The Great Deformation

by David Stockman

  Blessed with no training or experience in business, accounting, finance, and the tottering auto sector, the big-game-hunting AUSA found this to be a violation of a pending accounting standard called EITF 02-16. The block letters meant that it was an “emerging” rather than a settled standard and that the profession was still divided, but Cantwell was certain that Collins & Aikman’s rebate accounting practices were criminal violations ordered by me.

  Put in mind of what Samuel Johnson once said about the gallows, I found that a criminal indictment did, indeed, concentrate my mind. At least it did so long enough to prove to the top US attorney that in 15 million pages of discovery there was not a shred of evidence that anyone at Collins & Aikman had violated EITF 02-16 or even heard of it.

  By then Cantwell had already fled the courthouse for a berth in a top-drawer white-collar defense firm for good reason: she had brought a groundless indictment that now had to be withdrawn by the mighty Southern District of New York. When the charges were withdrawn, the case was also dropped against eight other employees of my company whose lives, needless to say, had been ruined by a badge-toting prosecutor trying to leapfrog up a legal career path. Needless to say, the case also attracted the usual quota of class action lawsuits and piling on by the SEC. All of these cases were settled for $7 million in nuisance money without any trial or any denial or admission of wrongdoing in any of the venues involved.

  Yet during a multiyear battle to prove there was nothing wrong with Collins & Aikman’s accounting, I had extensive occasion to delve into every nook and cranny of its balance sheet and other financial statements and come face to face with the debt monster I had created in this case, and had been doing in the LBO business as a general practice for years.

  Stated simply, the company had no shock absorbers because every imaginable asset had been hocked and every dime of even quasi-discretionary expense had been cut. Thus, all of the receivables had been sold to GE Capital or to “fast pay” lenders who discounted future payments from shipments to the Big Three. Nearly all of the equipment including multimillion-dollar plastic molding machines in eighty worldwide manufacturing plants had been sold for cash and leased back, creating mandatory rental payments just like regular debt. Trade credit from suppliers had been pushed to the breaking point, and the balance sheet itself was freighted down with several different bank revolvers, a half dozen flavors of junk bonds, tax-exempt economic development bonds, and other debt exotica.

  And yet Collins & Aikman was typical, if not conservative. It had started out as an M&A roll-up of interior component suppliers in 2001 with leverage at 3.8X EBITDA, a ratio which was exceedingly modest by the standards of the LBO blow-off phase in 2006–2007. But the problem was that as the auto industry’s deflationary crisis intensified, the whole supply chain descended into an orgy of price cutting and for an overpowering reason: the fixed cost of debt service was so great that any business that produced “variable contribution” to debt service was the object of ferocious competition, even if the return on plant capital and corporate overhead was negative.

  As price cutting intensified in this manner, cost cutting followed right behind. Auto companies all the way up the chain to and including GM were literally throwing their future down the drain in order to generate cash in the present period, and head-count reduction was the go-to angle of first resort. In the case of Collins & Aikman, we had started with 32,000 employers and were down to 20,000 or so based on the same $4 billion annual volume of business when the crash finally came.

  I had actually moved into the CEO suite in Detroit in order to be expense-cutter-in-chief because I thought I knew how to do it and my fund had hundreds of millions invested in the company. What I learned was that one day at a time, the debt monster can cause rational executives to devour their own enterprise.

  We started by getting rid of long-term expenses like marketing, R&D, new business development, information services, and human resource people, and then any and every frill including employee cafeterias, lawn care services, and weekend heating. Yet as the pricing and revenue deflated, even that wasn’t enough and so soon pensions were slashed, 401k matching was eliminated, bonuses were terminated, employee health-care cost sharing was drastically increased, cell phones were curtailed and expense accounts cut to the bone, and much more.

  But the debt kept rising and pricing and cash flow kept falling. So then it got really serious. The sales force was gutted, the company’s well-regarded engineering ranks were drastically pruned, assistant plant managers were eliminated, and more than half of all executives making more than $100,000 per year were terminated and their jobs assigned to those who remained. By April 2005, the company had been picked to the bones and was an accident waiting to happen. In short order it did.

  In my early days in the LBO business I had taken to speech making about the wondrous efficiency and productivity-generating powers of debt. During most of the years at Blackstone and my own fund I went to quarterly board meetings and harassed managers about the need to cut more and “restructure” faster. In the final days at Collins & Aikman I had become a desperate ax wielder, red in financial tooth and claw from sacrifices made to the monster of debt.

  Only in exile did I see that Collins & Aikman was not simply a one-off accident or case of bad timing, but that it was an economic deformation that would never have occurred on the free market. Its mountains of debt and off-balance sheet leverage had been raised right in the heart of Wall Street via syndications led by JPMorgan, Credit Suisse, Deutsche Bank, GE Capital, and many more. They had been able to distribute this toxic paper to hundreds of banks, CLOs, high-yield mutual funds, pension managers, insurance companies, and just plain speculators because in the world of bubble finance economic risk was badly underpriced and high-yield paper was drastically overowned.

  In the end, upward of $100 billion of losses were absorbed by investors in auto sector equities and debt when the house of cards collapsed in the bankruptcy of every major Detroit company save for Ford and Johnson Controls. This should have been the lesson of a lifetime, a thundering wake-up call that cheap debt, the Greenspan-Bernanke Put, the huge tax bias for debt, and capital gains are a mortal threat to free market capitalism. They generate behaviors which ultimately destroy enterprises and wealth, even as speculators like myself, Mitt Romney, and the rest of the LBO kings and hedge fund complex extract windfall rents along the way.

  But the canaries which fluttered briefly in the mine shaft in September 2008 just dropped dead. That’s all. As will be seen in chapter 30, the auto industry was on fire with speculative windfall gains within months of the horrid bailout of GM and the Fed’s shift to all-out money printing in March 2009. So the Truman Show of bubble finance has entered yet another season. After the failed election of 2012 and the conservative party’s embrace of a standard-bearer who was actually a member of the cast, there is nothing to stop the final triumph of crony capitalism.

  Sundown now comes to America because sound money, free markets, and fiscal rectitude have no champions in the political arena. The very antithesis of bubble finance, they are anathema to the Wall Street machinery of speculation and rent seeking which insouciantly demands more debt and more money printing to keep the fatal game going.

  CHAPTER 28

  BONFIRES OF FOLLY

  Bernanke’s False Depression Call and

  the $800 Billion Obama Stimulus

  THE BLACKBERRY PANIC OF 2008 WAS INDUCED BY TWO MEN, BEN Bernanke and Hank Paulson, who were in the wrong high office at the worst possible time. Bernanke, like Greenspan, was weak and no match for the furies that came screaming out of the canyons of Wall Street when the great financial bubble, decades in the making, violently exploded during the Lehman failure. Paulson, in fact, was one of the furies and single-handedly neutered the GOP for its final capitulation to fiscal folly.

  Under the circumstances, Bernanke was the more dangerous, and his stint as monetary commissar made the maestro look good by comparison. Even
after Greenspan surrendered his gold standard virginity in the political fleshpots of Washington, he had remained a numbers-crunching monetary experimentalist. Most certainly, he would have paused in September 2008 to ascertain why the financial system was suddenly in apparent meltdown.

  By contrast, Professor Ben Bernanke was a doctrinaire academic who “knew” what was happening. Except what he knew was dead wrong. So in becoming yoked to Bernanke’s calamitous error the nation was victim of a terrible fluke.

  Virtually no one in the nation’s capital had initially viewed the sinking stock market averages and collapsing CDOs which greeted officialdom on the morning of September 15, 2008, as a flashback to 1930–1933. Reasonably informed observers understood that the market had closed the previous Friday only 10 percent lower than where it had been in January 2007 before the subprime trouble started, and that by comparison the stock market meltdowns of 1987 and 2000–2001 had been far more severe—three to four times more severe.

  Perforce, these two more recent crashes were far more pertinent to the contemporary financial system than that of 1929, and neither had led to a depression or even a significant recession. The nation’s economy, in fact, kept on growing for several years after the 30 percent stock collapse on Black Monday in 1987, and suffered only a minor hiccup during 2001–2002 in the wake of an even larger decline in the stock averages.

  So Bernanke’s depression mongering was on its face reckless and inexcusable, and leaves no doubt about his culpability for the fear-driven fiscal mania that soon enveloped Washington. Indeed, not one in a thousand of the politicians, policy players, and cronies who inhabited the nation’s capital were in mind of the Great Depression on the morning of the Lehman event.

  The threat of the Great Depression 2.0, and the madcap doubling of the Fed’s balance sheet from $900 billion to $1.8 trillion during the next seven weeks, got interjected into the discourse only because Bernanke claimed to be a scholar of those seminal events. Ironically, Ben Bernanke, the full-fledged Keynesian, invoked the moral authority of Milton Friedman, the implacable anti-Keynesian, to sanction his case.

  Within nine months, the empirical data would prove that what was actually happening on September 15 didn’t remotely resemble the circumstances after the 1929 crash, and that the idea the nation was threatened by the Great Depression 2.0 was specious nonsense. But by then it was too late. Even if the evidence could have been properly interpreted, the nation’s political system had already gone off its rails.

  The folk memory of the Great Depression had been in deep hibernation, but Bernanke’s invocation of it in the context of tumbling financial markets and the hysteria surrounding the passage of TARP brought it roaring out of the remote caves of financial history. The impact was incendiary; it was a full-throated cry of “Fire” in Washington’s crowded theater of special interest plunder and statist projects of economic stimulus and social uplift.

  The city’s plodding policy machinery was electrified. The urgent project of stopping the Great Depression 2.0 was the legislative equivalent of suspending the fiscal and economic rules. Opening the floodgates to any and all measures of intervention and bailout, Bernanke’s depression bugaboo thus installed crony capitalism as the conclusive algorithm of American governance.

  The danger to free markets and political democracy was overwhelming. Depression fighting triggered a great doubling down by all of Washington’s policy factions: monetarists, Keynesians, and Republican tax cutters alike. They all scrambled to implement more of the same when, in truth, the financial crisis was a repudiation of these very doctrines: monetarism had produced serial bubbles and had ruined capital markets; tax cutting had generated massive public debt and deep subsidies for leveraged speculation; and Keynesianism had remained an all-purpose excuse for government spending and fiscal profligacy. Now the nation’s bedraggled economy would get massive doses of all three of these poisonous medications.

  MORE HOUSING BAILOUTS:

  THE DISASTER WHICH WON’T QUIT

  In truth, the American economy was already booby-trapped with deformations that had resulted from the application of these doctrines. The housing sector was in ruins, for example, because it had been battered by endless ministrations of the state, all of which had the purpose of overriding honest housing prices and free market choices about whether to rent or own, spend, or save, live in big houses or small, and accumulate home equity or cash it out.

  As previously reviewed, Fannie and Freddie, the Federal Reserve, the tax code, and Wall Street had all conspired to preternaturally jack up housing prices by 180 percent between 1994 and 2007, thereby paving the way for a thundering crash that since then has wiped out upward of four-fifths of the bubble-era gain in many leading markets. Yet, in stubborn denial that any lesson had been learned and spurred on by Bernanke’s depression bugaboo, post-crisis policy has degenerated into a mindless scramble to prop up the remnants.

  Lack of homeowner skin in the game was the indelible lesson of the subprime fiasco, but the Federal Housing Administration (FHA) was soon wheeled onto the battlefield with a massively ramped-up mortgage insurance program based on up to 97 percent loan-to-value ratios (LTV). Consequently, FHA insurance exploded from $300 billion to more than $1 trillion during the four years ending in June 2011, dragging the nation’s taxpayers once again directly into harm’s way.

  With virtually no down payment cushion, FHA insured mortgages quickly lapsed into “negative equity” as housing prices continued to fall throughout the period. An American Enterprise Institute (AEI) study recently estimated that more than half of FHA mortgages are “underwater,” meaning that as the American economy continues to flounder, borrowers will send back the keys and default rates will soar.

  In fact, already nearly 17 percent of FHA’s 7.6 million borrowers are delinquent, and this rate will continue to rise as the giant recent tranches of new mortgages go sour. Accordingly, the AEI study projects that the FHA fund will require a $50 billion taxpayer infusion—a prospect that is not only appalling, but also demonstrates the unrelenting hold of crony capitalism on public policy.

  It is now blindingly evident that big down payments are essential to a healthy mortgage market. Even the boneheads who control congressional housing policy would not willingly embrace FHA’s 97 percent LTV policy if they were not indentured to the National Association of Realtors, the mortgage bankers, the home builders, the Appraisal Institute, and the rest of the housing lobby.

  Similarly, the shock stemming from the failure of Fannie and Freddie in September 2008 and the quarter-trillion-dollar price tag for its nationalization have not slowed down the government-sponsored enterprise (GSE) racket at all. In a desperate gambit to prop up housing prices, Washington nearly doubled the lending limit for qualified mortgages to $730,000. So, instead of winding down the GSEs, Washington insinuated them even more deeply into home finance. They accounted for 70 percent of all mortgages by 2011, a figure which rises to 97 percent when all government programs including FHA and Veterans Administration are considered.

  There was also the home-buyers’ tax credit scam, another brainchild of the Bush administration and a noisy anti–Big Government Republican senator from Georgia, Johnny Isakson. This boondoggle was utterly stupid as a policy matter, but in that benighted state it perfectly illustrates the end game of crony capitalism: it is a place where eventually there is no plausible public purpose at all. Special interest lobbies simply conduct naked raids on the treasury. In this case, the real estate brokers and home builders secured an $8,000 per household tax credit for so-called “first-time” buyers in a desperate attempt to stimulate churn in a housing market that was otherwise dead as a doornail.

  In the end, $30 billion was spent during 2009 and 2010, at a time when the federal deficit was soaring above $1 trillion, while the ranks of the poor mushroomed due to the Great Recession. Still, there was no effort to target inherently scarce federal dollars by a means test. Instead, the policy was “come one and all” for tax
payers with family incomes up to $250,000.

  It is hard to think of a more capricious use of public money than to gift $8,000 to a $150,000 household, for example, that had been a serial house flipper but had wisely stayed out of the market for thirty-six months, thereby qualifying as a “first time” buyer. Beyond that, 90 percent of the 4 million taxpayers who claimed the tax credit bought existing homes, meaning that the credit directly stimulated only a tiny amount of new construction and jobs.

  In fact, the program amounted to a giant, random reshuffle of the capital gains being scalped from the existing US housing stock. The evidence clearly shows that the expiration of the tax credit on a date certain caused housing transactions to be pulled forward and crest as the deadline approached. For instance, the monthly sales rate for existing homes soared from a rock-bottom recession level of 4.3 million (annualized rate) before the tax credit incepted to a peak of nearly 7 million prior to the original November 2009 deadline, and then fell back to the recession bottom after the tax credit’s final expiration.

  So it might be fairly asked why $30 billion was wasted fiddling the existing housing stock turnover rate by a few months. But that would be the easy question. This artificial acceleration of housing demand also caused a temporary pause in the downward housing price correction. So when the tax credit expired the plunge resumed, meaning that last wave of proud new home buyers it had “incentivized” was instantly underwater.

  This whack-a-mole effect was especially pronounced in the lower tier of the housing market. Between mid-2010 (when the final extension expired) and December 2011, housing prices in the bottom one-third of the market dropped by 20 percent in Minneapolis, 30 percent in Chicago, and 50 percent in Atlanta. Lower-end households who got lured into home ownership via the tax credit thus ended up taking it in the chops yet again.