A partír de agosto del 2009 este blog se translada a la siguiente dirección: www.ecomonitor.wordpress.com
A partír de agosto del 2009 este blog se translada a la siguiente dirección: www.ecomonitor.wordpress.com
In 1996, an investor named Henry de Kwiatkowski sued Bear Stearns for negligence and breach of fiduciary duty. De Kwiatkowski had made—and then lost—hundreds of millions of dollars by betting on the direction of the dollar, and he blamed his bankers for his reversals. The district court ruled in de Kwiatkowski’s favor, ultimately awarding him $164.5 million in damages. But Bear Stearns appealed—successfully—and in William D. Cohan’s engrossing account of the fall of Bear Stearns, “House of Cards,” the firm’s former chairman and C.E.O. Jimmy Cayne tells the story of what happened on the day of the hearing:
Their lead lawyer turned out to be about a 300-pound fag from Long Island . . . a really irritating guy who had cross-examined me and tried to kick the shit out of me in the lower court trial. Now when we walk into the courtroom for the appeal, they’re arguing another case and we have to wait until they’re finished. And I stopped this guy. I had to take a piss. I went into the bathroom to take a piss and came back and sat down. Then I see my blood enemy stand up and he’s going to the bathroom. So I wait till he passes and then I follow him in and it’s just he and I in the bathroom. And I said to him, “Today you’re going to get your ass kicked, big.” He ran out of the room. He thought I might have wanted to start it right there and then.
At the time Cayne said this, Bear Stearns had spectacularly collapsed. The eighty-five-year-old investment bank, with its shiny new billion-dollar headquarters and its storied history, was swallowed whole by J. P. Morgan Chase. Cayne himself had lost close to a billion dollars. His reputation—forty years in the making—was in ruins, especially when it came out that, during Bear’s final, critical months, he’d spent an inordinate amount of time on the golf course.
Did Cayne think long and hard about how he wanted to make his case to Cohan? He must have. Cayne understood selling; he started out as a photocopier salesman, working the nine-hundred-mile stretch between Boise and Salt Lake City, and ended up among the highest-paid executives in banking. He was known as one of the savviest men on the Street, a master tactician, a brilliant gamesman. “Jimmy had it all,” Bill Bamber, a former Bear senior managing director, writes in “Bear Trap: The Fall of Bear Stearns and the Panic of 2008” (a book co-written by Andrew Spencer). “The ability to read an opponent. The ability to objectively analyze his own strengths and weaknesses. . . . He knew how to exploit others’ weaknesses—and their strengths, for that matter—as a way to further his own gain. He knew when to take his losses and live to fight another day.”
Cohan asked Cayne about the last days of Bear Stearns, in the spring of 2008. Wall Street had become so spooked by rumors about the firm’s financial status that investors withdrew their capital, and no one would lend Bear the money required for its day-to-day operations. The bank received some government money, via J. P. Morgan. But Timothy Geithner, then the head of the New York Federal Reserve Bank, didn’t open the Fed’s so-called “discount window” to investment banks until J. P. Morgan’s acquisition of Bear was under way. What did Cayne think of Geithner? Picture the scene. The journalist in one chair, Cayne in another. Between them, a tape recorder. And the savviest man on Wall Street sets out to salvage his good name:
The audacity of that prick in front of the American people announcing he was deciding whether or not a firm of this stature and this whatever was good enough to get a loan. Like he was the determining factor, and it’s like a flea on his back, floating down underneath the Golden Gate Bridge, getting a hard-on, saying, “Raise the bridge.” This guy thinks he’s got a big dick. He’s got nothing, except maybe a boyfriend.
Since the beginning of the financial crisis, there have been two principal explanations for why so many banks made such disastrous decisions. The first is structural. Regulators did not regulate. Institutions failed to function as they should. Rules and guidelines were either inadequate or ignored. The second explanation is that Wall Street was incompetent, that the traders and investors didn’t know enough, that they made extravagant bets without understanding the consequences. But the first wave of postmortems on the crash suggests a third possibility: that the roots of Wall Street’s crisis were not structural or cognitive so much as they were psychological.
In “Military Misfortunes,” the historians Eliot Cohen and John Gooch offer, as a textbook example of this kind of failure, the British-led invasion of Gallipoli, in 1915. Gallipoli is a peninsula in southern Turkey, jutting out into the Aegean. The British hoped that by landing an army there they could make an end run around the stalemate on the Western Front, and give themselves a clear shot at the soft underbelly of Germany. It was a brilliant and daring strategy. “In my judgment, it would have produced a far greater effect upon the whole conduct of the war than anything [else],” the British Prime Minister H. H. Asquith later concluded. But the invasion ended in disaster, and Cohen and Gooch find the roots of that disaster in the curious complacency displayed by the British.
The invasion required a large-scale amphibious landing, something the British had little experience with. It then required combat against a foe dug into ravines and rocky outcroppings and hills and thickly vegetated landscapes that Cohen and Gooch call “one of the finest natural fortresses in the world.” Yet the British never bothered to draw up a formal plan of operations. The British military leadership had originally estimated that the Allies would need a hundred and fifty thousand troops to take Gallipoli. Only seventy thousand were sent. The British troops should have had artillery—more than three hundred guns. They took a hundred and eighteen, and, for the most part, neglected to bring howitzers, trench mortars, or grenades. Command of the landing at Sulva Bay—the most critical element of the attack—was given to Frederick Stopford, a retired officer whose experience was largely administrative. Stopford had two days during which he had a ten-to-one advantage over the Turks and could easily have seized the highlands overlooking the bay. Instead, his troops lingered on the beach, while Stopford lounged offshore, aboard a command ship. Winston Churchill later described the scene as “the placid, prudent, elderly English gentleman with his 20,000 men spread around the beaches, the front lines sitting on the tops of shallow trenches, smoking and cooking, with here and there an occasional rifle shot, others bathing by hundreds in the bright blue bay where, disturbed hardly by a single shell, floated the great ships of war.” When word of Stopford’s ineptitude reached the British commander, Sir Ian Hamilton, he rushed to Sulva Bay to intercede—although “rushed” may not be quite the right word here, since Hamilton had chosen to set up his command post on an island an hour away and it took him a good while to find a boat to take him to the scene.
Cohen and Gooch ascribe the disaster at Gallipoli to a failure to adapt—a failure to take into account how reality did not conform to their expectations. And behind that failure to adapt was a deeply psychological problem: the British simply couldn’t wrap their heads around the fact that they might have to adapt. “Let me bring my lads face to face with Turks in the open field,” Hamilton wrote in his diary before the attack. “We must beat them every time because British volunteer soldiers are superior individuals to Anatolians, Syrians or Arabs and are animated with a superior ideal and an equal joy in battle.”
Hamilton was not a fool. Cohen and Gooch call him an experienced and “brilliant commander who was also a firstrate trainer of men and a good organizer.” Nor was he entirely wrong in his assessments. The British probably were a superior fighting force. Certainly they were more numerous, especially when they held that ten-to-one advantage at Sulva Bay. Hamilton, it seems clear, was simply overconfident—and one of the things that happen to us when we become overconfident is that we start to blur the line between the kinds of things that we can control and the kinds of things that we can’t. The psychologist Ellen Langer once had subjects engage in a betting game against either a self-assured, well-dressed opponent or a shy and badly dressed opponent (in Langer’s delightful phrasing, the “dapper” or the “schnook” condition), and she found that her subjects bet far more aggressively when they played against the schnook. They looked at their awkward opponent and thought, I’m better than he is. Yet the game was pure chance: all the players did was draw cards at random from a deck, and see who had the high hand. This is called the “illusion of control”: confidence spills over from areas where it may be warranted (“I’m savvier than that schnook”) to areas where it isn’t warranted at all (“and that means I’m going to draw higher cards”).
At Gallipoli, the British acted as if their avowed superiority over the Turks gave them superiority over all aspects of the contest. They neglected to take into account the fact that the morning sun would be directly in the eyes of the troops as they stormed ashore. They didn’t bring enough water. They didn’t factor in the harsh terrain. “The attack was based on two assumptions,” Cohen and Gooch write, “both of which turned out to be unwise: that the only really difficult part of the operation would be getting ashore, after which the Turks could easily be pushed off the peninsula; and that the main obstacles to a happy landing would be provided by the enemy.”
Most people are inclined to use moral terms to describe overconfidence—terms like “arrogance” or “hubris.” But psychologists tend to regard overconfidence as a state as much as a trait. The British at Gallipoli were victims of a situation that promoted overconfidence. Langer didn’t say that it was only arrogant gamblers who upped their bets in the presence of the schnook. She argues that this is what competition does to all of us; because ability makes a difference in competitions of skill, we make the mistake of thinking that it must also make a difference in competitions of pure chance. Other studies have reached similar conclusions. As novices, we don’t trust our judgment. Then we have some success, and begin to feel a little surer of ourselves. Finally, we get to the top of our game and succumb to the trap of thinking that there’s nothing we can’t master. As we get older and more experienced, we overestimate the accuracy of our judgments, especially when the task before us is difficult and when we’re involved with something of great personal importance. The British were overconfident at Gallipoli not because Gallipoli didn’t matter but, paradoxically, because it did; it was a high-stakes contest, of daunting complexity, and it is often in those circumstances that overconfidence takes root.
Several years ago, a team headed by the psychologist Mark Fenton-O’Creevy created a computer program that mimicked the ups and downs of an index like the Dow, and recruited, as subjects, members of a highly paid profession. As the line moved across the screen, Fenton-O’Creevy asked his subjects to press a series of buttons, which, they were told, might or might not affect the course of the line. At the end of the session, they were asked to rate their effectiveness in moving the line upward. The buttons had no effect at all on the line. But many of the players were convinced that their manipulation of the buttons made the index go up and up. The world these people inhabited was competitive and stressful and complex. They had been given every reason to be confident in their own judgments. If they sat down next to you, with a tape recorder, it wouldn’t take much for them to believe that they had you in the palm of their hand. They were traders at an investment bank.
The high-water mark for Bear Stearns was 2003. The dollar was falling. A wave of scandals had just swept through the financial industry. The stock market was in a swoon. But Bear Stearns was an exception. In the first quarter of that year, its earnings jumped fifty-five per cent. Its return on equity was the highest on Wall Street. The firm’s mortgage business was booming. Since Bear Stearns’s founding, in 1923, it had always been a kind of also-ran to its more blue-chip counterparts, like Goldman Sachs and Morgan Stanley. But that year Fortune named it the best financial company to work for. “We are hitting on all 99 cylinders,’’ Jimmy Cayne told a reporter for the Times, in the spring of that year, “so you have to ask yourself, What can we do better? And I just can’t decide what that might be.’’ He went on, “Everyone says that when the markets turn around, we will suffer. But let me tell you, we are going to surprise some people this time around. Bear Stearns is a great place to be.’’
With the benefit of hindsight, Cayne’s words read like the purest hubris. But in 2003 they would have seemed banal. These are the kinds of things that bankers say. More precisely—and here is where psychological failure becomes more problematic still—these are the kinds of things that bankers are expected to say. Investment banks are able to borrow billions of dollars and make huge trades because, at the end of the day, their counterparties believe they are capable of making good on their promises. Wall Street is a confidence game, in the strictest sense of that phrase.
This is what social scientists mean when they say that human overconfidence can be an adaptive trait. “In conflicts involving mutual assessment, an exaggerated assessment of the probability of winning increases the probability of winning,” Richard Wrangham, a biological anthropologist at Harvard, writes. “Selection therefore favors this form of overconfidence.” Winners know how to bluff. And who bluffs the best? The person who, instead of pretending to be stronger than he is, actually believes himself to be stronger than he is. According to Wrangham, self-deception reduces the chances of “behavioral leakage”; that is, of “inadvertently revealing the truth through an inappropriate behavior.” This much is in keeping with what some psychologists have been telling us for years—that it can be useful to be especially optimistic about how attractive our spouse is, or how marketable our new idea is. In the words of the social psychologist Roy Baumeister, humans have an “optimal margin of illusion.”
If you were a Wall Street C.E.O., there were two potential lessons to be drawn from the collapse of Bear Stearns. The first was that Jimmy Cayne was overconfident. The second was that Jimmy Cayne wasn’t overconfident enough. Bear Stearns did not collapse, after all, simply because it had made bad bets. Until very close to the end, the firm had a capital cushion of more than seventeen billion dollars. The problem was that when, in early 2008, Cayne and his colleagues stood up and said that Bear was a great place to be, the rest of Wall Street no longer believed them. Clients withdrew their money, and lenders withheld funding. As the run on Bear Stearns worsened, J. P. Morgan and the Fed threw the bank a lifeline—a multibillion-dollar line of credit. But confidence matters so much on Wall Street that the lifeline had the opposite of its intended effect. As Bamber writes:
This line-of-credit, the stop-gap measure that was supposed to solve the problem that hadn’t really existed in the first place had done nothing but worsen it. When we started the week, we had no liquidity issues. But because people had said that we did have problems with our capital, it became true, even though it wasn’t true when people started saying it. . . . So we were forced to find capital to offset the losses we’d sustained because somebody decided we didn’t have capital when we really did. So when we finally got more capital to replace the capital we’d lost, people took that as a bad sign and pointed to the fact that we’d had no capital and had to get a loan to cover it, even when we did have the capital they said we didn’t have.
Of course, one reason that over-confidence is so difficult to eradicate from expert fields like finance is that, at least some of the time, it’s useful to be overconfident—or, more precisely, sometimes the only way to get out of the problems caused by overconfidence is to be even more overconfident.
From an individual perspective, it is hard to distinguish between the times when excessive optimism is good and the times when it isn’t. All that we can say unequivocally is that overconfidence is, as Wrangham puts it, “globally maladaptive.” When one opponent bluffs, he can score an easy victory. But when everyone bluffs, Wrangham writes, rivals end up “escalating conflicts that only one can win and suffering higher costs than they should if assessment were accurate.” The British didn’t just think the Turks would lose in Gallipoli; they thought that Belgium would prove to be an obstacle to Germany’s advance, and that the Russians would crush the Germans in the east. The French, for their part, planned to be at the Rhine within six weeks of the start of the war, while the Germans predicted that by that point they would be on the outskirts of Paris. Every side in the First World War was bluffing, with the resolve and skill that only the deluded are capable of, and the results, of course, were catastrophic.
Jimmy Cayne grew up in Chicago, the son of a patent lawyer. He wanted to be a bookie, but he realized that it wasn’t quite respectable enough. He went to Purdue University to study mechanical engineering—and became hooked on bridge. His grades suffered, and he never graduated. He got married in 1956 and was divorced within four years. “At this time, he was one of the best bridge players in Chicago,” his ex-brother-in-law told Cohan. “In fact, that’s the reason for the divorce. There was no other woman or anything like that. The co-respondent in their divorce was bridge. He spent all of his time playing bridge—every night. He wasn’t home.” He was selling scrap metal in those days, and, Cohan says, he would fall asleep on the job, exhausted from playing cards. In 1964, he moved to New York to become a professional bridge player. It was bridge that led him to his second wife, and to a job interview with Alan (Ace) Greenberg, then a senior executive at Bear Stearns. When Cayne told Greenberg that he was a bridge player, Cayne tells Cohan, “you could see the electric light bulb.” Cayne goes on:
[Greenberg] says, “How well do you play?” I said, “I play well.” He said, “Like how well?” I said, “I play quite well.” He says, “You don’t understand.” I said, “Yeah, I do. I understand. Mr. Greenberg, if you study bridge the rest of your life, if you play with the best partners and you achieve your potential, you will never play bridge like I play bridge.”
Right then and there, Cayne says, Greenberg offered him a job.
Twenty years later, the scene was repeated with Warren Spector, who went on to become a co-president of the firm. Spector had been a bridge champion as a student, and Cayne somehow heard about it. “Suddenly, out of nowhere there’s a bridge player at Bear Stearns on the bond desk,” Cayne recalls. Spector tells Cohan, “He called me up and said, ‘Are you a bridge player?’ I said, ‘I used to be.’ So bridge was something that he, Ace, and I all shared and talked about.” As reports circulated that two of Bear Stearns’s hedge funds were going under—a failure that started the bank on its long, downward spiral into collapse—Spector and Cayne were attending the Spingold K.O. bridge tournament, in Nashville. The Wall Street Journal reported that, of the twenty-one workdays that month, Cayne was out of the office for nearly half of them.
It makes sense that there should be an affinity between bridge and the business of Wall Street. Bridge is a contest between teams, each of which competes over a “contract”—how many tricks they think they can win in a given hand. Winning requires knowledge of the cards, an accurate sense of probabilities, steely nerves, and the ability to assess an opponent’s psychology. Bridge is Wall Street in miniature, and the reason the light bulb went on when Greenberg looked at Cayne, and Cayne looked at Spector, is surely that they assumed that bridge skills could be transferred to the trading floor—that being good at the game version of Wall Street was a reasonable proxy for being good at the real-life version of Wall Street.
It isn’t, however. In bridge, there is such a thing as expertise unencumbered by bias. That’s because, as the psychologist Gideon Keren points out, bridge involves “related items with continuous feedback.” It has rules and boundaries and situations that repeat themselves and clear patterns that develop—and when a player makes a mistake of overconfidence he or she learns of the consequences of that mistake almost immediately. In other words, it’s a game. But running an investment bank is not, in this sense, a game: it is not a closed world with a limited set of possibilities. It is an open world where one day a calamity can happen that no one had dreamed could happen, and where you can make a mistake of overconfidence and not personally feel the consequences for years and years—if at all. Perhaps this is part of why we play games: there is something intoxicating about pure expertise, and the real mastery we can attain around a card table or behind the wheel of a racecar emboldens us when we move into the more complex realms. “I’m good at that. I must be good at this, too,” we tell ourselves, forgetting that in wars and on Wall Street there is no such thing as absolute expertise, that every step taken toward mastery brings with it an increased risk of mastery’s curse. Cayne must have come back from the Spingold bridge tournament fortified in his belief in his own infallibility. And the striking thing about his conversations with Cohan is that nothing that had happened since seemed to have shaken that belief.
“When I left,” Cayne told Cohan, speaking of his final day at Bear Stearns, “I had three different meetings. The first was with the president’s advisory group, which was about eighty people. There wasn’t a dry eye. Standing ovation. I was crying.” Until the very end, he evidently saw the world that he wanted to see. “The second meeting was with the retail sales force on the Web,” he goes on. “Standing ovation. And the third was a partners’ meeting that night for me to tell them that I was stepping down. Standing ovation, of the whole auditorium.” ♦
The first thing you need to know about Goldman Sachs is that it’s everywhere. The world’s most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money. In fact, the history of the recent financial crisis, which doubles as a history of the rapid decline and fall of the suddenly swindled dry American empire, reads like a Who’s Who of Goldman Sachs graduates.
By now, most of us know the major players. As George Bush’s last Treasury secretary, former Goldman CEO Henry Paulson was the architect of the bailout, a suspiciously self-serving plan to funnel trillions of Your Dollars to a handful of his old friends on Wall Street. Robert Rubin, Bill Clinton’s former Treasury secretary, spent 26 years at Goldman before becoming chairman of Citigroup — which in turn got a $300 billion taxpayer bailout from Paulson. There’s John Thain, the asshole chief of Merrill Lynch who bought an $87,000 area rug for his office as his company was imploding; a former Goldman banker, Thain enjoyed a multibilliondollar handout from Paulson, who used billions in taxpayer funds to help Bank of America rescue Thain’s sorry company. And Robert Steel, the former Goldmanite head of Wachovia, scored himself and his fellow executives $225 million in goldenparachute payments as his bank was selfdestructing. There’s Joshua Bolten, Bush’s chief of staff during the bailout, and Mark Patterson, the current Treasury chief of staff, who was a Goldman lobbyist just a year ago, and Ed Liddy, the former Goldman director whom Paulson put in charge of bailedout insurance giant AIG, which forked over $13 billion to Goldman after Liddy came on board. The heads of the Canadian and Italian national banks are Goldman alums, as is the head of the World Bank, the head of the New York Stock Exchange, the last two heads of the Federal Reserve Bank of New York — which, incidentally, is now in charge of overseeing Goldman — not to mention …
But then, any attempt to construct a narrative around all the former Goldmanites in influential positions quickly becomes an absurd and pointless exercise, like trying to make a list of everything. What you need to know is the big picture: If America is circling the drain, Goldman Sachs has found a way to be that drain — an extremely unfortunate loophole in the system of Western democratic capitalism, which never foresaw that in a society governed passively by free markets and free elections, organized greed always defeats disorganized democracy.
The bank’s unprecedented reach and power have enabled it to turn all of America into a giant pumpanddump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere — high gas prices, rising consumercredit rates, halfeaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you’re losing, it’s going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where it’s going: The bank is a huge, highly sophisticated engine for converting the useful, deployed wealth of society into the least useful, most wasteful and insoluble substance on Earth — pure profit for rich individuals.
They achieve this using the same playbook over and over again. The formula is relatively simple: Goldman positions itself in the middle of a speculative bubble, selling investments they know are crap. Then they hoover up vast sums from the middle and lower floors of society with the aid of a crippled and corrupt state that allows it to rewrite the rules in exchange for the relative pennies the bank throws at political patronage. Finally, when it all goes bust, leaving millions of ordinary citizens broke and starving, they begin the entire process over again, riding in to rescue us all by lending us back our own money at interest, selling themselves as men above greed, just a bunch of really smart guys keeping the wheels greased. They’ve been pulling this same stunt over and over since the 1920s — and now they’re preparing to do it again, creating what may be the biggest and most audacious bubble yet.
If you want to understand how we got into this financial crisis, you have to first understand where all the money went — and in order to understand that, you need to understand what Goldman has already gotten away with. It is a history exactly five bubbles long — including last year’s strange and seemingly inexplicable spike in the price of oil. There were a lot of losers in each of those bubbles, and in the bailout that followed. But Goldman wasn’t one of them.
BUBBLE #1 The Great Depression
Goldman wasn’t always a too-big-to-fail Wall Street behemoth, the ruthless face of kill-or-be-killed capitalism on steroids — just almost always. The bank was actually founded in 1869 by a German immigrant named Marcus Goldman, who built it up with his soninlaw Samuel Sachs. They were pioneers in the use of commercial paper, which is just a fancy way of saying they made money lending out shortterm IOUs to smalltime vendors in downtown Manhattan.
You can probably guess the basic plotline of Goldman’s first 100 years in business: plucky, immigrantled investment bank beats the odds, pulls itself up by its bootstraps, makes shitloads of money. In that ancient history there’s really only one episode that bears scrutiny now, in light of more recent events: Goldman’s disastrous foray into the speculative mania of precrash Wall Street in the late 1920s.
This great Hindenburg of financial history has a few features that might sound familiar. Back then, the main financial tool used to bilk investors was called an “investment trust.” Similar to modern mutual funds, the trusts took the cash of investors large and small and (theoretically, at least) invested it in a smorgasbord of Wall Street securities, though the securities and amounts were often kept hidden from the public. So a regular guy could invest $10 or $100 in a trust and feel like he was a big player. Much as in the 1990s, when new vehicles like day trading and etrading attracted reams of new suckers from the sticks who wanted to feel like big shots, investment trusts roped a new generation of regularguy investors into the speculation game.
Beginning a pattern that would repeat itself over and over again, Goldman got into the investmenttrust game late, then jumped in with both feet and went hogwild. The first effort was the Goldman Sachs Trading Corporation; the bank issued a million shares at $100 apiece, bought all those shares with its own money and then sold 90 percent of them to the hungry public at $104. The trading corporation then relentlessly bought shares in itself, bidding the price up further and further. Eventually it dumped part of its holdings and sponsored a new trust, the Shenandoah Corporation, issuing millions more in shares in that fund — which in turn sponsored yet another trust called the Blue Ridge Corporation. In this way, each investment trust served as a front for an endless investment pyramid: Goldman hiding behind Goldman hiding behind Goldman. Of the 7,250,000 initial shares of Blue Ridge, 6,250,000 were actually owned by Shenandoah — which, of course, was in large part owned by Goldman Trading.
The end result (ask yourself if this sounds familiar) was a daisy chain of borrowed money, one exquisitely vulnerable to a decline in performance anywhere along the line. The basic idea isn’t hard to follow. You take a dollar and borrow nine against it; then you take that $10 fund and borrow $90; then you take your $100 fund and, so long as the public is still lending, borrow and invest $900. If the last fund in the line starts to lose value, you no longer have the money to pay back your investors, and everyone gets massacred.
In a chapter from The Great Crash, 1929 titled “In Goldman Sachs We Trust,” the famed economist John Kenneth Galbraith held up the Blue Ridge and Shenandoah trusts as classic examples of the insanity of leveragebased investment. The trusts, he wrote, were a major cause of the market’s historic crash; in today’s dollars, the losses the bank suffered totaled $475 billion. “It is difficult not to marvel at the imagination which was implicit in this gargantuan insanity,” Galbraith observed, sounding like Keith Olbermann in an ascot. “If there must be madness, something may be said for having it on a heroic scale.”
BUBBLE #2 Tech Stocks
Fast-forward about 65 years. Goldman not only survived the crash that wiped out so many of the investors it duped, it went on to become the chief underwriter to the country’s wealthiest and most powerful corporations. Thanks to Sidney Weinberg, who rose from the rank of janitor’s assistant to head the firm, Goldman became the pioneer of the initial public offering, one of the principal and most lucrative means by which companies raise money. During the 1970s and 1980s, Goldman may not have been the planet-eating Death Star of political influence it is today, but it was a topdrawer firm that had a reputation for attracting the very smartest talent on the Street.
It also, oddly enough, had a reputation for relatively solid ethics and a patient approach to investment that shunned the fast buck; its executives were trained to adopt the firm’s mantra, “longterm greedy.” One former Goldman banker who left the firm in the early Nineties recalls seeing his superiors give up a very profitable deal on the grounds that it was a longterm loser. “We gave back money to ‘grownup’ corporate clients who had made bad deals with us,” he says. “Everything we did was legal and fair — but ‘longterm greedy’ said we didn’t want to make such a profit at the clients’ collective expense that we spoiled the marketplace.”
But then, something happened. It’s hard to say what it was exactly; it might have been the fact that Goldman’s cochairman in the early Nineties, Robert Rubin, followed Bill Clinton to the White House, where he directed the National Economic Council and eventually became Treasury secretary. While the American media fell in love with the story line of a pair of babyboomer, Sixtieschild, Fleetwood Mac yuppies nesting in the White House, it also nursed an undisguised crush on Rubin, who was hyped as without a doubt the smartest person ever to walk the face of the Earth, with Newton, Einstein, Mozart and Kant running far behind.
Rubin was the prototypical Goldman banker. He was probably born in a $4,000 suit, he had a face that seemed permanently frozen just short of an apology for being so much smarter than you, and he exuded a Spock-like, emotion-neutral exterior; the only human feeling you could imagine him experiencing was a nightmare about being forced to fly coach. It became almost a national clichè that whatever Rubin thought was best for the economy — a phenomenon that reached its apex in 1999, when Rubin appeared on the cover of Time with his Treasury deputy, Larry Summers, and Fed chief Alan Greenspan under the headline The Committee To Save The World. And “what Rubin thought,” mostly, was that the American economy, and in particular the financial markets, were over-regulated and needed to be set free. During his tenure at Treasury, the Clinton White House made a series of moves that would have drastic consequences for the global economy — beginning with Rubin’s complete and total failure to regulate his old firm during its first mad dash for obscene short-term profits.
The basic scam in the Internet Age is pretty easy even for the financially illiterate to grasp. Companies that weren’t much more than potfueled ideas scrawled on napkins by uptoolate bongsmokers were taken public via IPOs, hyped in the media and sold to the public for mega-millions. It was as if banks like Goldman were wrapping ribbons around watermelons, tossing them out 50-story windows and opening the phones for bids. In this game you were a winner only if you took your money out before the melon hit the pavement.
It sounds obvious now, but what the average investor didn’t know at the time was that the banks had changed the rules of the game, making the deals look better than they actually were. They did this by setting up what was, in reality, a two-tiered investment system — one for the insiders who knew the real numbers, and another for the lay investor who was invited to chase soaring prices the banks themselves knew were irrational. While Goldman’s later pattern would be to capitalize on changes in the regulatory environment, its key innovation in the Internet years was to abandon its own industry’s standards of quality control.
“Since the Depression, there were strict underwriting guidelines that Wall Street adhered to when taking a company public,” says one prominent hedge-fund manager. “The company had to be in business for a minimum of five years, and it had to show profitability for three consecutive years. But Wall Street took these guidelines and threw them in the trash.” Goldman completed the snow job by pumping up the sham stocks: “Their analysts were out there saying Bullshit.com is worth $100 a share.”
The problem was, nobody told investors that the rules had changed. “Everyone on the inside knew,” the manager says. “Bob Rubin sure as hell knew what the underwriting standards were. They’d been intact since the 1930s.”
Jay Ritter, a professor of finance at the University of Florida who specializes in IPOs, says banks like Goldman knew full well that many of the public offerings they were touting would never make a dime. “In the early Eighties, the major underwriters insisted on three years of profitability. Then it was one year, then it was a quarter. By the time of the Internet bubble, they were not even requiring profitability in the foreseeable future.”
Goldman has denied that it changed its underwriting standards during the Internet years, but its own statistics belie the claim. Just as it did with the investment trust in the 1920s, Goldman started slow and finished crazy in the Internet years. After it took a littleknown company with weak financials called Yahoo! public in 1996, once the tech boom had already begun, Goldman quickly became the IPO king of the Internet era. Of the 24 companies it took public in 1997, a third were losing money at the time of the IPO. In 1999, at the height of the boom, it took 47 companies public, including stillborns like Webvan and eToys, investment offerings that were in many ways the modern equivalents of Blue Ridge and Shenandoah. The following year, it underwrote 18 companies in the first four months, 14 of which were money losers at the time. As a leading underwriter of Internet stocks during the boom, Goldman provided profits far more volatile than those of its competitors: In 1999, the average Goldman IPO leapt 281 percent above its offering price, compared to the Wall Street average of 181 percent.
How did Goldman achieve such extraordinary results? One answer is that they used a practice called “laddering,” which is just a fancy way of saying they manipulated the share price of new offerings. Here’s how it works: Say you’re Goldman Sachs, and Bullshit.com comes to you and asks you to take their company public. You agree on the usual terms: You’ll price the stock, determine how many shares should be released and take the Bullshit.com CEO on a “road show” to schmooze investors, all in exchange for a substantial fee (typically six to seven percent of the amount raised). You then promise your best clients the right to buy big chunks of the IPO at the low offering price — let’s say Bullshit.com’s starting share price is $15 — in exchange for a promise that they will buy more shares later on the open market. That seemingly simple demand gives you inside knowledge of the IPO’s future, knowledge that wasn’t disclosed to the daytrader schmucks who only had the prospectus to go by: You know that certain of your clients who bought X amount of shares at $15 are also going to buy Y more shares at $20 or $25, virtually guaranteeing that the price is going to go to $25 and beyond. In this way, Goldman could artificially jack up the new company’s price, which of course was to the bank’s benefit — a six percent fee of a $500 million IPO is serious money.
Goldman was repeatedly sued by shareholders for engaging in laddering in a variety of Internet IPOs, including Webvan and NetZero. The deceptive practices also caught the attention of Nicholas Maier, the syndicate manager of Cramer & Co., the hedge fund run at the time by the now-famous chattering television asshole Jim Cramer, himself a Goldman alum. Maier told the SEC that while working for Cramer between 1996 and 1998, he was repeatedly forced to engage in laddering practices during IPO deals with Goldman.
“Goldman, from what I witnessed, they were the worst perpetrator,” Maier said. “They totally fueled the bubble. And it’s specifically that kind of behavior that has caused the market crash. They built these stocks upon an illegal foundation — manipulated up — and ultimately, it really was the small person who ended up buying in.” In 2005, Goldman agreed to pay $40 million for its laddering violations — a puny penalty relative to the enormous profits it made. (Goldman, which has denied wrongdoing in all of the cases it has settled, refused to respond to questions for this story.)
Another practice Goldman engaged in during the Internet boom was “spinning,” better known as bribery. Here the investment bank would offer the executives of the newly public company shares at extra-low prices, in exchange for future underwriting business. Banks that engaged in spinning would then undervalue the initial offering price — ensuring that those “hot” opening-price shares it had handed out to insiders would be more likely to rise quickly, supplying bigger firstday rewards for the chosen few. So instead of Bullshit.com opening at $20, the bank would approach the Bullshit.com CEO and offer him a million shares of his own company at $18 in exchange for future business — effectively robbing all of Bullshit’s new shareholders by diverting cash that should have gone to the company’s bottom line into the private bank account of the company’s CEO.
In one case, Goldman allegedly gave a multimillion-dollar special offering to eBay CEO Meg Whitman, who later joined Goldman’s board, in exchange for future i-banking business. According to a report by the House Financial Services Committee in 2002, Goldman gave special stock offerings to executives in 21 companies that it took public, including Yahoo! cofounder Jerry Yang and two of the great slithering villains of the financial-scandal age — Tyco’s Dennis Kozlowski and Enron’s Ken Lay. Goldman angrily denounced the report as “an egregious distortion of the facts” — shortly before paying $110 million to settle an investigation into spinning and other manipulations launched by New York state regulators. “The spinning of hot IPO shares was not a harmless corporate perk,” then-attorney general Eliot Spitzer said at the time. “Instead, it was an integral part of a fraudulent scheme to win new investment-banking business.”
Such practices conspired to turn the Internet bubble into one of the greatest financial disasters in world history: Some $5 trillion of wealth was wiped out on the NASDAQ alone. But the real problem wasn’t the money that was lost by shareholders, it was the money gained by investment bankers, who received hefty bonuses for tampering with the market. Instead of teaching Wall Street a lesson that bubbles always deflate, the Internet years demonstrated to bankers that in the age of freely flowing capital and publicly owned financial companies, bubbles are incredibly easy to inflate, and individual bonuses are actually bigger when the mania and the irrationality are greater.
Nowhere was this truer than at Goldman. Between 1999 and 2002, the firm paid out $28.5 billion in compensation and benefits — an average of roughly $350,000 a year per employee. Those numbers are important because the key legacy of the Internet boom is that the economy is now driven in large part by the pursuit of the enormous salaries and bonuses that such bubbles make possible. Goldman’s mantra of “long-term greedy” vanished into thin air as the game became about getting your check before the melon hit the pavement.
The market was no longer a rationally managed place to grow real, profitable businesses: It was a huge ocean of Someone Else’s Money where bankers hauled in vast sums through whatever means necessary and tried to convert that money into bonuses and payouts as quickly as possible. If you laddered and spun 50 Internet IPOs that went bust within a year, so what? By the time the Securities and Exchange Commission got around to fining your firm $110 million, the yacht you bought with your IPO bonuses was already six years old. Besides, you were probably out of Goldman by then, running the U.S. Treasury or maybe the state of New Jersey. (One of the truly comic moments in the history of America’s recent financial collapse came when Gov. Jon Corzine of New Jersey, who ran Goldman from 1994 to 1999 and left with $320 million in IPO-fattened stock, insisted in 2002 that “I’ve never even heard the term ‘laddering’ before.”)
For a bank that paid out $7 billion a year in salaries, $110 million fines issued half a decade late were something far less than a deterrent — they were a joke. Once the Internet bubble burst, Goldman had no incentive to reassess its new, profit-driven strategy; it just searched around for another bubble to inflate. As it turns out, it had one ready, thanks in large part to Rubin.
BUBBLE #3 The Housing Craze
Goldman’s role in the sweeping global disaster that was the housing bubble is not hard to trace. Here again, the basic trick was a decline in underwriting standards, although in this case the standards weren’t in IPOs but in mortgages. By now almost everyone knows that for decades mortgage dealers insisted that home buyers be able to produce a down payment of 10 percent or more, show a steady income and good credit rating, and possess a real first and last name. Then, at the dawn of the new millennium, they suddenly threw all that shit out the window and started writing mortgages on the backs of napkins to cocktail waitresses and excons carrying five bucks and a Snickers bar.
None of that would have been possible without investment bankers like Goldman, who created vehicles to package those shitty mortgages and sell them en masse to unsuspecting insurance companies and pension funds. This created a mass market for toxic debt that would never have existed before; in the old days, no bank would have wanted to keep some addict ex-con’s mortgage on its books, knowing how likely it was to fail. You can’t write these mortgages, in other words, unless you can sell them to someone who doesn’t know what they are.
Goldman used two methods to hide the mess they were selling. First, they bundled hundreds of different mortgages into instruments called Collateralized Debt Obligations. Then they sold investors on the idea that, because a bunch of those mortgages would turn out to be OK, there was no reason to worry so much about the shitty ones: The CDO, as a whole, was sound. Thus, junkrated mortgages were turned into AAArated investments. Second, to hedge its own bets, Goldman got companies like AIG to provide insurance — known as creditdefault swaps — on the CDOs. The swaps were essentially a racetrack bet between AIG and Goldman: Goldman is betting the excons will default, AIG is betting they won’t.
There was only one problem with the deals: All of the wheeling and dealing represented exactly the kind of dangerous speculation that federal regulators are supposed to rein in. Derivatives like CDOs and credit swaps had already caused a series of serious financial calamities: Procter & Gamble and Gibson Greetings both lost fortunes, and Orange County, California, was forced to default in 1994. A report that year by the Government Accountability Office recommended that such financial instruments be tightly regulated — and in 1998, the head of the Commodity Futures Trading Commission, a woman named Brooksley Born, agreed. That May, she circulated a letter to business leaders and the Clinton administration suggesting that banks be required to provide greater disclosure in derivatives trades, and maintain reserves to cushion against losses.
More regulation wasn’t exactly what Goldman had in mind. “The banks go crazy — they want it stopped,” says Michael Greenberger, who worked for Born as director of trading and markets at the CFTC and is now a law professor at the University of Maryland. “Greenspan, Summers, Rubin and [SEC chief Arthur] Levitt want it stopped.”
Clinton’s reigning economic foursome — “especially Rubin,” according to Greenberger — called Born in for a meeting and pleaded their case. She refused to back down, however, and continued to push for more regulation of the derivatives. Then, in June 1998, Rubin went public to denounce her move, eventually recommending that Congress strip the CFTC of its regulatory authority. In 2000, on its last day in session, Congress passed the now-notorious Commodity Futures Modernization Act, which had been inserted into an 11,000-page spending bill at the last minute, with almost no debate on the floor of the Senate. Banks were now free to trade default swaps with impunity.
But the story didn’t end there. AIG, a major purveyor of default swaps, approached the New York State Insurance Department in 2000 and asked whether default swaps would be regulated as insurance. At the time, the office was run by one Neil Levin, a former Goldman vice president, who decided against regulating the swaps. Now freed to underwrite as many housingbased securities and buy as much credit-default protection as it wanted, Goldman went berserk with lending lust. By the peak of the housing boom in 2006, Goldman was underwriting $76.5 billion worth of mortgagebacked securities — a third of which were subprime — much of it to institutional investors like pensions and insurance companies. And in these massive issues of real estate were vast swamps of crap.
Take one $494 million issue that year, GSAMP Trust 2006S3. Many of the mortgages belonged to secondmortgage borrowers, and the average equity they had in their homes was 0.71 percent. Moreover, 58 percent of the loans included little or no documentation — no names of the borrowers, no addresses of the homes, just zip codes. Yet both of the major ratings agencies, Moody’s and Standard & Poor’s, rated 93 percent of the issue as investment grade. Moody’s projected that less than 10 percent of the loans would default. In reality, 18 percent of the mortgages were in default within 18 months.
Not that Goldman was personally at any risk. The bank might be taking all these hideous, completely irresponsible mortgages from beneath-gangster-status firms like Countrywide and selling them off to municipalities and pensioners — old people, for God’s sake — pretending the whole time that it wasn’t gradeD horseshit. But even as it was doing so, it was taking short positions in the same market, in essence betting against the same crap it was selling. Even worse, Goldman bragged about it in public. “The mortgage sector continues to be challenged,” David Viniar, the bank’s chief financial officer, boasted in 2007. “As a result, we took significant markdowns on our long inventory positions … However, our risk bias in that market was to be short, and that net short position was profitable.” In other words, the mortgages it was selling were for chumps. The real money was in betting against those same mortgages.
“That’s how audacious these assholes are,” says one hedgefund manager. “At least with other banks, you could say that they were just dumb — they believed what they were selling, and it blew them up. Goldman knew what it was doing.”
I ask the manager how it could be that selling something to customers that you’re actually betting against — particularly when you know more about the weaknesses of those products than the customer — doesn’t amount to securities fraud.
“It’s exactly securities fraud,” he says. “It’s the heart of securities fraud.”
Eventually, lots of aggrieved investors agreed. In a virtual repeat of the Internet IPO craze, Goldman was hit with a wave of lawsuits after the collapse of the housing bubble, many of which accused the bank of withholding pertinent information about the quality of the mortgages it issued. New York state regulators are suing Goldman and 25 other underwriters for selling bundles of crappy Countrywide mortgages to city and state pension funds, which lost as much as $100 million in the investments. Massachusetts also investigated Goldman for similar misdeeds, acting on behalf of 714 mortgage holders who got stuck holding predatory loans. But once again, Goldman got off virtually scot-free, staving off prosecution by agreeing to pay a paltry $60 million — about what the bank’s CDO division made in a day and a half during the real estate boom.
The effects of the housing bubble are well known — it led more or less directly to the collapse of Bear Stearns, Lehman Brothers and AIG, whose toxic portfolio of credit swaps was in significant part composed of the insurance that banks like Goldman bought against their own housing portfolios. In fact, at least $13 billion of the taxpayer money given to AIG in the bailout ultimately went to Goldman, meaning that the bank made out on the housing bubble twice: It fucked the investors who bought their horseshit CDOs by betting against its own crappy product, then it turned around and fucked the taxpayer by making him pay off those same bets.
And once again, while the world was crashing down all around the bank, Goldman made sure it was doing just fine in the compensation department. In 2006, the firm’s payroll jumped to $16.5 billion — an average of $622,000 per employee. As a Goldman spokesman explained, “We work very hard here.”
But the best was yet to come. While the collapse of the housing bubble sent most of the financial world fleeing for the exits, or to jail, Goldman boldly doubled down — and almost single-handedly created yet another bubble, one the world still barely knows the firm had anything to do with.
BUBBLE #4 $4 a Gallon
By the beginning of 2008, the financial world was in turmoil. Wall Street had spent the past two and a half decades producing one scandal after another, which didn’t leave much to sell that wasn’t tainted. The terms junk bond, IPO, subprime mortgage and other once-hot financial fare were now firmly associated in the public’s mind with scams; the terms credit swaps and CDOs were about to join them. The credit markets were in crisis, and the mantra that had sustained the fantasy economy throughout the Bush years — the notion that housing prices never go down — was now a fully exploded myth, leaving the Street clamoring for a new bullshit paradigm to sling.
Where to go? With the public reluctant to put money in anything that felt like a paper investment, the Street quietly moved the casino to the physical-commodities market — stuff you could touch: corn, coffee, cocoa, wheat and, above all, energy commodities, especially oil. In conjunction with a decline in the dollar, the credit crunch and the housing crash caused a “flight to commodities.” Oil futures in particular skyrocketed, as the price of a single barrel went from around $60 in the middle of 2007 to a high of $147 in the summer of 2008.
That summer, as the presidential campaign heated up, the accepted explanation for why gasoline had hit $4.11 a gallon was that there was a problem with the world oil supply. In a classic example of how Republicans and Democrats respond to crises by engaging in fierce exchanges of moronic irrelevancies, John McCain insisted that ending the moratorium on offshore drilling would be “very helpful in the short term,” while Barack Obama in typical liberal-arts yuppie style argued that federal investment in hybrid cars was the way out.
But it was all a lie. While the global supply of oil will eventually dry up, the shortterm flow has actually been increasing. In the six months before prices spiked, according to the U.S. Energy Information Administration, the world oil supply rose from 85.24 million barrels a day to 85.72 million. Over the same period, world oil demand dropped from 86.82 million barrels a day to 86.07 million. Not only was the shortterm supply of oil rising, the demand for it was falling — which, in classic economic terms, should have brought prices at the pump down.
So what caused the huge spike in oil prices? Take a wild guess. Obviously Goldman had help — there were other players in the physicalcommodities market — but the root cause had almost everything to do with the behavior of a few powerful actors determined to turn the oncesolid market into a speculative casino. Goldman did it by persuading pension funds and other large institutional investors to invest in oil futures — agreeing to buy oil at a certain price on a fixed date. The push transformed oil from a physical commodity, rigidly subject to supply and demand, into something to bet on, like a stock. Between 2003 and 2008, the amount of speculative money in commodities grew from $13 billion to $317 billion, an increase of 2,300 percent. By 2008, a barrel of oil was traded 27 times, on average, before it was actually delivered and consumed.
As is so often the case, there had been a Depression-era law in place designed specifically to prevent this sort of thing. The commodities market was designed in large part to help farmers: A grower concerned about future price drops could enter into a contract to sell his corn at a certain price for delivery later on, which made him worry less about building up stores of his crop. When no one was buying corn, the farmer could sell to a middleman known as a “traditional speculator,” who would store the grain and sell it later, when demand returned. That way, someone was always there to buy from the farmer, even when the market temporarily had no need for his crops.
In 1936, however, Congress recognized that there should never be more speculators in the market than real producers and consumers. If that happened, prices would be affected by something other than supply and demand, and price manipulations would ensue. A new law empowered the Commodity Futures Trading Commission — the very same body that would later try and fail to regulate credit swaps — to place limits on speculative trades in commodities. As a result of the CFTC’s oversight, peace and harmony reigned in the commodities markets for more than 50 years.
All that changed in 1991 when, unbeknownst to almost everyone in the world, a Goldmanowned commoditiestrading subsidiary called J. Aron wrote to the CFTC and made an unusual argument. Farmers with big stores of corn, Goldman argued, weren’t the only ones who needed to hedge their risk against future price drops — Wall Street dealers who made big bets on oil prices also needed to hedge their risk, because, well, they stood to lose a lot too.
This was complete and utter crap — the 1936 law, remember, was specifically designed to maintain distinctions between people who were buying and selling real tangible stuff and people who were trading in paper alone. But the CFTC, amazingly, bought Goldman’s argument. It issued the bank a free pass, called the “Bona Fide Hedging” exemption, allowing Goldman’s subsidiary to call itself a physical hedger and escape virtually all limits placed on speculators. In the years that followed, the commission would quietly issue 14 similar exemptions to other companies.
Now Goldman and other banks were free to drive more investors into the commodities markets, enabling speculators to place increasingly big bets. That 1991 letter from Goldman more or less directly led to the oil bubble in 2008, when the number of speculators in the market — driven there by fear of the falling dollar and the housing crash — finally overwhelmed the real physical suppliers and consumers. By 2008, at least three quarters of the activity on the commodity exchanges was speculative, according to a congressional staffer who studied the numbers — and that’s likely a conservative estimate. By the middle of last summer, despite rising supply and a drop in demand, we were paying $4 a gallon every time we pulled up to the pump.
What is even more amazing is that the letter to Goldman, along with most of the other trading exemptions, was handed out more or less in secret. “I was the head of the division of trading and markets, and Brooksley Born was the chair of the CFTC,” says Greenberger, “and neither of us knew this letter was out there.” In fact, the letters only came to light by accident. Last year, a staffer for the House Energy and Commerce Committee just happened to be at a briefing when officials from the CFTC made an offhand reference to the exemptions.
“I had been invited to a briefing the commission was holding on energy,” the staffer recounts. “And suddenly in the middle of it, they start saying, ‘Yeah, we’ve been issuing these letters for years now.’ I raised my hand and said, ‘Really? You issued a letter? Can I see it?’ And they were like, ‘Duh, duh.’ So we went back and forth, and finally they said, ‘We have to clear it with Goldman Sachs.’ I’m like, ‘What do you mean, you have to clear it with Goldman Sachs?'”
The CFTC cited a rule that prohibited it from releasing any information about a company’s current position in the market. But the staffer’s request was about a letter that had been issued 17 years earlier. It no longer had anything to do with Goldman’s current position. What’s more, Section 7 of the 1936 commodities law gives Congress the right to any information it wants from the commission. Still, in a classic example of how complete Goldman’s capture of government is, the CFTC waited until it got clearance from the bank before it turned the letter over.
Armed with the semi-secret government exemption, Goldman had become the chief designer of a giant commodities betting parlor. Its Goldman Sachs Commodities Index — which tracks the prices of 24 major commodities but is overwhelmingly weighted toward oil — became the place where pension funds and insurance companies and other institutional investors could make massive longterm bets on commodity prices. Which was all well and good, except for a couple of things. One was that index speculators are mostly “long only” bettors, who seldom if ever take short positions — meaning they only bet on prices to rise. While this kind of behavior is good for a stock market, it’s terrible for commodities, because it continually forces prices upward. “If index speculators took short positions as well as long ones, you’d see them pushing prices both up and down,” says Michael Masters, a hedgefund manager who has helped expose the role of investment banks in the manipulation of oil prices. “But they only push prices in one direction: up.”
Complicating matters even further was the fact that Goldman itself was cheerleading with all its might for an increase in oil prices. In the beginning of 2008, Arjun Murti, a Goldman analyst, hailed as an “oracle of oil” by The New York Times, predicted a “super spike” in oil prices, forecasting a rise to $200 a barrel. At the time Goldman was heavily invested in oil through its commoditiestrading subsidiary, J. Aron; it also owned a stake in a major oil refinery in Kansas, where it warehoused the crude it bought and sold. Even though the supply of oil was keeping pace with demand, Murti continually warned of disruptions to the world oil supply, going so far as to broadcast the fact that he owned two hybrid cars. High prices, the bank insisted, were somehow the fault of the piggish American consumer; in 2005, Goldman analysts insisted that we wouldn’t know when oil prices would fall until we knew “when American consumers will stop buying gas-guzzling sport utility vehicles and instead seek fuel-efficient alternatives.”
But it wasn’t the consumption of real oil that was driving up prices — it was the trade in paper oil. By the summer of 2008, in fact, commodities speculators had bought and stockpiled enough oil futures to fill 1.1 billion barrels of crude, which meant that speculators owned more future oil on paper than there was real, physical oil stored in all of the country’s commercial storage tanks and the Strategic Petroleum Reserve combined. It was a repeat of both the Internet craze and the housing bubble, when Wall Street jacked up presentday profits by selling suckers shares of a fictional fantasy future of endlessly rising prices.
In what was by now a painfully familiar pattern, the oil-commodities melon hit the pavement hard in the summer of 2008, causing a massive loss of wealth; crude prices plunged from $147 to $33. Once again the big losers were ordinary people. The pensioners whose funds invested in this crap got massacred: CalPERS, the California Public Employees’ Retirement System, had $1.1 billion in commodities when the crash came. And the damage didn’t just come from oil. Soaring food prices driven by the commodities bubble led to catastrophes across the planet, forcing an estimated 100 million people into hunger and sparking food riots throughout the Third World.
Now oil prices are rising again: They shot up 20 percent in the month of May and have nearly doubled so far this year. Once again, the problem is not supply or demand. “The highest supply of oil in the last 20 years is now,” says Rep. Bart Stupak, a Democrat from Michigan who serves on the House energy committee. “Demand is at a 10-year low. And yet prices are up.”
Asked why politicians continue to harp on things like drilling or hybrid cars, when supply and demand have nothing to do with the high prices, Stupak shakes his head. “I think they just don’t understand the problem very well,” he says. “You can’t explain it in 30 seconds, so politicians ignore it.”
BUBBLE #5 Rigging the Bailout
After the oil bubble collapsed last fall, there was no new bubble to keep things humming — this time, the money seems to be really gone, like worldwide-depression gone. So the financial safari has moved elsewhere, and the big game in the hunt has become the only remaining pool of dumb, unguarded capital left to feed upon: taxpayer money. Here, in the biggest bailout in history, is where Goldman Sachs really started to flex its muscle.
It began in September of last year, when then-Treasury secretary Paulson made a momentous series of decisions. Although he had already engineered a rescue of Bear Stearns a few months before and helped bail out quasi-private lenders Fannie Mae and Freddie Mac, Paulson elected to let Lehman Brothers — one of Goldman’s last real competitors — collapse without intervention. (“Goldman’s superhero status was left intact,” says market analyst Eric Salzman, “and an investmentbanking competitor, Lehman, goes away.”) The very next day, Paulson greenlighted a massive, $85 billion bailout of AIG, which promptly turned around and repaid $13 billion it owed to Goldman. Thanks to the rescue effort, the bank ended up getting paid in full for its bad bets: By contrast, retired auto workers awaiting the Chrysler bailout will be lucky to receive 50 cents for every dollar they are owed.
Immediately after the AIG bailout, Paulson announced his federal bailout for the financial industry, a $700 billion plan called the Troubled Asset Relief Program, and put a heretofore unknown 35yearold Goldman banker named Neel Kashkari in charge of administering the funds. In order to qualify for bailout monies, Goldman announced that it would convert from an investment bank to a bankholding company, a move that allows it access not only to $10 billion in TARP funds, but to a whole galaxy of less conspicuous, publicly backed funding — most notably, lending from the discount window of the Federal Reserve. By the end of March, the Fed will have lent or guaranteed at least $8.7 trillion under a series of new bailout programs — and thanks to an obscure law allowing the Fed to block most congressional audits, both the amounts and the recipients of the monies remain almost entirely secret.
Converting to a bank-holding company has other benefits as well: Goldman’s primary supervisor is now the New York Fed, whose chairman at the time of its announcement was Stephen Friedman, a former co-chairman of Goldman Sachs. Friedman was technically in violation of Federal Reserve policy by remaining on the board of Goldman even as he was supposedly regulating the bank; in order to rectify the problem, he applied for, and got, a conflictofinterest waiver from the government. Friedman was also supposed to divest himself of his Goldman stock after Goldman became a bankholding company, but thanks to the waiver, he was allowed to go out and buy 52,000 additional shares in his old bank, leaving him $3 million richer. Friedman stepped down in May, but the man now in charge of supervising Goldman — New York Fed president William Dudley — is yet another former Goldmanite.
The collective message of all this — the AIG bailout, the swift approval for its bankholding conversion, the TARP funds — is that when it comes to Goldman Sachs, there isn’t a free market at all. The government might let other players on the market die, but it simply will not allow Goldman to fail under any circumstances. Its edge in the market has suddenly become an open declaration of supreme privilege. “In the past it was an implicit advantage,” says Simon Johnson, an economics professor at MIT and former official at the International Monetary Fund, who compares the bailout to the crony capitalism he has seen in Third World countries. “Now it’s more of an explicit advantage.”
Once the bailouts were in place, Goldman went right back to business as usual, dreaming up impossibly convoluted schemes to pick the American carcass clean of its loose capital. One of its first moves in the postbailout era was to quietly push forward the calendar it uses to report its earnings, essentially wiping December 2008 — with its $1.3 billion in pretax losses — off the books. At the same time, the bank announced a highly suspicious $1.8 billion profit for the first quarter of 2009 — which apparently included a large chunk of money funneled to it by taxpayers via the AIG bailout. “They cooked those firstquarter results six ways from Sunday,” says one hedgefund manager. “They hid the losses in the orphan month and called the bailout money profit.”
Two more numbers stand out from that stunning first-quarter turnaround. The bank paid out an astonishing $4.7 billion in bonuses and compensation in the first three months of this year, an 18 percent increase over the first quarter of 2008. It also raised $5 billion by issuing new shares almost immediately after releasing its firstquarter results. Taken together, the numbers show that Goldman essentially borrowed a $5 billion salary payout for its executives in the middle of the global economic crisis it helped cause, using halfbaked accounting to reel in investors, just months after receiving billions in a taxpayer bailout.
Even more amazing, Goldman did it all right before the government announced the results of its new “stress test” for banks seeking to repay TARP money — suggesting that Goldman knew exactly what was coming. The government was trying to carefully orchestrate the repayments in an effort to prevent further trouble at banks that couldn’t pay back the money right away. But Goldman blew off those concerns, brazenly flaunting its insider status. “They seemed to know everything that they needed to do before the stress test came out, unlike everyone else, who had to wait until after,” says Michael Hecht, a managing director of JMP Securities. “The government came out and said, ‘To pay back TARP, you have to issue debt of at least five years that is not insured by FDIC — which Goldman Sachs had already done, a week or two before.”
And here’s the real punch line. After playing an intimate role in four historic bubble catastrophes, after helping $5 trillion in wealth disappear from the NASDAQ, after pawning off thousands of toxic mortgages on pensioners and cities, after helping to drive the price of gas up to $4 a gallon and to push 100 million people around the world into hunger, after securing tens of billions of taxpayer dollars through a series of bailouts overseen by its former CEO, what did Goldman Sachs give back to the people of the United States in 2008?
Fourteen million dollars.
That is what the firm paid in taxes in 2008, an effective tax rate of exactly one, read it, one percent. The bank paid out $10 billion in compensation and benefits that same year and made a profit of more than $2 billion — yet it paid the Treasury less than a third of what it forked over to CEO Lloyd Blankfein, who made $42.9 million last year.
How is this possible? According to Goldman’s annual report, the low taxes are due in large part to changes in the bank’s “geographic earnings mix.” In other words, the bank moved its money around so that most of its earnings took place in foreign countries with low tax rates. Thanks to our completely fucked corporate tax system, companies like Goldman can ship their revenues offshore and defer taxes on those revenues indefinitely, even while they claim deductions upfront on that same untaxed income. This is why any corporation with an at least occasionally sober accountant can usually find a way to zero out its taxes. A GAO report, in fact, found that between 1998 and 2005, roughly twothirds of all corporations operating in the U.S. paid no taxes at all.
This should be a pitchforklevel outrage — but somehow, when Goldman released its post-bailout tax profile, hardly anyone said a word. One of the few to remark on the obscenity was Rep. Lloyd Doggett, a Democrat from Texas who serves on the House Ways and Means Committee. “With the right hand out begging for bailout money,” he said, “the left is hiding it offshore.”
BUBBLE #6 Global Warming
Fast-forward to today. It’s early June in Washington, D.C. Barack Obama, a popular young politician whose leading private campaign donor was an investment bank called Goldman Sachs — its employees paid some $981,000 to his campaign — sits in the White House. Having seamlessly navigated the political minefield of the bailout era, Goldman is once again back to its old business, scouting out loopholes in a new government-created market with the aid of a new set of alumni occupying key government jobs.
Gone are Hank Paulson and Neel Kashkari; in their place are Treasury chief of staff Mark Patterson and CFTC chief Gary Gensler, both former Goldmanites. (Gensler was the firm’s cohead of finance.) And instead of credit derivatives or oil futures or mortgage-backed CDOs, the new game in town, the next bubble, is in carbon credits — a booming trillion dollar market that barely even exists yet, but will if the Democratic Party that it gave $4,452,585 to in the last election manages to push into existence a groundbreaking new commodities bubble, disguised as an “environmental plan,” called cap-and-trade.
The new carboncredit market is a virtual repeat of the commodities-market casino that’s been kind to Goldman, except it has one delicious new wrinkle: If the plan goes forward as expected, the rise in prices will be government-mandated. Goldman won’t even have to rig the game. It will be rigged in advance.
Here’s how it works: If the bill passes, there will be limits for coal plants, utilities, natural-gas distributors and numerous other industries on the amount of carbon emissions (a.k.a. greenhouse gases) they can produce per year. If the companies go over their allotment, they will be able to buy “allocations” or credits from other companies that have managed to produce fewer emissions. President Obama conservatively estimates that about $646 billion worth of carbon credits will be auctioned in the first seven years; one of his top economic aides speculates that the real number might be twice or even three times that amount.
The feature of this plan that has special appeal to speculators is that the “cap” on carbon will be continually lowered by the government, which means that carbon credits will become more and more scarce with each passing year. Which means that this is a brand new commodities market where the main commodity to be traded is guaranteed to rise in price over time. The volume of this new market will be upwards of a trillion dollars annually; for comparison’s sake, the annual combined revenues of all electricity suppliers in the U.S. total $320 billion.
Goldman wants this bill. The plan is (1) to get in on the ground floor of paradigmshifting legislation, (2) make sure that they’re the profitmaking slice of that paradigm and (3) make sure the slice is a big slice. Goldman started pushing hard for capandtrade long ago, but things really ramped up last year when the firm spent $3.5 million to lobby climate issues. (One of their lobbyists at the time was none other than Patterson, now Treasury chief of staff.) Back in 2005, when Hank Paulson was chief of Goldman, he personally helped author the bank’s environmental policy, a document that contains some surprising elements for a firm that in all other areas has been consistently opposed to any sort of government regulation. Paulson’s report argued that “voluntary action alone cannot solve the climatechange problem.” A few years later, the bank’s carbon chief, Ken Newcombe, insisted that capandtrade alone won’t be enough to fix the climate problem and called for further public investments in research and development. Which is convenient, considering that Goldman made early investments in wind power (it bought a subsidiary called Horizon Wind Energy), renewable diesel (it is an investor in a firm called Changing World Technologies) and solar power (it partnered with BP Solar), exactly the kind of deals that will prosper if the government forces energy producers to use cleaner energy. As Paulson said at the time, “We’re not making those investments to lose money.”
The bank owns a 10 percent stake in the Chicago Climate Exchange, where the carbon credits will be traded. Moreover, Goldman owns a minority stake in Blue Source LLC, a Utahbased firm that sells carbon credits of the type that will be in great demand if the bill passes. Nobel Prize winner Al Gore, who is intimately involved with the planning of cap-and-trade, started up a company called Generation Investment Management with three former bigwigs from Goldman Sachs Asset Management, David Blood, Mark Ferguson and Peter Harris. Their business? Investing in carbon offsets. There’s also a $500 million Green Growth Fund set up by a Goldmanite to invest in greentech … the list goes on and on. Goldman is ahead of the headlines again, just waiting for someone to make it rain in the right spot. Will this market be bigger than the energyfutures market?
“Oh, it’ll dwarf it,” says a former staffer on the House energy committee.
Well, you might say, who cares? If cap-and-trade succeeds, won’t we all be saved from the catastrophe of global warming? Maybe — but capandtrade, as envisioned by Goldman, is really just a carbon tax structured so that private interests collect the revenues. Instead of simply imposing a fixed government levy on carbon pollution and forcing unclean energy producers to pay for the mess they make, cap-and-trade will allow a small tribe of greedy-as-hell Wall Street swine to turn yet another commodities market into a private taxcollection scheme. This is worse than the bailout: It allows the bank to seize taxpayer money before it’s even collected.
“If it’s going to be a tax, I would prefer that Washington set the tax and collect it,” says Michael Masters, the hedgefund director who spoke out against oilfutures speculation. “But we’re saying that Wall Street can set the tax, and Wall Street can collect the tax. That’s the last thing in the world I want. It’s just asinine.”
Cap-and-trade is going to happen. Or, if it doesn’t, something like it will. The moral is the same as for all the other bubbles that Goldman helped create, from 1929 to 2009. In almost every case, the very same bank that behaved recklessly for years, weighing down the system with toxic loans and predatory debt, and accomplishing nothing but massive bonuses for a few bosses, has been rewarded with mountains of virtually free money and government guarantees — while the actual victims in this mess, ordinary taxpayers, are the ones paying for it.
It’s not always easy to accept the reality of what we now routinely allow these people to get away with; there’s a kind of collective denial that kicks in when a country goes through what America has gone through lately, when a people lose as much prestige and status as we have in the past few years. You can’t really register the fact that you’re no longer a citizen of a thriving first-world democracy, that you’re no longer above getting robbed in broad daylight, because like an amputee, you can still sort of feel things that are no longer there.
But this is it. This is the world we live in now. And in this world, some of us have to play by the rules, while others get a note from the principal excusing them from homework till the end of time, plus 10 billion free dollars in a paper bag to buy lunch. It’s a gangster state, running on gangster economics, and even prices can’t be trusted anymore; there are hidden taxes in every buck you pay. And maybe we can’t stop it, but we should at least know where it’s all going.
By Matthew Benjamin and Alison Sider
July 17 (Bloomberg) — The debate over whether the $787 billion stimulus package is sufficiently large or efficiently designed obscures a broader question, some economists say: Can any fiscal measure pull the economy out of the recession?
With credit still crimped and the outlook for consumer demand gloomy due to rising unemployment and increased personal saving, no amount of government intervention will be able to stanch the hemorrhaging of jobs and quickly ease the U.S. out of its deepest recession in a half-century, they said.
“Many households that want to borrow can’t, and many that can borrow won’t because they now must save for retirement the old-fashioned way,” said Richard Clarida, global strategic adviser at Newport Beach, California-based Pacific Investment Management Co., the world’s biggest bond-fund manager. “As a result, the multiplier from even a well-designed stimulus package is likely to be quite modest.”
The stimulus plan passed in February “is executing pretty much as expected,” yet it “won’t affect the economy’s primary problems, which are falling values of assets like homes and stocks,” said Doug Holtz-Eakin, who was director of the Congressional Budget Office from 2003 to 2006 and is now president at DHE Consulting LLC in Washington. So far, about $60 billion in spending and $43 billion in tax relief has been dispensed, accounting for 13 percent of the plan’s total.
The slow pace of recovery has driven bond yields lower as investors continue to seek the safety of U.S. government debt. Ten-year note yields are down 38 basis points, or 0.38 percentage point, since June 10.
The outlook for many companies also is clouded. General Electric Co.’s second-quarter profit from continuing operations declined 47 percent, and revenue fell 17 percent, the company said in a statement today. GE, the world’s biggest maker of power-generation equipment and services, is targeting more than 400 stimulus projects valued at $200 billion worldwide, the Fairfield, Connecticut-based company’s chairman and chief executive officer, Jeffrey Immelt, said. While little has been realized so far this year, Immelt said he expects more in the second half.
Proponents of the stimulus said the economic situation and the prospects for recovery would be much bleaker if no fiscal response had been put in place.
Even though a second stimulus package is unlikely at this point, those advocating such a measure said it may be needed precisely because the effects of the first have been so modest.
The combination of rising unemployment and thrifty consumers “definitely lowers the multiplier effect” of every stimulus dollar spent, said Dean Baker, a co-director of the Center for Economic and Policy Research in Washington. “That just means you need more stimulus. There’s really no alternative.”
Obama administration officials such as Treasury Secretary Timothy Geithner said the measure needs time to work and are appealing for patience.
“The stimulus program was designed to make a contribution over a two-year period and the biggest impact on investment will come in the second half of this year,” Geithner said yesterday in an Internet chat with Les Echos newspaper in Paris.
Martin Feldstein, a professor of economics at Harvard University in Cambridge, Massachusetts, and former head of the National Bureau of Economic Research, said the stimulus may provide a short-term boost that will quickly ebb.
“We’ll get that bounce for a couple of quarters but then it will fade out,” Feldstein said.
It’s too early to consider another round of fiscal priming, Geithner said. “I don’t think we’re in a position yet to make that judgment.”
For the moment, the initial measure has shown little impact. The net worth of households has fallen almost 22 percent, by almost $14 trillion, since 2007, to the lowest level in five years. House prices have fallen more than 32 percent from their 2006 peak, according to the S&P/Case-Shiller national index, while the Standard & Poor’s index of 500 stocks is 40 percent below its October 2007 level.
The crisis reminded Americans that home values can fall as well as rise and that bull markets don’t last forever, causing consumers to stash away a much larger portion of their incomes. Government data showed that the household savings rate rose to 6.9 percent in May, from zero in April 2008. The May figure is the highest in almost 16 years.
Nouriel Roubini, an economist at New York University who is chairman of RGE Monitor, and Richard Berner, co-head of global economics at Morgan Stanley in New York, forecast the rate could rise to 10 percent. Economists Reuven Glick and Kevin Lansing of the Federal Reserve Bank of San Francisco estimated in a May 18 paper that Americans would continue to boost their rate of savings, which could reach 10 percent by 2018. Such a jump would trim three-quarters of a percentage point per year from consumer spending.
“There’s been a fundamental change in people’s behavior,” said Lyle Gramley, a senior economic adviser with New York-based Soleil Securities Corp. and a former Federal Reserve governor.
Rising joblessness could further damp the ability of consumers, whose spending in recent years has made up more than two-thirds of the economy, to continue to shoulder that burden.
Contractions in industries such as autos, construction and financial services have helped shrink payrolls by 6.5 million since the recession began in 2007, Labor Department figures show. The June jobless rate reached 9.5 percent, the highest since 1983.
Federal Reserve officials are anticipating a jobless rate of 9.8 percent to 10.1 percent this year, according to the central bank’s latest economic forecast. In an interview last month, President Barack Obama also said the jobless rate would exceed 10 percent before turning for the better.
In addition, the rolls of the long-term unemployed are growing, with 29 percent of the jobless out of work for more than 26 weeks, the most since records began in 1948. A broader measure of underemployment that includes those who want full- time positions but work part-time has almost doubled over the past two years, to 16.5 percent.
Consumer spending is forecast to rise 1.5 percent in the fourth quarter and 1.7 percent for all of 2010, according to a July Bloomberg survey of more than 50 economists. The average quarterly increase from 1997 through 2007 was 3.5 percent.
The U.S. consumer “clearly is not going to be the consumption animal that he was for the last 10 or 20 years,” Joshua Shapiro, chief U.S. economist at MFR Inc. in New York, said in a July 6 interview with Bloomberg radio.
Retailers such as San Francisco-based Gap Inc., operator of the Old Navy and Banana Republic chains, and Abercrombie & Fitch Co., a teen-clothing franchise based in New Albany, Ohio, are feeling the pinch. Both reported June sales declines steeper than analysts estimated.
Airlines including Fort Worth, Texas-based AMR Corp., parent of American Airlines, are suffering as business travel declined. The world’s second-largest carrier’s traffic, measured in miles flown by paying passengers, fell 8.2 percent for the quarter, as American and other airlines discounted fares to fill planes. American filled 81.8 percent of its available seats in the second quarter, down from 82.5 percent a year earlier.
Credit, which consumers often turn to during recessions, remains difficult to obtain for many Americans.
About 50 percent of domestic banks tightened credit standards on prime mortgages in the first months of 2009, up from 45 percent in January, according to a survey of bank loan officers conducted by the Federal Reserve in April.
“Although financial market conditions had improved, credit was still quite tight in many sectors,” the central bank said in minutes of the Federal Open Market Committee’s June 23-24 meeting, released earlier this week.
What this means, Clarida said, is that “you’re not going to get the bang per buck that some of the stimulus proponents hoped for.”
By Krishna Guha and Sarah O’Connor
Is the US recession over? A handful of bullish economists are starting to claim that it is, or that it very soon will be
“The trough of the recession is imminent, if it has not already been passed,” said Neal Soss, chief economist at Credit Suisse.
“I have declared the recession (almost) officially over,” Marc Prado, market strategist at Cantor Fitzgerald, told clients this week. “The May data clearly has turned the corner.”
This is still very much a minority view. Most economists think the economy is stabilising but the low point has not yet been reached.
Richard Berner, chief US economist at Morgan Stanley, agrees. “I think a few months later – perhaps September to October.”
The National Bureau of Economic Research business cycle dating committee, which decides when recessions begin and end, has not even begun discussing the end date and will probably not reach a verdict for 18 months or more.
But the fact that the end of the recession is being discussed at all is a sign of how far the debate has moved on. The “recession is over” camp highlights new claims for unemployment benefits and new orders for manufacturing goods.
Robert Gordon, professor at Northwestern University and a member of the NBER business cycle committee, recently published research that shows past recessions typically ended four to six weeks after new unemployment claims peaked.
The latest data, to the end of May 23, suggests new claims may have peaked at nearly 660,000 a week.
“My reasoning leads me to conclude that the ultimate NBER trough of the current business cycle is likely to occur in May or June 2009,” Mr Gordon said.
The ISM manufacturing survey for May rose to 42.8 – consistent with past recession troughs. The new orders index rose above 50 to 51.1 for the first time since December 2007, when this recession began.
“The 51.1 reading points to a big swing in industrial production over the next few months – from steep contraction to flat or even modest expansion,” Credit Suisse’s Mr Soss said.
The Conference Board consumer confidence survey jumped from 40 to 54.9 in May, while data suggest housing has bottomed in volume terms even if prices are still falling.
Nonetheless, most experts remain sceptical that the recession is already over.
The NBER committee takes a broad overview of economic activity, emphasising gross domestic product but also looking at aspects such as monthly employment, personal income, manufacturing output and wholesale sales data.
Most forecasters think the economy will only start growing in the second half of the year. The ISM non-manufacturing survey showed that service sector activity only inched higher in May while new orders fell slightly. This is a reminder that while manufacturing may get a decent lift as the inventory cycle ends, the much larger service sector may not.
Even new unemployment claims remain higher than in the worst month of the last recession. Real disposable incomes have risen only because of stimulus tax breaks and higher benefit payments. Consumer spending, adjusted for inflation, fell in March and April.
Mr Frankel said he would be looking for a break in payrolls data to corroborate the notion that the economy was bottoming.
Martin Feldstein, another Harvard professor and NBER cycle dating committee member, said “it is possible but unlikely” that the recession is already over.
“I think it is a more likely scenario that we are seeing the favourable effects of the fiscal stimulus,” he said. “That, for a while, will offset the general diminished trend we have seen over the past two quarters, but it is a one-shot thing.”
Most economists think a relapse is unlikely and that easing financial strains and ongoing ultra-low interest rates will support at least a muted recovery.
But if Mr Feldstein is right, there is a risk of a double-dip recession – or a renewed bout of weakness so close to the original one that it will ultimately be judged to have been part of the same recession.
Copyright The Financial Times Limited 2009
By George Soros
The Obama administration is expected on Wednesday to propose a reorganisation of the way we regulate financial markets. I am not an advocate of too much regulation. Having gone too far in deregulating – which contributed to the current crisis – we must resist the temptation to go too far in the opposite direction. While markets are imperfect, regulators are even more so. Not only are they human, they are also bureaucratic and subject to political influences, therefore regulations should be kept to a minimum.
Three principles should guide reform. First, since markets are bubble-prone, regulators must accept responsibility for preventing bubbles from growing too big. Alan Greenspan, the former chairman of the Federal Reserve, and others have expressly refused that responsibility. If markets cannot recognise bubbles, they argued, neither can regulators. They were right and yet the authorities must accept the assignment, even knowing that they are bound to be wrong. They will, however, have the benefit of feedback from the markets so they can and must continually recalibrate to correct their mistakes.
Second, to control asset bubbles it is not enough to control the money supply; we must also control the availability of credit. This cannot be done with monetary tools alone – we must also use credit controls such as margin requirements and minimum capital requirements. Currently these tend to be fixed irrespective of the market’s mood. Part of the authorities’ job is to counteract these moods. Margin and minimum capital requirements should be adjusted to suit market conditions. Regulators should vary the loan-to-value ratio on commercial and residential mortgages for risk-weighting purposes to forestall real estate bubbles.
Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion; moreover, markets are supposed to function without any discontinuity in the sequence of prices. Under these conditions market risks can be equated with the risks affecting individual market participants. As long as they manage their risks properly, regulators ought to be happy.
But the efficient market hypothesis is unrealistic. Markets are subject to imbalances that individual participants may ignore if they think they can liquidate their positions. Regulators cannot ignore these imbalances. If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk in the market in addition to the risks most market participants perceived prior to the crisis.
The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem. The agents were more interested in maximising fee income than in protecting the interests of bondholders. That is the verity that was ignored by regulators and market participants alike.
To avert a repetition, the agents must have “skin in the game” but the 5 per cent proposed by the administration is more symbolic than substantive. I would consider 10 per cent as the minimum requirement. To allow for possible discontinuities in markets securities held by banks should carry a higher risk rating than they do under the Basel Accords. Banks should pay for the implicit guarantee they enjoy by using less leverage and accepting restrictions on how they invest depositors’ money; they should not be allowed to speculate for their own account with other people’s money.
It is probably impractical to separate investment banking from commercial banking as the US did with the Glass-Steagall Act of 1933. But there has to be an internal firewall that separates proprietary trading from commercial banking. Proprietary trading ought to be financed out of a bank’s own capital. If a bank is too big to fail, regulators must go even further to protect its capital from undue risk. They must regulate the compensation packages of proprietary traders so that risks and rewards are properly aligned. This may push proprietary trading out of banks into hedge funds. That is where it properly belongs. Hedge funds and other large investors must also be closely monitored to ensure that they do not build up dangerous imbalances.
Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogenous, standardised and transparent.
Custom-made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. I have in mind credit default swaps. Consider the recent bankruptcy of AbitibiBowater and that of General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else’s life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.
The writer is chairman of Soros Fund Management and author of ‘The Crash of 2008’ (PublicAffairs 2009)
Copyright The Financial Times Limited 2009
By Shobhana Chandra
“I’m really quite scared that we could muddle along,” Krugman said in a lecture today at the London School of Economics and Political Science. “I really do see the possibility of a global version of the Japanese ‘lost decade’ without the prospect of an export-led recovery. This could be unpleasant for a very long time.”
U.S. stocks erased a decline yesterday after Krugman said the economy will probably emerge from the recession by September. Recent reports showing smaller declines in housing and manufacturing and fewer job losses have reinforced forecasts that the slump may end this year.
“The ‘oh-my-God-the-world-is-ending’” phase of the economic downturn is over, and financial markets are “stabilizing,” Krugman said today. Still, “the employment situation is continuing to look bad and will probably get worse,” he said.
Krugman said he has “no idea” what will power the U.S. out of recession. The U.S. fiscal stimulus package, while not “trivial,” isn’t large enough to fuel sustained growth. Also, with the global economy in the doldrums, the U.S. can’t rely on a revival from a surge in exports, he said.
Even the end of a recession “doesn’t mean the same thing as it did in the old days,” said Krugman, a Princeton University economist. Unemployment may remain high longer than after the end of prior economic contractions, he said.
The National Bureau of Economic Research, based in Cambridge, Massachusetts, is the official arbiter of U.S. recessions and expansions. Robert Hall, the head of the NBER’s business-cycle-dating committee, said last week that it’s “way too early” to say the contraction is over.