Drastically overpriced debt is eventually smacked with painful losses on the free market, but not on a Wall Street served by compliant central bankers. When the Bernanke Fed bailed out Bear Stearns in March 2008, for example, it was sitting on tens of billions of impaired or worthless assets.
Among this financial sludge was $1.1 billion of the undistributed Extended Stay paper. Accordingly, the taxpayers of America through their central bank became the owners of busted bonds which, on the margin, had funded nearly half of Blackstone’s legendary profit on the sale to Lightstone.
In this saga of low-rent hotel rooms the evils of bubble finance are starkly revealed. It demonstrates vividly how the mega-LBO frenzy of the second Greenspan bubble escalated income and wealth to the top 1 percent, or in this case the top 0.0001 percent. But even more importantly it documents why Washington’s frantic bailouts after September 15, 2008, were so misguided and counterproductive.
The time was long overdue for a classic liquidation of the massive credit bubble which had built up since the 1980s. A generation of speculators who rode it to the peak needed to be unhorsed once and for all. And it could have been easily achieved: Bernanke only needed to ignore the Cramer rant which echoed throughout the canyons of Wall Street in August 2007 and, instead, order the Fed’s open market desk to sit firmly on its hands.
So doing, the Fed would have engaged in the right sort of “accommodation.” It would have facilitated Wall Street’s desperate need for a financial housecleaning, just as J. P. Morgan did with such sublime effect in October 1907.
By staying out of the Treasury market the Fed would have permitted short-term interest rates to soar, thereby laying low the financial meth labs all along Wall Street. Their toxic inventories would have been dumped into the market at fire sale prices; they would have had no choice because trading desks would have been faced with crushing double-digit funding rates in the repo and wholesale money markets—rates which would have been rising by the hour and threatening to soar to terrifying levels. That is how panics ended in historic times, and that’s why speculation did not become deeply embedded and institutionalized as it has in the age of bubble finance.
The result would have been a bonfire of speculative paper that would not have been forgotten for a generation. Every single investment bank, including Goldman, Morgan Stanley, and the embedded hedge funds at JPMorgan, Citibank, and Bank of America would have been rendered instantly insolvent and dismembered under court and FDIC protection. Speculators would have denounced the Greenspan Put for decades to come. No banking institution reckless enough to make $100,000 bridge loans against $35,000 hotel rooms would have reemerged from the conflagration.
Just as importantly, the bonfires would have largely burned out in the canyons of Wall Street. The nonfinancial businesses of Main Street would have been largely unscathed for four principal reasons.
First, after having already massively inflated its debt, from $4 trillion to $11 trillion during the fifteen years ending in 2008, the business sector needed to liquidate borrowings, not go into hock even further. A period of high interest rates and scarce new debt availability would have been economically therapeutic.
Secondly, at that moment in time viable and solvent businesses did not need cheap debt to finance productive assets. Huge sectors of the US economy centered on commercial real estate, retailing, hospitality, and other forms of discretionary consumer spending were already vastly overbuilt. A period of high-cost debt, therefore, would have dramatically reduced the rampant malinvestments of the Greenspan bubbles and forced businesses to fund only high-return projects out of internal cash flow or expensive long-term debt.
Thirdly, high interest rates would have shut down the multitrillion flow of new debt to financial engineering. As previously shown, buybacks, buyouts, and takeovers contribute little to real business productivity and growth of national wealth, and mostly serve to scalp economic rents from Main Street and channel them to the top 1 percent.
Finally, thousands of drastically overleveraged business like Extended Stay America would have been forced into bankruptcy but they would have nevertheless continued to function under court protection. More importantly, they did not need Wall Street to reorganize their finances. Several trillions of business debt that had been incurred to fund LBOs, stock buybacks, and corporate takeovers could have been repudiated by debtors in bankruptcy court and replaced by simplified, equity-based capital structures.
Businesses thus freed from the yoke of Wall Street–originated debt would have emerged from Chapter 11 and have been controlled by the knowledgeable businessmen and skilled employees who had operated them all along. The American economy would thereby have embarked on the road to definancialization. Real economic productivity, investment, innovation, and growth based on honest free enterprise might have again become possible.
Instead, after the Lehman event, the madcap money printing of the Bernanke Fed and the bailout frenzy of the Paulson Treasury Department stopped the Wall Street cleansing in its tracks. The only thing that changed was that the remnants of the “departed”—Bear Stearns, Merrill Lynch, Lehman, Wachovia—were recycled back into the even greater girth of the “reprieved”—Goldman, Morgan Stanley, JPMorgan, Bank of America, Barclays, Citigroup, and Wells Fargo.
The system which finally failed in September 2008 was actually reincarnated in even more destructive aspect. The Bernanke Put was far more insidious than the Greenspan Put because it refused to permit even a 10 percent correction in the stock averages before pumping a new round of juice into Wall Street.
Likewise, the carry trade became an even more one-sided gift to speculators: risk assets could now be funded in the wholesale money markets for virtually nothing, while hedge fund operators were solemnly promised by the monetary central planners that their cost of carry would be frozen at nearly zero for years on end.
BLACKSTONE DOUBLE DIP
But the worst effect was that the Wall Street machinery and principal participants in the financial engineering régime were soon back in business. This cardinal reality was made starkly evident in the court papers issued upon Extended Stay America’s discharge from bankruptcy in May 2010. The hotel company’s proud new owner was, well, the Blackstone Group. And to underscore that speculators had returned to the scene of the prior strangulation, as it were, its partner in the deal was the John Paulson hedge fund.
The ever gullible financial press was wont to characterize this outcome as a triumph of capitalism; that is, the mobilization of flexible private equity capital to reorganize and recapitalize a failed business enterprise. But that was dead wrong because the Blackstone-Paulson partnership didn’t recapitalize anything. What it did, instead, was utilize the same cadre of Wall Street lawyers and bankers to shrink and shuffle the busted debt paper from the Lightstone deal into a new deck of about $3.5 billion of notes, bonds, and preferred stock.
The second Blackstone deal, therefore, brought only trivial amounts of actual fresh equity—a couple hundred million—to the table. The Blackstone-Paulson investors essentially performed the same old trick that had become standard fare before the Wall Street crisis: they bought another call option on a debt-laden enterprise that was leveraged at 10:1.
Whether the resulting 50 percent haircut on the total capitalization, from $8 billion to about $4 billion, was the right value for the 76,000 aging hotel rooms in the Extended Stay portfolio would be determined by real-world events. But the underlying facts were not encouraging: the financial deformations that had led to Extended Stay’s boom, crash, and rebirth had produced a giant malinvestment in the overall hotel sector.
In fact, the ultimate indication that the Wall Street playpen known as the US hotel sector is not on the level lies in a startling statistic: there are 13.2 million hotel rooms in the world, and 5.6 million of them are located in the United States. Thus, with 4 percent of the global population we have 42 percent of the hotel rooms.
The American economy is drastically overhote
led in part because a significant swath of its labor force has become nomadic. Some of this may be attributable to new-style traveling tech workers and old-style traveling salesmen. But mainly it is due to a drastic policy-induced deformation. The Fed’s massive creation of dollar liabilities drove tradable goods production to the mercantilist “cheap labor” regions of the Asian rice paddies. At the same time, it fueled an orgy of real estate development and construction on the “cheap land” precincts of the sun and sand belts at home.
As previously explained, at least 10 million tradable goods jobs had been off-shored during the Greenspan era, meaning that jobs had become scarce where people used to live (Flint, Michigan). At the same time, the debt-fueled boom in the Sunbelt—health care, retirement communities, resorts and leisure, and endless construction of new housing developments, shopping malls, and other commercial real estate projects—happened on the margin, where people didn’t yet live (Ft. Myers, Florida).
Not surprisingly, the extended-stay hotel segment, where business travel accounts for 75 percent of room night demand, grew like Topsy during the two Greenspan bubbles. It provided a way station for nomadic workers and populations in transit. As in the case of all malinvestments, however, the music eventually stops when the speculative bubble which finances them implodes. That has now happened, thereby causing the ranks of nomadic finance, construction, leisure industry, and retail and consumer service workers to significantly diminish.
Accordingly, the extended-stay hotel segment remains overbuilt and overvalued a half decade after new construction peaked. Yet the Fed’s ZIRP (zero interest) policy perversely thwarts the free market’s curative capacities to punish speculation and liberate assets from the encumbrance of excessive debt. Instead, it perpetuates the “extend and pretend” illusion that the debt is money good because it encumbers an asset that is vastly inflated in value.
ECONOMIC SUFFOCATION BY BERNANKE’S RENTIERS
In effect, Bernanke is the godfather of the debt zombies. His radical interest rate repression campaign has not created much new lending, but it has disabled and overridden the free market’s capacity to liquidate bubble-era credit. Instead of taking the drastic debt write-downs which are warranted, banks and other lenders have been enabled to pursue the “extend and pretend” route; that is, extending maturities on debt that can never be repaid while booking it at par because borrowers stay current on interest payments.
The low interest rates on bubble-era debt, as well as post-crisis restructured debt, are laughable by all historic standards. Banks should be reserving heavily against the maturity cliffs ahead, but are not being required to do so owing to the utter folly emanating from the Eccles Building; namely, the Fed’s fatuous promise that one day it will be able to “normalize” interest rates without triggering a debt-impairing conflagration on Wall Street and another plunge on Main Street.
So by not taking the deep reserves required, Wall Street banks are (again) reporting phony profits. Indeed, led by JPMorgan they are massively reversing out reserves they had previously taken in order to goose their earnings and levitate the value of executive stock options. And phantom banking profits are only the surface issue.
The real economic problem is that by keeping properties and businesses encumbered with too much restructured and rescheduled zombie debt—as was evident in the so-called restructuring of Extended Stay America by Blackstone and Paulson—free cash flow is siphoned off to pay what are essentially unearned rents. These ill-gotten receipts are collected by Keynes’s famous rentiers who nowadays are called PMs (portfolio managers) at fixed-income funds.
Stated differently, bubble-era properties and companies are being bled to death by uneconomic interest payments and thereby precluded from reinvesting in plant, equipment, technology, new products, human resources, and all the other ingredients of sustainability. After a decade as a debt zombie, therefore, the typical commercial property will have lapsed into a state of terminal decay and the typical operating business will have become a hollowed-out cipher.
None of this would have been a surprise to pre-Keynesian-era economists because they knew that credit inflations are tricksters. They fund artificial demand which gives rise to secondary and tertiary waves of additional demand, usually to build new infrastructure and production capacity that ends up redundant when the bubble pops.
This crack-up boom cycle so well known to the ancients was vividly at work in the extended-stay hotel segment. At the peak of the bubble, nomadic workers in construction, finance, and real estate were actually creating part of their own demand; that is, they were filling rooms that justified even more construction. Yet developers couldn’t fill up rooms with their own workers indefinitely, nor could the Fed permanently extend the speculative building mania in commercial real estate.
As a result, the nation is now saddled with vastly more capacity—malls, lodging, restaurants, car dealerships, office buildings, movie houses—than can be justified by the sustainable income and spending capacity of the American economy. Ironically, the monetary central planners take this overhang as evidence of insufficient “demand” and therefore a need for more money printing. Like nineteenth century practitioners of the bleeding cure, they single-mindedly press ahead toward the patient’s eventual demise.
PART V
SUNDOWN IN AMERICA:
THE END OF FREE MARKETS
AND DEMOCRACY
CHAPTER 27
WILLARD M. ROMNEY AND
THE TRUMAN SHOW
OF BUBBLE FINANCE
THE 2012 PRESIDENTIAL ELECTION SIGNALED THE ONSET OF SUNdown in America, and not merely because an avowed big-spending statist won the race. Rather, it’s because the Republican candidate proved in words and lifelong deeds that there is no conservative party left in America—at least not one that is willing or able to defend sound money, free markets, and fiscal rectitude. So the drift into the crony capitalist end game will now accelerate, suffocating what remains of free market prosperity and honest political democracy.
Mitt Romney made numerous revelatory choices in his quest for the Oval Office and they unfailingly showed that the old-time conservative economics cannot be revived. Gerry Ford would never have bailed out GM, and Bill Simon would have busted down the door to the Oval Office if his president had even mentioned it. And for good reason. As will be seen in chapter 30, the auto bailout was a frontal assault on the free market: the GOP candidate should have denounced it from the rooftops as an $80 billion theft from innocent taxpayers.
Yet candidate Romney tried to bury the issue. Mumbling a tortured retreat from his 2008 “Let Detroit Go Bankrupt” editorial, he insinuated that his disagreement with Obama was on the bankruptcy venue, not the bailout. The reason that Romney did not take what was a defining issue of our times to the nationwide electorate was obvious enough: his handlers believed that finessing the auto bailout was crucial to Ohio and to the outcome in the electoral college.
And that it why all is lost. The bailout “saved” perhaps 10,000 jobs in Ohio, a figure that represents two-tenths of 1 percent of the 5 million votes cast there. So Romney’s de facto flip-flop on the auto bailout was both a profile in cowardice and proof that the Republican political apparatus believes that the party’s core free market principle is an electoral loser.
Romney’s assault on fiscal rectitude, likewise, would have made Eisenhower shudder and George Humphrey turn apoplectic. The true issue of the 2012 campaign was the exploding national debt, and the true facts were that honest ten-year fiscal projections produced cumulative deficits of $20 trillion. As will be seen in chapter 33, that would be the mathematical result of Republican tax policy and the welfare state–warfare state status quo based on an “unrosy” scenario; that is, a ten-year forecast identical to the US economy’s actual performance during the last ten years.
Facing this terminal challenge to fiscal solvency, Mitt Romney choose to double down on the GOP’s tax-cut elixir, proposing a 20 percent rate reduction on top of th
e Bush tax cuts which had already added trillions to the national debt. K Street greeted with mirthful nonchalance his ritual promise to recoup the $5 trillion revenue loss by closing tax “loopholes,” duly noting that the candidate did not name a single one of them out loud.
ROMNEY’S RYAN COP-OUT
But Romney’s true fiscal dereliction was on the spending side of the budget, where the welfare state and warfare state status quo got a hearty embrace. The proof, oddly enough, was in Romney’s adoption of the Ryan budget as his fiscal plan and its author as his running mate. Notwithstanding Democratic arm-waving, the Ryan budget provided that not a single recipient of Social Security or Medicare would face benefit cuts for a decade.
The GOP’s fiscal plan of 2012 for all practical purposes, therefore, gave final bipartisan validation to FDR’s eighty-year-old mistake in enacting social insurance. So doing, it put the lie to Ryan’s pretensions to being the scourge of Big Government. It also revealed that what passed for the GOP anti-spending agenda was a brutal, unprincipled attack on the means-tested safety net, a position that candidate Romney famously and perhaps inadvertently crystallized in his lament about the 47 percent.
The ten-year projection for total domestic spending at election time was about $33 trillion and its internals illuminate why the Ryan budget amounted to a declaration of class war, even if its earnest author was simply trying to come up with a big number for budget “savings.” The social insurance core of the welfare state, Social Security and Medicare, account for nearly $19 trillion, or 55 percent, of all projected domestic spending in the next decade. Hiding behind the phony rigmarole of trust funds and insurance argot, Ryan gave social insurance a free pass through 2022, notwithstanding that trillions of this huge expenditure would go to upper-income and wealthy retires who hadn’t earned it and didn’t need it.
The Great Deformation Page 75
