Like the operators of McDonald’s drive-through windows, brokers simply tapped the screen and another serving of home mortgage loans would instantly appear. Brokers then obtained the money for loan disbursements to homeowners simply by drawing down their warehouse lines until enough volume was achieved to facilitate a block sale of freshly minted mortgages to their Wall Street partners. The latter then completed the securitization and distribution process, harvesting generous fees and markups at each step along the way.
At the peak of the housing boom, outstanding warehouse lines offered by the top Wall Street houses soared to several hundred billion dollars. These huge credit lines constituted an efficient financial superhighway to transport truckloads of sketchy mortgages from Main Street America directly to Wall Street.
Needless to say, the operators of these fly-by-night mortgage-stamping machines were not “bankers” in any traditional sense of the word—they had no skin in the game. Wall Street actually even went further, hiring traditional banks to write subprime and other riskier mortgages. It then periodically bought all the resulting loans on a wholesale basis, meaning that what remained of George Bailey’s Savings and Loan was enlisted in the rinse-and-repeat style of mortgage lending as well.
Accordingly, the residential loan books of the commercial banking system were surprisingly clean, even as the securitized mortgage meltdown gathered force in the fourth quarter of 2008. At that point, total commercial bank assets were $11.6 trillion. Yet only $200 billion, a tiny 1.7 percent of total assets, consisted of “toxic assets”; that is, private-label mortgage-backed securities of the type originated by the Wall Street securitization machine and which were now plummeting in value.
Furthermore, these minor holdings of toxic private-label mortgage assets were dwarfed by commercial banking system investments of nearly $1 trillion in Fannie Mae and Freddie Mac mortgage-backed securities. These “agency” backed mortgage securities had always been considered blue chip credits and a close imitation of Treasury bonds, and had officially become “risk free” upon the US government’s nationalization of Freddie and Fannie.
From a big-picture perspective, then, the nation’s hinterland banks had played a pretty good hand of mortgage finance poker. First, they had sold off most of their subprime originations to the Wall Street securitization machine. Next, they largely avoided reinvesting in the garbage securities Wall Street crafted from these subprime loan pools. And finally, they backfilled their investment accounts by buying mortgage securities wrapped with Uncle Sam’s money-good insurance via the Freddie and Fannie guarantees, not the bogus kind sold to Wall Street and the European banks by AIG.
WHY THE MAIN STREET BANKS WERE MONEY GOOD
The commercial banks had retained on their own balance sheets about $2 trillion of residential mortgages and home equity lines of credit. But these mortgages were overwhelmingly of prime credit quality and had stayed on the books as “whole loans,” rather than having been sliced and diced into tradable securities. So as the economy tumbled into recession and average home prices plunged by 35 percent, any elevation of losses would be charged to loan loss reserves and written off over years, not sold at fire-sale prices on Wall Street’s crashing market for securitized paper. The commercial banking system was not vulnerable to a panic, just a slow multi-year resolution.
In short, the GSE securities plus the whole mortgage loans added up to $3.2 trillion in housing assets, but the Freddie–Fannie (GSE) paper was money good and the whole loans were higher quality and were backed by substantial loan loss reserves required by regulators. So the Main Street commercial banking system was surprisingly well insulated from the putative financial “contagion” on Wall Street.
Much the same can be said for the remaining $6 trillion of non-home mortgage assets which sat on commercial bank balance sheets at the time of the crisis. About $1.6 trillion of this was low-risk revolving and term credit to business and industry known as “C&I (commercial and industrial) loans.”
Most of these business loans occupied the senior slot, or the highest payment ranking, in borrower capital structures and usually had a first lien on the operating assets of the borrower’s business. So the risk of loss was modest, and the prospect of a C&I loan meltdown was essentially nonexistent. In fact, the truly risky business credit, $1.5 trillion of then-outstanding unsecured and subordinated debt, was all in junk bonds, and nearly all of these were owned by institutional investors and mutual funds, not banks.
The story was much the same in the case of the commercial real estate loan books of the Main Street banks; that is, loans on office buildings, strip malls, retail properties, and housing land acquisition and development. Once again, nearly half of the $3 trillion in outstanding commercial real estate debt had been sold to Wall Street, where it had been securitized and packaged into commercial mortgage-backed securities (CMBSs). By the time of the crisis, these hot potatoes were languishing unsold on Wall Street balance sheets or stuffed into the portfolios of pension funds and insurance companies, but they were no longer in the loan books of the Main Street banking system.
The commercial banking system had retained about $1.7 trillion of whole loans in the various commercial real estate categories, but there was little risk of a selling contagion. Most of these loans were “interest only” with a five-to ten-year bullet maturity, meaning that it would take years for borrowers to run out of cash and default on interest payments when failed strip malls and unfinished subdivisions eventually became foreclosures. That prospective slow bleed-off was irrelevant to the bonfires which raged on Wall Street in September 2008.
Indeed, busted commercial real estate loans have accounted for most of the five hundred bank closures conducted by the FDIC in the years since the crisis. Yet all of these shutdowns were orchestrated over weekends with such clockwork precision that hardly a single retail depositor anywhere in the nation was ever alarmed. Unlike Wall Street’s hot money funding, Main Street loan portfolios were bedded down with high-persistency deposits. Losses would be realized over time through the bleeding cure, not a fire sale.
The remaining $2 trillion of assets on the commercial banking systems balance sheet as of October 2008 were not even remotely exposed to contagion risk. About $1 trillion of this total consisted of credit card, auto, and other consumer loans that were well secured with collateral and provisioned with deep loss reserves. The other $1 trillion consisted overwhelmingly of US Treasury securities and investment grade corporate bonds.
The workout in the commercial banking sector, therefore, has turned out to be a slow-motion write-down, not a red-hot meltdown of the type which afflicted Wall Street. There was no basis for a retail bank run and never would have been one in the absence of TARP.
This outcome was readily ascertainable in September 2008, by means of a cursory examination of the collective balance sheet of the nation’s non–Wall Street banking system. There was absolutely no reason for panic about the financial “contagion” spreading to Main Street banks. Nor was there any excuse for suspending the normal rules which required the FDIC to close failed banks and to completely wipe out debt and equity security holders.
THE URBAN LEGEND OF SKIPPED PAYROLLS AND DARK ATMS
Another false vector of the contagion story centered on the panic in the money market mutual fund sector and the resulting drastic shrinkage of the commercial paper market. It was from this chain of events that the urban legend arose about ATMs going dark and business payrolls being skipped. In truth, the commercial paper market had become a giant bubble and needed to be cut down to size, but the implication that this necessary unwind had brought the payments system to the verge of collapse was not even remotely accurate.
In fact, after Congress courageously voted down the first TARP bill, the orchestrators of the bailout, Chairman Bernanke and Secretary Paulson, cynically deployed these payments freeze horror stories to spook congressmen and other policymakers into falling in line. As Senator Mel Martinez recalled their pitch, �
�I just remember thinking, you know, Armageddon … if these guys in the middle of it … believe this to be as dark as they are painting it, it must be pretty darned dark.”
Senator Martinez’s recollections reveal the true contagion: it was the contagion of fear which two panic-stricken men, Bernanke and Paulson, spread through the nation’s capital like wildfire during the hours after the Lehman failure. Yet nothing like the financial nuclear meltdown alleged by Washington officialdom ever occurred or threatened.
The heart of the false panic was rooted in the money market mutual fund sector. Total short-term deposits at the time of the crisis had reached a big number: $3.8 trillion. So an honest-to-goodness “run” by investors would have been scary indeed. It turns out, however, that the “run” amounted to little more than a circular movement of cash among different money market fund types, with virtually zero impact on the Main Street economy.
As it happened, roughly $1.9 trillion, or half of total money market deposits, were held in a category of fund which invested exclusively in US Treasury and agency debt or tax-exempt muni bonds. During the entire period of the Wall Street crisis, this “governments only” segment of the money market fund industry experienced no losses or investor liquidations whatsoever.
By contrast, the other $1.9 trillion was in “prime” funds. In addition to investing in safe government securities and bank CDs, the prime funds were also permitted to hold commercial paper, thereby slightly enhancing interest rate yields compared to purely government funds.
During the several weeks after the Lehman failure about $430 billion, or slightly less than 25 percent of deposits, fled the “prime” fund half of the industry. This flight was triggered when the largest and oldest of these funds, the Reserve Prime Fund, announced that it “broke the buck” owing to the fact that about $750 million of its $60 billion in assets had been invested in Lehman commercial paper. Yet obscured in the hubbub was the fact that the resulting losses were tiny—just 3 percent of assets. In reality, breaking the buck was a money fund marketing pratfall, not the precursor to Armageddon; it amounted to a modest wake-up call disabusing investors of the industry’s phony claim that money market accounts were absolutely safe and immune to loss.
So the unexpected shock from the Reserve Prime Fund’s breaking the buck triggered a “run” on the prime funds of significant magnitude during the week or two after September 15. Yet according to the Financial Crisis Inquiry report, most of this so-called flight money did not get very far; that is, 85 percent, or $370 billion, of this outflow simply migrated to what were perceived to be safer “government only” money market funds.
In truth, the “run” was almost entirely within the money market mutual fund sector, with the debit going to the “prime” funds and the credit to the “government” funds. Indeed, this migration frequently involved nothing more than investors hitting the SEND button! They simply moved their deposits between these two types of accounts at the same fund management company.
Bernanke, Paulson, and the other bailsters focused exclusively on the gross outflow from the prime funds and waved this $430 billion bloody shirt incessantly. Needless to say, they did not bother to tell Congress that only a net amount of $60 billion, or 2 percent of total assets, had actually left the money market fund industry during the three weeks before the October 3 TARP vote.
Nor did they mention that most of the $60 billion which did leave the money market sector had gone into CDs and other bank deposits, and that none had ended up in mattresses. Moreover, all of this data was published in real time by the Investment Company Institute, so it should have been evident to policy makers, even in the heat of the crisis, that the circular flow from “prime” funds into “government only” money funds and banks (which got the $60 billion) posed no threat whatsoever to financial system stability.
CHAPTER 3
DAYS OF CRONY CAPITALIST PLUNDER
THE APPROXIMATE 25 PERCENT SHRINKAGE OF THE PRIME FUNDS did induce a painful corrective adjustment. In this case, the hit was to the commercial paper market, but the ensuing correction was all about losses on Wall Street, not harm to Main Street.
On the eve of the crisis about $650 billion, or one-third of prime fund assets, were invested in commercial paper, making these funds the largest single investor class in the $2 trillion commercial paper market. Consequently, when the wave of money moved from prime funds to government-only funds which could not own commercial paper, open market rates on the A2/P2 grade of thirty-day commercial paper spiked sharply. Loan paper that had yielded only 1 percent prior to the spring of 2008 suddenly soared to over 6 percent during the September crisis.
Any garden variety economist might have suggested that commercial paper had been seriously overvalued. The flight from prime funds was living proof that the market had been artificially buoyed by big chunks of demand from what were inherently risk-intolerant prime fund investors. Now, the commercial paper market was in a violent rebalancing mode, causing borrowers to experience the joys of “price discovery” as interest rates sought a higher, market-clearing level.
THE REAL BAILOUT CATALYST: JEFF IMMELT’S THREATENED BONUS
At that particular moment, however, General Electric CEO Jeff Immelt was apparently in no mood for a lesson in price discovery. In fact, he was then learning, along with the rest of Wall Street, an even more painful lesson about the folly of lending long and borrowing short. Notwithstanding that General Electric was one of just a handful of AAA-rated American corporations, it was suddenly discovering that its hugely profitable finance company, General Electric Capital, was actually an unstable house of cards.
GE Capital’s financial alchemy rested on a simple but turbocharged formula straight out of the Wall Street playbook. At the time of the crisis, GE Capital boasted $650 billion of financial investments from customized deals in real estate, equipment leasing, working capital finance, and private equity. While these highly proprietary investments yielded generous rates of return, they were also highly illiquid and prone to blow up at higher than normal loss rates, thus bearing an asset profile that called for generous amounts of equity capital funding. In fact, however, GE Capital’s massive balance sheet was leveraged nearly 10 to 1 and included upward of $100 billion of short-term commercial paper.
Needless to say, this huge load of commercial paper carried midget interest rates (4.7 percent), which helped fuel impressive profit spreads on GE’s assets. But this ultra-cheap CP funding also bore short maturities, meaning that GE Capital had to rollover billions of commercial paper debts day in and day out.
When commercial paper rates suddenly spiked during the Lehman crisis, GE was caught with its proverbial pants down. But rather than manning-up for the financial hit that his company deserved, Jeff Immelt jumped on the phone to Treasury Secretary Paulson and yelled “Fire!”
Within days, the sell-off in the commercial paper was stopped cold by Washington’s intervention, sparing GE the inconvenience of having to pay market rates to fund its massive pool of assets. The Republican government essentially nationalized the entire commercial paper market.
Even a cursory look at the data, however, shows that Immelt’s SOS call was a self-serving crock. His preposterous message had been that the commercial paper market was seizing up and that GE was on the edge of collapse—a risible proposition. Nevertheless, that assertion quickly became gospel among panic-stricken officialdom, and from there it rapidly spread to Wall Street and the financial press.
Not surprisingly, even two years later when the dust had settled and facts were readily available to refute this horary untruth, Secretary Paulson insisted upon repeating the GE legend in his memoirs. Describing round the clock staff activities on Wednesday, September 17, he noted that “our most pressing issue” had been to “help the asset-backed commercial paper market before it pulled down companies like GE.”
That was garbled nonsense. GE was not even a significant issuer of “asset-backed commercial paper” (ABCP). Those small a
mounts it did issue ($5 billion) were non-recourse and self-liquidating, meaning that GE Capital would have already passed ownership of the embedded assets to the ABCP conduit and its investors would have taken a hit, not GE.
By the same token, it was a huge issuer of unsecured commercial paper (100 billion), but even that was not remotely capable of felling the mighty GE. The required rollover funding was less than $5 billion per week, which was petty cash for a $200 billion (sales) global corporation with an AAA credit rating.
Although GE was not heading into a black hole, it was facing the need for a painful bout of liquidity generation which would have required either a fire sale of some of its sticky assets or a highly dilutive issuance of long-term equity or debt capital. Both courses were feasible, but each would have resulted in a sharp blow to earnings and top executive bonuses.
Instead of allowing the free market to resolve the matter, however, the taxpayers were thrown into the breach in still another variation of stopping the alleged “run” on Wall Street’s cheap wholesale funding. Again, a necessary and healthy market correction was cancelled while the cronies of capitalism were kept in the clover.
WHY THE ATMS WOULD NOT HAVE GONE DARK: THE SECRET OF “GAIN ON SALE” ACCOUNTING
The commercial paper bailout incited by Jeff Immelt was utterly unnecessary. The facts show that the bailsters conjured up still more economic goblins where none actually existed. What the commercial paper bailout mainly did was prop up the banking industry’s “gain on sale” profit scam.
The single most salient fact about the $2 trillion commercial paper market was that upward of $1 trillion was accounted for by the aforementioned ABCP, or asset-backed commercial paper segment. This was just another form of securitization, and it amounted to the financial equivalent of a twice-baked potato.
The Great Deformation Page 6
