Bought and Paid For

by Charles Gasparino

  Either way, one thing is certain: Bob Rubin was Wall Street’s inside guy within the Clinton administration, where he appointed top officials who believed, as he did, that Big Government and Big Finance could work and prosper together. The massive amounts of debt sold by the federal government to finance that Big Government needed to be auctioned first to the Wall Street firms, which took healthy fees before they sold it to their customers. Likewise, municipal governments needed Wall Street to underwrite their debt, and as in the case of Orange County, pump up returns with fancy, and risky, bets on the markets.

  Meanwhile, Rubin’s massive risk taking on Goldman’s trading desk was being replicated across Wall Street and could only be accomplished through government policies in one form or another. Sometimes it would take more than just Federal Reserve interest-rate cuts to save Wall Street, as Rubin himself began to argue in early 1995, just as Bill Clinton appointed him Treasury secretary.

  “The objective of promoting United States exports, jobs, security of our borders, in our judgment, is being accomplished,” Rubin said in 1995. He was describing what was at the time the largest intervention by the U.S. government in the free markets in memory. In January of that year, the bond markets had seized up with the sudden devaluation of the Mexican peso. America’s southern neighbor, a major trading partner, was on the verge of default, and Wall Street panicked.

  The big firms had suffered a tough year in 1994, particularly in the bond markets, as the Fed raised interest rates and the banks saw the value of their bond holdings begin to sink. Amid these losses, Wall Street viewed its investments in Mexico as a savior of sorts. (The Street ignored, of course, the fact that economic booms are normally followed by steep busts, especially in economies that, like Mexico’s, are just beginning to embrace free-market economic principles.)

  So now Wall Street was realizing it had bet wrong, as it was holding billions of dollars’ worth of Mexican bonds, currency swaps, and other securities tied to the peso. In other words, if Mexico went down, Wall Street would certainly suffer massive losses and, God forbid, smaller year-end bonuses.

  Robert Rubin, President Clinton’s Treasury secretary and onetime Goldman Sachs boss, was about to orchestrate his first bailout.

  Of course, in terms of size and scope the response to the Mexican “peso crisis” would barely resemble the massive banking bailouts that would come some fifteen years later, when President Bush and his successor, Barack Obama, pumped trillions into the banking system. But the peso crisis was a dry run for the bailouts that would be coming in 1998 (following the collapse of the hedge fund Long-Term Capital Management) and in 2008. Many feel, as do I, that the peso bailout was a critical signal to Wall Street that it could take as much risk as it wanted because the government was always there, ready and waiting to help the bankers out when their risk taking went bad, as it always eventually does.

  Rubin’s plan was to buy pesos on the open market and then issue $50 billion in guarantees on Mexican debt. The move was unprecedented because it was done by the administration—the Treasury Department, to be exact—without congressional approval.

  And that’s where Rubin faced the heaviest criticism. Taking some of the most intense flak was Rubin’s deputy, Larry Summers. Some members of the Senate Finance Committee viewed Summers with as much suspicion as Rubin because he was the point man on the bailout. Some called for his resignation. Senator Alfonse D’Amato of New York would later accuse Summers of outright lying about the true state of Mexico’s financial health prior to the crisis, citing Treasury documents that showed that officials had become increasingly alarmed by Mexico’s trade deficit well before the crisis itself.

  “The looting of America, on behalf of the new world order, has begun,” wrote the economic populist Pat Buchanan. “Never again should a President be allowed to disregard the will of Congress to raid the U.S. Treasury to bail out Wall Street banks or a foreign regime.” Buchanan went on to accuse Rubin of supporting the Mexican bailout to enrich his old investment-banking firm, Goldman Sachs. It’s unclear if helping Goldman was indeed Rubin’s motive (he denied any such thing), but there is no doubt the bailout aided the firm by stabilizing the already skittish markets and preventing further losses for Goldman and its fellow firms.

  In selling his bailout plan to the American people, Rubin argued that a Mexican default would be catastrophic for the world economy, that it presented “systemic risk.” A Mexican collapse, he argued, would trigger a massive wave of defaults around all the world’s emerging markets, creating a tidal wave of fiscal pain that would eventually envelop the United States. Playing off anti-immigrant sentiment in the border states, Rubin, who when he was in the United States spent most of his time shuttling between Washington and New York, argued that a collapse of the Mexican economy would spark a rush of illegal immigration to California and Texas.

  If the fear of millions of Mexicans running into our backyard wasn’t enough, the administration also tried to sell the bailout as a jobs-saving necessity, claiming that the U.S. economy had seven hundred thousand jobs that were dependent on a thriving Mexican economy. And so the first great government-run bailout was enacted.

  The bailout didn’t exactly turn around the Mexican economy as Rubin and company had predicted, mainly because Mexico was saddled with a huge debt burden to repay the U.S. government. So why didn’t it just walk away and default on all those bonds? Rubin, like any good bond trader, would have made it clear to Mexico that if it did that, Mexico would be virtually barred from the borrowing markets, a disaster for any government. A Mexican default, in Rubin’s view, would have threatened the stability of not just the South American economies but, more important, his beloved friends on Wall Street and his old firm, Goldman Sachs.

  There would be consequences for Mexico’s mistakes, but not for the Wall Street firms that held Mexican paper. Because of Rubin’s actions, the big firms avoided massive losses and were able to generate big bonuses. And with that, Wall Street and Big Government came to understand the meaning of teamwork. The big firms would underwrite the massive amounts of debt being sold to keep the welfare state afloat, and the welfare state would bail out the big firms from some of their most disastrous forays into risk.

  Following the Mexican bailout, the notion of “moral hazard” (the financial theory that the ability to take risk without consequences leads to even greater and more reckless risk taking) was solidified in every Wall Street CEO’s and trader’s mind. Rubin and his team would say that such bailouts are a necessary evil to prevent such massive losses that the entire financial system would undergo a gut-wrenching “systemic” collapse. Maybe so, but the lack of consequences taught the Wall Street risk takers a valuable lesson, even if they had slept through this part of college economics class: When they lost money and it came time to pay the bill, the government and the American taxpayer would provide backup—again and again.

  None of that seemed to matter to Rubin or even to most members of Congress, who, despite some initial dissent, slowly but surely came to believe that the plan was a success. Nearly two years after the bailout was passed in a lavish ceremony in the Roosevelt Room, White House officials were nearly giddy with the news that Mexico had repaid its $13 billion bailout to America—three years ahead of schedule.

  A reporter peppered President Clinton with questions about a recent decline in the value of the peso—an indication that despite all the money spent, the country’s economy was still ailing, even if the government had paid back the loan. Clinton, grinning from ear to ear, passed the question to Rubin, explaining, “You’ve made so much more money than I have, and so should be the one to answer the question.”

  The usually reserved Rubin, who has been known to be low-key about his vast fortune, couldn’t contain his excitement at the president’s calling attention to his money-making prowess. “There is a point to that!” he said. Later in the ceremony Summers would joke that he would love just a slice of the estimated $580 million in profits the
U.S. government claimed to have made on the deal, even as the Mexican economy imploded, thanks to the stiff terms Rubin negotiated.

  “Larry, anything you can negotiate I’m happy to split with you,” Mr. Rubin shot back.

  Whether the Treasury actually turned a profit really doesn’t matter (that $580 million in “profit,” after all, is barely a drop in the bucket of the U.S. government’s titanic spending); it was the moral hazard that was created, the belief in the minds of Wall Streeters that their friends in DC were ready to ride to the rescue.

  Rubin, of course, didn’t need the money he was joking about with Summers, and in a few years he would become even more wealthy thanks to his ability to help arrange benefits for the securities industry.

  In 1998, Rubin was still at the Treasury Department, but he was setting the stage for his return to Wall Street. It was around this time that the massive Citigroup merger was announced. It was a landmark deal: Citigroup was the combination of a commercial bank, Citicorp (one of the world’s largest banks), with Traveler’s Group, the massive brokerage, investment-banking, and insurance empire run by Sandy Weill.

  There was just one problem with the deal: It was technically illegal under the Glass-Steagall Act, which, as discussed at the beginning of this chapter, Weill had been campaigning for years to abolish.

  So as soon as the merger was announced, Weill and his team of lobbyists went to work in Washington. Rubin was one of their main contacts to do the job. One of the odd things about enlisting Rubin in this effort was that when he had been at Goldman he had argued against Glass-Steagall’s repeal. The reason: Creating a megabank like Citigroup would have put a partnership like Goldman at a megadisadvantage. But times were changing. Goldman was now in the process of going public—raising money and capital to grow and compete in the securities industry, where size mattered. And maybe more than that, Rubin didn’t want to remain in government forever. He wanted a job on Wall Street. In other words, Citigroup, with its “financial supermarket” business model—whereby it not only opened bank accounts to average people, made loans and mortgages, sold CDs and mutual funds, et cetera, but also sold insurance, traded bonds with the likes of Goldman and Morgan Stanley, underwrote public offerings, sold debt to large institutional clients, and did all the other activities that ordinary investment banks did—seemed like a perfect fit for Rubin in his postgovernment life.

  But first he would have to undertake his second bailout of Wall Street.

  “Yes, Gary, what is it?” asked Robert Rubin one Saturday afternoon in mid-September 1998. Rubin had been relaxing at his home in New York City when he received a call from Gary Gensler, a former partner of his at Goldman, who was once again working for him at Treasury as assistant secretary for financial markets.

  Gensler is one of those people in government whose power far outweighs his name recognition. There are many bureaucrats running around Washington, but there are very few who can say that they play a major role in controlling an industry that pumps out trillions of dollars in revenues each year. In other words, Gensler was the point man in the vast federal apparatus that monitors Wall Street when times are good and bails out the big firms when they aren’t so good.

  And the news from Gensler wasn’t good. The hedge fund Long-Term Capital Management (known as LTCM), run by trading whiz John Meriwether, had made massive profits in recent years from trading esoteric bonds based on computer models designed by Nobel Prize-winning economists. LTCM had made fortunes from exotic bets on little-known corners of the financial world, like Danish mortgage bonds, of all things. But now it was imploding, literally ready to collapse, because it had bet enormously wrong on the direction of everything from the bonds issued by the U.S., European, and Japanese governments to the share price of the Royal Dutch Shell petroleum company.

  Instead of letting LTCM fail—a move that true free-market devotees would advocate as a way to punish excessive risk taking and teach the gamblers not to gamble—Rubin’s idea was to bail it out. Once again, as with the Mexican peso, Rubin worried about systemic risk. Rubin was concerned about this possibility because the big Wall Street firms, which dealt with LTCM, piggybacked (i.e., copied) many of its trades and would lose massive amounts of money too.

  The panic selling an LTCM collapse, Rubin thought, would lead to massive losses in the market at all the major firms, including his old firm, Goldman Sachs. At least two firms, Lehman Brothers and Merrill Lynch, might take such heavy losses they might not survive. Goldman would have to postpone, maybe indefinitely, its IPO.

  As Rubin put it in his biography, In an Uncertain World, “In normal circumstances, the government shouldn’t worry about the tribulations of any particular firm or corporation. But if the situation threatens the financial system, some kind of government action might be the best among bad choices.”

  The solution that the Treasury and the Fed came up with demonstrated the true strength of the ties between the big Wall Street firms (or at least most of them) and their benefactors in Washington. The firms were summoned to the offices of the New York Federal Reserve Bank, the most important of the Fed’s regional banks because it provides oversight of the banking system and conducts “open-market operations” that control the nation’s money supply. The solution was pretty simple: The Fed was ready to pump money into the banking system in an effort to help eliminate the losses on the bad trades the banks had copied from LTCM. Each of the big banks (with the exception of Bear Stearns, whose CEO refused to join the effort) would each pony up around $300 million (Lehman Brothers could just afford $100 million) and buy the fund’s assets for $3.6 billion.

  Taken another way, they each spent hundreds of millions to save countless billions, because after a few hectic weeks and some modest losses at Merrill Lynch, Lehman, Goldman, and the rest, Wall Street recovered. It wasn’t just the dot-com bubble, then in full swing, that generated such massive profits for the Wall Street firms that took all those fleeting Internet companies public. The bond markets exploded as well, thanks to the Fed’s dumping all that money into the system with low interest rates. In the months after the LTCM collapse, Wall Street was standing tall. Combined with the revenues from underwriting dot-com IPOs, the soaring trading revenues breathed new life into Lehman Brothers and Merrill Lynch; Morgan Stanley had one of its longest periods of prosperity in years, as did Goldman Sachs, Rubin’s old firm, which finally completed its long-awaited IPO.

  With Wall Street on a roll, Main Street prospered as well. It didn’t matter that many of the dot-com stocks underwritten by the Wall Street firms would turn out to be busts. It didn’t matter that President Clinton’s chief regulator, Arthur Levitt, chairman of the SEC and the man charged with making sure mom and pop investors get a fair shake, seemed blind to this massive fleecing of the investment public. It also didn’t matter that the bond traders who were minting money once again by buying, selling, and packaging esoteric debt had been given the signal from government that they could take as much risk as they wanted without suffering the consequences.

  Everyone was happy, at least for the moment.

  It is impossible, of course, to know whether letting market forces take their course and allowing LTCM to fail would have created the type of financial tsunami that Rubin feared—the same tidal wave that nearly destroyed the system ten years later when Lehman Brothers was allowed to fail. Wall Street was smaller then, and the risk in the system from derivatives and the funky mortgage bonds that would doom the banks in 2008 was far, far less.

  But one thing is certain: By bailing out Wall Street, Rubin and his cohorts at the Federal Reserve essentially doubled down on moral hazard. It’s why, for example, insurance companies insist on deductibles or copayments; if they didn’t, customers would have no reason to, say, worry about getting into a car accident (aside from the possibility of personal injury) because they wouldn’t bear any cost for doing so. In the context of Wall Street, bailouts create a moral hazard by planting the idea in the minds of firms that if one
of their competitors is bailed out, they will be too if they run into trouble. As a result, these firms have no qualms about engaging in reckless and excessive risk taking.

  And yet first with the Mexican peso crisis and later with the LTCM bailout, the federal government was introducing moral hazard into Wall Street in a big way. Unsurprisingly, the risk taking on Wall Street would rise over the next decade to unprecedented levels. Until, of course, the system came crashing down.

  The dot-com bubble would end in 2000, and by the time President George W. Bush took office in 2001, a mild recession had set in, soon compounded by the September 11 terrorist attacks, which caused a major sell-off in the market. A new government was in power, but “Rubinomics” was administered from Washington once again. Following the attacks, the Fed began slashing interest rates to historic lows, igniting the bond markets once again and setting the stage for the biggest housing bubble of all time as banks, flush with cash, lent money to anyone with a heartbeat.

  Robert Rubin was at one of those banks.

  “I had a number of offers,” Rubin would later brag, “but Citigroup was the best.” Rubin, of course, was talking about his new gig at Citigroup, where he carried the amorphous title of “chairman of the executive committee.” Before he left the Treasury Department in July 1999, Rubin did several things. First, he began looking for a job on Wall Street. He held extensive talks with Hank Greenberg, the fair-minded but volatile CEO of insurance giant American International Group (AIG). They couldn’t reach a deal, Greenberg later said, because “I didn’t want to pay him $8 million a year to fly around the world.”