|Intro. [Recording date: February 19, 2010.] Why book title Bailout Nation and how does that relate to the financial crisis? Title coined by Bill Fleckenstein, did forward for book, author of Greenspan's Bubbles. Concept: we had turned from, at least the mythology of a nation that was very independent minded, pick yourself up by your bootstraps--a land where anybody clever who worked hard could make something of himself. Went from that to a group of overpaid bankers, coddled and rescued from their own folly by the government. Perfect fit for what was taking place. Not a nation that studies a lot of history; book traces that history. A lot of people think it started in 2008 with the rescue of Bear Stearns. Goes back longer. Look at universe of bailouts in two ways. One thing if you are an extreme skier and you go out into the back woods and get in trouble--you took on the risk yourself. Different from people walking down the street and a building falls down, earthquake. People in trouble through no fault of their own and those who elected to take a risk, to be aggressive, speculate and run into trouble. First real bailout, where government says you behaved in aggressive behavior and got into trouble, and if we were truly a capitalist nation you would suffer the consequences of your own folly, was Lockheed--1971. They knew their way around the government, around government defense contracting. They had tried to get into building private sector planes; overextended themselves; built a couple private-sector planes that weren't well regarded in marketplace. Found themselves in precarious liquidity positions, running out of money; yet they have all these big government contracts--during the time of the Vietnamese War. Went to the government and said if you don't give us a loan, we're going to go bankrupt and how is that going to help your war effort? Close debate. Might have been one where the Vice President had to break the tie. Recognized that it was not business as usual. William Proxmire, very conservative, coined the phrase "corporate welfare" to describe the idea. Unconscionable to think that a company in trouble would go to the government. One of the justifications was: It's only a loan. Expect to get it back. They did get it back; turned out to look like it was not a big deal. When you make law, policy, govern the nation, idea is to be broad and pass rules that cover everybody, not to carve out specific exceptions for connected companies whose management is close to some elected official. Why not loans to Grumman, Rockwell, Northrup, other competitors? Giving a strategic advantage and disadvantaging everybody else. Any time we look at government actions, government is essentially picking winning and losers. Great if you are in the winning pile--got a big tax rebate or mortgage modification. But if you are in the losing pile, who was practical and put 30% down, those people are in the losing pile. Best example: if you are a first-time home buyer and prices remain elevated because of all the government subsidies, you are the loser and the existing homeowners, who you overpaid, are the winners. Lockheed perfect example: they won, got low interest loan they wouldn't get from the private sector. Also create the incentive for rent-seeking--rather than trying to make better airplanes next time, might as well just go to Washington. Moral hazard: encourage more and more of them.
|The next one--Chrysler. A couple of minor things in between. Continental Illinois--1984; not minor. Railroad issues took place in the 1970s. Chrysler was a sea change. You'll notice that these things tend to happen in election years. Lockheed was before the 1972 election; Chrysler was before the 1980 election. Not a coincidence it was a swing state, could have gone either way. End up with this icon of American industry that through a series of really bad decisions that go back to the 1950s--bad cars, bad design, bad union contracts that they had--Big 3, or "Big Two and a Half" as referred to by Barron's at the time, the half being Chrysler, signed contract after WWII, millions of GIs returning home from war. Instead of risking a strike or falling behind in production, GM, Ford, and Chrysler signed a very generous contract with the union giving strong health care and pension benefits, guaranteed jobs; never perceiving what would happen at the end of the baby boom. Took about 25 years before the effects were widespread. Combine that with the price of oil spiking in the 1970s and you have a recipe for, as Warren Buffett said: The tide goes out and you can see that no one is wearing a bathing suit. Of the Big 3, Chrysler had the worst cars, structure, balance sheet; teetering on the verge of collapse. Government didn't make the loan, but they guaranteed the loan. Again it got paid back. Russ started teaching in 1980; student did a pencil drawing of Lee Iacocca with legend "Our Hero"--sarcastic. Iacocca efforts to keep out Japanese cars. Continental Illinois decision--1984. Let's talk about Chrysler for one more minute. Counterfactuals: we don't have access to an alternative universe; have to hypothesize: ask what would the American auto industry look like today if instead of being rescued, Chrysler were forced to go through the difficult process of bankruptcy reorganization, perhaps even liquidation. Everybody stops and says, would have lost a couple hundred thousand jobs. Here's what we know happened. From 1980 till two or three years ago, the United Auto Workers Union (UAW) went from a million and a half members to, today, under 300,000; the Big 3 auto share went from greater than 75% of the U.S. market to now under 50%; ultimately GM and Chrysler had to file bankruptcy in 2009. Which we are still paying for. Counterfactual: If we would have said to Chrysler, you are doing a lousy job, and while we are concerned, what we should do--the most the government should do is say you are a significant player, you should reorganize; and if you liquidate and cannot find private sector financing, we'll match the private sector financing. Warren Buffett. Had Chrysler gone through that process, we know for a fact they would have gotten out from the onerous pension and health care obligations. We can imagine that it would have put the fear of God into the senior management of GM and Ford--though they might just have snickered at Chrysler. Perhaps might have made the UAW more interested in negotiating less of a Detroit- and more of a Silicon-Valley-type of contract with less guaranteed benefits and more stock options, so that the employees participated more in the upside, incentive to do a good job. Instead, just kicked the can down the road.
|Continental Illinois, first large financial institution rescue. Highly leveraged bank making a lot of risky bets with other people's money. What a shocker. Observation: they didn't get bailed out per se. It's their creditors who got bailed out. In the United States, we bail out creditors. Sometimes we let the firm fail, but we almost never let the creditors go down. That encourages creditors to be riskier and less prudent in their loans. Continental Illinois goes down in 1984. Next: 1998 Long Term Capital Management (LTCM): how much weight? Background: Highly leveraged firm--meaning using other people's money, borrowed money, to make risky bets. Leverage: extremely leveraged; plus little air of mystery. Before quants were as well-understood as they are today, previous to black-box trading being as ubiquitous as it is today. Nobel Laureates with very clever model managed to find small anomalies, small inefficiencies, and arbitraged them away; made a lot of money in the beginning. Got credit at cheap terms; lenders hoped to be able to imitate that. Mean reversion--we there are these relationships with different asset classes, so when this relationship gets too far out of whack, we'll just take the other side of the bet. If you are doing it with leverage, you have to hope you are taking that bet just as the stretched rubber band comes back to position and not before it keeps stretching. They had deployed so much leverage and bought so much esoteric--Russian--bonds that were really small, tiny odd little things. Buy a 10 or 30 year Treasury note, very liquid. If you are going to buy a small, thinly traded note that there is not a buyer or seller for, when you go to liquidate that position you won't get anywhere near the bid price. Will go from $100 to $20. LTCM was an opportunity to send a message to the marketplace. Beanie Baby hedge fund syndrome: if you choose to not buy stocks, bonds, options, futures, commodities, things that are easy to trade, then we're not going to rescue you. Imagine a hedge fund set up to only buy Star Wars collectibles and Beanie Babies. That's what LTCM did. Why should the NY Fed stepped in to save them? Had they not done that, it wouldn't have been fatal; would have punished the companies that made bad bets. A billion here, a billion there, would have been painful knee-skinning. Two questions about LTCM. First, the firm that didn't get rescued. Idea: Moral hazard helped create the crisis, but then have to deal with two things, one related to LTCM and one related to Drexel Burnham, which does not get rescued. They went bankrupt; world didn't end. Unpleasant, skinned knee. Been suspected that the head, Joseph, was despised by Nicholas Brady, Secretary of the Treasury--claim of James Stewart. Weren't rescued, was a signal that some folks might not get rescued. LTCM wasn't exactly rescued. Fed orchestrated it: all who lent money to LTCM, rather than go bankrupt, figure out how to keep them afloat for awhile so there aren't big consequences, big collapse, perhaps not. The creditors themselves played the role in the rescue. The Fed orchestrated it, brought them to the table; weren't happy that LTCM might go under; not entirely voluntary. The firms that were involved did pay a price. Fair assessment; didn't pay much of a price. Distinction between LTCM and Drexel--criminal investigation into Drexel, Michael Milken, insider trading scandal. Drexel not perceived as a warning against speculation, but as if one of your senior guys gets caught doing something illegal, you are at risk. Not a publically traded company at the time; irony of Drexel is at the time they were the fifth largest investment bank, which is what Bear Stearns was. The difference between the two--no allegations that Bear Stearns was doing anything illegal. Company caught in huge scandal; trading partners said they didn't need this. Milken was the big rainmaker there. Look at it as a whole separate animal. Right that the bailouts primarily have served to rescue the creditors. Bear Stearns rescue: bondholders of Bear made 100% whole. Lehman becomes a weird exception. Insular chief executive who had the opportunity to rescue the firm and blew it. Warren Buffett made an offer: would give $2 billion, terms were better than what he ended up doing with Goldman Sachs and GE--by then the crisis was more dangerous. Not just from Buffett; would get more from others if Buffett gave them some. Bernanke, Paulson--view of Buffett's offer being turned down. Fly on the wall. What they then did wrong: let's do a controlled bankruptcy. Could have done something similar with Lehman.
|Kind of tried with Lehman. Different theory: what the government did with Bear Stearns--we don't want them to go bankrupt, so to make them attractive to a suitor, guaranteed what ended up being $29 billion worth of assets that perhaps aren't worth very much, to make it easy for JP Morgan Chase to acquire them; and they did. With Lehman, tried to do the same thing, but wouldn't give that guarantee. Barclay's, regulator, Bank of England, isn't going to be happy about this; but weren't going to do it this time. Could be that Fuld (Lehman's CEO) is an idiot. Public story: had to draw the line somewhere. Proceed to never draw the line anywhere and pay 100 cents on the dollar. In book, biggest creditor of Bear Stearns was JP Morgan; they had a huge amount at stake if Bear Stearns went bankrupt. Very happy to acquire those assets. Who were Lehman's creditors? Most of their creditors seem to have been Asian banks, who didn't have a lot of pull in Washington. Also: when Bear Stearns was rescued, they didn't go bankrupt. "Controlled bankruptcy"--what does that mean for somebody who held credit default swaps (CDSs) on Bear Stearns, people who bought insurance against Bear Stearns's potential bankruptcy, versus people who held Lehman credit default swaps, who did go bankrupt, were now owed money because the government let them go bankrupt? Massive economic stake in both of those actions, winners and losers. When you look at what took place when Bear Stearns was in the process of collapse--people who bought credit default swaps not so much betting on their bankruptcy but betting on their credit worthiness also had positions in options and bet on the stock prices. Scuttlebutt: they didn't make as much money as they would have made had Bear Stearns's bonds gone to zero, but made enough on the equity side that we shouldn't get too bent out of shape. Don't buy that argument: the government steps in and back to making winners and losers. Whoever is on one side of that CDS trade that should have been paid off is now a loser instead of a winner. Some argument to be made that when you have systemic risks, one of the risks that is involved is that the government won't allow one of these companies to go belly up. After LTCM, anyone making that bet should have been aware that sometimes the government does come in. Regardless, close Super Bowl game; clock winding down, government steps in and decides to add 3 points, changing the outcome of the game. Kick the field goal. Decision-making process picking winners and losers. In housing: another billion and a half dollars coming in to prop up housing. When you prop up housing, you are punishing people who want to buy--renters, newlyweds saving to own; holding down interest rates punishes the elderly who are hoping to generate their income off of some bonds. Need to be more cognizant of picking winners and losers; very often rewarding the profligate and punishing the prudential.
|Theme of book: Federal Reserve and monetary policy--going back as far as 1987 to Alan Greenspan's behavior, not bailing out the way Bernanke did or Paulson with a $700 billion dollar check, or taking over Fannie Mae and Freddie Mac's obligations--a trillion dollars on my balance sheet and yours instead of whoever lent them the money--but instead bailing out implicitly. Trying to manipulate interest rates and prop up asset markets. Greenspan didn't pay a price for it for a long time. Benjamin Disraeli quote: The one thing we learn from history is that we learn nothing from history. Watched this unfold as a trader and market watcher; go back and learn more details. Didn't realize between the 1980s and 1990s the Fed Chairman could cut interest rates on his own. Belongia podcast. Greenspan did it six times--wasn't secretive, made him look more authoritative. Note in the book, hubris on his part; one of the rate cuts; at the next meeting the FOMC took away the Fed Chairman's ability to do that. In 1987, new Fed chief, a little green, new, learning process. The 1987 crash, unique event. Stocks don't drop 20-30% because traders switch to decaf. For the most part, markets do a fairly decent job. Could spend months debating why it collapsed, speculation trying to uncover what might have caused it. Portfolio insurance, creaky infrastructure; book Black Monday, reasons why you couldn't get through to your brokerage firm; intemperate comments from the U.S. Treasury Secretary about the dollar; 23% one-day drop on top of 15% leading up to that point. Greenspan learned you could have a market crash and clean up afterwards, no broader effects in the larger economy. Take that one antidote and say, let's look at history and see if it's a one-off. It was the exception to the rule. Always been major repercussions. Great Depression followed the Crash of 1929. Japan, United States in 2000. Tulip bubble. Greenspan instead drew the conclusion it was easy to clean up. How did he clean up? Strongest tool the Fed has--cutting interest rates. We cut rates fairly aggressively after the 1987 crash. Caused a little boom in the real estate market; monthly costs lower; prices of housing. Not true that housing prices have never collapsed. Post Depression era housing prices collapsed; from 1989 to 1996, in major cities, mild price decline in housing prices. Happened in our lifetime--people just repeating what they'd heard and not looking at the data.
|Greenspan and the stock market--started to recognize that he could more or less influence the outcome of the stock market by raising or lowering the price of interest rates. What was the mechanism? Broader context of what came before: huge spike of inflation during the 1970s; Volker taking interest rates very high; even when the back of inflation was broken, rates had come down but really were somewhat elevated compared to historical levels. In the mid-1980s had the economy recovering, stock market doing well, but Fed rates around 8%, mortgage rates in 7-9% range; still had room to take rates lower. Every time we ran into a minor recession--nothing to be feared. Famous quote: during recessions and bear markets money returns to its rightful owners--careful people make money. Every time there was a threat to the stock market, would see some rate cuts. Traders on Wall Street figured out that they just had to sell stocks and Greenspan would say they were seeing problems the Fed wasn't seeing, so let's head off a recession and cut interest rates. Whole other level; irony; Ayn Rand--pulling the levers constantly. Between him and his shrink. Once you have that wave of applause from traders--Greenspan got standing ovations--he kept the rally and the market going, criticized for not cutting rates sooner. Irony there. Belongia, former researcher in the St. Louis Fed--challenge, Fed has one lever, the discount rate--it can have loose money or tight money; trying to do at least four things: keep full employment, keep the economy growing, keep stable prices, involved in fighting poverty--community banking activity and oversight. Rehabilitation rules to overcome redlining. Minor factor in what took place. Really employment and fighting inflation, 95% of what the Fed does. The Fed has a lot of mission creep. Employs lots of economists. Supposed to keep the economy humming at a steady rate of growth, supposed to have a fight-poverty thing in the background; then add keeping asset prices stable. Emotional impact on Greenspan or any Chair responding to the adulation--making them winners--he's forgetting who is losing. He's the maestro. Mission creep: speech excerpted in book--psychology of traders--now the shrink-in-chief for traders? Used "confidence." Sometimes you want lack of confidence. If the building is on fire, you want to run. Not part of the Fed's job description.
|In 2001; 2003-2004, he kept interest rates low. Now people agree it was a big mistake; but at the time, we'd faced 9/11, confidence was shattered, people were scared; tech bubble had just popped; had to make sure we didn't fall into a Japan-like deflation and horrible recession. Interest rate drops viewed as necessary. But that really wasn't the timing. September 11 happened; Ritholz's office in 2 World Trade but working in Long Island office that day. Not an abstract event, on cell phone with head trader; everybody had gotten out. Struck that the Fed cut didn't happen that day. The Fed cut rates an hour before the markets reopened the following Monday morning. September 11 had been the preceding Tuesday. The very name "Trade Center" reflected global capitalism. He waited; so the Fed was all about the stock market, not about the country. As if, if we could make the market well, everything would fall into place. Enormous change in policy. Ben Bernanke almost didn't get reconfirmed.
|Perspective. Two parallel tracks of bailout. One is literal bailout--Fed or Treasury makes good for the creditors, who should have lost some if not all of their money. We did that many times in this last crisis, and before that as well. At the same time, we have a Fed manipulating interest rates in the hopes of keeping financial markets from never going down too much--the "Greenspan put." Two tracks which both encourage risk-taking, remove the loss from the profit-loss equation to some extent. Not entirely--Lehman went broke. Some people lost their money. But remarkable number of people made an enormous amount of money: Fuld of Lehman, Jimmy Cayne of Bear Stearns--had a lot of paper losses, but each left with $500 million of their own stock which they sold prudentially, not by playing recklessly with their own money. What was the psychological impact on the players in the market? Do you think they expected to be bailed out, thought there was a chance, or subconscious possibility that removed a fear? Which players are we talking about? A lot of stupid people made dumb decisions and lost all their money. But the savvy people, traders, senior management, didn't lose so much. Dividing line: senior management of the publically traded companies and the big non-public Wall Street partnerships. Historically, most of those partnerships--like law firms--were non-public; a decision was made to allow them to go public at some point. It's not a coincidence that every single company that got into trouble, there's a lot of OPM (Other People's Money) involved through a senior manager. The most you can lose is what you have in stock--stocks and options. If the company goes out of business, that goes to zero. The shareholders and taxpayers took a loss; but managers like Fuld were wisely, prudently investing their own shares all along. When Bear Stearns was trading at 172 and Jimmy Cayne was worth 1 point something billion, he couldn't cash that out. Gave him the cover to play recklessly with other people's money. Puzzle: why did those other people lend the money? Those stock prices were fraudulent--based on an artificial inflation of earnings based on sheer recklessness, sheer speculation--"mark to make-believe." Race course: If you set the record on the straightaway, you don't break the record--you are going too fast to slow down and make the turn and you hit the wall. That speed record shouldn't really count. That's pretty much what the investment companies did. How hard is it to sell stock at 150 if you don't care? Flat out, pedal to the metal. Number two--key psychology, difference--if you are in a publically traded company you have a limited amount of exposure to the amount you own in stocks and options. In partnerships, different legal standard. If a partnership did what Lehman did and loses $50 billion, first the assets of the partnership are exhausted by creditors. They take the building, the art on the walls. Once that's exhausted, you get to go after each and every partner--take the houses, cars, Monet's. None of the partnerships or the partnerships that went public late got anywhere near the problems. Neither did the hedge funds. If you are an invested in a hedge fund, limited liability partner; but if you are the hedge fund manager, they can take house, collection, everything else. We know of 380 small firms that went belly up--10-30 men shops that existed to sell loans to people on Wall Street. But of the 50-100 year old multi-billion firms--the partnerships managed to avoid this mess. Management in publicly traded firms were willing to take big risks with shareholder's money.
|Pet causes of the crisis, one thing people point at: Change in structure in the industry. Miss the point that that's not a random event. If you look at the history, they go public in the 1980s, in the aftermath--could be a coincidence but maybe not--of the Continental Illinois bailout. It says to financial players, if you leverage, you might not pay a price for it; if you borrow a lot of money, you may be able to get it because those folks may be willing to take a greater risk than they used to because now they may get bailed out. You can build an investment model on 30:1 or sometimes more leverage and you're going to make an enormous amount of money along the way. It might not blow up, not a plan. We changed the risk environment they played in. Puzzle is why anybody stayed a partner; and most didn't. Senior manager from old European money, famous name, didn't care about going public--a few of them, happy running business, didn't feel the need to go public; happy to be a quiet little partnership. But few and far between. Vast bulk of publicly traded companies happy to go for the leverage. Hard-scrabble traders, reputation for not being Ivy League firms. Pop-psychology. Hyper-competitive, hyper-aggressive that you don't see in the old firms of Europe. Fine so long as you are not playing with my money. Wasn't about wanting more money--about who is winning. Money was just a score.
|Book: span of stuff it tries to explain in accessible way--history, pieces of the puzzle, nontechnical coverage. Question: What have you learned? Nation hasn't learned enough; but what have you learned personally from living through this remarkable time? About book: six blind men describing an element--didn't want to just describe one aspect of this. Learned two lessons, sort of surprised. First, this country has more or less become ungovernable. Have not taken any steps to fix what was broken. Many errors leading up to this, no single factor, thirty or so people and things to blame, about half a dozen more important. Torches and pitchforks, people would rise up. Didn't expect the sudden death of Michael Jackson, close finale in American Idol--as long as the population is fed, they roll over and don't care; on to the next issue. Diffuse outrage. Half full view--when you almost don't confirm the Times Man of the Year as Fed Chairman, there's some optimism. Second thing: how human nature is never-changing. We've come through the crisis--buildings are still standing, feed kids and send them to school, economy marches on. Speaking to investors in the last 2-3 years, if you avoided the bloodshed, great; if you managed to jump back in in March, that's a good thing. People are already asking where they are going to get their 10% again. Handful of people rotated out of stocks and into housing and got caught; rotated into commodities and got hurt; what's the next bubble? The Onion is supposed to be a parody, but the headlines are true--one not too long ago, "America Demands Another Bubble to Invest In." Hope I've learned to jump out before the next bubble pops. Country ungovernable; and human nature never changes.