The Roots of Bailout Nation
Ah, a crisis-free summer! Stocks are rallying, credit markets are no longer in a panic, and the big banks—at least most of them—have survived. Although, of course, we’re all trillions of dollars poorer.
So, I thought it was a good time to reflect on what got us here. My beach reading this summer, aside from the usual novels I promise to finish but rarely do, included Bailout Nation, by Barry Ritholtz.
Bailout joins a growing list of books about The Crisis. It’s a good old-fashioned polemic, written by a noted blogger and financial analyst who, unlike most economists and journalists (including yours truly), saw this all coming. But few people in Troy listened to Cassandra, either: That big wooden horse full of Greeks looked so cool.
Ritholtz’s book takes us along two parallel tracks: the history of financial bailouts in America and a scathing account of Alan Greenspan’s two-decade reign as Federal Reserve chairman. Along with some monumental failures by Congress and regulators and the bottomless venality of financial firms, those two tracks came together in a catastrophic train wreck whose damage may not be cleared for a generation.
How did we get to the point where US taxpayers have propped up Fannie Mae, Freddie Mac, AIG, Citibank, Bank of America, General Motors, and Chrysler (again)? Ritholtz claimed it started small, back in 1971, when Congress and the Nixon Administration saved Lockheed Aircraft from bankruptcy.
This all-but-forgotten episode, which Ritholtz calls the first government bailout of an individual company, set the stage for what was to follow: Penn Central Railroad, Chrysler, and Continental Illinois National Bank and Trust all relied on taxpayer largesse to save them from themselves.
As time went on, the bailouts got bigger and the federal government got more comfortable using them. And the usual necessary purging effects of the free market went out the window. “Creative destruction is a brilliant concept to discuss in grad school,” he writes, “but with real money on the line, it becomes readily dismissed as an abstract academic concept.”
In fact, Ritholtz has a much too brief description of a ten-step pattern he says is common to all the major bailouts, from “risk event” through “interested party” agitation to “deepening panic” and “major intervention/bailout” all the way to “unintended consequences.”
In all cases, he says, the companies demonize their early critics, then lobby politicians furiously as the danger grows. When the inevitable crisis comes, officials warn of “systemic risk” or “economic catastrophe” and steamroll Congress and the public into taking actions they wouldn’t otherwise accept. Mr. Paulson, I presume?
Ritholtz is at his best in dissecting the record of another leading figure, Alan Greenspan, whom he calls most responsible for the debacle we’ve just experienced. Attacking Greenspan has become almost a requirement among analysts of the crisis, but Ritholtz brings fresh analysis as he eviscerates decision after decision in Mr. Greenspan’s long tenure.
“The Greenspan Fed created an endemic culture of excessive risk taking,” he writes. “Greenspan learned early on that the solution to every problem was to throw money at it—liquidity in the parlance of central bankers—even though doing so ultimately leads to bigger problems down the road.”
That started during the 1987 stock market crash, which occurred months after Greenspan succeeded Paul Volcker and continued through the 1990-1991 recession, the dot.com bust a decade later, September 11th, and so on.
Greenspan refused to deflate the Internet bubble of the 1990s even though a simple tool at his disposal, “constraining margin lending, would have tamped down some of the mad speculation.”
Instead, he waited for the bubble to burst and then “in January 2001, started an extraordinary rate-cutting process, one for which there is no comparison.” That rate-cutting campaign, to stave off what Ritholtz calls a relatively mild recession, led to the present disaster.
“Bailout Nation” demonstrates better than any account I have read how unusual that Fed policy was. During previous recessions, he writes, “rates had been below 2%—but only for a few weeks or months at a time. Incredibly, the Greenspan Fed maintained a 1.75% cap on the Fed funds rate from September 2001 to September 2004.”
Then came the coup de grace, as the Fed cut the federal funds rate to 1% in June 2003, and kept it there for 12 months. “While the Fed funds rate had been as low as 1% some 46 years earlier, it had never been allowed to stay that low for more than a year!,” Ritholtz states..
Why did he do it? Ritholtz argues that “the only plausible explanation for the radical rate cuts was asset prices. Greenspan was hell-bent on bailing out stock investors.”
From interviews with people involved in those decisions, I’ve come to a different conclusion, which Ritholtz himself supplies later on: “The possibility of a double-dip recession was real, and that was making the Federal Reserve very nervous.”
In other words, they panicked and overreacted. Sound familiar?
The Fed was to repeal those ultralow interest rates starting in 2004, but the damage had been done: “The combination of ultralow rates, new types of exotic mortgages, changes in lending standards, and massive securitization created the perfect storm for a housing boom.”
Meanwhile, with rates at rock-bottom lows, institutional investors were hungry for yield, and “the nearly insatiable assembly line Wall Street was running for mortgage-backed securities” eagerly obliged them. Throw in rubber-stamp rating agencies, inept regulation by Greenspan’s Fed and the Securities and Exchange Commission, and former Sen. Phil Gramm’s (R-Tex.) wrongheaded lifting of key regulatory constraints, especially for derivatives, and you have a recipe for disaster.
So, where are we now? In a recent video interview, Ritholtz told me he doesn’t think the reforms proposed so far will change much: The administration and Congress still haven’t repudiated the bailout as a solution and some institutions—notably Citigroup—are still too big to fail. And there’s been little change in either the rating agencies’ practices or Wall Street compensation that caused reckless people to take unconscionable risks with shareholders’ and taxpayers’ money.
But there should be little doubt that having the Fed regulate “systemically risky” financial institutions after the poor job it’s done would make as much sense as putting FEMA in charge of national security after Hurricane Katrina.
“It’s consistent with rewarding incompetence and failure,” Ritholtz told me.
Unfortunately that’s become standard operating procedure in Bailout Nation USA. Still, you’ve got to draw the line somewhere.
Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own.