New York City recruiting office - 23rd & Broadway (Flatiron Building).
Ilargi: Of course I sympathize with the people who are trying to get through to their Congressmen and Senators with petitions and pleas and plans, screaming for them not to accept the $700 billion -at any one time- Paulson plan. I sympathize because they are dead right: it’s so bad as to be disgusting.
What they don’t seem to realize is that their representatives have no choice. Not if they want to keep their jobs, that is. Whichever party would let the plan fail, is assured of a gaint sized mud bucket full of blame for the financial mayhem that will cripple the US economy between now and the election. And there will be a lot of that: I would suggest you look upon the Paulson plan as a way to divvy up the spoils of war while the bombs have only just started dropping.
It doesn’t matter that the mayhem will come anyway, whether there’s a plan or not. If they vote for it, they can claim they’ve done all they could, and followed the advice of the finest experts the country has to offer. And the other party did the same.
Voting the Paulson plan down equals losing the election. Sure, there will be discussions, some heated and frantic, but believe me, nobody wants to rob their party of any and all chances at winning the presidency. That is why the plan will be there later today, even if there must certainly be a few elected heads being severely scratched.
The people who have contocted the plan are obviously aware of all this. There is no time to discuss alternatives, not 6 weeks before the election. Political Check Mate.
The entire system is based on appearances, not truth finding. In the same vein as a company CEO who can’t reveal the true problems his company may be in, because his first duty is to protect the value of the shareholders, politicians simply can’t speak the truth.
If anyone stood up and told the people the real story, that their country, their welfare, and the future of their children is rapidly being gift-wrapped in a hell-bent handbasket, they’d unleash a storm of biblical proportions. And even if they’d miraculously survive that ordeal, people would move away from them and vote for the nexy guy, who promises solutions and money and sunny days and whatever else the people like to hear.
Yes, both the CEO and the politician have the option of getting out of their positions. But that doesn't change what's wrong: the next liar will simply take over.
The truth doesn’t have a place in US politics. If I may paraphrase Jay Hanson: "Democracy only works until the people figure out they can vote themselves an ever larger piece of the pie". We are today finding out that, alas and unfortunately, the pie itself does not get ever larger.
Nice try, the USA. But fatally flawed from the start.
Bank-Rescue Compromise Plan Is Under Review by U.S. Lawmakers
U.S. lawmakers are reviewing a tentative agreement to revive credit markets by authorizing a $700 billion plan to buy troubled assets from financial institutions.
"The deal is done," Senator Judd Gregg, a New Hampshire Republican, a ranking member of the Budget Committee, said this morning. The House and Senate may vote tomorrow, Gregg said. Still, Republican House members are waiting to see the compromise proposal written into legislation before making a final decision to support it, said Representative Eric Cantor of Virginia. "We're waiting to see what this looks like on paper to see if we have an agreement," Cantor said.
The negotiations were completed about midnight when lawmakers agreed to require the president to offer a plan to recoup any loss to the taxpayers after five years, said a Democratic congressional aide. That clause was intended to address concerns about the cost of the program.
The agreement alters the Bush administration's original request for unchecked authority to purchase distressed debt securities from financial companies reeling from the record number of home foreclosures. That plan evoked a blizzard of emails and phone calls from voters outraged at being asked to foot the bill for the mistakes of Wall Street investors.
During weeklong negotiations, lawmakers reduced the initial cost by half to $350 billion, with the remainder to be authorized later, and they added provisions creating an oversight structure and help to homeowners facing foreclosure.
The compromise also includes a proposal by House Republicans, whose objections scuttled an earlier agreement in principle, that provides for government insurance for mortgage- backed securities. The plan also imposes limits on the compensation of executives at participating companies.
"It will be the first time in American history that there will be legislative restrictions on CEO compensation," said House Financial Services Chairman Barney Frank, Democrat of Massachusetts. Lawmakers want to announce a firm agreement before Asian financial markets open late today, Senate Majority Leader Harry Reid said. The deadline reflects concern that markets will be further rocked by lack of an agreement after the Standard & Poor's 500 index recorded its largest weekly drop since May.
Treasury Secretary Paulson last night said the proposed deal "will work and be effective." More work needs to be done, "but I think we're there," he said.
Paulson and Federal Reserve Chairman Ben S. Bernanke proposed the plan after the collapse and bankruptcy of Lehman Brothers Holding Inc. and the Federal Reserve's takeover of American International Group Inc. earlier this month. They said it was needed to revive lending and restore the flow of credit to the U.S. economy.
President George W. Bush warned yesterday that legislative action was needed to avoid a "deep and painful recession."
Bush spokesman Tony Fratto said early this morning that administration officials are "pleased with the progress tonight and appreciate the bipartisan effort to stabilize our financial markets and protect our economy." He said Bush had spoken last night with House Speaker Nancy Pelosi on the negotiations.
The proposal immediately provides $250 billion, and another $100 billion could be used at the request of the president. Congress would have to review the expenditure of the remaining $350 billion, according to an outline distributed to reporters. The package includes a provision aimed at "preventing golden parachutes" for executives of companies who leave firms that have sold troubled assets to the government, said Senator Kent Conrad, a North Dakota Democrat.
Companies that sell debt to the government will issue stock warrants to the government so that taxpayers "can gain as companies recover" from economic difficulties, Conrad said. House Republicans initially balked at the cost of Paulson's plan. Missouri Representative Roy Blunt, the lead negotiator for House Republicans, said his colleagues wanted to "bring both free-market principles and taxpayer protections to the table." "I think we will be able to have an announcement" later today, Blunt said.
Republican leadership aides said that provisions favored by unions that own significant stakes in companies through pension plans were dropped. That includes a requirement for shareholder votes on executive-compensation issues. At one point during the negotiations, billionaire Warren Buffett spoke by telephone to a lawmaker involved in the talks to offer "his best thinking about market reaction to various things," said Conrad. "People are trying to reach out to the best minds that they know."
Presidential candidates Barack Obama and John McCain backed the compromise. "My inclination is to support it," Obama, a Democrat, said on CBS' "Face the Nation." Obama said the agreement reflects his core concerns by putting limits on executive compensation, providing congressional oversight and protecting taxpayers.
McCain urged lawmakers to "swallow hard" and support the proposal in an interview today on ABC's "This Week" program.
"Let's get this deal done, signed by the president, get moving," McCain, a Republican, said. "It's going to restore confidence and get some credit out there, get this economic system moving again, which is basically in gridlock today."
'We're there,' says Paulson as Wall Street prepares for $700 billion bail-out
Lawmakers in Washington believe they can force through the biggest bail-out of Wall Street since the 1930s within hours, and in doing so halt the domino collapse of American banks.
Speaking from Capitol Hill just after midnight in Washington, Republicans and Democrats said they believed that they would be able to publish an agreement on the internet today that will be voted on tomorrow.
The plan calls for the Treasury Department to buy deeply distressed mortgage-backed securities and other bad debts held by banks and other investors. The money should help troubled lenders make new loans and keep credit lines open. The government would later try to sell the discounted loan packages at the best possible price. Such a measure is designed to stop the collapse of American banks and help Wall Street to start functioning normally.
In the early hours of this morning, Henry Paulson, US Treasury Secretary, said: "We're there." Tony Fratto, spokesman for the White House, added: “We’re very pleased with the progress made tonight. We appreciate the bipartisan effort to deal with this urgent issue.”
While it was pointed out that there are remaining problems over the details of the $700 billion deal, it is clear that the option of taking stakes in banks who benefit from the bail-out is being considered. Lawmakers are also considering reducing taxes on the wealthy.
It is not known how far either side has compromised in reaching an agreement, although at one point Republicans also raised the issue of offering just $500bn instead of the proposed $700bn.
Fed to price assets however it pleases
Bernanke wants to buy banks' junk at hold-to-maturity values rather than at market prices. Q: Um, what constitutes a “fire sale”?
In attempting to resolve the financial crisis currently gripping the U.S. economy by buying up to $700 billion in bank assets, the Federal Reserve is running full steam into the fair-value accounting debate and largely ignoring it for its own purposes.
While the details of how the government will go about pricing the assets it purchases are unclear, one mechanism the Treasury is unlikely to use is actual market prices, which Federal Reserve chairman Ben Bernanke told Congress last Wednesday he considers to be of the “fire sale” variety.
Instead, when buying and accounting for the assets, Mr. Bernanke said the Treasury will use hold-to-maturity prices, which could run as high as three times current market prices. So, while refusing to suspend fair-value accounting rules for banks, the Fed is proposing not to use them when determining how it will spend taxpayer money.
To compensate for paying far more than market value, congressional leaders have pushed for a final package that would give the government equity stakes in institutions selling assets. That, in essence, would give taxpayers a guarantee against losses, but would also give existing and prospective private investors pause and could inhibit banks' ability to raise additional capital through traditional means.
According to the plan outlined last week, the Treasury would hold a so-called reverse auction, under which banks would indicate a price at which they are willing to sell, with the Treasury picking up the cheapest offers. Such a method could raise market prices closer to what they'd be if the securities were held to maturity, and help the banks' books look better.
To arrive at a price, buyers and sellers will use models looking at data such as default rates, discounted cash flow and recovery rates. Since current owners of the troubled assets have better information than the Treasury about the future performance of the assets, it gives sellers an unfair advantage.
Since using models is allowed under current fair-value accounting rules if market prices are considered to be “fire sale,” there's a middle ground between the market prices and such models that Mr. Bernanke indicated the Treasury would ignore. That prompted criticism from several analysts who contend that some recent trades should be included in determining the price the Treasury should pay.
The main issue with fair value lies in whether forced, or distressed, sales are taking place. Mr. Bernanke argues that market illiquidity is producing fire-sale prices, which shouldn't be taken into account.
“Because of the complexity of these securities and the serious uncertainties about the economy and the housing market, there is no active market for many of these securities, and thus today the fire-sale price may be much less than the hold-to-maturity price,” he told the Senate Banking Committee last week.
But according to a 2007 Center for Audit Quality paper on measuring fair value in illiquid markets, it isn't appropriate to assume that all transactions in a relatively illiquid market are forced or distressed transactions, or to disregard observable prices, even if the market is relatively thinner compared with previous market volume.
Under FAS 157, such transactions would constitute level two inputs, whereas what Mr. Bernanke is proposing amounts to mark-to-model accounting, or level three. “From an accounting perspective, if there are prices you can use from the marketplace, then you should use those prices,” said Lawrence Levine, a director at RSM McGladrey.
Even if Mr. Bernanke can justify the use of hold-to-maturity prices following a model, the result is that taxpayers might have to eat the difference. For example, Merrill Lynch sold collateralized debt obligations made up of mortgage-backed securities at 22 cents on the dollar in July, which would constitute an indicative trading price. Analysts and market participants think the government could come up with hold-to-maturity prices about three times as high as trading prices.
That suggests that taxpayers could end up paying about 65 cents for similar securities. Based on the estimated $700 billion they would ultimately pay for the securities, either all at once or in installments, such a premium would mean they'd start out with an immediate loss of $301 billion on what Treasury Secretary Henry Paulson characterized as their “investment.”
“It seems to me what the government is doing is they're subsidizing companies at the expense of taxpayers,” said Mr. Levine.
It wasn't clear at press time exactly what type of equity the bailout plan would offer. One proposal involves acquiring contingent shares in the institutions selling the assets, which would vest if the government resells an asset at a loss.
Of course, giving taxpayers a guarantee against losses has knock-on effects. “If the Treasury is holding an option to acquire equity interests in a financial institution, other potential investors may be reluctant to make an equity investment in that company,” Ohmsatya Ravi, a Banc of America Securities analyst, wrote in a report last week.
What's more, if the government has contingent shares in financial institutions selling troubled assets, it could be viewed as a guaranty of the assets, and thus may preclude so-called true sale treatment. “In that event, the financial institution could not remove the assets from its books,” Mr. Ravi said.
Still, Mr. Bernanke objected to the idea of suspending fair-value accounting for banks, which was floated as an alternative by conservative Republicans, on the grounds investors would respond negatively. His objection echoed that offered by Robert Herz, chairman of the Financial Accounting Standards Board, in a speech this month. “That is what Japan tried to do rather unsuccessfully for over a decade,” said Mr. Herz.
Instead, Mr. Bernanke defended what critics say is his own variation of mark-to-market accounting. “Banks will have a basis for valuing those assets and will not have to use fire-sale prices,” he said. “Their capital will not be unreasonably marked down. Liquidity should begin to come back to these markets. [...] And taxpayers should own assets at prices close to hold-to-maturity values, which minimizes their risk.”
But unless they get equity in return for the investment, they'll have to wonder if and when they'll get back any of the premium they will have paid.
Ilargi: Russ WInter is still my man. He's the only one who agrees with me about what the plan really is.
Tar Pit Operation at Work
”Teker kirilinca yol gosteren cok olur” “Many will point the right way after the wheel is broken” - Turkish Proverb
The JPM takeout of WAMU is significant and once again illustrates the “Tar Pit Operation”. The details indicate (on its face) that no FDIC funds were involved.
- Carrion is stuck in the Pit.
- Saber Tooth (Friend of Hankenstein-FOH ) takes the Carrion in a government orchestrated “rescue” or “hand off”. Carrion shareholders and debt holders are completely wiped out. The FDIC gets brownie points for not taking a hit (or a small one), and can then point to the anti moral hazard lesson “to be learned”.
- The assets and trashed securities of the Carrion are taken for a song.
- A portion of the low cost basis trashed securities FOH (JPM in this instance) has taken are then marked up and profitably sold to the US Treasury’s deal making Leviathan.
The next step to look for is the Leviathan arrangement with Congress to emerge. They may now need a Black Friday or Monday demonstration to act, but act they will. A few more big banks will likely fail over the weekend providing the political cover.
As part of the “compromise” Hankenstein’s Leviathan will come as a tranche deal (say $200 billion at first) whereby Hankenstein initially gets a “trial stash” to work with. Once Hankenstein gets the first tranche he works a smoke and mirrors razzle dazzle whereby fixed “prices” are established.
Since Fannie Mae and Freddie Mac have been seized as well, look for those and failed banks to be the center of the action. Securities Leviathan buys will also be flipped for small profits, and within weeks this will be revealed to the Public as part of a new found transparency propaganda machine. Leviathan will win brownie points for its early “wins” for the Taxpayers.
Unfortunately more “failures” will emerge as the Tar Pit fills up. Hankenstein will ask for and receive more tranches from Congress, and his role as middle man (wholesaler) to facilitate the monster asset handoff to FOHs will accelerate as will the hidden cost to the taxpayer.
Hundreds of billions of assets are wholesaled in back door razzle dazzle transactions before January 20, 2009. Then Hank’s Boyz rip up and take the bathroom toilets off the walls, and a steaming sack of turds is left at the front door of the White House as a welcome present to the next President.
Ilargi: Karl Denninger is right. But this serves mainly as a preview of what will happen, no matter how nuts it is.
Mathematics FAIL Paulson / Bernanke Bailout Plan (PDF)
Known Facts United States non-financial private debt is $32.4 trillion dollars and household debt is $10.0 trillion as of 2Q 2008. This encompasses mortgages, auto loans, credit cards, HELOCs, commercial and industrial loans, LBO monies outstanding and all other forms of non-financial (e.g. not including margin loans and similar) debt.
Henry Paulson and Ben Bernanke have asked for a $700 billion "revolving credit line" with which to buy "troubled" assets. Congress is strongly considering giving it to Mr. Paulson with some set of conditions. The assertion has been made by both Mr. Paulson and Mr. Bernanke that absent this credit line and absorption of these "troubled" assets, the financial markets will imminently seize and fail.
The assertion has been made that the taxpayer will not recognize large losses and might make a profit. House prices are projected to fall by another 15-30% nationally (depending on who you ask); therefore, whatever level of stress exists in the system today far more will exist over the next few years.
Mathematics $700 billion dollars is 2.16% of all non-financial private debt and 7% of all household debt. Provision of this credit line therefore would allow removal of a maximum of just over 2% of the current nonfinancial private debt from the banking system, assuming only US domiciled debt is included.
If the imminent failure of the United States financial system is going to be averted by 2.16% (maximum) of the outstanding private non-financial debt being removed from the banks' hands and transferred to the taxpayer as the "responsible party", then the system is under leverage of 46.29:1.
If, as many have projected, the actual losses to be sustained are $2.5-3 trillion in residential housing and a like amount among commercial real estate, credit cards and LBO loans, then the aggregate requirement is not $700 billion it is in the neighborhood of five to nine times what has been requested. If this is the case the aggregate requirement is double the US Federal Budget. The government cannot raise that amount.
Conclusions Either (1) the system is not about to fail imminently OR (2) it will fail irrespective of whether this bill passes, as the actual amount required to "resolve" the problem exceeds the government's ability to finance it.
If no failure is imminent then we are giving $700 billion to the people who caused the mess for no purpose other than enriching them. If the latter then we need the $700 billion for social programs and other spending that will become necessary as we work through a financial collapse and crisis worse than anything since the 1930s.
EITHER WAY THIS BILL IS UNSUPPORTABLE IN ANY FORM; THE MATH DOES NOT LIE. ARE YOU PREPARED FOR A FULL PAGE AD IN USA TODAY AND/OR THE WALL STREET JOURNAL LISTING THOSE WHO CAN'T DO BASIC MATH? (PDF)
Ilargi: Peter Schiff has an uneasy feeling too.
Making a Deal with the Devil
Just yesterday, Henry Paulson's "bailout" bill, with only a few anti-Wall Street, pro-Main Street fig leaves slapped on by Democrats, appeared ready to sail through Congress on a bi-partisan tide. But something funny happened on the way to the printing press. It appears as if some conservative House Republicans are reluctant to sell their souls and ditch any remaining pretense towards American-style capitalism.
What's left of the Barry Goldwater wing of the Republican Party, which maintains its natural tendency to trust the markets and not government, has dug in its heels. But, Bush, Paulson and the Democrats have argued that our problems are so dire that free enterprise principles must go out the window. The struggle is historic, but the Congressmen are fighting a losing battle. Sadly, Americans now appear willing to abandon their economic heritage at the first sting of financial pain.
Although passage does seem inevitable, it is nevertheless the wrong thing to do. Central government planning did not work in the Soviet Union and it will not work here. Only free market forces are capable of sorting through the mess. Political meddling will make the problems worse.
In selling the bill to Americans, many are pointing to the Resolution Trust Corporation as an example of similar intervention that worked in the past. However, there is no proof that RTC actually helped as we have no way of knowing what might have happened had the government stayed out.
Missing in this discussion is that the Savings & Loan crisis of the 1980's, much like the current crisis, was a byproduct of government interference in the free market. By insuring bank deposits through the FDIC, the government created a moral hazard that resulted in extreme risk taking among member banks, whose depositors sought only high yields, without any regard for the risks that the banks were incurring. Banks that refused to take big risks lost deposits to those banks that did.
Absent FDIC insurance, depositors would have considered risks as well as rewards, and the S & L crisis never would have happened in the first place! The urgency for passing this bailout bill is based on the claim that the American economy will collapse if nothing is done. If the government were to stay out, and allow the market to function, there will certainly be a great deal of economic pain.
Companies will go bankrupt, banks will fail, real estate and stock prices will keep falling, and many people will lose their jobs. However, government action will not prevent any of this. At best, it will merely delay the inevitable, but only at the cost of increasing the severity of the underlying problems, thus making their ultimate resolution that much more painful to endure.
The bottom line is that there is no way to resolve our economic problems without a severe recession, and our politicians need to level with the public. As a nation, we gambled on the alluring riches of real estate and we lost. The price must be paid. Contrary to the Bush Administration rhetoric, the fundamentals of our economy are not sound. If they were, we would not be in this mess. Recessions are meant to restore balance, purge excess, and liquidate mal-investments. On that score we have a lot of work to do.
We are being told that this plan will help the economy by keeping the spigots of consumer credit flowing. However, to really address the fundamental problems, those spigots must be tightened. Since we have already borrowed and spent ourselves into bankruptcy, the last thing we need is for consumers to borrow more.
Our leaders maintain that without this bailout consumers will not be able to borrow money to buy cars. So what is wrong with that? We already have plenty of cars, and if we are broke, why do we need to buy more? Instead, we need drive our old cars longer, pay off our underwater auto loans, and produce more cars for export.
It is also argued that without access to credit parents will not be able to borrow money to send their kids to school. That's fine by me as it will force Universities to reduce tuitions to levels families can actually afford. They will either have to cut out all of that bureaucratic fat, or go out of business for lack of customers. In the end it is impossible for the American economy to be rebuilt on a sounder foundation of savings and production without a lot of economic pain.
Government efforts to reinforce the shaky foundation of borrowing and consuming will result in the entire structure falling down around us.
Ilargi: Psssst..... Mind if I scare the color out of your skin?
Bailout Negotiations Enter Evening Session
The idea of charging large financial firms fees to set up an industry-funded rescue insurance fund was gaining momentum as key House and Senate negotiators continued to meet Saturday evening to iron out the final details of a $700 billion rescue package for Wall Street.
Lawmakers and staff reconvened their meeting around 7:30 p.m. EDT in the offices of House Speaker Nancy Pelosi (D., Calif.), hopeful they could broker a deal on the much anticipated but exceedingly difficult-to-negotiate legislation that would have the federal government buy up billions of dollars of soured assets.
The mood was said to be "optimistic" entering the evening talks, according to a Senate aide familiar with the talks, after policymakers -- including Treasury Secretary Henry Paulson -- made progress during an afternoon negotiating session. Staff predicted a long night of negotiations, however, an observation backed up by the delivery of food from sandwich shop Cosi to Ms. Pelosi's office just before 8 p.m. EDT.
Congressional negotiators have been consulting with outside experts including billionaire investor Warren Buffett amid a focus on market reaction to the plan. "We've had Warren Buffett on the phone tonight, other experts that we've been consulting," Sen. Kent Conrad (D., N.D.) told reporters as he walked through the U.S. Capitol. He declined to identify other people with whom lawmakers have consulted.
Senate Majority Leader Harry Reid (D., Nev.), in an appearance on the Senate floor earlier Saturday, said there are only a "handful of issues still lingering" for lawmakers to finalize. He said his goal was for the Congress and the Bush administration to at the very least release an outline of the bailout plan before Asian markets open Sunday evening.
The Senate aide said a number of specific ideas appeared to be gaining traction Saturday evening, most notably the concept of creating a "financial stability" fund financed by Wall Street and styled in the mold of the deposit insurance program run by the Federal Deposit Insurance Corp. Lawmakers had considered levying a tax on some securities transactions to help offset the cost of the $700 billion rescue plan, but the idea of assessing fees on a wide swath of financial firms to help pay for current and future government bailouts had its proponents.
The aide said specific language was still being worked out, but that negotiators were deliberating whether to assess the fees on all types of financial firms -- including possibly hedge funds and other nontraditional institutions -- and whether to put the fund in place now or in the future depending on the eventual cost to taxpayers from the current rescue plan. The fees and the fund would likely only apply to larger firms over a certain asset size.
A draft of the financial stability fund language suggest it would apply to financial firms, "the failure of which would result in direct pecuniary losses to the Federal Government, due to reliance upon Federal loans, advances, or other provisions of financial instruments or securities."
Also gaining steam was a proposal to eliminate the tax deductions for companies on executive compensation for top officers that is above $400,000. Eliminating so-called "golden parachutes" and excessive executive pay-outs for firms that sell toxic assets to the government has been a key issue for lawmakers on both sides of the aisle in their deliberations with the Treasury Department.
Lawmakers were also said to be making headway on their insistence that the government receive mandatory warrants in firms that sell directly or auction their bad assets to the government. "We're just shopping language right now and it's going back to have some lawyers look at the latest offer," said Mr. Conrad (D., N.D.), the chair of the Senate Budget Committee, as he was heading back into the evening session.
One issue still to be resolved was how the $700 billion authority to Treasury to buy up toxic assets will be meted out.
Lawmakers want Treasury to receive the authority in tranches, receiving $250 billion immediately and another $100 billion if needed as certified by the president. The remaining $350 billion would be subject to a Congressional vote, giving lawmakers the opportunity to vote to rescind the funds.
But a Senate aide familiar with the discussions said Treasury is pushing for a larger initial authority, likely around $500 billion.
Lawmakers appeared to have the advantage on the issue ahead of the evening talks, the Senate aide said, though no part of the deal had been completely finalized.
Congressional and Treasury staff members have been trying to resolve the various issues related to the Wall Street bailout plan all week, and staff discussions lasted all day Friday and extended into the wee hours of Saturday morning to no avail.
Rep. Roy Blunt (R., Mo.), one of the negotiators, said that progress was being made but he wouldn't discuss specifics.
The bailout negotiations took a step forward Friday, when Senate Democrats agreed to include an insurance-based scheme as an option as part of the Wall Street bailout package in a bid to win support of House Republicans, who have been the main obstacle to reaching an agreement.
Sen. Charles Schumer (D., N.Y.) said that while Democrats would allow the insurance idea to be included, he didn't think that any financial firms would choose to take part in such a scheme. "I offered on behalf of Sens. (Christopher) Dodd and Reid that we would put their proposal in as an option," said Mr. Schumer. "No one would have to use it, but it would be there as an option."
According to lawmakers on both sides of the aisle, the plan proposed by Mr. Paulson, which would see the federal government buy up to $700 billion in toxic mortgage-linked assets, will form the core of any solution. Sen. Judd Gregg (R., N.H.), one of the lawmakers taking part in the talks to thrash out an agreement, said Saturday morning that the negotiators would stay in the meeting until an agreement is reached. "The basic understanding is once we get into that room we are going to stay there until we have an agreement," he said.
Senate Minority Leader Mitch McConnell (R., Ky.) said he hoped that if a deal could be reached Sunday, then lawmakers could vote on it Monday. Initially there were to be four lawmakers -- one representing each party in both houses of Congress at the talks. They were Messrs. Gregg and Dodd in the Senate and Reps. Barney Frank (D., Mass.) and Blunt in the House. Mr. Frank is the chairman of the House Financial Services Committee, Mr. Blunt is the Minority Whip, while Mr. Dodd is the chairman of the Senate Banking Committee hearing, and Mr. Gregg is the ranking member on the Senate budget panel.
But they were joined by several other senior Democrats, and there are as of late Saturday nine Democrats in the room compared with just the two Congressional Republicans, and Paulson. After an apparent agreement was announced by lawmakers Thursday, House Republicans threw a wrench into the process by saying they would not support the deal, proposing instead their own alternative plan. That plan would be based around the idea of an industry-funded insurance pool to provide certainty to the markets, rather than a taxpayer-funded scheme.
Mr. Conrad, the chairman of the Senate Budget Committee, said the insurance proposal had come up earlier in the negotiations, but that Treasury and the Federal Reserve rejected it. Mr. Schumer said it could end up bankrupting firms, given the premiums would be so high. House Republicans appeared to be conceding the point that the insurance scheme wouldn't replace the asset purchase plan as they had previously insisted.
The Republicans' priority is "making sure there is an insurance program in there in the tool kit of the secretary," said Rep. Adam Putnam of Florida, the chairman of the Republican House Conference.
Senate passes $634B spending bill
Automakers gained $25 billion in taxpayer-subsidized loans and oil companies won elimination of a long-standing ban on drilling off the Atlantic and Pacific coasts as the Senate passed a sprawling spending bill Saturday. The 78-12 vote sent the $634 billion measure to President Bush, who was expected to sign it even though it spends more money and contains more pet projects than he would have liked.
The measure is needed to keep the government operating beyond the current budget year, which ends Tuesday. As a result, the legislation is one of the few bills this election year that simply must pass. Bush's signature would mean Congress could avoid a lame-duck session after the Nov. 4 election.
White House spokesman Tony Fratto said the bill "stands as a reminder of the failure of the Democratic Congress to fund the government in regular order." But, he said, it "puts the United States one step closer to ending our dependence on foreign sources of energy" by lifting the offshore drilling ban and opening up huge reserves of oil shale in the West.
The Pentagon is in line for a record budget. In addition to $70 billion approved this summer for operations in Iraq and Afghanistan, the Defense Department would receive $488 billion, a 6 percent increase. The spending bill also offers aid to victims of flooding in the Midwest and recent hurricanes across the Gulf Coast.
Such a huge bill usually would dominate the end-of-session agenda on Capitol Hill. But it went below the radar screen because attention focused on the congressional bailout of Wall Street. The measure settles dozens of battles that have brewed for months between the Democrats who run Congress and the White House and its GOP allies.
The administration won approval of the defense budget. Democrats wrested concessions from the White House on $23 billion for disaster-ravaged states, a doubling of low-income heating subsidies, and smaller spending items such as $24 million more for food shipments to the elderly.
The loan package for automakers would reward them with $25 billion in below-market loans, costing taxpayers $7.5 billion to subsidize the retooling of plants and development of technologies to help U.S. carmakers to build cleaner, more fuel efficient cars. Companies would not have to begin repaying the loans for five years, drawing objections from Sen. Jon Kyl, R-Ariz., who predicted they would return for more help when the money is due.
Republicans made ending the coastal drilling ban a central campaign issue this summer as $4-plus per gallon gasoline stoked voter anger and turned public opinion in favor of more exploration. The action does not mean drilling is imminent and still leaves the oil-rich eastern Gulf of Mexico off limits. But it could set the stage for the government to offer leases in some Atlantic federal waters as early as 2011.
Also in the bill is money to avert a shortfall in Pell college aid grants and solve problems in the Women, Infants and Children program delivering healthy foods to the poor. In addition to the Pentagon's budget, there is $40 billion for the Homeland Security Department and $73 billion for veterans' programs and military base construction projects. Combined with the Defense Department's spending, that amounts to about 60 percent of the budget work Congress must pass each year.
Democrats came under criticism from the GOP for short-circuiting the normal process for a spending bill after it became clear that Republicans would force difficult votes on the drilling ban. Democrats also wanted to avoid an election-year clash with Bush that would have played in his favor. They are willing to take their chances that Democrat Barack Obama will be elected president in November and permit increases for scores of programs squeezed by Bush each year.
Bush had threatened to veto bills that did not cut the number and cost of pet projects in half or cause agency operating budgets to exceed his request. Democrats ignored the edict as they drafted the plan and the White House has apparently backed down.
Taxpayers for Common Sense, a watchdog group, discovered 2,322 pet projects totaling $6.6 billion. That included 2,025 in the defense portion alone that cost a total of $4.9 billion. Critics of such projects are likely to discover numerous examples of links to lobbyists and campaign contributions.
Mr. Practical speaks
Hank Paulson and Ben Bernanke have asked for too much “money” with too little detail. They have also asked for immunity from review. This is very strange. Why not implement their plan with clear guidelines, accountability, and transparency? Nothing really happened from a few weeks ago to create this sense of urgency.
Frankly I think the public is giving much too much trust to a few men who might not really understand what they are doing or worse, have a different agenda than protecting tax-payers. Perhaps they are trying to protect our Asian lenders instead?
Or perhaps it is because of the Fed’s complicity in our current state of affairs and thus their desire to bail out the equities of banks?
Whatever it is, on its face they plan to assume ownership of debt at a price much higher than would clear the market. This is not appropriate. When the government assumes the market is not pricing assets properly and uses taxpayer money to bid them higher, that is socialism, pure and simple.
But their argument to do so is flawed. This is not merely a liquidity issue as they profess: there is not enough capital to support the debt.
That is not a liquidity issue, that is a solvency issue.
To ignore that economic implication is naivety at best: as the government re-prices assets, risk will grow, not be reduced, and growth will slow. So any plan that injects capital into insolvent banks at the very least needs to offer equity to the fund they plan on creating.
I am not advocating what they are doing. I am pointing out the very least that should be done if they are going to go this route: minimal and staggered funding, full transparency and accountability, and dilution of equity from failed institutions.
But their goal seems to be to spur stock prices higher through their ban on short selling, which is shameful, and using taxpayer money to transfer profits to financial companies. That will only protect the wealthy establishment at the expense of the middle class, as any bailout tends to do.
The middle class will pay for this in either higher taxes or a much lower dollar in the future. Their claim that the taxpayers may actually make “money” out of this is ridiculous.
Is Purchasing $700 billion of Toxic Assets the Best Way to Recapitalize the Financial System? No! It is Rather a Disgrace and Rip-Off Benefitting only the Shareholders and Unsecured Creditors of Banks
Whenever there is a systemic banking crisis there is a need to recapitalize the banking/financial system to avoid an excessive and destructive credit contraction. But purchasing toxic/illiquid assets of the financial system is not the most effective and efficient way to recapitalize the banking system.
Such recapitalization – via the use of public resources – can occur in a number of alternative ways: purchase of bad assets/loans; government injection of preferred shares; government injection of common shares; government purchase of subordinated debt; government issuance of government bonds to be placed on the banks’ balance sheet; government injection of cash; government credit lines extended to the banks; government assumption of government liabilities.
A recent IMF study of 42 systemic banking crises across the world provides evidence on how different crises were resolved. First of all only in 32 of the 42 cases there was government financial intervention of any sort; in 10 cases systemic banking crises were resolved without any government financial intervention. Of the 32 cases where the government recapitalized the banking system only seven included a program of purchase of bad assets/loans (like the one proposed by the US Treasury).
In 25 other cases there was no government purchase of such toxic assets. In 6 cases the government purchased preferred shares; in 4 cases the government purchased common shares; in 11 cases the government purchased subordinated debt; in 12 cases the government injected cash in the banks; in 2 cases credit was extended to the banks; and in 3 cases the government assumed bank liabilities. Even in cases where bad assets were purchased – as in Chile – dividends were suspended and all profits and recoveries had to be used to repurchase the bad assets.
Of course in most cases multiple forms of government recapitalization of banks were used. But government purchase of bad assets was the exception rather than the rule. It was used only in Mexico, Japan, Bolivia, Czech Republic, Jamaica, Malaysia, and Paraguay. Even in six of these seven cases where the recapitalization of banks occurred via the government purchase of bad assets such recapitalization was a combination of purchase of bad assets together with other forms of recapitalization (such as government purchase of preferred shares or subordinated debt).
In the Scandinavian banking crises (Sweden, Norway, Finland) that are a model of how a banking crisis should be resolved there was not government purchase of bad assets; most of the recapitalization occurred through various injections of public capital in the banking system. Purchase of toxic assets instead – in most cases in which it was used – made the fiscal cost of the crisis much higher and expensive (as in Japan and Mexico).
Thus the claim by the Fed and Treasury that spending $700 billion of public money is the best way to recapitalize banks has absolutely no factual basis or justification. This way of recapitalizing financial institutions is a total rip-off that will mostly benefit – at a huge expense for the US taxpayer - the common and preferred shareholders and even unsecured creditors of the banks. Even the late addition of some warrants that the government will get in exchange of this massive injection of public money is only a cosmetic fig leaf of dubious value as the form and size of such warrants is totally vague and fuzzy.
So this rescue plan is a huge and massive bailout of the shareholders and the unsecured creditors of the financial firms (not just banks but also other non bank financial institutions); with $700 billion of taxpayer money the pockets of reckless bankers and investors have been made fatter under the fake argument that bailing out Wall Street was necessary to rescue Main Street from a severe recession. Instead, the restoration of the financial health of distressed financial firms could have been achieved with a cheaper and better use of public money.
Indeed, the plan also does not address the need to recapitalize those financial institutions that are badly undercapitalized: this could have been achieved by using some of the $700 billion to inject public funds in ways other and more effective than a purchase of toxic assets: via public injections of preferred shares into these firms; via required matching injections of Tier 1 capital by current shareholders to make sure that such shareholders take first tier loss in the presence of public recapitalization; via suspension of dividends payments; via a conversion of some of the unsecured debt into equity (a debt for equity swap).
All these actions would have implied a much lower fiscal costs for the government as they would have forced the shareholders and creditors of the banks to contribute to the recapitalization of the banks. So less than $700 billion of public money could have been spent if the private shareholders and creditors had been forced to contribute to the recapitalization; and whatever the size of the public contribution were to be its distribution between purchases of bad assets and more efficient and fair forms of recapitalization (preferred shares, common shares, sub debt) should have been different.
For example if the private sector had done its fair matching share only $350 billion of public money could have been used; and of this $350 billion half could have taken the form of purchase of bad assets and the other half should have taken the form of injection of public capital in these financial institutions. So instead of purchasing – most likely at an excessive price - $700 billion of toxic assets the government could have achieved the same result – or a better result of recapitalizing the banks – by spending only $175 billion in the direct purchase of toxic assets.
And even after the government will waste $700 billion buying toxic assets many banks that have not yet provisioned for such losses/writedowns will be even more undercapitalized than before. So this plan does not even achieve the basic objective of recapitalizing undercapitalized banks.
The Treasury plan also does not explicitly include an HOLC-style program to reduce across the board the debt burden of the distressed household sector; without such a component the debt overhang of the household sector will continue to depress consumption spending and will exacerbate the current economic recession.
Thus, the Treasury plan is a disgrace: a bailout of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the US taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown.
It is pathetic that Congress did not consult any of the many professional economists that have presented alternative plans that were more fair and efficient and less costly ways to resolve this crisis. This is again a case of privatizing the gains and socializing the losses; a bailout and socialism for the rich, the well-connected and Wall Street. And it is a scandal that even Congressional Democrats have fallen for this Treasury scam that does little to resolve the debt burden of millions of distressed home owners.
For JPMorgan, More Deals Possible In The US, Abroad
With its U.S. branch network and retail banking business greatly expanded, JPMorgan Chase & Co.'s future focus might turn abroad. JPMorgan Chairman and Chief Executive James Dimon stopped well short of declaring the company's retail banking expansion in the U.S. complete after the acquisition of the banking operations of Washington Mutual Inc.
But he also reiterated his long-held desire to add capacity abroad. "We do a lot of business abroad, so we have ambitions there, too," Dimon said Friday during a conference call with reporters. JPMorgan Chase shares recently traded up almost 3% to $46.40.
The main difference between rivals JPMorgan Chase and Citigroup Inc. has long been the extent of their overseas operations and the degree to which they have diversified their revenue abroad. Like Citi, JPMorgan Chase has expanded in China, and Dimon has expressed his desire to match Citi's sizable operations in Japan. Dimon has often said that expanding consumer operations beyond the U.S. is on his to-do list.
But he, and many other JPMorgan Chase insiders, have said the company would be cautious in pursuing consumer deals abroad, and that filling the bank's retail and consumer banking businesses at home held a higher priority. That's the opposite consumer strategy from Citi, which has been lukewarm about expanding the U.S. consumer and retail banking business.
JPMorgan retail chief Charles Scharf told reporters during a conference call Friday that, before JPMorgan acquired most of WaMu's operations, the thrift had been "on the top of the list" as a way for JPMorgan Chase to expand its retail banking business. For the next couple of years, focusing on the domestic business might keep Dimon and Scharf busy.
The integration of Washington Mutual will take time, if only because integrating a thrift into a bank has always been more difficult than bank-to- bank deals. Thrifts are less familiar with bankers' strategy to sell more products to the same customers, a tight focus of Scharf and Dimon.
And even when the integration is complete, JPMorgan Chase is very likely to work on grabbing more market share in California and Florida, its new banking markets, before turning its focus abroad, said Frank Barkocy, director of research at Mendon Capital Advisors Corp.
With the WaMu deal, JPMorgan Chase's deposit market share in California and Florida is 12.2% and 3.9%, respectively, and JPMorgan Chase has shown that it likes to acquire share even in markets where it is already dominant. In 2006, it bought the retail banking operations of what is now Bank of New York Mellon Corp.
The combined company has no presence in most of the Great Plains and adjoining states such as Minnesota and Montana. Dimon might skip those areas, Barkocy said. Asked during the conference call whether he believes JPMorgan Chase is finished expanding through acquisition in the U.S., Dimon quipped: "I was thinking of retiring tomorrow." He was quick to add: "This is still a big country and there are a lot of places we are not in. We can grow" organically or "might acquire in the United States," Dimon said.
However, there might be an impediment: the national deposit market-share cap that restrict banks from acquiring more than 10% of national deposits. The WaMu deal would push JPMorgan Chase "slightly" above that cap, Scharf said. Analyst David Hendler of CreditSitghts Inc. calculated the combined company's deposit market share as 10.5%, a whisker short of Bank of America Corp.'s (BAC) 10.8%.
Thrift deposits don't count in the 10% limit - only bank deposits - which allowed Bank of America to buy Countrywide Financial Corp. But Scharf said the WaMu deposits will count towards the cap "in the next transaction." Like Bank of America, JPMorgan Chase could get around it if deposits run off in the meantime.
Another U.S. consumer business Dimon might expand is subprime credit-card lending. JPMorgan Chase's own portfolio was high quality, but with WaMu came the portfolio the thrift acquired years ago with Providian Financial Corp. Subprime credit-card lending, "if it's done well and done right, is O.K.," Dimon said. "Providian has a lot of very good stuff," though JPMorgan Chase might not continue all of the card lender's strategies, he said.
Scharf said he isn't thinking of divesting any of the businesses JPMorgan Chase bought with the two WaMu thrift subsidiaries, but reiterated that the combined company will consolidate branches - during the conference call Thursday he put the number of branches closed at between 400 and 500. Those closures could come both from WaMu and JPMorgan Chase branches in market were there is much overlap - in, for example, Illinois, Texas, Colorado, and New York.
Asked how many job losses might result, Scharf said he doesn't have a number yet, but said that particularly the branch staff might find work at other JPMorgan Chase branches. The company is hiring, he said. But many observes said that, eventually, JPMorgan Chase will turn its focus abroad.
"Theoretically, [WaMu] should be everything Jamie wants," said Nancy Bush, who runs her own research firm, NAB Research LLC. As Barkocy indicated, she said, Thursday's deal will keep JPMorgan busy for years. Even in its existing business, Dimon sill has to deal with "the hurricane on Wall Street," Bush said. "But when we have our financial act together, they'll look abroad," she said.
Dimon said, "The dollar is weaker," which makes it harder to buy right now, and "there are very important things to finish here." Still, "The priorities will change over time, but they are not predetermined" to shift from the U.S. to overseas automatically because JPMorgan Chase feels it is done building here, he said.
Robert I. Lipp, who for years advised Dimon on JPMorgan Chase's plans to expand the consumer business internationally, said in a recent interview that the company has "a great desire, a real interest from a strategic point of view" to expand abroad. Lipp left JPMorgan Chase last month to join private-equity firm Brysam Global Partners.
JPMorgan Chase has considerable wholesale banking operations abroad, particularly capital markets and treasury and securities services businesses. But during JPMorgan Chase's analyst day earlier this year, Dimon said the lack of international consumer operations "is probably our biggest, and I would say only, strategic conundrum."
"It's very complicated," he said. "If we can do smart things, we're going to do them. We don't want to leave my successor a hodgepodge of crap, just to say 'we did it.' I think over the next five years we will hopefully find and execute some really neat" deals.
Goldman targets failed banks’ deposits
After morphing last week from Wall Street’s biggest investment firm into Main Street’s fourth-largest bank holding company, Goldman Sachs is prowling for deposits. But don’t expect it to send an army of investment bankers out in search of a deal just yet. Instead, it says it may buy the assets of a bank gone bust.
“We plan to build our banking business organically and by buying retail deposits and bank assets in the wholesale market, not through opening branches,” a Goldman Sachs spokesman told FinancialWeek.com last week. “For example, the FDIC is selling IndyMac assets, and those might be the sort of thing we’d be interested in looking at.”
Before last week, 15 banks with total deposits of roughly $30 billion had failed since the beginning of 2007, according to data from the Federal Deposit Insurance Corp. IndyMac was the largest of that group, with more than $19 billion in deposits. The FDIC took control of the thrift after regulators shut it down in July.
With 117 more banks holding $78 billion in assets on the FDIC’s list of “problem institutions,” according to its second-quarter report on the health of the banking industry, Goldman could have plenty of additional opportunities to snap up deposits in the months ahead—just as J.P. Morgan Chase did last week when it snagged $188 billion in deposits, along with other assets, when Washington Mutual became the largest failure in U.S. banking history.
The time could also be right for Goldman to go shopping for acquisitions. Its transformation clears some of the regulatory hurdles that could have made it difficult to acquire or merge with a bank. And after announcing last week that it raised $10 billion in fresh capital, half from Warren Buffett’s Berkshire Hathaway in exchange for preferred shares and half from the sale of common stock, it may look to add to the $20 billion in deposits already held by its subsidiaries.
If Goldman decides to bid for IndyMac’s assets, it will have to move quickly. The FDIC hired Lehman Brothers to manage the sale and sought to find a buyer within 90 days, a period that expires on Oct. 8. FDIC officials have said they would like to sell the bank whole, but would consider breaking it up if necessary.
Lehman has since sought federal bankruptcy protection while it sells units and reorganizes, but an FDIC spokesman said the firm continues to oversee IndyMac’s sale. A spokesman for Barclays Capital, which bought Lehman Brothers’ U.S. investment banking business last week, didn’t respond to a request for comment.
When a bank nears failure, the FDIC typically approaches potential buyers who have told the agency they would be interested in acquiring the assets of troubled institutions, said spokesman David Barr. Working behind the scenes, the FDIC collects bids and selects a buyer without the involvement of the failing bank. After state or federal regulators shutter the bank, it goes into receivership and the FDIC transfers its assets to the winning bidder.
IndyMac is different because the FDIC acts as the thrift’s conservator, keeping it running with an eye to selling its assets. (The Office of Thrift Supervision, IndyMac’s regulator, said in July that a run by depositors forced officials to take it over before a buyer could be found.) With $32 billion in assets, it’s the third-biggest bank bust in U.S. history, behind the 1984 collapse of Continental Illinois and last week’s collapse of Washington Mutual. It operates 33 locations across Southern California. Goldman wouldn’t say whether it would manage those branches if it bought some or all of IndyMac’s assets.
One of the benefits of buying bank deposits from the FDIC—instead of merging with or acquiring an operational bank—is that the regulator sells “clean” assets, Mr. Barr said. When two banks merge, or when a bank buys another bank, it’s usually saddled with the target’s liabilities and debts, not to mention potentially toxic mortgage-related securities or other real estate investments that could be sitting on the balance sheet.
“It’s a fairly good deal for the assuming bank, because not only do they get an instant bank, with branches and employees and deposit customers, but it’s a clean bank,” Mr. Barr said. “The receivership is like a filtering process. All the troubles and headaches that caused the bank to fail are left behind with the FDIC in receivership, so the acquiring bank gets clean assets.”
In addition to its thrift business, IndyMac was a major purveyor of so-called liar loans that didn’t require verification of the borrower’s income, and it held some $20 billion in mortgages on its balance sheet as of March 31, according to Securities and Exchange Commission filings. Its non-performing loans, which included seriously delinquent mortgages and foreclosures, skyrocketed to 6.5% of the company’s total assets, from 1.1% a year earlier. Within three months, regulators moved in and closed the bank.
Part of the mission of IndyMac Federal Bank, as the government-run company currently managing the thrift is known, is to “maximize the value of the institution for a future sale,” according to an FDIC statement. To boost IndyMac’s value, the FDIC has tried to cut its proportion of bad assets by rewriting loan terms and halting foreclosures for borrowers who fell behind on mortgages held by the company.
The FDIC won’t comment on how it would package IndyMac’s assets if it decided to break up the company, spokesman Andrew Gray said.
Bank of America’s acquisition of Merrill Lynch, worth some $50 billion when it was announced, led many Wall Street observers to wonder whether Goldman Sachs and Morgan Stanley, the last of the independent bulge-bracket investment firms, could survive on their own. A merger with a commercial bank could give them access to stable capital in the form of deposits, which aren’t nearly as volatile as funding obtained in the tumultuous credit market. Rumors circulated that Morgan Stanley was nearing a deal with Wachovia, while Goldman CFO David Viniar downplayed the value a deal with a bank would bring the firm.
Morgan Stanley sold as much as 20% of itself to Japanese bank Mitsubishi UFJ in an $8.4 billion deal announced last Tuesday. That reportedly ended its talks with Wachovia, but, like Goldman, it will launch its own efforts to build deposits, in part through its network of 500 brokerage locations. “We’re going to look at all things, including acquiring deposit-based institutions,” a spokesman said.
Paulson's past raises questions about current proposal
Henry Paulson spent his life amassing a fortune on Wall Street. Now, as Treasury secretary, he is demanding unprecedented authority—and $700 billion in cash—to bail out the teetering U.S. banking sector.
That some sort of action is needed to rescue the financial system from itself is hardly a point of contention. But Mr. Paulson’s blueprint has drawn widespread criticism, in part because his close relationship with the industry is perceived as clouding his perspective.
In legal terms, Mr. Paulson’s actions are perfectly acceptable. He is simply acting as the Treasury secretary in setting policies that will apply to the financial sector as a whole. Indeed, he divested himself of Goldman Sachs shares reportedly worth $485 million when he took office, to comply with government ethics rules.
Still, experts say that because of his background as a banker, Mr. Paulson may be prone to overstating the importance of Wall Street to the health of the overall economy.
“His mind-set is one that has been molded by a Wall Street-centric view,” said Anthony Sabino, professor of law and business at St. John’s University. “What I find as a shortcoming is that he’s refusing to acknowledge that Wall Street has to pay for its mistakes.” Mr. Paulson presided over Goldman Sachs during the boom times for housing and was a staunch advocate of the lax regulatory approach that many blame for the current financial crisis.
The timing of Mr. Paulson’s change of heart has also raised questions. Until recently, the secretary said repeatedly that the housing slump was contained and would not infect the banks or the real economy. His rescue plan came just as it seemed that Goldman was next in the cross-hairs of a panic that has taken down financial giants like Lehman Brothers, Bear Stearns and AIG.
In addition, the draft legislation contained language that would excuse Treasury officials, including Mr. Paulson, from any court review of their actions—the bailout’s own get-out-of-jail-free card. “I find this particularly troubling,” said Jared Harris, professor of ethics and strategy at the University of Virginia’s Darden School of Business.
As if to anticipate the rescue’s passage, Warren Buffett’s Berkshire Hathaway announced last Sunday that it was investing $5 billion in Goldman Sachs on terms that give Berkshire a 10% dividend and warrants to buy Goldman shares at a preferential price. In contrast, taxpayers would enjoy no such privilege under the Treasury’s plan, a major sticking point in the negotiations with Congress.
The issue of executive pay also looms large in discussions surrounding any bailout. Both voters and lawmakers have expressed concern about a taxpayer rescue of financial institutions that does not include severe monetary penalties for those banks. “This round-about doubtful solution for sure helps the secretary’s friends on Wall Street and maybe not much else,” said Edward Leamer, director of UCLA’s Anderson Forecast.
Yet while Mr. Paulson argued this week that he shares the concerns of Congress on executive compensation, the former banker, whose net worth has been estimated to be as much as $700 million, did not initially make the issue a priority in his plan. Indeed, the first drafts of the Treasury’s legislative proposal were a scant three pages and made no mention of executive pay.
Faced with opposition from Congress, Mr. Paulson did come around to the view that restraints on compensation should be part of any bailout. “Many of you cite this as a serious problem and I agree,” he said in testimony this week. He has also made clear throughout the latest leg of the crisis that it is not the government’s intention to boost profits for investors who took imprudent risks. “A stable system requires that risk-taking bring both reward and loss,” he said in June.
Examples of high-flying pay packages not matched by corporate successes abound. Richard Fuld, who ran now-bankrupt Lehman Brothers, earned nearly half a billion dollars between 1993 and 2007. In this context, economists are especially outraged by some of the language included in the rescue plan, especially its preclusion of future legal action against Mr. Paulson and his team.
“I don’t think it looks good,” said Paul Kasriel, chief economist at Northern Trust, in Chicago. “I’m not accusing him but it raises questions.” This is not to say that Mr. Paulson is actively deceiving Congress to protect the interests of his former Wall Street peers. The secretary is highly regarded by his peers in Washington. Still, his background as a banker does inform his approach to tackling the crisis.
Mr. Harris, of The University of Virginia, puts it succinctly: “It’s clear that Paulson brings a particular viewpoint to this challenge and hence it’s obvious that the proposed solution represents the view of thinking from the perspective of the banks.”
Bernanke Jumps Out of Political Fray After Warning of Collapse
Ben S. Bernanke jumped into the political fray this week when he urged quick action from Congress to deal with "grave threats" to the financial system. Now he's trying to jump back out.
The Federal Reserve chairman hasn't returned to Capitol Hill after two days of congressional testimony earlier this week. He has made it clear to Treasury officials and lawmakers that he isn't taking part in negotiating details of a $700 billion proposal to rescue the financial system even as the plan runs into a political buzzsaw.
By letting Treasury Secretary Henry Paulson be the point man with Congress, Bernanke may be trying to restore the Fed's position as a neutral party in Washington and preserve the central bank's independence. That's after he put both on the line by endorsing Paulson's plan and using the Fed's balance sheet to rescue creditors of Bear Stearns Cos. and American International Group Inc.
"There wasn't any alternative," said former Fed Governor Lyle Gramley, now senior economic adviser at Stanford Group Co. in Washington. "The Fed and the Treasury had to get together. There could be no divisions." Now, Gramley says, Bernanke is "just trying to maintain his neutral stance politically." While Bernanke has retreated from the limelight, he is talking to Paulson as many as a dozen times a day and taking calls from members of Congress.
In his conversations with lawmakers, he is avoiding discussion of specific provisions of the Paulson plan and sticking to three principles: the plan has to be enticing enough to attract a large number of banks, it must protect taxpayers and it can't deliver windfalls to executives or institutions. "I'm not empowered to negotiate for the Treasury," he told lawmakers at a Sept. 24 hearing.
Two days ago, Senate Majority Leader Harry Reid said Paulson and Bernanke were invited to discussions with lawmakers after talks broke down, causing some news organizations to report that both were headed over. In fact, only Paulson went to Capitol Hill. Bernanke's stance is winning praise from both Democrats and Republicans, even though the plan he supports has drawn little but opposition from lawmakers' constituents.
"Bernanke's been a total straight shooter on this," Senator Sherrod Brown, an Ohio Democrat who sits on the Banking Committee, said in an interview at the Capitol. "People trust him. He doesn't have the Wall Street bias that Paulson has. And he doesn't have the Bush administration coloring, if you will, that others have."
Senator Bob Corker, a Tennessee Republican on the Banking Committee, said the Fed chairman has been "a very stabilizing force." "He's playing, I think, an appropriate role," Corker said in an interview. "He's there on the other end of the phone in about five minutes."
When the 54-year-old Fed chairman took office in 2006, he said he wouldn't get involved in such things as federal budget issues, breaking with his predecessor, Alan Greenspan. One of the responsibilities of the chairman is "preserving the independence and non-partisan status" of the Fed, Bernanke told the Banking Committee at the time. "Bernanke, from the day he took office, decided that he wanted to stay out of issues that didn't involve monetary policy," said Gramley.
Even so, Bernanke is likely to review whatever final plan is presented to the White House, in part because the Fed Board regulates the holding companies of banks. Bernanke and Paulson have worked closely together, having breakfast several times a month, including yesterday, since Paulson, the former Goldman Sachs Group Inc. chairman, joined the Bush administration in 2006.
Treasury signed off on the Fed's decision in March to lend $29 billion to secure Bear Stearns' sale to JPMorgan Chase & Co. and last week's $85 billion loan to AIG, which exposed taxpayers to risk. Those moves, along with the Fed and Treasury's decision to let Lehman Brothers Holdings Inc. file for bankruptcy, put the central bank in the position of picking winners and losers.
Asked if Bernanke should take a bigger role in the bailout talks, Reid said the Fed chief "has been very helpful." Given Bernanke's background as a Great Depression scholar, the former Princeton University economist "comes with a portfolio that is meaningful to these discussions," Reid told reporters in Washington yesterday. "He's always been available whenever he's been asked to come."
At the same time, Bernanke and Paulson are getting political lessons of their own, given the backlash over a plan that Americans see as aiding Wall Street and not Main Street. "There's been some degree of amazement from the White House -- and certainly Secretary Paulson and Chairman Bernanke - - that people who run for elective office have constituencies that they have to take care of," Reid said.
Regulators Seek to Increase Confidence in Fortis Bank
Belgian and Dutch central banks and regulators were discussing measures to restore confidence in Fortis, the financial-services company whose stock plunged 35 percent in Brussels trading last week.
"We are working on enhancing the confidence in the market of the Fortis share," Hein Lannoy, a spokesman for the Belgian financial regulator CBFA, said today by telephone. He declined to be more specific. The parties will hold a conference call and "if necessary there will be a physical meeting," Lannoy said.
Brussels and Amsterdam-based Fortis needs more capital after spending 24 billion euros ($35 billion) on ABN Amro Holding NV assets last year just as the U.S. subprime-mortgage market started to collapse. Fortis tumbled a record 20 percent two days ago, when the company picked Filip Dierckx to replace Herman Verwilst as chief executive officer. The move was aimed at reassuring investors concerned that a plan to raise 8.3 billion euros would force Fortis to sell assets at knock-down prices.
"Fortis failed to restore confidence on its own and that can only be done now with the help of the regulatory institutions or rivals," said Corne van Zeijl, a senior portfolio manager at SNS Asset Management in Den Bosch, the Netherlands, who oversees about 750 million euros and owns Fortis shares.
The Dutch central bank governing board met late yesterday with Finance Minister Wouter Bos, Het Financieele Dagblad and news service ANP reported. "Bos is being informed meticulously by the Dutch central bank," ministry spokesman Jilles Heringa said. Heringa and Herman Lutke Schipholt, a spokesman for the Dutch central bank, declined to confirm the meeting.
Talks about a takeover of Fortis by ING Groep NV and BNP Paribas SA stalled late yesterday amid demands for state guarantees, De Standaard reported on its Web site, without saying where it got the information. The Sunday Times reported the Belgian central bank and regulator are preparing to bail out Fortis. The newspaper didn't say where it got the information.
Fortis last week said it had earmarked for sale banking and insurance businesses that may be valued as high as 10 billion euros. The Belgian company said it won't sell assets at fire-sale prices and doesn't have an urgent need for funds. The financial-services company said on June 26 it would sell so-called non-core assets, notes and asset-backed debt to raise money. Fortis planned to part with 2 billion euros of assets this year and next. The lender also scrapped a 1.4 billion-euro dividend and sold 1.5 billion euros of shares to investors, including Ping An Insurance (Group) Co.
Verwilst and Dierckx appeared together at an impromptu press conference in Brussels on Sept. 26 to reassure investors about the capital-raising plan. While the company may sell more assets than it earlier expected as it becomes harder to raise money by other means, the bank's financial position is "solid," Verwilst said. Customer moves at its Benelux banking unit have remained limited to less than 3 percent of assets since the start of the year, Fortis said.
Fortis has about 3 billion euros of bonds maturing this year and needs to refinance an additional 7 billion euros next year, said Ivan Lathouders, an analyst at Banque Degroof SA in Brussels, in a report last week. Fortis, formed in the 1990 merger of the Dutch insurance company NV Amev, Belgian insurer AG Group and the Dutch bank VSB, said last week it had a funding base of more than 300 billion euros from sources including retail and private deposits and institutional investors.
Fortis has about 5.2 million retail customers. It employs about 85,000 people and operates 2,500 retail branches including ABN Amro. The company reported a 49 percent decline in second-quarter profit on credit-related writedowns on Aug. 4. The banking business's core Tier I ratio, which measures a bank's ability to absorb losses, was 7.4 percent at the end of June compared with Fortis's own target of 6 percent.
The company's structured credit portfolio, which includes collateralized debt obligations and U.S. mortgage-backed securities, amounted to 41.7 billion euros at the end of June. Fortis said Aug. 4 the pretax impact of the credit market turmoil on its earnings was 918 million euros in the first half.
Belgian and Dutch regulators restricted short-selling in the shares and derivatives of financial companies for three months last week to curtail a market rout. The rules require investors betting on a decline in stock prices to arrange to borrow the shares before selling them. The Belgian and Dutch regulators also requested investors to refrain from lending the securities.
US Corporate Debt Default Rate Could Top 23% by 2010
The US corporate debt default rate could reach its highest level since 1981 in the next three years, Standard & Poor’s says.Based on our estimates of a worst-case scenario, the three-year U.S. cumulative default rate between 2008 and 2010 among speculative-grade nonfinancials will rise to 23.2%, the worst on record since 1981.
If realized, this estimate suggests that 353 speculative-grade rated nonfinancial firms could default between 2008 and 2010, with potentially more than 200 of these defaults materializing in the second half of 2009 and in 2010.
Consumer-sensitive sectors — such as consumer products, media and entertainment, and retail and restaurants — will be among the worst hit, in line with what happened in 1990-1992.
Credit troubles catching companies everywhere in commercial paper jam
Corporate borrowers are paying significantly more for debt than they were prior to Labor Day, according to a survey of corporate finance executives conducted by Financial Week.
Borrowing costs for half of the respondents to the online survey had increased anywhere from 100 basis points to 500 basis points since Sept. 1, with the other half reporting increases of up to 99 basis points since the 15-month-old credit crunch degenerated this month into a global credit crisis.
Almost 60% of 700 respondents said they have been talking more frequently with their lenders since corporate credit conditions tightened after Labor Day. Nearly half said they’ve been in more frequent contact with their corporate insurance brokers and underwriters in the wake of the Sept. 22 federal bailout of insurance giant American International Group. And a third said they’ve done the same with customers, vendors and suppliers to more closely monitor their ability to provide or pay for goods or services.
More than two-thirds reported investigating the holdings of their company’s money-market funds in recent weeks, and nearly 40% said they had transferred cash this month into what they deem the safest of instruments, including Treasuries and Treasury-only funds. The deepening credit crisis promises to further crimp already constrained corporate dealmaking.
Funeral services company Service Corp. International, for example, has a bid outstanding to acquire competitor Stewart Enterprises and expects to finance the acquisition with debt, leaving CEO Thomas Ryan to hope the credit markets settle down by the time the deal comes to fruition.
“Today it would be pretty difficult for anyone to try to finance anything through the capital markets,” Mr. Ryan said. The tightening of corporate credit intensified last week as Congress debated the merits of the Bush administration’s $700 billion plan to bail out the nation’s banks.
The cost of lower-rated 30-day commercial paper soared to a record high last Wednesday, according to the Federal Reserve. The Fed’s commercial paper survey showed spreads on A2/P2 paper widening to 409 basis points, from 288 basis points the previous Friday. Not long after the credit crisis began in mid-2007, the spread between the two grades of paper spiked to 160 basis points. Now, it’s more than double that level.
Not surprising-ly, the spike in short-term costs has been accompanied by a plunge in borrowing. Total U.S. commercial paper outstanding slumped $61 billion, or 3.5%, to a seasonally ad-justed $1.7 trillion for the week ended Sept. 24. On a non-seasonally adjusted basis, outstanding commercial paper dropped $44 billion, to $1.64 trillion.
Though rates on AA 30-day paper fell to 190 basis points last Wednesday from 240 the previous Friday, some of the most highly rated and biggest issuers of commercial paper—the financing arms of equipment makers such as Caterpillar, Deere and General Electric—were growing warier of the market. Caterpillar and Deere said they may cut their reliance on commercial paper after General Electric moved in that direction.
“The commercial paper market is experiencing more dislocation than we have ever seen,” said Jim Turner, head of debt capital markets at BNP Paribas in New York. “Some very creditworthy is-suers are only able to issue overnight rather than the more typical 30 days or longer, and if you’re a corporate treasurer, that situation probably makes it hard to sleep.”
To reduce the leverage of GE finance subsidiary GE Capital by roughly 10%, its parent said last Thursday it would reduce the dividend it demands from GE Capital from 40% of its earnings to 10% and suspend the current GE stock buyback. GE Capital will also extend maturities on its debt by cutting issuance of commercial paper to around 10% to 15% of GE Capital’s total debt.
The company insisted that GE Capital has sufficient liquidity and no need to raise additional debt in 2008. But GE’s stock has suffered recently because of the company’s exposure to the credit markets.
The rise in commercial paper costs reflects a growing lack of confidence in short-term credit markets, as investors pulled a record amount of cash—$182 billion—out of money-market funds in the two weeks ended Sept. 24, after the first shareholder losses in 14 years.
Money funds are the biggest buyers of commercial paper, which typically helps companies cover day-to-day expenses such as payroll and rent. Some companies are already scrambling. Goodyear Tire & Rubber said it plans to draw $600 million from its U.S. revolving credit facility due to what it termed “a temporary delay” in its ability to access $360 million in cash currently invested with the Reserve Primary Fund.
The Reserve Primary Fund, a troubled money-market fund, has delayed the payment of requested redemptions pursuant to an SEC order allowing an orderly disposition of its securities. Goodyear said the SEC’s action was the catalyst for the company’s decision to borrow against the credit facility.
Goodyear said its other U.S. cash investments remain fully accessible by the company. The company said it will use the money it’s borrowing to support what it calls “seasonal working capital needs” and to enhance its cash liquidity position.
Goodyear may not be alone, judging by the fact that 61% of respondents to the Financial Week survey said they had looked deeper into the holdings of their money funds in recent weeks.
“If you can’t [issue commercial paper], we have some serious problems,” said Jerry R. Marlatt, a partner in the financial products group of Clifford Chance in New York, who works with issuers of asset-backed commercial paper. “We’re at a key intersection here in terms of confidence.”
Behind Insurer’s Crisis, Blind Eye to a Web of Risk
“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”
— Joseph J. Cassano, a former A.I.G. executive, August 2007
Two weeks ago, the nation’s most powerful regulators and bankers huddled in the Lower Manhattan fortress that is the Federal Reserve Bank of New York, desperately trying to stave off disaster.
As the group, led by Treasury Secretary Henry M. Paulson Jr., pondered the collapse of one of America’s oldest investment banks, Lehman Brothers, a more dangerous threat emerged: American International Group, the world’s largest insurer, was teetering. A.I.G. needed billions of dollars to right itself and had suddenly begged for help.
The only Wall Street chief executive participating in the meeting was Lloyd C. Blankfein of Goldman Sachs, Mr. Paulson’s former firm. Mr. Blankfein had particular reason for concern. Although it was not widely known, Goldman, a Wall Street stalwart that had seemed immune to its rivals’ woes, was A.I.G.’s largest trading partner, according to six people close to the insurer who requested anonymity because of confidentiality agreements.
A collapse of the insurer threatened to leave a hole of as much as $20 billion in Goldman’s side, several of these people said. Days later, federal officials, who had let Lehman die and initially balked at tossing a lifeline to A.I.G., ended up bailing out the insurer for $85 billion. Their message was simple: Lehman was expendable. But if A.I.G. unspooled, so could some of the mightiest enterprises in the world.
A Goldman spokesman said in an interview that the firm was never imperiled by A.I.G.’s troubles and that Mr. Blankfein participated in the Fed discussions to safeguard the entire financial system, not his firm’s own interests.
Yet an exploration of A.I.G.’s demise and its relationships with firms like Goldman offers important insights into the mystifying, virally connected — and astonishingly fragile — financial world that began to implode in recent weeks.
Although America’s housing collapse is often cited as having caused the crisis, the system was vulnerable because of intricate financial contracts known as credit derivatives, which insure debt holders against default. They are fashioned privately and beyond the ken of regulators — sometimes even beyond the understanding of executives peddling them.
Originally intended to diminish risk and spread prosperity, these inventions instead magnified the impact of bad mortgages like the ones that felled Bear Stearns and Lehman and now threaten the entire economy.
In the case of A.I.G., the virus exploded from a freewheeling little 377-person unit in London, and flourished in a climate of opulent pay, lax oversight and blind faith in financial risk models. It nearly decimated one of the world’s most admired companies, a seemingly sturdy insurer with a trillion-dollar balance sheet, 116,000 employees and operations in 130 countries.
“It is beyond shocking that this small operation could blow up the holding company,” said Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn. “They found a quick way to make a fast buck on derivatives based on A.I.G.’s solid credit rating and strong balance sheet. But it all got out of control.”
The insurance giant’s London unit was known as A.I.G. Financial Products, or A.I.G.F.P. It was run with almost complete autonomy, and with an iron hand, by Joseph J. Cassano, according to current and former A.I.G. employees. A onetime executive with Drexel Burnham Lambert — the investment bank made famous in the 1980s by the junk bond king Michael R. Milken, who later pleaded guilty to six felony charges — Mr. Cassano helped start the London unit in 1987.
The unit became profitable enough that analysts considered Mr. Cassano a dark horse candidate to succeed Maurice R. Greenberg, the longtime chief executive who shaped A.I.G. in his own image until he was ousted amid an accounting scandal three years ago.
But last February, Mr. Cassano resigned after the London unit began bleeding money and auditors raised questions about how the unit valued its holdings. By Sept. 15, the unit’s troubles forced a major downgrade in A.I.G.’s debt rating, requiring the company to post roughly $15 billion in additional collateral — which then prompted the federal rescue.
Mr. Cassano, 53, lives in a handsome, three-story town house in the Knightsbridge neighborhood of London, just around the corner from Harrods department store on a quiet square with a private garden. He did not respond to interview requests left at his home and with his lawyer. An A.I.G. spokesman also declined to comment.
At A.I.G., Mr. Cassano found himself ensconced in a behemoth that had a long and storied history of deftly juggling risks. It insured people and properties against natural disasters and death, offered sophisticated asset management services and did so reliably and with bravado on many continents. Even now, its insurance subsidiaries are financially strong.
When Mr. Cassano first waded into the derivatives market, his biggest business was selling so-called plain vanilla products like interest rate swaps. Such swaps allow participants to bet on the direction of interest rates and, in theory, insulate themselves from unforeseen financial events.
Ten years ago, a “watershed” moment changed the profile of the derivatives that Mr. Cassano traded, according to a transcript of comments he made at an industry event last year. Derivatives specialists from J. P. Morgan, a leading bank that had many dealings with Mr. Cassano’s unit, came calling with a novel idea.
Morgan proposed the following: A.I.G. should try writing insurance on packages of debt known as “collateralized debt obligations.” C.D.O.’s. were pools of loans sliced into tranches and sold to investors based on the credit quality of the underlying securities.
The proposal meant that the London unit was essentially agreeing to provide insurance to financial institutions holding C.D.O.’s and other debts in case they defaulted — in much the same way some homeowners are required to buy mortgage insurance to protect lenders in case the borrowers cannot pay back their loans.
Under the terms of the insurance derivatives that the London unit underwrote, customers paid a premium to insure their debt for a period of time, usually four or five years, according to the company. Many European banks, for instance, paid A.I.G. to insure bonds that they held in their portfolios.
Because the underlying debt securities — mostly corporate issues and a smattering of mortgage securities — carried blue-chip ratings, A.I.G. Financial Products was happy to book income in exchange for providing insurance. After all, Mr. Cassano and his colleagues apparently assumed, they would never have to pay any claims. Since A.I.G. itself was a highly rated company, it did not have to post collateral on the insurance it wrote, analysts said. That made the contracts all the more profitable.
These insurance products were known as “credit default swaps,” or C.D.S.’s in Wall Street argot, and the London unit used them to turn itself into a cash register. The unit’s revenue rose to $3.26 billion in 2005 from $737 million in 1999. Operating income at the unit also grew, rising to 17.5 percent of A.I.G.’s overall operating income in 2005, compared with 4.2 percent in 1999. Profit margins on the business were enormous. In 2002, operating income was 44 percent of revenue; in 2005, it reached 83 percent.
Mr. Cassano and his colleagues minted tidy fortunes during these high-cotton years. Since 2001, compensation at the small unit ranged from $423 million to $616 million each year, according to corporate filings. That meant that on average each person in the unit made more than $1 million a year.
In fact, compensation expenses took a large percentage of the unit’s revenue. In lean years it was 33 percent; in fatter ones 46 percent. Over all, A.I.G. Financial Products paid its employees $3.56 billion during the last seven years. The London unit’s reach was also vast. While clients and counterparties remain closely guarded secrets in the derivatives trade, Mr. Cassano talked publicly about how proud he was of his customer list.
At the 2007 conference he noted that his company worked with a “global swath” of top-notch entities that included “banks and investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals.” Of course, as this intricate skein expanded over the years, it meant that the participants were linked to one another by contracts that existed for the most part inside the financial world’s version of a black box.
Goldman Sachs was a member of A.I.G.’s derivatives club, according to people familiar with the operation. It was a customer of A.I.G.’s credit insurance and also acted as an intermediary for trades between A.I.G. and its other clients. Few knew of Goldman’s exposure to A.I.G. When the insurer’s flameout became public, David A. Viniar, Goldman’s chief financial officer, assured analysts on Sept. 16 that his firm’s exposure was “immaterial,” a view that the company reiterated in an interview.
Later that same day, the government announced its two-year, $85 billion loan to A.I.G., offering it a chance to sell its assets in an orderly fashion and theoretically repay taxpayers for their trouble. The plan saved the insurer’s trading partners but decimated its shareholders.
Lucas van Praag, a Goldman spokesman, declined to detail how badly hurt his firm might have been had A.I.G. collapsed two weeks ago. He disputed the calculation that Goldman had $20 billion worth of risk tied to A.I.G., saying the figure failed to account for collateral and hedges that Goldman deployed to reduce its risk.
Regarding Mr. Blankfein’s presence at the Fed during talks about an A.I.G. bailout, he said: “I think it would be a mistake to read into it that he was there because of our own interests. We were engaged because of the implications to the entire system.”
Mr. van Praag declined to comment on what communications, if any, took place between Mr. Blankfein and the Treasury secretary, Mr. Paulson, during the bailout discussions.
A Treasury spokeswoman declined to comment about the A.I.G. rescue and Goldman’s role. The government recently allowed Goldman to change its regulatory status to help bolster its finances amid the market turmoil.
Regardless of Goldman’s exposure, by last year, A.I.G. Financial Products’ portfolio of credit default swaps stood at roughly $500 billion. It was generating as much as $250 million a year in income on insurance premiums, Mr. Cassano told investors. Because it was not an insurance company, A.I.G. Financial Products did not have to report to state insurance regulators. But for the last four years, the London-based unit’s operations, whose trades were routed through Banque A.I.G., a French institution, were reviewed routinely by an American regulator, the Office of Thrift Supervision.
A handful of the agency’s officials were always on the scene at an A.I.G. Financial Products branch office in Connecticut, but it is unclear whether they raised any red flags. Their reports are not made public and a spokeswoman would not provide details. For his part, Mr. Cassano apparently was not worried that his unit had taken on more than it could handle. In an August 2007 conference call with analysts, he described the credit default swaps as almost a sure thing.
“It is hard to get this message across, but these are very much handpicked,” he assured those on the phone. Just a few months later, however, the credit crisis deepened. A.I.G. Financial Products began to choke on losses — though they were only on paper.
In the quarter that ended Sept. 30, 2007, A.I.G. recognized a $352 million unrealized loss on the credit default swap portfolio.
Because the London unit was set up as a bank and not an insurer, and because of the way its derivatives contracts were written, it had to put up collateral to its trading partners when the value of the underlying securities they had insured declined. Any obligations that the unit could not pay had to be met by its corporate parent. So began A.I.G.’s downward spiral as it, its clients, its trading partners and other companies were swept into the drowning pool set in motion by the housing downturn.
Mortgage foreclosures set off questions about the quality of debts across the entire credit spectrum. When the value of other debts sagged, calls for collateral on the securities issued by the credit default swaps sideswiped A.I.G. Financial Products and its legendary, sprawling parent.
Yet throughout much of 2007, the unit maintained that its risk assessments were reliable and its portfolios conservative. Last fall, however, the methods that A.I.G. used to value its derivatives portfolio began to come under fire from trading partners. In February, A.I.G.’s auditors identified problems in the firm’s swaps accounting. Then, three months ago, regulators and federal prosecutors said they were investigating the insurer’s accounting.
This was not the first time A.I.G. Financial Products had run afoul of authorities. In 2004, without admitting or denying accusations that it helped clients improperly burnish their financial statements, A.I.G. paid $126 million and entered into a deferred prosecution agreement to settle federal civil and criminal investigations.
The settlement was a black mark on A.I.G.’s reputation and, according to analysts, distressed Mr. Greenberg, who still ran the company at the time. Still, as Mr. Cassano later told investors, the case caused A.I.G. to improve its risk management and establish a committee to maintain quality control.
“That’s a committee that I sit on, along with many of the senior managers at A.I.G., and we look at a whole variety of transactions that come in to make sure that they are maintaining the quality that we need to,” Mr. Cassano told them. “And so I think the things that have been put in at our level and the things that have been put in at the parent level will ensure that there won’t be any of those kinds of mistakes again.”
At the end of A.I.G.’s most recent quarter, the London unit’s losses reached $25 billion. As those losses mounted, and A.I.G.’s once formidable stock price plunged, it became harder for the insurer to survive — imperiling other companies that did business with it and leading it to stun the Federal Reserve gathering two weeks ago with a plea for help.
Mr. Greenberg, who has seen the value of his personal A.I.G. holdings decline by more than $5 billion this year, dumped five million shares late last week. A lawyer for Mr. Greenberg did not return a phone call seeking comment. For his part, Mr. Cassano has departed from a company that is a far cry from what it was a year ago when he spoke confidently at the analyst conference.
“We’re sitting on a great balance sheet, a strong investment portfolio and a global trading platform where we can take advantage of the market in any variety of places,” he said then. “The question for us is, where in the capital markets can we gain the best opportunity, the best execution for the business acumen that sits in our shop?”
Shiny Happy Bankers
In my imagination, a bank — a real bank — is suffused with a hush, which is interrupted, rarely, by the low gong of a massive vault slamming shut. The sole personnel are the huissiers of Geneva fortresses, those solemn openers and closers of locked doors.
Clients dress in bespoke suits and stand reverent before the ramparts that secure their annuities in gold bars and serve as bulwarks against their ruin. A bank’s own practice of borrowing and lending on its clients’ fortunes is not spoken of too directly, lest it cloud the illusion that when the money is out of sight, it’s in the vaults.
In my fantasies, banks are never financial-services firms, and Bill Clinton did not sign the 1999 law that repealed the Glass-Steagall Act of 1933, allowing commercial and investment banks to merge. It seems that the once-glorious Wall Street investment banks — Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns — don’t share my fantasy.
Even as they were sick, dying or dead, their Web sites had a chipper, customer-service vibe. They were still babbling about helping me realize my dreams. And money, when I could follow it on these silly sites, tripped around the globe, becoming euros and yen only to spread subprime stardust on razed fields where enchanted condos grew.
It was a missed opportunity. After all, it might have been an excellent time to shore up the confidence of those who wondered what American banks were up to, if not protecting our money. But the banks were sticking with their goofy bravado. On Merrill Lynch’s Web site, a line drawing of a bull still defined the 1914 firm that was being acquired by Bank of America. That trademark bull stood beside a one-line announcement of the acquisition.
Otherwise, you’d never have known it wasn’t another bullish morning at Merrill, which — on the “About Us” page — still billed itself as “one of the world’s leading wealth-management, capital-markets and advisory companies, with offices in 40 countries and territories and total client assets of approximately $1.6 trillion.”
Sometime in the 1980s or ’90s banks stopped using gunmetal hues and deadbolt imagery to sell their services. Those things must have signaled nothing but meager returns. Ever since, anyone who banked in vaults apparently risked being locked in a safe and missing the party. With few exceptions, come-ons from financial institutions — to regular Joes and rich investors alike — stopped emphasizing how measured and trustworthy the banks were. Instead, they styled themselves hard-charging, optimistic, ready with a loan or a Vegas-style risk and in the business of building castles on clouds.
I’m spooked, honestly, by Merrill Lynch’s bull, just as I was by the daisy-smiley “Live Richly” ad campaign from the retail bank Citibank. Likewise, cheerful children, as they appeared in photos on the Web site of Washington Mutual, the savings and loan, struck me as way too vulnerable to project continuity and seriousness.
Over at Lehman.com, I came upon an audio file of a Sept. 10 “investor call” by Richard S. Fuld Jr., the chairman and chief executive of Lehman Brothers. In his remarks, Fuld unfurled “a substantial de-risking of our balance sheet” that he said would “allow the firm to return to future profitability.” It’s perversely interesting to hear a C.E.O. whose firm was just a few days away from flat-out bankruptcy evince unruffled self-assurance. Whether the plane is going down or just bumping in turbulence, the captain apparently always says the same thing.
The fact that a corporate entity has some of the same qualities as an individual — a name, a personality, a tax burden — can make it hard not to read its demise as that of a superman who survived war and disease . . . and so why not this? The Lehman Web site, which said nothing about the firm’s bankruptcy filing apart from one paragraph in a press release, did little to discourage such an understanding.
The site’s “history” section asked readers to draw a straight line from a general store in the antebellum South — “Henry Lehman, an immigrant from Germany, opened his small shop in the city of Montgomery, Ala., in 1844” — to cotton trading; the postwar founding of the Cotton Exchange; the financing of railroads, retailers like Sears, airlines, film studios like Paramount, radio, television and wildcat oil drilling; to the years leading up to the current corporate rubble.
Indeed, long before subprime mortgages became the rage, Lehman seems to have sought out cockamamie schemes. If it sounded risky, weird and American, evidently, Lehman was there. Until it wasn’t. As late as last year, according to its site, Lehman Brothers was ranked the No. 1 “Most Admired Securities Firm.” Lehman keeled over? I just saw him in the pink of health in ’07!
While Lehman’s site looked studiously determined to pretend nothing was wrong, Merrill’s opted for insane.
When I clicked on “Global Philanthropy,” up came a collage of kooky images, including sneakers, gold coins, Condoleezza Rice and Elmo. Help. They were losing direction. They needed vaults. Web design is not destiny, but it’s interesting to note that Morgan Stanley, one of the few major investment banks to muddle through the subprime crisis (at least as of a week and a half ago), used gold and history on its home page — the gilded balcony seats of what looks like a European opera house.
I hesitated before going to Goldman Sachs because I hazily envisioned Goldman, which was seriously shaken but still standing (again: at least as of a week and a half ago), as above the populist silliness of Citigroup, the wacky overextension of Merrill and the dour denial of Lehman. I imagined Goldman’s site would feature, if not vaults or Old World trappings, at least a dull, literal interface that would make the bank look serious. What I found was almost the opposite. The Goldman home page showed a big photograph of a young black woman in cornrows. A caption read: “Mary is one of the first 10,000 women scholarship recipients.”
Of course. While the other banks were trying to scare up money anywhere they could find it, Goldman was giving it away. To individuals, for wholesome reasons. I clicked through to the bank’s history page and found a luxuriously produced video series, complete with stories about Marcus Goldman, the founder, in his “Prince Albert frock coat and high silk hat.” You got the distinct sense that Goldman Sachs didn’t stumble from regional cotton deals (or a few lucky gambles) into the complex abstractions of contemporary investment banking.
Instead, it started in 1869 in commercial paper — securities — and began doing business internationally off the bat. Maybe Goldman is not just one of the original investment banks; it may also be the only true investment bank, the one that will be left after the imitators have crumbled.
Look, I’m only going by the sites. Goldman’s production values were stirring. In video after video, produced as if for PBS, members of the firm speak, and man, were they impressive with their blue-chip accents. Collectively, they came on strong. You wanted to be them — or, failing that, to give them your money.
There was also an old audio clip (on a page gauzy with vintage images) of Lyndon Johnson calling Sidney J. Weinberg, a Goldman senior partner. The government requesting aid from the banks? That’s right; how tables have turned. “I want you to give me some suggestions and ideas and come in and try to help me,” Johnson drawls. Weinberg, for his part, savors his role as benefactor to the president. “I’m at your disposal any time,” he tells Johnson. “I will give you everything I got.” In the elegant hush that follows, you can almost hear the wink.
Changed Financial Landscape
For our country’s sake, I hope our Washington politicians can work out a mindful financial sector bailout package over the weekend. Not that I am pro-bailout or for government intervention. It’s just that our financial system is teetering at the precipice. Last night’s federal takeover and “sale” of Washington Mutual, our nation’s largest bank failure to date, was yet another major body blow. Confidence has now been shaken so brutally that our policymakers can do little to repair the damage. Yet at this point, stop-gap measures to restrain collapse seem more appealing to me than no measures at all.
The Financial Structure that fueled myriad Credit Bubbles, asset Bubbles, economic Bubbles and overliquefied the entire world is today no longer viable. Wall Street finance is at this point an unmitigated bust, with a few of the “holdout” sectors (i.e. the Credit default market and the hedge fund community) now succumbing. The great Financial Alchemy of transforming endless risky loans into perceived safe and liquid “money”-like instruments has run its historic course. And with risky loans – household, financial sector, business, municipal and speculator – having come to play such a prominent role in the nature of spending and “output”, the near elimination of risky lending will prove a momentous financial and economic development. The U.S. Bubble economy is today in dire straits.
We’ve reached the point where it has become difficult to secure new borrowing unless one is of quite sound Credit standing. This is the case for individuals seeking to buy automobiles and homes; to afford myriad discretionary and luxury goods and services; to finance educations; or to make the types of big ticket purchases that had been bolstering our Bubble Economy. Lenders are now moving aggressively to cut home equity and Credit card lines. And, importantly, recent developments have significantly tightened Credit Availability for businesses of all sizes. Securitization markets have been largely shut down for awhile now. Now acute stress has incapacitated the money markets.
Unless some dramatic development reverses the current course, it will not be long before a self-reinforcing cycle of company payroll and spending cutbacks takes hold. At the same time, the municipal bond market is in disarray. The economic impact from major cutbacks in state and local government spending will be significant. Today’s finance-related economic headwinds are Cat-4 (and gaining) Hurricane Systemic Credit Seizure, compared to last year’s Tropical Storm Subprime. Federal Reserve-dictated interest rates are extremely low – and the Fed and global central bankers have injected unfathomable amounts of liquidity – yet Credit Conditions have turned the tightest they’ve been in decades.
The Lehman bankruptcy marked a major inflection point in the confidence of contemporary “money.” It was a decisive blow against trust in various money market instruments – the very foundation of our monetary system. “Money” has now tightened significantly for virtually all players that had previously enjoyed cheap short-term financings. This list certainly includes the hedge fund community.
The Lehman bankruptcy also marked a major inflection point in confidence for the various “daisy chain” players involved in intermediating risky loans into contemporary “money.” The market was convinced Lehman was “too big to fail.” Its failure inflicted thousands of market participants with losses – from Primary Reserve Money Fund investors caught with short-term Lehman paper to holders of Lehman’s long-term bonds. Investors all over the world were impacted. The hedge fund community suffered mightily. The status of hundreds of billions of derivatives and counterparty obligations was suddenly up in the air or in the hands of the bankruptcy court. And, importantly, huge losses were suffered in the Credit Default Swap marketplace – the marrow of one of history’s most spectacular speculative manias.
Trying to add a bit of simplicity to the Complexity of a Credit Market Breakdown, I’ll say the Lehman collapse marked a critical inflection point in at least five major respects: First, the Crisis of Confidence jumped the “firebreak” from risk assets to contemporary “money,” shattering trust in various facets of contemporary finance that was forged over decades. Second, it required the marketplace to reexamine exposures to various direct and indirect counterparty risks, a terminal blow for derivatives markets. Third, it pushed the Credit default swap marketplace into full-fledged dislocation and instigated a long-overdue regulator onslaught. Fourth, it decisively burst the “leveraged speculating community”/hedge fund Bubble. This has ushered in another round of problematic de-leveraging and accelerated the reversal of “Ponzi Finance” dynamics. Fifth, it instilled global fear with respect to the risks of participating in the inter-bank lending market with American institutions.
Basically, the Lehman collapse marked the end of “Wall Street” risk intermediation as a significant component of system financial intermediation. Going forward, Credit growth will be chiefly generated by the banking system, supported by various forms of government backing (Fed, FDIC, Washington bailouts/recapitalizations, etc.), the government-operated GSEs, and various forms of federal government debt issuance. Importantly, this new financial structure will ensure minimal risky lending as well as significantly reduced risk-taking. And from a global perspective, I believe newfound fears of lending to the American financial sector marks the beginning of the end of our economy’s capacity for trading new financial claims for imports of energy and goods.
Over time the Changed Financial Landscape will have a profound impact on the underlying economic structure. Our economy will have no alternative than to get by on less Credit, less risk intermediation, and fewer imports. In the near-term, the effects will be a rapid and pronounced slowdown of our economy’s “output.” And while we’ll only know over time, I’d bet this new financial structure will allocate much less finance to entrepreneurial activities, productive endeavors and the asset markets – while at the same time providing ample (government-directed) purchasing power to ensure stubborn consumer price inflation.