Why “too big to fail” has to be dealt with this time

Three Decades of Subsidized Risk

by Charles Gasparino
Friday, November 6, 2009

I recently sat down with legendary investor Ted Forstmann to discuss why, on the one-year anniversary of the financial meltdown, the press has largely ignored the role of government in creating the meltdown—and possibly setting the stage for another one—by allowing Wall Street to borrow cheaply and easily during the past three decades.

“I guess reporters think writing about greedy investment bankers is more interesting,” Mr. Forstmann laughed.

Mr. Forstmann knows a thing or two about greedy investment bankers: He’s been calling them on the carpet for years, most famously during the 1980s when he fulminated against the excesses of the junk-bond era. He also knows that blaming banking greed alone can’t by itself explain the financial tsunami that tore the markets apart last year and left the banking system and the economy in tatters.

The greed merchants needed a co-conspirator, Mr. Forstmann argues, and that co-conspirator is and was the United States government.

“They’re always there waiting to hand out free money,” he said. “They just throw money at the problem every time Wall Street gets in trouble. It starts out when they have a cold and it builds until the risk-taking leads to cancer.”

Mr. Forstmann’s point shouldn’t be taken lightly. Not by the press, nor by policy makers in Washington. But so far it has been, and the easy money is flowing like never before. Interest rates are close to zero; in effect the Federal Reserve is subsidizing the risk-taking and bond trading that has allowed Goldman Sachs to produce billions in profits and that infamous $16 billion bonus pool (analysts say it could grow to as high as $20 billion). The Treasury has lent banks money, guaranteed Wall Street’s debt and declared every firm to be a commercial bank, from Citigroup with close to $1 trillion in U.S. deposits, to Morgan Stanley with close to zero. They are all “too big to fail” and so free to trade as they please—on the taxpayer dime.

The conventional wisdom as perpetuated in the media is that these bailout mechanisms are unique, designed to ameliorate a once-in-a-lifetime financial “perfect storm.” They are unique, but only in size. A quick look back at the past three decades will demonstrate what Mr. Forstmann meant when he said the government has been ready to hand out free money nearly every time risk-taking led to losses.

The first mortgage market meltdown of the mid-1980s, spurred by the Fed’s supply of easy money, was among the most painful market upheavals in the history of the bond market. The pioneers of the mortgage bond market, Lew Ranieri of Salomon Brothers and Larry Fink of First Boston (the same Larry Fink now considered a sage CEO at money management powerhouse BlackRock), lost what were then unheard-of sums of money. (Mr. Fink concedes to losses of over $100 million.)

“What happened then was a dry run of what was to come,” Mr. Fink recently told me, as he looked back on the market he created, which would eventually lie at the heart of the most recent financial crisis. Wall Street took excessive risk in mortgage bonds amid the easy money supplied by the Fed—and lost. When the crisis began, the Fed under then Chairman Alan Greenspan slashed interest rates—as it would do after Orange County, Calif., declared bankruptcy in 1994 because of bad bets on complex bonds; and again in 1998 when the hedge fund Long-Term Capital Management (LTCM) blew up; and of course in the bond-market crisis of 2007 and 2008. The lower rates each time lessened the pain of the risk-taking gone awry, and opened the door for increased risk down the line.

Easy money wasn’t the only way government induced the bubble. The mortgage-bond market was the mechanism by which policy makers transformed home ownership into something that must be earned into something close to a civil right. The Community Reinvestment Act and projects by the Department of Housing and Urban Development, beginning in the Clinton years, couldn’t have been accomplished without the mortgage bond—which allowed banks to offload the increasingly risky mortgages to Wall Street, which in turn securitized them into triple-A rated bonds thanks to compliant ratings agencies.

The perversity of these efforts wasn’t merely that bonds packed with subprime loans received such high ratings. It was also that by inducing homeownership, the government was itself making homeownership less affordable. Because families without the real economic means to repay traditional 30-year mortgages were getting them, housing prices grew to artificially high levels.

This is where the real sin of Fannie Mae and Freddie Mac comes into play. Both were created by Congress to make housing affordable to the middle class. But when they began guaranteeing subprime loans, they actually began pricing out the working class from the market until the banking business responded with ways to make repayment of mortgages allegedly easier through adjustable rates loans that start off with low payments. But these loans, fully sanctioned by the government, were a ticking time bomb, as we’re all now so painfully aware.

A similar bomb exploded in 1998, when LTCM blew up. The policy response to the LTCM debacle is instructive; more than anything else it solidified Wall Street’s belief that there were little if any real risks to risk-taking. With $5 billion under management, LTCM was deemed too big to fail because, with nearly every major firm copying its money losing trades, much of Wall Street might have failed with it.

That’s what the policy makers told us anyway. On Wall Street there’s general agreement that the implosion of LTCM would have tanked one of the biggest risk takers in the market, Lehman Brothers, a full decade before its historic bankruptcy filing. Officials at Merrill, including its then-CFO (and future CEO) Stan O’Neal, believed Merrill’s risk-taking in esoteric bonds could have led to a similar implosion 10 years before its calamitous merger with Bank of America.

We’ll never know if LTCM’s demise would have tanked the financial system or simply tanked a couple of firms that bet wrong. But one thing is certain: A valuable lesson in risk-taking was lost. By 2007, the years of excessive risk-taking, aided and abetted by the belief that the government was ready to paper over mistakes, had taken their toll.

With so much easy money, with the government always ready to ease their pain, Wall Street developed new and even more innovative ways to make money through risk-taking. The old mortgage bonds created by Messrs. Fink and Ranieri as simple securitized pools had morphed into the so-called collateralized debt obligations (CDOs), complex structures that allowed Wall Street banks as well as quasi-governmental agencies Fannie Mae and Freddie Mac to securitize ever riskier mortgages.

Mr. O’Neal, the man considered most responsible for Merrill’s disastrous foray into risk-taking, told me in an interview last year that in the fall of 2007, when he saw that the firm’s problems were insurmountable, he had a deal to sell Merrill to Bank of America for around $90 a share. But Merrill’s board rejected it, believing he would be selling out cheaply. The CDOs would eventually recover, they argued, as the Fed pumped life into the markets.

Likewise, nearly to the minute he was forced to file for bankruptcy, former Lehman CEO Dick Fuld believed the government wouldn’t let Lehman die. After all, government largess had always been there in the past.

All of which brings me back to Mr. Fortsmann’s comment about policy makers helping turn a cold into cancer. What if the Fed hadn’t eased Wall Street’s pain in the late 1980s, and again after the 1994 bond-market collapse? What if policy makers in 1998 had allowed the markets to feel the consequences of risk—allowing LTCM to fail, and letting Lehman Brothers and possibly Merrill Lynch die as well?

There would have been pain—lots of it—for Wall Street and even for Main Street, but a lot less than what we’re experiencing today. Wall Street would have learned a valuable lesson: There are consequences to risk.

—Mr. Gasparino is a CNBC on-air editor and the author, most recently, of “The Sellout: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System,” just published by HarperBusiness.

4 Responses

  1. To the extent that PotUS BH Obama appointed the colossal failures to be his financial advisors and Sec of the Treas. I’d say every bit of flack he gets, he deserves. Obama was never an organizer from the streets, but from the board rooms of Chicago. As to Hamilton, sorry the facts say something else Hamilton hard wired the Federal government at the very beginning to bail out the wealthy and otherwise give a leg up when one was not needed. He set up the funding act in large part to bail out the bond speculators, whom of the Constitutional Convention represented the majority present. Governance of the economy was studiously absent in the drafting of that document. The First Bank of the US may have been partly owned by the government, AND it provided the value to purchase share in that bank by declaring full value to bonds taken on to pay for expenses related to supporting the “revolution.” He was also the person who as Sec of the Treasury his first tax to repay those bonds was the Spirits tax, which was an excise tax which was in the case of major distillers in urban areas they were allowed to report on their own production levels on a voluntary basis. While the effects upon rural areas where specie money was scarce and whiskey was used both as a basis for barter and a much cheaper way of transporting grain to market, N.A> Rothschild threatened retribution when Jefferson allowed its charter to collapse, hence the War of 1812 where Washington DC was specifically burned down. In the Constitution was designed to serve the property owners, and the Bill of Right was an afterthought added as a compromise to get the Constitution ratified. In large part is was about preserving the liberties of the wealthy against “too much” democracy. A significant number of former tories were involved in that process and the standing model of admiration was the Bank of England and the British East Indies Company.
    The not yet fully recognized fact that the big Wall Street used government as an accomplice via its insider appointments to essentially burn down the economy to make a major profit because they had invested in the collapse of the housing market through AIG’s otc CDS short bets is just another layer of criminal fraud. Everytime that the power for private interests to create currency has been given bribery has been part of the equation, and that includes even the highest office holder. Hoover was getting discounts on stock purchases prior to the 1929-33 collapse. I guess that was a measure of being “business friendly.” For the moment I would like to see a resurrecting of Clay’s Whigs with a national public banking system and a sovereignty based currency with full public auditing. So instead we have the exact opposite by design. cf Re-Imagining Economics at http://www.economics.arawakcity.org

  2. Mike

    I had to answer this because of some disagreement I have with what you said. Not with the end result. The two possibilities you stated are certainly very good possibilities. Maybe both of them in sequence, plus there are other possibilities or combination of possibilities. If the current administration continues to pour money into the economy, the first possibility becomes less and the second becomes greater. If the country slips into depression, then the first possibility becomes more real.

    But on to my disagreement. President Obama has just as big of share in the blame as anyone, in my opinion more. Sure, he inherited 50 years of irresponsible spending, however except for the 8 years under ‘W’, most of that belongs to the Democrats of which Obama is one and of that persuasion and was in Congress doing his part. But Obama had just as big an opportunity to move things in a different direction, but he chose not to, mainly because of his liberal underpinnings and his ‘I owe you’s’ to his constituency. In fact, his policies are definitely hurrying us along the path to the final conclusion. So, I believe he is as culpable as anyone.

    Third parties are always possibilities, but it seems like we almost have to be to the revolution state before they happen, because of the entrenchment of the status quo.

  3. mike
    Our gov or congress has not issued money since mid 1800’s.
    The fed has and on the other had couldn’t careless about interest rates, interest if anything appears to only be a diversion for the greatest heist of all time and it is taking place while we all watch ;THE NEWS MEDIA BULLSHIT Truly a JOKE!
    Banks have no need to nor will they lend any money now way to risky , besides they are busy reaping it from the our complicit gov,who is handing it out to the “too big to Nail” not “too big to Fail”!They are all in bed together..
    hahaha and… suprise!!!! look who’s screwed and by whom ..the middle class screwed by the unholy trinity “fed,fed reserve,industry corporate pig . the slaughter is only beginning

  4. Something has to give, either the bond and mortgage market collapses to pennies on the dollar
    and we wind up with massive deflation or the dollar
    collapses and we wind up with massive runaway inflation.
    Personally, I believe it will be the former (ie the
    collapse of the bond and mortgage market) because
    the Fed has run out of ammunition (ie interest at 0%)
    and the problem is still there, as massive as ever.
    The only thing the Fed accomplished was to post-
    pone the pain for a few months. It’s too bad Mr. O’Bama will get the blame for something he had no
    control over, (that’s why the Republicans ran McCain
    against him, they didn’t want their boy in there when the caca hits the fan). So when the collapse occurs,
    the Republicans,who caused it in the first place, will
    be able to blame it on the Democrats!
    What we really need is a “third party” that “gets it”.
    Perhaps we could call it by the name of the old “Federalist” party of Alexander Hamilton. It is
    clear He “got it” back at the beginning of the Republic
    and set up the “First US Bank” which was government
    owned, and issued currency based on the National
    debt, not on private banker debt created out of nothing
    as we have with the Federal Reserve. After all, only
    Congress is supposed to have the power to issue money and the Banks are only supposed to lend money they have on deposit, not monetize real estate
    values as they have been doing and then selling mortage backed securities worth 10x the value of the
    underlying mortgages. Wake up America!

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