THERE WERE NO INNOCENTS

Around the globe "Anglo-Saxon" capitalism is now indicted or on trail. But very few stop to ask what David Ricardo and Adam Smith certainly would have had they been equipped with a crystal ball.

by Delroi T. Pusser for The International Chronicles

 
A broad premise: as a nation, the United States of America is transmogrifying into a land of men, not laws. Of vested interests ready to discard democratic principles when they inconvenience a buck. With an economy premised on politically-connected authoritarian finance, not accountable capitalism. Consequently, around the globe “Anglo-Saxon" capitalism is now indicted or on trial, as evidenced by the recent G20 symposium of econo-sanctimony and multilateral palliatives. But very few stop to ask what David Ricardo and Adam Smith certainly would have had they been equipped with a crystal ball ~200 years ago - what is authentically capitalist about today’s bailouts, violated contract rights and thoroughly government-intervened markets?

And if you are willing to entertain the above, then a begged question: looking over the desolate expanse that entails the Lilliputians of the political class, regulators, financiers and real estate consumers, where would the hopeful but naive look to find glimmers of once apparent American Exceptionalism?

Within the stewards of the D.C. beltway? They who took the global economic crisis as license to create ~$13 trillion (i.e. 100% of U.S. GDP) of subsidies and rescue facilities? Facilities that have been hurriedly conceived in spasms of panic, rooted in an ironic absence of faith in capitalism's recuperative powers. Facilities that are patently extra-constitutional in that they violate the founding fathers' intentions which were that the treasury never serve as a public trough for commerce and private sector rent-seeking.

Perhaps among our regulators? They who acted as little more than supplicant butlers and chamber maids to the anti-fiduciary bordello of avarice that became Wall Street.

Speaking of which, would one find the better strains of America's bygone can-do perspicacity among the mandarins of the finance community? They who nearly without exception championed hyper-numerate fairy tales of risk management and utility maximization that really distilled down to little more than something-for-nothing ponzi scheming.

But perchance our hopes of locating some American stalwarts lie in the consumer class (all of us)? We who much, much, much more often than not have voted as ahistorical, lumpen indolents for the craven, self-exonerating excuse-peddling legislators we deserve; we who have conducted ourselves as real estate day traders, debt-addled consumers of today with income presumed of tomorrow.

Looking for the American Original among this crew? No on all four counts I'd say.
 

The Numbers Are Not Your Friends
 
My opening tirades are heavy handed giveaways, but that doesn’t mean they’re invalid. Let me cite a few broad figures to orient the folks as to where I’m going in this jeremiad:

•    Consider 2000-2006 U.S. GDP growth, which averaged 2.7%. Please know that without the consumption made possible by residential refinancings (i.e. the extraction of equity capital from homes through the serial restructuring of mortgages), U.S. GDP would have contracted three years and averaged an anemic 1% the other three years in the 2000-2006 period. In other words, U.S. economic prosperity was a ruse - it was debt-fueled affluence not productivity-based commerce. And it was a bi-partisan ruse, embraced wholeheartedly by various administrations for ~30 years, starting with the late 1970’s Community Reinvestment Act, bolstered by Presidential entreaties for a larger “Ownership Society” earlier in this decade. Every U.S. inhabitant deserved to own a home evidently. Helpfully, the usefully insentient among us accepted announcements that a permanent Goldilocks economy had arrived. The key: the presumed perfection of risk management and diversification via the alchemy of derivatives and securitization in real estate finance. The action: by 2006, fully 30% of U.S. residential lending consisted of securitized (i.e. mortgages bundled and resold as bonds) sub-prime lending. The result: economic perdition, one condo at a time.         

•    Consider new Treasury and Federal Reserve-directed commitments created within the last 18 months – all $12.8 trillion of them – to serve as an economic social safety net for a multitude of ailing U.S. industries. Ignoring a reported $60 trillion of unfunded legacy entitlements, the new industry entitlements amount to $42,000 per capita of obligations that will have to be met via future taxes of some sort. Considering that we are nearing the tipping point at which only 50% of working Americans actually pay income taxes and the U.S. workforce is estimated at ~225 million, we can broadly estimate that the above-referenced bailout commitments equate to ~$114,000 of new tax liabilities for every working, net tax-paying American.

•    Consider the Federal Reserve balance sheet, which in early 2008 stood at ~$900bn but now encompasses an obese three times this figure, nearly $3 trillion. In the abstract, why is this alarming, beside the fact that it defines a Brobdingnagian surge in the money supply? Although the minutiae of monetary economics might serve as an unparalleled soporific for most, readers should fight this urge and focus -- the composition of the Federal Reserve’s asset base has effectively been destroyed. Where it once was backed almost exclusively by high-grade treasury I.O.U.s, the bloated asset base is now “collateralized” by  private sector assets of unknown quality. That’s right, unspecified flotsam & jetsam exchanged by unidentified rescued banks has been accepted at the Fed in exchange for Treasury obligations. The Fed has refused to divulge details to the public, despite the fact that claims on the public’s future wealth is all that supports this capital-for-effluvia exchange.  Transparent democracy, post-modern style.                   
 
 
 Kevorkian Kapitalists
 
So if our defining economic figures are this impaired, what is our  leadership’s strategy to reverse the pauperizing slide? Expedience. The rationale we hear among our economic stewards is "this is not the time for Schumpeterian 'creative destruction'...for now, we must first stabilize the economy with stimulus spending". Under this rationale, the underbrush of sclerotic investments in our post-modern economy won’t be cleared for fear of political and economic collateral damage. This is akin to killing capitalism to save the capital markets. Practically, it means we dive-bomb down a philosophical slippery slope into a repository of populist justifications for more "stimulus" narcotics. These industry rescues, spread about to what seems like every commercial sector clutching the beg bowl, only calcify the economic distortions -- rampant malinvestments, lack of domestic savings -- in our economy. In the act, we pretend away the structural deformities that are the basis of our macroeconomic malady. Above, I wielded the word narcotic pointedly -- the stimulus spending is so in that there is no orderly way to remove this capital tsunami from the economy once stability is reestablished, and there is no realistic probability of "growing" our way out of the sea of electronically created currency sloshing about the economy. Our government therefore will invariably resort to the two most expedient methods of confronting our all-enveloping debt load: it will renounce portions of it via inflation, and tax what I assume will continue to be a somnolent citizenry into further submission for the remainder.

At its basest, the irony is Hellenic in its self-defeatism. The noxious toxin that has felled our macroeconomy – unsupportable debt – is now prescribed as the medicine to repair us. The “Minsky Moment” (when debt becomes so large that interest payments, let alone principal amortizations, are too large to make) is seen not as a precipice to recoil from, but instead as a ledge from which to swan-dive, in socialist nanny-state diapers, into an even larger sea of debt entitlements. And so as the few sober among us attempt the painful act of reversion to the mean, of returning to sane savings rates and *income*-supported consumption, the government leans the other way, devising temporary, serial rescues that insulate market distortions and encourage federal, state, and municipal balance sheets to increase leverage. In conjunction, the government has become the price setting buyer in the credit markets, most importantly, suppressing interest rates throughout the yield curve. But who is the 2nd (private market) buyer? Most government-directed rescue efforts have focused on lowering interest costs, not principal reductions, so borrowers are benefiting from temporary breathing room but not making real progress reducing debt loads and improving savings rates. When does the private market take over for the government in the credit markets? And what happens when the government tries to remove itself from the credit markets and rates likely spike?   

When the government is the demand and the supply, when its the investor and investment advisor, the results are invariably dismal. Distressed asset investing is what the government is attempting, it’s one of the most difficult and nuanced investment arenas. Pay too much for assets, and returns (“for the taxpayer”) will be insufficient, although the banks selling the assets will benefit. Pay too little, and prospects for taxpayer returns theoretically improve but banks will incur the very losses the bailouts have been designed to avoid. To date, the government seems to have decided to err in support of banks, as independent oversight committees have discovered that federal capital injections into hobbled banks last year represented over-payments of ~$80bn on materially weaker terms than similar investments made by private distressed investors.

The treasury’s new vehicle –- The Public, Private Investment Partnership (PPIP) -- is the new beltway attempt to square the circle between private bank supports, public taxpayer hosings, and negative publicity. The PPIP distills down to massaging the question of asset price with the use of publicly supplied leverage. Invest in an asset at the wrong price using all equity and your results are inadequate; invest at the same price using equity and a lot of debt and the equity portion of the investment can still experience high returns, with the lower returns assigned to debt-holders. This strategy has been private equity investing in a nutshell for years. So the PPIP asks private institutional investors to contribute ~$0.16 on every $1 of investments and the government (you and I) will (involuntarily) invest the remainder. Put another way, investments in the PPIP program will be levered 6x using taxpayer funds …and this is the best part … on a low interest, *non-recourse* basis for the private investors. In fairness, the virtue of this investment approach is that involving experienced private investors will reduce the likelihood of massive over-payments such as those made by the government last year. The vice is that if the investments don’t succeed, $0.84 of every dollar invested have been squandered without recourse to the taxpayer.    
   
This strategy is an improvement on last year’s brazen bailouts, but it remains conspicuous in that the banks responsible for the original lending offenses are insulated from further fallout. Those risks are assumed by taxpayers. 
 

Bailout - Membership Has Its Privileges
 
As misdirected as our government’s efforts have been, here’s what perhaps has reflected most disreputably on Washington in the eyes of the constitutionally appreciative – the erratic, un-uniform and often extra-constitutional manner in which the government has applied its fixes.

For example, among the hurried extra-constitutional kung fu that our public sector economic stewards have orchestrated, one of the more subterranean is the alteration of a dusty vestige of tax arcana known as Tax Code Section 382 (TCS382). This directive bars companies from merging simply to avail themselves of each others’ tax shelters stemming from operating losses. Amid investment banks’ rush last autumn to merge and become bank holding companies in order to access federal bailout capital, the treasury unilaterally waived TCS382, without so much as a midnight press release. This bit of unconsulted regulatory relief ostensibly saved merging financial firms ~$140bn. Convenient for the Treasury, and even more so for its well-vested beneficiaries, but inconvenient for constitutional sticklers who rightly point out that under the constitution, only the House of Representatives can originate or amend the tax code.

Intuitively, it seems that financial bailouts were defined by the strength of the public sector-private bank nexus of vested interests. This has been rephrased more palatably for popular consideration as “who is ‘systemic’ in its financial risk and who isn’t”. So subjective on the strength a firm’s connections in Washington and how far afield its risk managers and traders had wandered off the sanity ward, we witnessed: a euthanization (Bear Stearns - bond holders saved, and remaining franchise shuttered for the price of its building); a defenestration (Lehman Brothers - chapter 11); a ritualized asphyxiation (AIG, rescued *three* times, but read on below for a principle reason why); and several midnight salvations (Goldman Sachs, Morgan Stanley, et. al. granted  midnight bank holding charters, the easier to access federal cash). 

From a bailout perspective, what differentiated the financial firms in question? Very little. They all operated under the same broad operating errors: long-term assets funded by short-term liabilities, leverage levels congregating around 30x, inflated equity bases predicated on fanciful asset values.
So then why the vastly disparate fixes? Observers can defensibly debate the merits and feasibility of what should have occurred -- prepackaged bankruptcies, stakeholder haircuts, or public capital injections in exchange for severe managerial concessions – but the government without question should have acted as a more uniform, less captive arbiter of these insolvent and illiquid banks.      
 
 
The Fallacy of Competent Captaincy
 
I continually wonder, how can the senior managers of banks who received taxpayer rescue funds still be working? An oft-used excuse is that these are the most talented members of the industry, thus they must be incentivized and retained in order to steward us out of the economic crisis. I think of this as The fallacy of Competent Captaincy – the very people who ran us aground are supposedly the most capable of navigating us to safety.

It would be slightly less insulting if these paladins of financial wizardry weren’t so evidently unrepentant. Despite the fact that without public assistance, the enormity of impaired assets would have vaporized many of Wall Street’s most venerated operators, bailout funds have been routinely waylaid to finance acquisitions and subsidize dividends. The much-reported payment of bonuses is a more vexing issue, pitting often legally binding employment contracts versus common sense  (though constitutionally irrelevant) indignation. But the more germane point here is that money is fungible, and it’s frequently being used for purposes that don't appear to be the last ditch lifeline that government rescue architects claim. For instance, to take only one of numerous examples, consider bank PNC Financial and its purchase of rival National City Corp. for $5.8bn late last year almost simultaneously with its receipt of a $7.7bn tranche of capital from the Treasury. Would it have made the acquisition without the involuntary helping hand of taxpayers?

And what to make of the board level consequence-free rescue of leviathans Citibank and Bank of America? The former has received a $45bn preferred equity infusion and a $306bn backstop guarantee on its capital base, the latter $45bn and $118bn under a similar framework, with no senior management or board removals. The board members who have left Citibank have done so of their own volition -- not fired, in avoidance of the spiraling inconvenience of bad publicity. But the ultimate ignominy is not on disgraced board members who have demonstrated their pedestrian though maximally remunerated mediocrity, but on shareholders ...who didn't marshal enough anger to force senior managerial accountability before embarrassing Page Six disclosures rendered the proper 'superannuation' effect instead.

Speaking of perverse financial sector hi-jinks with taxpayer funds, AIG merits special mention. Here we have what was previously a globally dominant multi-product insurance titan, undone by stratospheric bets underwritten on debt-related insurance derivatives. These instruments  rendered AIG’s holding company balance sheet leverage ~150:1 at its height in late 2007/early 2008. This means a 0.67% decline (…yes, 67th of 1 percent…) in the value of AIG’s asset base would vaporize the holding company’s entire equity account.

Its rescue was deemed a systemic imperative for the financial system, with forecasts of wholesale capital markets ruination -- due to the tentacles of AIG’s counter-party risk reaching nearly every notable financial firm -- if the insurance behemoth wasn’t saved.     

Inconvenient, but fair enough …except that ex-post facto, it was revealed that sizable portions of the collective $170bn extracted from John and Jane Q’s billets for AIG was actually routed to investment and foreign banks who were the insurance giant’s derivatives counter-parties.

The rescue had nothing to do with saving the insurance operations of AIG per se (which at operating subsidiary levels are reported to be sound). Instead it was intended to forestall losses at counter-party banks who had insurance derivative trades with AIG in their capacity as  sophisticated investors fully aware of the seemingly remote but extant risks incurred in these formally unguaranteed transactions. Think of the derivative instruments in question as private performance contracts entered into by various firms, all licensed as sophisticated investors. And now we learn that the rescue was, in material effect, a pass-through vehicle financed by taxpayers, routed through AIG, to preclude losses at Goldman Sachs, Deutsche Bank et al. fairness and the (new) American way?   
 

Is Deregulation The Absence Or Disregard Of Regulation?
 
Maybe all the Trotskyite clamoring for regulation we witness today is a rational tonic to the malfeasance found daily in our newspaper’s business sections. But before the regulatory pitchforks and manacles are prepared, the mildly sentient among us should know this: mortgage underwriting, credit ratings, property appraisal, lending standards, income verification …all of the issues that have been at the epicenter of the credit implosion *already* carry copious amounts of regulation.

In fact, nearly every financial scandal that has plagued us in the last several years entails a product or service that is formally regulated.  “Those unregulated capitalists…” has become the mantra for the political left, but before you accept this overarching premise dear reader, know this – the last eight years, a supposed deregulatory carnival, saw a record amount of regulatory code written. In 2001, 64,000 pages of rules and regulations were added to the federal registry. In 2007, 78,000 pages were added. Much of it detailing the transparency of the capital markets. Much of it ignored. In the main, new regulations are not needed. A novel adherence to existing regulations desperately is. 
 
 
The 1st World Looking So 3rd
 
Continuing on the theme of novel adherence, consider this: the advice provided by the US and the IMF to countries with currency and monetary crises typically wrought by fiscal imbalances has always been one of painful short-term austerity measures and belt-tightening. The basic prescription customarily entailed unpopular decisions like allowing failing businesses to do just that in the markets, with more efficient survivors left to prosper in the culled environment. It meant establishing fiscal policies conducive to commerce (i.e. lower taxes) and the realistic prospect of collection. It meant conducting responsible monetary policies that preserve currency integrity. So how is it that in a cruel slapstick flourish, these are all policies the U.S. currently renounces in practice with stimulus and rescue programs that are their very opposite?

Here's the principal reality that the received-wisdom apparatchiks on business television channels haven't admitted yet: the monetary & fiscal experiment the U.S. is conducting is simply boilerplate 3rd-world finance. It has been tried repeatedly by what are customarily  derided as Banana Republics, always ending in wholesale socioeconomic trauma. We're trying it too and maintaining the fiction that the collective mandarins in the Fed, Treasury, and our Executive and Legislative bodies are somehow conjuring something innovative and precedent-setting.

They are not.

Before this stagflationary crisis has  passed, many in the U.S. will know what it was like to be an Argentine or Brazilian citizen during various episodes over the last 25 years when communities took to the streets banging pots protesting lack of employment, expropriated savings and a government captive to plutocrats.

 


   

Delroi T. Pusser is a Wall Street bigwig with 20 years in the financial services industry. 5 in commercial banking, 15 in equity market and distressed asset research. Delroi is currently on the lam in the woods of New England, attempting to make sense of the Collapse of Capitalism.
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published this page in The Attic 2012-03-27 00:26:53 -0400