the part that makes Mr. Gross salivate. If things go badly, the government is responsible for repaying all that debt. “It’s just like in blackjack,” he says. “That puts the odds in your favor. If you don’t bet too much and if you stay at the table long enough, the odds are high that you are going to go home with some extra money in your pocket.” Indeed, for all of Mr. Gross’s anguished talk about the crisis, there’s no escaping the fact that Pimco isn’t exactly suffering. In November, the Total Return fund became the world’s largest mutual fund with $128.4 billion in assets, according to Morningstar. Since then, its assets under management have climbed to $158 billion. The firm once had trouble luring prospective employees to Newport Beach. Now Pimco is being deluged with résumés.
Meanwhile, some of the most powerful people in the nation call Mr. Gross for advice. “Paulson will call, Geithner will call, and I’ll be like, ‘Yabba-dabba’ or ‘Blah-blah-blah,’ ” he says with a measure of self-deprecation — and an equal dose of pride. “I turn into a walking, talking idiot.” Mr. Gross has been through crises before. He nearly died — and briefly lost part of his scalp — in 1966 when he crashed his car while making a doughnut run for his fraternity brothers at Duke University. He spent much of his senior year recovering in the hospital. He also became obsessed with blackjack after reading “Beat the Dealer: A Winning Strategy for the Game of Twenty-One,” by Edward O. Thorp, an M.I.T. mathematics professor (who is now a very successful hedge fund manager).
After he got his diploma, Mr. Gross hopped a freight train to Las Vegas with $200 sewed into his pant leg. He played blackjack for 16 hours a day. “After a while it gets pretty boring and pretty stinky,” he recalls. “People lose money. They don’t win it. You’re just watching the dealers.” Even so, in four months, he turned $200 into $10,000 and used his winnings to pay for his studies toward an M.B.A. at the University of California, Los Angeles. He thought he could apply the lessons learned at the blackjack table to the stock market. After getting the degree, he called all the big Wall Street brokerage firms. Nobody called him back.
Finally, his mother showed him a classified ad for a junior credit analyst in the bond department at the Pacific Investment Management Company, a subsidiary of Pacific Mutual Life. Although Mr. Gross had no interest in bonds, he took the job as a steppingstone to stock-picking. Back then, the bond market was a sleepy corner of the financial world. Mr. Gross’s job was to make sure that Pimco avoided buying bonds from companies that might go belly-up and burn their creditors. By the mid-1970s, the market had become sexier as shrewd investors like Mr. Gross began trading bonds like stocks — and began earning outsize profits.
In short order, Mr. Gross also dived into the first mortgage-backed securities (which carried comfy government guarantees) and began studiously monitoring interest rates so he could place bets on his own macroeconomic predictions. This was highly unusual for a bond fund manager — and still is. “There are a lot of big bond shops that frankly don’t feel confident doing this,” says Lawrence Jones, a Morningstar analyst. “It’s not part of their tool kit.”
Mr. Gross played well on television. In 1983, he became a regular on “Wall Street Week” on PBS; he loved the attention, and his ubiquity gave Pimco a big boost. Four years later, Pimco rolled out the Total Return fund. Over the next 10 years, its assets soared to $24 billion from $165 million. Much of this was because of shrewd investing. But TV did wonders, too. “It doesn’t do you any good to be good if nobody knows about you,” Mr. Gross says.
In 1999, he warned in his monthly investment column that the dot-com bubble would soon burst. The next year, it did. Despite the market downdraft, Mr. Gross’s fund ended 2000 up 12 percent, and that same year he and his partners sold Pimco to Allianz for $3.3 billion. Mr. Gross received $233 million for his stake, and Allianz also agreed to pay him $40 million in retention bonuses and seems to be giving him free rein. Not that Mr. Gross was going anywhere.
Free from distraction in a gym across the street from his offices, Mr. Gross happily rides a stationary bike, followed by a half-hour of yoga. Toward the end of his routine, he stands on his head for a few minutes in a position called the Feathered Peacock. He wobbles so much that you expect him to lose his balance and fall over, but he says some of his best ideas have come to him while he was upside down.
One of those insights came in 2005, when — while standing on his head — he began to worry about the real estate bubble. He’d watched the prices of homes climb into the stratosphere in Southern California, and he says he felt as if he were witnessing something out of “Alice in Wonderland.” Was this happening all around the country? Pimco dispatched 11 mortgage analysts to 20 cities to find out. They posed as prospective homebuyers and drove around with unsuspecting real estate agents and mortgage brokers who told them how easily they could get a home loan. “It was a little deceptive,” Mr. Gross says. “I didn’t feel good about that, but I didn’t know how else to get the real information.”
Mr. Gross says he thought it was obvious what was driving this madness: subprime mortgages. He was certain that the real estate market would collapse and take the economy down with it, and he made those thoughts known in letters to his investors. Pimco steered clear of risky housing debt, which meant that, for a time, some of his competitors who stockpiled the briefly lucrative products outperformed him. For a fiercely competitive man, it was an awkward time. “Bill takes it hard when the numbers aren’t what he thinks they should be,” his wife, Sue, confided by e-mail. “In 2006, he recommended a Pimco bond fund to the owner of a local doughnut shop, and when it didn’t do well for a while, he could hardly go in the shop for his favorite coconut cake doughnut.”
Fortunately for Mr. Gross, but not for the economy, this couldn’t last forever. The housing bubble finally burst in 2007, and the crisis followed. He was vindicated. Yet this was only part of the reason for his success. He also predicted in one of his monthly columns that the government would have to pump billions of dollars into the economy to avert a total collapse. At the same time, he and his Pimco team came up with an audacious plan: invest in bond sectors that Washington would be forced to support — like government-backed mortgages guaranteed by Fannie Mae and Freddie Mac.
Mr. Gross whimsically calls this strategy “shake hands with the government.” And he used his access to the news media to get the government’s attention. In a CNBC interview on Aug. 20, 2008, he argued that Americans were putting “their money in the mattress” because the government hadn’t rescued imperiled financial institutions like Fannie and Freddie. On Sept. 7, Henry M. Paulson Jr., then the Treasury secretary, announced that the government was taking over Fannie and Freddie. The value of the Total Return fund rose by $1.7 billion in a single day.
Michele Davis, Mr. Paulson’s former spokeswoman, says Mr. Gross’s TV appearances had nothing to do with the decision: “There are $5.4 trillion of Fannie and Freddie securities around the world. Investors here and across the globe were worried and voicing the same concerns.” But some of Pimco’s critics aren’t convinced. “The Treasury Department watches CNBC all day,” says Steven Eisman, a portfolio manager and banking expert at FrontPoint Partners, an investment firm. “I know that for a fact. He was putting pressure on them.”
Mr. Gross says nothing could have been further from his mind. He says he goes on TV with “a disbelief that people will believe or act on what I say,” adding that “people should think independently.” At the same time, Pimco tried to influence the direction of the bailout itself. In the spring of 2008, Pimco’s chief executive, Mohamed A. el-Erian, a former policy expert at the International Monetary Fund, floated a plan in Washington for a public-private partnership similar to the P.P.I.P. plan that Mr. Geithner later unveiled. It didn’t get much traction.
But then Lehman Brothers collapsed on Sept. 15. Mr. Paulson asked Congress to pass the Troubled Asset Relief Plan, better known as TARP, which would enable the government to spend $700 billion to buy mortgage securities from teetering banks. The Treasury turned to Pimco and others for help. “When we first asked for the TARP legislation in September, we were looking at purchasing assets,” says Ms. Davis, the former Treasury spokeswoman. “We definitely talked to Pimco and a lot of other asset managers. You had to find out how such a program might work and bounce ideas around to see how this thing would work.”
In the midst of the crisis, in October, Mr. Gross’s friend, Mr. Buffett, wrote to Mr. Paulson suggesting a plan similar to the one Mr. Erian had been pushing. However, Mr. Buffett says he came up with his idea independently. “I called Bill Gross and Mohamed and said: ‘I’ve got this idea. If it goes forward, I hope you guys would manage it and would do it on a pro bono basis,’ ” Mr. Buffett recalled in an interview. “Within an hour, they said they were on board and they were willing to do whatever was called for.”
Mr. Gross publicly announced that his firm would do the job free. “I got call after call, e-mail after e-mail saying what Bill offered was right for the country and that he was a great American,” says a Pimco spokesman, Mark J. Porterfield. At first, it looked as if the Treasury might take Mr. Gross up on the offer. But his hopes were temporarily dashed when the Treasury simply gave TARP funds to the banks instead of purchasing bad assets.
And at the same time, people began to wonder about Mr. Gross’s motives. He made it clear that he was not afraid to put Pimco’s interests ahead of the government’s in the bailout. As part of its “shake hands with the government” strategy, Pimco had bet that the Bush administration would come to the rescue of the nation’s banks and other financial institutions. So it bought a variety of those bonds, including those of GMAC, the financial division of General Motors.
In November, as the economy continued to weaken, GMAC asked the Fed for permission to become a bank holding company so it could receive TARP financing. The central bank granted GMAC’s wish, with one caveat: GMAC had to swap 75 percent of its debt for equity, allowing GMAC to potentially buy back a big chunk of its bonds for just 60 cents on the dollar. Mr. Gross balked at the arrangement because, as a GMAC bondholder, he would have been forced to take a big financial haircut. “We said: ‘It doesn’t look too good to us. We think we’ll just hold onto the existing bonds,’ ” he remembered.
Much to the amazement of many people on Wall Street, the Federal Reserve, which declined to comment, still allowed GMAC to become a bank holding company and the government later guaranteed all of its debt, meaning that Mr. Gross’s GMAC bonds would be worth 100 cents on the dollar when they mature. Mr. Gross is unapologetic about the outcome. “The government has a vested interest, and it’s not necessarily aligned with Pimco’s interest,” he says.
Simon Johnson, a former chief economist for the International Monetary Fund and now a professor at the Sloan School of Management at M.I.T., says he isn’t surprised that Mr. Gross is such a virulent foe of nationalization. As Professor Johnson points out, Pimco is a major bondholder in some of the biggest banks. Nationalization would hurt his portfolio. “It would reduce the present value of his holding,” says Professor Johnson, himself a proponent of nationalization. “Therefore, he is not going to look good as an investment manager.”
What of Mr. Gross’s predictions that nationalization would deepen the recession? Professor Johnson acknowledges that there are risks either way, but says he thinks that people should be skeptical when powerful financiers make doomsday predictions. “I think we pay undue deference to people who are very rich and have been successful in the financial sector in this country,” he says. “We think they are the gurus who think they have unique expertise, and if Bill Gross tells us there will be a panic, it must be true. Well, no, I don’t believe it. These guys all say this kind of thing.”
The twist, of course, is that the Obama administration has embraced the same public-private partnership proposal that Pimco has been pushing along and that Mr. Paulson briefly considered last fall. Mr. Gross says that the Geithner plan is better because the government provides such generous debt financing. Pimco is proud of its partnership with the government. Mr. Erian points out that the firm’s executives have been members of the Treasury Department’s Borrowing Advisory Committee (along with many other Wall Street executives) for years. Its current representative, the Pimco managing director Paul McCulley, says part of his job is to ingratiate himself with officials at the Treasury and the Federal Reserve so Pimco can better understand impending policy decisions. He boasts that he is on a “first-name basis” with both Mr. Geithner and the Fed chairman, Ben S. Bernanke.
“We have a whole lot bigger profile now than we did years ago, but the fact of the matter is we’ve been doing the same thing in the last year that we’ve been doing for the last 10 years,” Mr. McCulley says. “I’d like to think we’re having some influence in the public policy arena. And I say that first and foremost as a citizen.” Citizen — but also investor. And some critics of the financial benefits that Pimco might snare if the P.P.I.P. gets rolling are quick to point out what Pimco stands to gain.
“The critics would argue that all the benefits go to Pimco,” says Representative Scott Garrett, Republican of New Jersey, who is a member of the House Financial Services Committee and a skeptic of the Geithner plan. “Well, maybe not all the benefits. But they get the best ones right out the door. And the taxpayers are on the hook.” The Obama administration says it will soon select lead fund managers for P.P.I.P. It’s almost certain that Pimco will be among them. “If you are trying to encourage investment from the private sector, isn’t it only logical to involve the most successful asset management organizations in the private sector?” says Thomas C. Priore, chief of ICP Capital, a boutique fixed-income investment bank.
And being selected by the government has other benefits, Mr. Priore adds. “If any endowment or public pension plan representative is looking for an asset management firm, he or she won’t get fired for hiring Pimco because, well, the government hired Pimco,” he says. “That certainly enhances your franchise value.” P.P.I.P.’s fate remains uncertain. When the Treasury Department put 19 of the nation’s largest banks through a stress test, many passed the exam and their stocks prices rose. They have raised $50 billion in new capital. Now some of them are likely to hold on to their distressed mortgage securities in the hope that the housing market recovers — rather than face the pain of selling the assets at a loss now (a situation that may get dicey if housing doesn’t, in fact, recover).
The Treasury now says that Mr. Geithner expects P.P.I.P. to serve as “backstop” for banks that find themselves in a pinch. There’s a darker scenario, possibly. If mortgage default rates do soar, some big banks may fail. Then the administration would have to seriously consider nationalization, which might devastate Mr. Gross’s holdings. He is, of course, well of aware of this possibility and says he’s watching Mr. Geithner as closely as he watched the blackjack dealers in Las Vegas.
“We just don’t want to flush it all down the drain,” he says. “You want to shake hands with the government. But maybe it shouldn’t be a super-firm handshake.” At a lunchtime meeting this past spring at Pimco, executives tell Mr. Gross that they’re worried about the fallout the firm will face if it receives a financial windfall as part of P.P.I.P. “The risk is that you have a Congress with a populist bug,” Mr. McCulley says.
Dan Ivascyn, another of the firm’s managing directors, agrees. “I think there is a risk that we’re going to get criticized,” he says. “I think Pimco could get roughed up.” “I think there is a much bigger chance of us getting roughed up personally,” says Scott Simon, head of Pimco’s mortgage-backed securities team. Finally, Mr. Gross weighs in. “So what are you saying?” he asks. “If we fail, we’ll get the shaft, and if we succeed, we’ll get the shaft?”
Give Bankruptcy a Chance
The conventional wisdom about the bailouts of 2008 goes something like this. Federal regulators started off on the right foot by bailing out Bear Stearns and midwifing its sale to JPMorgan Chase. They were right to bail out AIG six months later, but botched the execution. And Lehman Brothers, the only exception to the bailout rule, showed once and for all that bankruptcy is not an adequate way to handle the collapse of a large financial institution.But what if regulators hadn't bailed out Bear Stearns? If we conduct this simple thought experiment, it raises serious questions about both the conventional wisdom and the Obama administration's new proposals for regulating investment banks and bank and insurance holding companies.
Bankruptcy starts to look much better, although it could use several market-correcting tweaks. The Bear Stearns saga unfolded in March 2008. After the markets lost confidence in Bear and its $18 billion of cash reserves began to disappear, Bear Stearns chief executive Alan Schwartz called Tim Geithner, who was head of the New York Federal Reserve Bank. Geithner, then-Treasury Secretary Hank Paulson, and Ben Bernanke pushed Bear into the arms of JPMorgan, a much healthier bank. The deal was structured so that the creditors of Bear Stearns were fully protected, Bear's shareholders took a serious haircut, and the government kicked in a $29 billion guarantee of Bear's most dubious assets.
If regulators had decided not to bail Bear out, the short-term effects might have been jarring. Regulators were particularly worried about the extremely short-term loans--known as "repo" loans--that investment banks depend on for financing. A repo loan is structured as a sale of securities by the borrower to the lender, with a promise by the borrower to buy the securities back the next day. If there were a major default in this previously safe lending market, the market might have frozen up and major repo lenders who were not repaid might have been destabilized or even failed.
Some of these consequences might have ensued, but the risk of widespread ripple-effect collapses--also known as contagion effects or systemic risk--was almost certainly overstated. The creditors of Bear Stearns would have suffered losses, and the shareholders would have been wiped out. But this hard medicine would have sent a very clear message to the managers, creditors, and shareholders: Better watch what the company is doing, or you could get burned. In more technical terms, a Bear Stearns bankruptcy would have eliminated moral hazard--the tendency not to take precautions if you'll be spared the consequences of bad outcomes.
When Bear Stearns fell, Lehman Brothers was widely viewed as similarly vulnerable, since it too was highly leveraged and heavily exposed to subprime mortgages. Yet Richard Fuld, Lehman's chief executive, rejected a proposed investment by Warren Buffett and refused to seriously consider selling the company in the months after the Bear Stearns bailout. When Lehman filed for bankruptcy six months later, on September 15, 2008, no one even knew who Lehman owed money to and who the counterparties on its derivatives contracts were.
AIG was similar. The most impressive document produced by AIG on the eve of its collapse was a secret report designed to show federal regulators just how devastating a bankruptcy would be. As summarized in the New York Times, the report predicted that derivatives markets and the insurance industry could collapse if AIG defaulted. These responses made perfect sense if you assumed--as everyone did after the Bear Stearns bailout--that regulators would bail out any big, troubled financial institution. Not only was there no need to plan for bankruptcy, but the bailout strategy gave Lehman and AIG an incentive not to prepare for the worst. The more unprepared they were, the worse the bankruptcy option would look and the more likely a bailout would be forthcoming.
This, not the bankruptcy system, is why Lehman's collapse was so disastrous. Lehman, its suitor Barclays, and everyone else assumed the government was standing by with buckets of money. But regulators played bait and switch, deciding at the last minute not to provide bailout funds after all. Lehman's failure to prepare, and the way it was dumped into bankruptcy, were the problems. The bankruptcy itself has gone remarkably smoothly.
If Bear had been left to file for bankruptcy back in March, the managers and investors of Lehman and AIG surely would have acted differently in the weeks before their failures. The prospect of bankruptcy would have given them a very different perspective on the implications of their financial difficulties. At the least, they would have gotten their books in order and started looking for buyers for their businesses much earlier.
By all accounts, Paulson, Geithner, and Bernanke--the three musketeers of the financial crisis--never seriously considered stepping to the side and allowing Bear Stearns to file for bankruptcy. Why is this? One reason is that the mere whisper of systemic risk strikes fear into the hearts of financial regulators. If regulators agree to a misguided bailout, there are few immediate consequences. But if they forgo the bailout and the default infects other institutions, they could face a marketwide collapse and eternal condemnation. Given the stakes, regulators routinely overestimate the likelihood of systemic risk.
These particular regulators--Geithner, especially--were even more wired for bailouts than most. Paulson, the former head of Goldman Sachs--one of the healthiest investment banks--is a problem solver and deal maker. His instinct is to make a deal and move on--which is what regulators did with Bear and JPMorgan. Bernanke, as is well known, was a scholar of the Depression at Princeton prior to his appointment to the Federal Reserve. The mistake he vowed never to repeat was being too tightfisted with government money in a time of crisis, as the Depression-era Fed certainly was.
With Bear Stearns and AIG especially, Geithner seems to have been the point man. Geithner cut his teeth in the international affairs division of the Treasury, and as a key underling to Larry Summers, when Summers was secretary of the Treasury in the Clinton administration. The 1990s saw two key crises that seem to have permanently shaped Geithner's instincts: Mexico's currency crisis in 1994, and the collapse in 1998 of Long Term Capital Management, the giant hedge fund run by superstar economists and mathematicians.
Both times, regulators opted for a bailout (funded by private banks in LTCM's case), and both bailouts are widely viewed as successful interventions. Mexico's crisis passed, and Long Term's collapse had little evident lasting effect on the market. What is often forgotten is that these bailouts, successful as they were, did have a cost: They protected investors against the downside risk of lending to developing countries. Investors kept pouring money into these markets after the Mexican bailout, which contributed to crises in Asia and elsewhere at the end of the decade.
But the bailouts are remembered as successes. The lesson Geithner learned is that bailouts are always the best response when a large institution or country is in trouble. This lesson lies at the heart of the Treasury's proposals for reforming U.S. financial regulation. In addition to requiring hedge fund advisers to register with the SEC, imposing disclosure requirements for derivatives, and expanding the Fed's systemic risk authority, the proposals authorize bank regulators to step in and take over "systemically important" nonbank financial institutions, as the FDIC already does with commercial banks (that is, banks that take deposits).
By taking resolution authority away from the bankruptcy courts and giving it to bank regulators, this proposal extends and institutionalizes the bailout policy of the past year. If the proposals pass, large financial institutions will have the same incentives that Bear Stearns, Lehman, and AIG had: to make sure a default would be as messy as possible, and count on negotiating a bailout with banking regulators if things go sour.
A more sensible approach would be to give the bankruptcy laws a chance. The prospect of bankruptcy at the end of the line would discourage excessive risktaking in the first instance, encourage creditors to monitor the institutions they have invested in, and if dark clouds do develop, encourage managers to make plans for an orderly bankruptcy. Bailouts will be even less necessary, and bankruptcy more sensible, when the administration's other reforms are put in place.
As one of their principal justifications for bailing out Bear Stearns, regulators claimed that Bear's books were so unclear that they had no idea what its exposure was. The new disclosure and capital requirements will significantly reduce this opacity. The current bankruptcy laws aren't perfect. The principal shortcoming is best illustrated by AIG. AIG had a huge portfolio of the financial derivatives known as credit default swaps in its financial products subsidiary. These contracts act like insurance, with one party buying protection from the other in the event a third party defaults on its obligations.
Unlike most creditors, the counterparties to AIG's derivatives contracts would have been permitted to cancel the contracts and to sell any collateral they held if AIG had filed for bankruptcy, thanks to the exemption from the ordinary bankruptcy rules these contracts enjoy. (Both parties can claim credit for this special treatment: Alan Greenspan, the Clinton and Bush Treasury Departments, and the derivatives trade group all lobbied for it in the 1990s and 2000s.) If AIG had filed for bankruptcy, all of these counterparties could have canceled their contracts at the same time. Defenders of the AIG bailout argue that the mass cancellation of these contracts could have paralyzed the credit default swap market, driven down asset values as everyone tried to sell their collateral at the same time, and led to the failures of other institutions.
It is far from clear that the dire predictions were accurate. But with a simple, two-part tweak, the bankruptcy laws could be adjusted to respond to these systemic risk concerns. First, instruct the Fed to survey the nation's financial institutions, much as it did with the recent stress tests, and identify which are too interconnected to fail. This would remove any uncertainty as to who is and is not in the club. Second, add a small handful of provisions to the bankruptcy laws for these systemically important institutions. The key provision would simply apply the ordinary stay--the rule that creditors cannot cancel their contracts or try to collect what they are owed--to the derivatives counterparties of a systemically important debtor.
The derivatives stay would have one obvious benefit and one not so obvious one. The obvious benefit is that it would prevent the creditors of the next AIG from all demanding collateral or cancelling their contracts at the same time. By filing for bankruptcy, the company could halt the carnage that bank regulators worry about. The less obvious benefit is that this rule would encourage derivatives counterparties to deal with institutions that are not systemically important. A counterparty that dealt with an ordinary institution would always have the right to cancel its contracts, even in bankruptcy, whereas those that deal with behemoths would be subject to the stay in bankruptcy. Unlike the administration's proposals, which simply assume that we will continue to have institutions that are too big and interconnected to fail, the bankruptcy alternative would thus help curb the tendency for big institutions to grow relentlessly bigger.
The bankruptcy alternative would not prevent regulators from regulating. Nothing would stop them from imposing high capital requirements on systemically important institutions, for instance, to make them less risky. But it would give creditors an incentive to pay close attention to the creditworthiness of systemically important institutions. And it would give the managers of these institutions a reason to file for bankruptcy before the house of cards crumbled, rather than running to regulators to beg for money.
Ilargi: A very quick translation of an article from Montreal French daily La Presse.
Selling off Canada Inc.
Relatively speaking, no country has more of its major companies to foreign interests since the early 2000s than Canada. This is the sad conclusion that comes from the Montreal consulting firm Secor, after analysis of transactions of purchases and sales of companies valued at over $ 1 billion,as reported by Bloomberg.
Between 2000 and 2008, Canada has a deficit of 158 billion U.S. dollars (acquisitions abroad less acquisitions of Canadian companies by foreign interests). It is thus the third largest "selling" country, behind the United States (-220 billion U.S.) and the United Kingdom (-158 billion U.S.).
"Even if some transactions may benefit the selling country, the loss of control over the ownership of enterprises is worrying," says Ken Smith, associate director of the New York office of Secor, in an article published in the June edition of the Harvard Business Review. Ken Smith devaluates the migration of service industry professionals who tend to stay close to their head offices.
In comparison, France stands out as the most enthusiastic buyer of large companies abroad, with a surplus of 234 billion dollars due to "an aggressive industrial policy worldwide". Further behind are Spain (101 billion U.S.) and Belgium (79 billion U.S.). In short, contrary to what one might think to read some alarmist headlines, the Europeans are much more greedy than the Chinese, who ranked only 10th among the buyers country for this period.
Ownership by large multinationals enhances the influence of the country, in the eyes of Ken Smith. "The United States, the United Kingdom and Canada will be delayed if they do not care about the imbalances in the global industrial restructuring," he warns. Protectionism is not the solution, argues Ken Smith. However, countries must do their utmost to promote their companies.
Countries must apply pressure so that their businesses can acquire companies abroad as easily as if they were a local company. The directors do not always yield to the pressure from hedge funds and private investment funds, who only care about the short-term interest of the company. Leaders need to worry about the size of their business, not to fall behind their international competitors in acquisition mode. All important things, but without lapsing into defeatism is to wonder if it is not too late.
UK local councils dip into pension fund savings
Local authorities across Britain are believed to be borrowing hundreds of millions of pounds from staff pension schemes in order to boost returns on their own cash deposits - without sharing the full interest with the pension fund. Unions want this investment practice, which is outlawed in the private sector, to be banned immediately. They have suggested that councils' investment strategies may already be illegal.
The Local Government Association insisted that councils were acting within the regulations. "The law requires councils to invest their pension fund money properly and prudently, and that is what they do," it said. The controversy highlights potential conflicts of interest among council finance officers, many of whom are responsible for pension investments as well as for the general council funds used to finance day-to-day services.
Councils are allowed to invest 10% of their pension fund money and have typically elected to put the borrowed cash in high-interest accounts. In return, the pension funds receive a highly uncompetitive interest rate, based on seven-day Libor (inter-bank rates). Critics of the scheme have been quick to see echoes of the Robert Maxwell scandal, when the publisher used more than £300m of Mirror Group pension money to subsidise his business empire.
Lord Oakeshott, the Liberal Democrat pension spokesman, said councils were acting irresponsibly and in breach of basic governance principles. "Why should public pension funds have inferior corporate governance standards and protection from conflicts of interest than private funds? Councils playing this game are on a slippery slope that ended with Bob Maxwell mixing pension fund cash with his own. They should stop it now, for good," he said.
Colin Meech, the national officer of the public service union Unison, said: "The government has been negligent and has not observed UK pension fund law, principally the Occupational Pension Scheme (Investment) Regulations 2005, which disbar employers from borrowing from their staff retirement funds. According to legal advice obtained by the union, this is a potentially criminal act." Local government investment decisions have faced unprecedented scrutiny in the wake of the Icelandic banking crisis. About £1bn of local authority cash has been trapped in three failed banks: Kaupthing, Landsbanki and Glitnir.
Freedom of information requests by the local authority journal The MJ discovered that, in several cases, a good proportion of deposits were drawn from the Local Government Pension Scheme. Most local government pension schemes have suffered large falls in value over the past two years, which will only be made worse by part of their investments being channelled into low-interest bank deposit accounts.
In Poll, Wide Support for Government-Run Health
Americans overwhelmingly support substantial changes to the health care system and are strongly behind one of the most contentious proposals Congress is considering, a government-run insurance plan to compete with private insurers, according to the latest New York Times/CBS News poll. The poll found that most Americans would be willing to pay higher taxes so everyone could have health insurance and that they said the government could do a better job of holding down health-care costs than the private sector.
Yet the survey also revealed considerable unease about the impact of heightened government involvement, on both the economy and the quality of the respondents’ own medical care. While 85 percent of respondents said the health care system needed to be fundamentally changed or completely rebuilt, 77 percent said they were very or somewhat satisfied with the quality of their own care. That paradox was skillfully exploited by opponents of the last failed attempt at overhauling the health system, during former President Bill Clinton’s first term. Sixteen years later, it underscores the tricky task facing lawmakers and President Obama as they try to address the health system’s substantial problems without igniting fears that people could lose what they like.
Across a number of questions, the poll detected substantial support for a greater government role in health care, a position generally identified with the Democratic Party. When asked which party was more likely to improve health care, only 18 percent of respondents said the Republicans, compared with 57 percent who picked the Democrats. Even one of four Republicans said the Democrats would do better. The national telephone survey, which was conducted from June 12 to 16, found that 72 percent of those questioned supported a government-administered insurance plan — something like Medicare for those under 65 — that would compete for customers with private insurers. Twenty percent said they were opposed.
Republicans in Congress have fiercely criticized the proposal as an unneeded expansion of government that might evolve into a system of nationalized health coverage and lead to the rationing of care. But in the poll, the proposal received broad bipartisan backing, with half of those who call themselves Republicans saying they would support a public plan, along with nearly three-fourths of independents and almost nine in 10 Democrats.
The poll, of 895 adults, has a margin of sampling error of plus or minus three percentage points. Mr. Obama and many Democrats have argued that a public plan would be essential, in the president’s words, to “keep insurance companies honest.” But Mr. Obama has also signaled a willingness to compromise for Republican support, perhaps by establishing member-owned insurance cooperatives instead. It is not clear how fully the public understands the complexities of the government plan proposal, and the poll results indicate that those who said they were following the debate were somewhat less supportive.
But they clearly indicate growing confidence in the government’s ability to manage health care. Half of those questioned said they thought government would be better at providing medical coverage than private insurers, up from 30 percent in polls conducted in 2007. Nearly 60 percent said Washington would have more success in holding down costs, up from 47 percent. Sixty-four percent said they thought the federal government should guarantee coverage, a figure that has stayed steady all decade. Nearly 6 in 10 said they would be willing to pay higher taxes to make sure that all were insured, with 4 in 10 willing to pay as much as $500 more a year.
And a plurality, 48 percent, said they supported a requirement that all Americans have health insurance so long as public subsidies were offered to those who could not afford it. Thirty-eight percent said they were opposed. In a follow-up interview, Matt Flurkey, 56, a public plan supporter from Plymouth, Minn., said he could accept that the quality of his care might diminish if coverage was universal. “Even though it might not be quite as good as what we get now,” he said, “I think the government should run health care. Far too many people are being denied now, and costs would be lower.”
While the survey results depict a nation desperate for change, it also reveals a deep wariness of the possible consequences. Half to two-thirds of respondents said they worried that if the government guaranteed health coverage, they would see declines in the quality of their own care and in their ability to choose doctors and get needed treatment. “It is the responsibility of the government to guarantee insurance for all,” said Juanita Lomaz, a 65-year-old office worker from Bakersfield, Calif. “But my care will get worse because they’ll have to limit care in order to cover everyone.”
When asked their opinion of specific changes being considered in Washington, three-fourths of those surveyed said they favored requiring health insurers to cover anyone, regardless of pre-existing medical conditions. Only a fifth supported taxing employer-provided health benefits to help pay the cost of coverage for the uninsured. And there was deep uncertainty about whether employers should be required to either help insure their workers or pay into a fund for covering the uninsured.
Three of four people questioned said unnecessary medical tests and treatments had become a serious problem, suggesting that they would support calls by health researchers for a payment system that would better reward appropriate care. But an even higher number, 87 percent, said the inability of people to have the needed tests and treatments was a serious problem. One in four said that in the last 12 months they or someone in their household had cut back on medications because of the expense, and one in five said someone had skipped a recommended test or treatment.
The poll found that Americans were far less satisfied with the cost of health care than with the quality of it. Mr. Obama, who has emphasized the need to reduce costs, has found an audience for his argument that health care legislation is vital to economic recovery. Eighty-six percent of those polled said rising costs posed a serious economic threat. Yet only a fifth of those with insurance said the cost of their own medical care posed a hardship. And only a fourth said that keeping health costs down was a more urgent need than providing coverage for the country’s nearly 50 million uninsured. That was a notable change from a Times/CBS poll taken in early April, when 40 percent said that controlling costs was more pressing.
Ilargi: If you needed an additional reason to lose your faith in (the reasoning power of) makind, do read this.
Efficient market theory is not to blame
I recently summoned up the courage to direct Ted Snyder (dean of the Booth School of Business at the University of Chicago) towards my latest book. As the author of a text claiming that mathematical theories can destroy the financial markets – a text that puts a lot of blame on the current business school status quo, with its unhealthy adoration for the theoretical method – I was not sure if Mr Snyder would be pleased to hear from me.I needn’t have feared, as he proved non- confrontational.
He did, though, press me on whether I had included in my analysis the work of Eugene Fama (a legendary Chicago professor) warning that the distribution of returns has fat tails and thus is not a normal distribution, contrary to what financial economics has long argued. I replied that my book was not so much about the failings of finance theory per se as about those instances when theory can wreak havoc in the markets and society. And as far as I could tell, Prof Fama’s theories have neither caused demonstrable pain nor display an insurmountable potential to do so. Prof Fama is best known as the godfather of efficient market theory which, in essence, says you cannot beat the market and should content yourself with investing in index funds.
Of course, this theory (with its implications that all investors are rational beings who always have all relevant information and swiftly act on it) has long been refuted, not just on obvious empirical grounds (I mean, Warren Buffett does exist) but even by theorists themselves (Prof Fama himself relented in later years). But the credit crisis seems to have resurrected the long-dormant debate about the theory. It is not just that what has happened inescapably loads extra ammunition into the markets-are-not-efficient gun. Some observers are actually claiming that the efficient market hypothesis (EMH) is to blame for the mayhem. This, I believe, is off-target, and possibly counterproductively so.
It is unquestionably true that quantitative finance played a decisive role in the mayhem, but there is a world of difference between (purportedly) having had an intellectual influence and having had a demonstrably direct link to the chaos. Espousers of the “efficient market theory did it” camp seem to argue that, by providing unmitigated faith in the soundness of quoted market prices, the notion that everything is behaving rationally, and that no dangerous bubbles can take shape, the analytical machination made investors and policymakers complacent and careless, allowing the (very real, very irrational) housing-related blow-up to happen.
This line of reasoning suffers from an obvious drawback: can we really assume that all professionals are basing their actions all the time on the dictates of the efficient market hypothesis? That they are even aware of the existence of such theory? Of course not. I mean, it’s not as if the Merrill Lynch traders who gorged on subprime credit default obligations did so because they religiously abided by Prof Fama’s (earlier, at least) pontifications. Or that regulators allowed the insane leverage to take place because their brains repeatedly flashed out the “markets are efficient, markets are efficient!” signal.
Efficient market theory is an ideology a few may share, but it is not a mechanism for direct action-taking. As such, and unlike the theories that truly caused the crisis, it cannot lead to activities by professionals that may cause trouble. There is also the point that the efficient market hypothesis says markets cannot be beaten, and yet the current nightmare was created by those who very much wanted to outperform. Had Wall Street and the City abided by the theory, they would have gorged on index funds rather than on subprime CDOs. They would have tried to make money by boringly replicating the index, not by selling optionality though credit default swaps.
Rather than being followed, the efficient market theory was scorned. If we want to look for mathematical concoctions to blame for the malaise, we should focus on those with a demonstrable capacity to raise hell and that did raise hell this time around: things like value at risk, which are routinely used as risk guides on trading floors and, embedded in the formula for setting leverage-determining regulatory capital requirements. I don’t see “efficient markets theory” or “beta” in that formula. Naively blaming the efficient markets hypothesis, while a valuable exercise when it comes to pointing out the innate flaws of financial economics, distracts us from the truly important issues.