 National
Review, November 17, 2008
Death by Rescue
How botched bailouts doomed companies that didn't need to fail
By Donald L. Luskin
The road to hell is paved with bad interventions. This
year’s emergency sallies into the banking system by the Fed, the Treasury,
the FDIC, and the SEC have backfired. They were intended to ameliorate a
credit crisis and to keep it from spreading. Instead they’ve inflamed the
crisis into an outright panic that now has spread around the world and
triggered a recession.
Conservatives may rightly object to all this government
meddling in private markets on general principle. But the more salient
objection is that government has botched it. The attempts to deal with
failures at Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill
Lynch, AIG, Washington Mutual, and Wachovia were not rescues or bailouts at
all—they were wipeouts, seemingly intended more to punish than to rescue.
They were government takings of private property for public use—seizures of
shareholder wealth in troubled firms in the name of saving the
system—without the just compensation promised in the Fifth Amendment and
often beyond the legal authority of the government agencies involved.
Each of these seizures was ad hoc, and most were
carried out over a weekend in secret. And each was handled differently, with
no apparent rhyme or reason as to which agency would be involved, which
firms would be saved and which wouldn’t, or whose ox would be gored.
Stockholders almost always got zeroed out. Bank depositors and
insurance-policy holders were always saved. But for bondholders, commercial
creditors, derivatives counterparties, and securities-account holders, it
was totally arbitrary—different each time. And as often as not, these
exercises had powerful unintended consequences, with the government fixing
one trouble spot only to create another elsewhere in the system.
The fact that government agencies that should have been
rescuers became destroyers instead—and the utter uncertainty about how and
when these agencies would exercise their powers—caused investors’ confidence
to collapse. Federal agencies unintentionally created an incentive structure
that rewarded investor behavior that would exacerbate the crisis and
punished behavior that would mitigate it.
I’M FROM THE GOVERNMENT, AND I’M HERE
TO HELP
There were many causes of the credit crisis. Surely the
Federal Reserve’s keeping interest rates at below-market levels from 2002 to
2005 contributed to the undue growth of credit, and congressional mandates
on Fannie Mae and Freddie Mac intended to encourage low-income home loans
contributed to the deterioration of mortgage-lending standards. It is also
obvious that many banks took imprudent positions, recklessly leveraging
their balance sheets to the extent that even a small correction would lead
to large losses that would then ripple through the markets, causing even
more losses.
It is clear who bears responsibility for rescuing the
global financial system from collapse as such excesses unwind. Through the
establishment of safety-net institutions such as the Federal Reserve and the
FDIC, the federal government presents itself as the rescuer. So when action
becomes necessary, government must do its job and do it well—even if some
banks have behaved recklessly, and even if they have done so precisely
because they’ve known they would be rescued. If the Titanic is sinking,
anyone who promised to save it must save it for the sake of all those on
board, even if it means also saving the life of the negligent captain who
rammed an iceberg.
Now that Treasury is armed with $700 billion from
Congress for more rescues, the risk is greater than ever that government
will continue to make matters worse. Happily, it appears that Treasury
secretary Henry Paulson has learned from past mistakes; so far, he is using
his power wisely. Sadly, much of that power will have to go toward repairing
damage from the botched rescues that went before.
The first major mistake, which established the template
for all the mistakes to come, was Bear Stearns. In mid-March, Bear was beset
by a classic bank run and faced failure. The Fed facilitated an emergency
acquisition of Bear by JPMorgan Chase to head off the systemic risk that
might arise from a disorderly collapse. The deal was announced on a Sunday
night after a weekend of frantic negotiations. Morgan was to acquire Bear
for a price of $2 per share—Bear’s stock having closed Friday at $30. The
Fed made a $30 billion loan to Morgan to buy Bear’s portfolio of illiquid
mortgage-backed securities, which came with a guarantee that the Fed would
take the lion’s share of any losses.
A key problem in the Bear deal was the price. As soon
as the deal was announced at $2 per share, stockholders began protesting
that they could probably recover more in bankruptcy. But bankruptcy was
something the Fed couldn’t allow to happen because of the systemic risks
involved—it simply had to find an acquirer for Bear, and the low price made
Morgan a very willing acquirer indeed. In other words, for the sake of the
overall financial system, the Fed decided to sacrifice the interests of Bear
shareholders to the interests of Morgan shareholders. Ultimately, under the
threat of litigation, the deal got renegotiated at $10—evidence that $2 had
been far too low.
The Fed had rationalized the initial price with a
“moral hazard” argument. The market, it reasoned, must be taught that a bank
couldn’t expect the Fed to bail it out after it had taken undue risks. It’s
hard to fault the sense of rough justice underlying that conclusion. But its
unintended consequences would prove, in the end, to be extremely harmful—as
is often the case when governments meddle in markets. The Fed, which was
created almost 100 years ago specifically to save banks that get in trouble,
had with Bear Stearns accidentally created an incentive structure to destroy
banks.
When the Fed sets the precedent that it will, on a
weekend when normal market processes aren’t available, hand over a troubled
bank to a competitor at a price well below its market value—below even its
value in bankruptcy—there’s no incentive to remain a shareholder at all.
Long-term shareholders, who ought to be incentivized to stick with banks
that run into difficulty, instead receive the message that they should flee
at the first sign of trouble lest they be wiped out by the “rescue.”
Stronger banks, sovereign-wealth funds, and other private investors that
might profitably help a troubled bank by investing in it learn instead to
wait for trouble to boil over into crisis, at which time the Fed will
practically give the bank away on a Sunday night.
What’s worse, speculators get the message that they can
push banks over the brink by shorting their stocks and spreading rumors,
driving share prices so low that it becomes prohibitively costly to raise
new capital—assuming anyone would dare invest new capital—and the Fed or
some other regulator then has no choice but to step in and put them out of
their misery. Such speculative attacks work on any bank the government deems
“systemically important”—the new way of saying “too big to fail.”
FALLING ONE BY ONE
By creating a perverse incentive system that punished
shareholder loyalty and courageous new investments while rewarding
mischievous short sellers and rumormongers, the Fed created a situation in
which any firm “too big to fail” suddenly became too big not to fail. Banks
and other financial companies were beset by speculators, abandoned by their
shareholders, and rendered unable to raise new capital, until some
combination of the Fed, the Treasury, and the FDIC euthanized them. One by
one they fell: Fannie, Freddie, Lehman Brothers, Merrill Lynch, AIG,
Washington Mutual, and Wachovia.
 Consider Fannie Mae and Freddie Mac. In mid-July,
Congress rushed legislation to passage that gave Paulson authority to rescue
the two troubled mortgage firms. He told Congress the authority would be
like “a bazooka,” and that simply having it meant he probably wouldn’t have
to use it. Three weeks later he used it. On the weekend of September 6–7,
Paulson threw Fannie and Freddie into “conservatorship”—which is to say,
Treasury took them over—wiping out what the day before had been $30 billion
in shareholder wealth while making a few short sellers very wealthy.
Why did Paulson use his bazooka after all, and why on
that weekend? The reason leaked to the press was that an expert
forensic-accounting team had been poring over the GSEs’ books and was
shocked to discover accounting irregularities; in fact, they had discovered
nothing that hadn’t already been discussed in great detail in the financial
press.
Over the weekend of September 13–14, the Fed and the
Treasury found they couldn’t arrange a private-sector rescue of Lehman
Brothers, so the venerable investment bank was allowed to fail. Its failure
set in motion destabilizing systemic consequences in global markets,
including the failure of money-market funds that held Lehman’s
debt—precisely the consequences the authorities had said it was essential to
avoid in the case of Bear Stearns. Those consequences will be felt for years
to come as they play out in bankruptcy courts in jurisdictions around the
world.
Two weekends later, having failed to save Lehman, a
bank that needed to be saved, the authorities nearly destroyed Wachovia in
the name of saving it—when it didn’t need to be saved at all. The FDIC
forced Wachovia to be acquired by Citigroup for $1 per share. As part of the
deal, the government underwrote much of the risk of Wachovia’s mortgage
portfolio with taxpayer money. Just days later, Wells Fargo judged that
Wachovia was still very much a going concern and offered to pay $7 a share
for it, without asking for government guarantees. Wachovia shareholders and
taxpayers should be delighted. Citigroup, claiming it had exclusive rights
to negotiate a deal, is suing.
So why was Lehman allowed to fail? Statements from the
Fed at the time suggest a belief—now, it seems, quite mistaken—that the
system could survive its failure. More recently, Fed chairman Ben Bernanke
has said that the Fed lacked the legal authority to do what would have been
necessary to rescue Lehman. But that rings false, given that the constraints
of legal authority were an early casualty of the credit crisis. For example,
the Bear Stearns rescue hinged on the $30 billion “loan” to Morgan for
Bear’s mortgage portfolio, but it wasn’t a loan at all—it was an outright
acquisition, and it is far from clear that the Fed has any legal authority
to acquire busted mortgage-backed securities. The Fed does have the
authority to make loans, so the acquisition was disguised as a loan with the
help of clever lawyers.
The authority for the Fed’s acquisition of a
controlling interest in AIG—again, dressed up as a loan—is even more
dubious. The Treasury put up the money to fund the Fed’s $85 billion
injection into AIG—which has now swollen to $120 billion. The Fed was simply
a convenient conduit for something Treasury wanted to do but would have
needed congressional approval to execute directly. As an independent agency
with broad and hazily defined powers, the Fed was better positioned than
Treasury to put its signature on the deal. As for the Fed’s independence—a
cornerstone of its credibility as the most important and prestigious central
bank in the world—its complicity with Treasury in the rogue AIG operation
pretty much puts an end to that myth.
URGENCY, THEN INACTION
As each domino fell, the panic deepened and made it
more likely that the next domino would tumble. Paulson and Bernanke sought
to get matters under control with a massive and unified display of
power—shock and awe, if you will—and thereby was born TARP: the $700 billion
Troubled Asset Relief Program.
Paulson spent two weeks convincing Congress and the
American people that, unless he was immediately granted nearly unbounded
power to throw $700 billion at the problem he himself had done so much to
create, the nation would enter a depression. At the end of the two weeks—on
October 3—he got his wish. The moment President Bush inked his signature on
the legislation authorizing TARP, Paulson should have announced that
Treasury was buying hundreds of billions of dollars of troubled assets, in
trades arranged over the previous two weeks. Instead, having stressed how
urgent it was to act quickly, he did nothing.
Or next to nothing. Paulson put out a press release
saying that Treasury, the Fed, the FDIC, and the SEC would have a meeting to
decide what to do. And the Treasury website posted “procurement guidelines”
for private-sector vendors seeking to work with Treasury on TARP.
The SEC put out a press release too. Having three weeks
before enacted a provisional ban on short-selling—to halt the speculative
attacks incentivized by the string of botched rescues—the commission
announced that with the passage of TARP the ban would be lifted. Only an SEC
lawyer could believe that the mere passage of a law giving Treasury
authority to act would hold the avalanche of short-selling at bay.
Between Paulson’s inaction and the SEC’s ineptitude,
the S&P 500 lost about 20 percent of its value in the week following the
enactment of TARP. Why, Paulson must have wondered, didn’t they greet us as
liberators? It was time for yet more improvisation, once more on a weekend.
But this time Paulson got it right: Gone was the idea
of buying troubled assets. Over the weekend of October 11–12, Paulson met
with the CEOs of the nine largest and most powerful U.S. banks. Apparently
he got very tough with them: He locked them in a room, reports said, and
forced them to accept $125 billion in capital investments from the Treasury,
with another $125 billion to go to smaller banks later. One has to suspect
that this was a cover story, sleight-of-hand to distract attention from the
fact that Treasury’s investment was being made on the most generous terms
imaginable. Consider that, three weeks apart, Treasury and Warren Buffett
both made $10 billion investments in nonvoting perpetual preferred stock of
Goldman Sachs. The difference is that Goldman’s cost for Buffett’s capital
is about 18 percent per annum over the next five years. Its cost with
Paulson is only about 7 percent. The other banks all got the same sweet deal
from Paulson that Goldman did.
It is disturbing that there is not a single word in the
TARP legislation that authorizes a direct capital investment in a bank.
There are “provisions related to film and television productions” and an
“exemption from excise tax for certain wooden arrows designed for use by
children.” But nothing about the Treasury’s buying stock in a bank.
Legal questions aside, the Treasury’s $250 billion
investment in U.S. banks marks an important turning point. For the first
time in this saga, an institution that is supposed to rescue troubled banks
is actually rescuing troubled banks—without wiping out shareholders in the
process.
This is the way the authorities should have handled the
credit crisis from the very beginning, from Bear Stearns onward. If we’re
going to do bailouts at all, they should be real bailouts. And this one is.
This bailout is big, too, representing nearly 20
percent of total U.S. bank capital as reported by the FDIC. That $250
billion in fresh capital effectively grants the banking system the staying
power to ride out the storm in something like $2.5 trillion in troubled
assets, given that banks typically hold assets worth about ten times their
capital. That’s enough to cover every single U.S. subprime and Alt-A
mortgage that isn’t already owned or guaranteed by Freddie or Fannie, plus
every single junk bond and leveraged bank loan in the world—with a couple
hundred billion dollars left over. And that’s only $250 billion of Paulson’s
$700 billion authority.
But then again Paulson, Bernanke, and all the rest have
done a great deal of damage. And it’s not just in the banking system, and
it’s not just in the U.S. The banking crisis has infected the real economy,
turning a slowdown into a serious recession. And it’s a global phenomenon.
We won’t get out of this mess quickly. But with Paulson finally doing the
right thing, at least we can make a start.
Mr. Luskin is chief investment officer of Trend Macrolytics LLC, an
economics and investment-research firm. |
