Bailout Nation E-Book

Barry Ritholtz

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 452

Veröffentlichungsjahr: 2009

Beschreibung

An engaging look at what led to the financial turmoil we now find ourselves in Bailout Nation offers one of the clearest looks at the financial lenders, regulators, and politicians responsible for the financial crisis of 2008. Written by Barry Ritholtz, one of today's most popular economic bloggers and a well-established industry pundit, this book skillfully explores how the United States evolved from a rugged independent nation to a soft Bailout Nation-where financial firms are allowed to self-regulate in good times, but are bailed out by taxpayers in bad times. Entertaining and informative, this book clearly shows you how years of trying to control the economy with easy money has finally caught up with the federal government and how its practice of repeatedly rescuing Wall Street has come back to bite them. * The definitive book on the financial crisis of 2008 * Names the culprits responsible for this tragedy-from financial regulators to politicians * Shows how each bailout throughout modern history has impacted what happened in the future * Examines why the consumer/taxpayer is left suffering in an economy of bubbles, bailouts, and possible inflation * Ritholtz operates a hugely popular blog, www.ritholtz.com/blog Scathing, but fair, Bailout Nation is a voice of reason in these uncertain economic times.

Leseprobe

Table of Contents

Praise

Title Page

Copyright Page

Dedication

Foreword

Acknowledgements

Introduction

Part I - A BRIEF HISTORY OF BAILOUTS

Chapter 1 - A Brief History of Bailouts

Chapter 2 - The Creation of the Federal Reserve, and Its Role in Creating Our ...

Chapter 3 - Pre-Bailout Nation (1860-1942)

Chapter 4 - Industrial-Era Bailouts (1971-1995)

INTERMEZZO

Part II - THE MODERN ERA OF BAILOUTS

Chapter 5 - Stock Market Bailouts (1987-1995)

Chapter 6 - The Irrational Exuberance Era (1996-1999)

Chapter 7 - The Tech Wreck (2000-2003)

Chapter 8 - The Backwards, Rate-Driven Economy

INTERMEZZO

Chapter 9 - The Mad Scramble for Yield

Part III - MARKET FAILURE

Chapter 10 - The Machinery of Subprime

INTERMEZZO

Chapter 11 - Radical Deregulation, Nonfeasance

Chapter 12 - Strange Connections, Unintended Consequences

Chapter 13 - Moral Hazard: Why Bailouts Cause Future Problems

Part IV - BAILOUT NATION

Chapter 14 - 2008: Suicide by Democracy

Chapter 15 - The Fall of Bear Stearns

Chapter 16 - Dot-Com Penis Envy

Chapter 17 - Year of the Bailout, Part I: The Notorious AIG

Chapter 18 - The Year of the Bailout, Part II: Too Big to Succeed?

INTERMEZZO

Part V - POST-BAILOUT NATION

Chapter 19 - Casting Blame

Chapter 20 - Misplaced Fault

Mortgage Interest Deduction

Naked Shorting

Community Reinvestment Act (CRA)

Fannie Mae and Freddie Mac, aka “Phonie & Fraudie”

Chapter 21 - The Virtues of Foreclosure

Chapter 22 - Casino Capitalism

Postscript - Advice to a New President

Notes

Index

Praise forBailout Nation

“The greatest economic calamity in a generation has now swept fromWall Street through Main Street, to Iceland, Europe, and beyond.Barry Ritholtz not only saw the financial tidal wave coming, but triedto warn us before it hit, when few believed anything like it couldhappen. Now that clean-up is at hand, who better to explain whatwent wrong? Read this book: when Barry Ritholtz speaks, as thesaying goes, attention must be paid.”

—Jeff Matthews Author, Pilgrimage to Warren Buffett’s Omaha

“This thrilling page-turner is really a doctoral thesis in disguise on the history of financial debacles and the inner workings of the global financial system and modern economics. Barry is truly one of Wall Street’s important thinkers and rising stars. Bravo Barry!”

—Jeffrey A. Hirsch Editor-in-Chief, Stock Trader’s Almanac

“Barry Ritholtz, long known to readers of The Big Picture for telling it like it is, does exactly that in Bailout Nation. With sparkling clarity and his inimitable brashness, Barry names names and tells you where to look for the bodies who are profiting from the unprecedented $8 trillion government bailout.”

—Michelle Leder Author, Financial Fine Print and Footnoted

“Part history lesson, part social commentary, part in-depth analysis, Bailout Nation serves up a riveting indictment of the age of hubris and excess.”

—Michael Panzner Financial Armageddon

“As Wall Street wizards were turning into welfare kings, Barry Ritholtz was there to chronicle every new outrage on his blog, The Big Picture. Now he’s focused on the really Big Picture—how we got into this mess—with his great new book, Bailout Nation.”

—Jesse Eisinger Portfolio

“Barry Ritholtz crystallizes the absurdity of the bailouts and why America’s addiction to them is doomed to fail. This should be required reading for every future politician with a conscience.”

—Herb Greenberg former journalist, CNBC, Marketwatch, and now director of GreebergMeritz Research & Analytics

“Barry Ritholtz is leading the first wave of critical analysts who are trying to make sense of the past year beyond the official explanations. He not only illustrates the conflicts and contradiction in current economic leaders and policies, but suggests some solutions and even opportunities in this sea of global financial misery. I’m already looking forward to volume two.”

—Christopher Whalen Institutional Risk Analytics

“Bailout Nation provides a timely review and analysis of the issues and problems that led to and are evidenced in the present financial turmoil. These forensics are much needed today.”

—David Kotok Cumberland Advisors

“Barry Ritholtz has a one-two combination punch of insight and skepticism that leaves financiers, bankers and politicians out cold on the floor. This is pungent and funny required reading about the current crisis.”

—Dr. Paul KedroskyInfectious GreedPartner, Ventures West VC

Copyright © 2009 by Barry Ritholtz. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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eISBN : 978-0-470-53598-1

To Wendy,who has bailed me out of more than a few jams

Foreword

Do you find yourself wondering: How did we get here? How did the United States of America get into such a predicament whereby in one year, 2008, the financial system nearly vaporized, the stock market crashed, real estate tanked, and major corporations were being bailed out (or begging to be) on a regular basis. How did our great country, a bastion of capitalism, devolve into a Bailout Nation where the gains were privatized but the losses were socialized?

This terrific book by Barry Ritholtz will explain to you how this sorry state of affairs came to pass. By reading it you will come to understand how we got here, which is a necessary prerequisite for understanding how to navigate the future.

The primary reason that I wrote Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve (McGraw-Hill, 2008) was so that when the U.S. credit/housing bubble inevitably burst, people would understand why such enormous financial and economic problems were occurring, seemingly erupting out of nowhere. But they didn’t erupt out of nowhere; these problems were created over time by the monetary policies of the Federal Reserve, specifically the targeting of interest rates and the Fed’s ongoing refusal to recognize the flaws in this approach.

Although nearly everything that has transpired since my book was published in February 2008 I had expected to occur, I was still shocked by the total collapse of so many major financial firms, such as Bear Stearns, Countrywide Financial, Fannie Mae, and Freddie Mac in such a short amount of time.

But that is what happens to highly leveraged financial entities when significant portions of their underlying assets are found to be essentially worthless. The mind-set of deregulation that was championed by Federal Reserve Chairman Alan Greenspan in the wake of the Long-Term Capital Management (LTCM) bailout in 1998 is partially responsible for the massive overleveraging of nearly the entire financial system in the United States.

That Wall Street bailout (which led to the notion of the “Greenspan put”) set the stage for what we are witnessing today in the United States (and in the United Kingdom), with the prudent being forced to bail out the reckless. As Barry notes, “The parallels between what doomed LTCM in 1998 and what forced Wall Street to run to Washington for a handout in 2008 are all there.”

The United States has abandoned its capitalist roots, and the country has morphed into a Bailout Nation; now almost any large entity that finds itself in trouble feels the government (taxpayers really) should provide financial support. Similarly, homeowners who overextended themselves also feel that they too should be rescued from their mistakes.

Barry weaves together the problems created by the Federal Reserve’s interest rate targeting policies with the determination on the government’s part to thwart the “creative destruction” aspect of capitalism. We have now arrived at a juncture where our government seems to embrace free markets only when they deliver the results it wants. If they don’t, an attempt is made to alter the outcome, leading to unintended consequences down the road, which often are more severe than the original problem.

Ritholtz also names the villains in this tragedy—the rogues’ gallery of politicians and officials who screwed up big time—and demonstrates what they did to make the problem either bigger or worse. He also shows how each bailout throughout modern history has impacted what happens in the future—for example, why Chrysler should have been allowed to fend for itself in 1980, and the impact that has on future bailouts.

This book is the history of how the United States evolved from a rugged, independent nation to a soft Bailout Nation, one in which too few question why we ask the taxpayers “to allow financial firms to self-regulate, but then pony up trillions to bail them out.”

However much we dislike the predicament we are in, the only way it can be remedied is if people learn in some detail what has transpired and so, armed with knowledge, demand change. Reading this book will prepare you to be able to do just that.

BILL FLECKENSTEIN March 2009

Acknowledgments

All books are collaborative efforts, and Bailout Nation was more so than most. There were many people whose contributions were crucial to getting this project off the ground, and keeping it going when things started to falter.

Over the course of the past year, I wrote this book while working in an asset management firm, heading a research shop, all the while running a very active blog. This book was possible only thanks to the many helping hands involved.

Much of the book was written in real time, and early versions of parts of this appeared on The Big Picture (www.ritholtz.com). I would post ideas a few hundred words at a time, and readers would critique, poke, and prod my thought process along. These brave souls have my everlasting gratitude. Many of the insights, quotes, obscure references, and artworks within the book come courtesy of them.

There were many professional journalists and writers who selflessly shared sources, ideas, and insights with me. In particular, Dan Gross, Jesse Eisinger, Randall Forsyth, and Herb Greenberg all greatly impacted my process. If there are any parallels between my book and Dan’s, it’s because we batted more than a few ideas off of each other. Special thanks go to Thomas Donlan of Barron’s, who took my disjointed ramblings in A Memo Found in the Street (“Dear D.C.”) and turned them into a concise thing of beauty.

Numerous other authors were helpful with the process of writing a book, as well as influencing my own research and writing. I owe special thanks to Nouriel Roubini, Bill Fleckenstein, and Michael Panzner for advice and comfort. Various fund managers and analysts generously shared their insights, most notably Doug Kass, James Bianco, Scott Frew, Chris Whalen, and David Kotok.

I grew up in a household where stocks and real estate were fodder for dinner-table conversations. My now-retired mother was a successful real estate agent, and used to regale us with dark tales of corruption and criminality in the real estate business (especially about C1 and C2). Her subversive view of the industry she worked in definitely rubbed off on me. (Thanks, Mom!)

The artwork in the book came to me courtesy of a few fantastic artists: John Sherffius of the Boulder Daily Camera is the creator of the fabulous jacket illustration to Bailout Nation. His political cartoons are also at the beginning of each of the five parts of the book. His dry wit and deft pen strokes communicate more with one picture that I can with thousands of words. J. C. Champredonde is the wicked mind behind the investment banks as casinos illustrations. You will find his work toward the end of the casino capitalism chapter and on the Web at www.stereohell.com. His art perfectly captures the past decade of casino capitalism. Jess Bachman of WallStats.com did amazing work on the Anatomy of a Crisis. R. J. Matson lent us a cartoon—corporate welfare.

Special thanks also go to Bill McBride of Calculated Risk for his informative real estate charts, and to Ron Griess of The Chart Store for the historical market charts.

Few writers particularly enjoy being edited. I was fortunate at TheStreet.com to work with Aaron Task—a rare editor who genuinely makes your work better (as opposed to merely different). When McGraw-Hill first approached me about doing this book (more about them later), I knew without question who I was willing to entrust my words to. Aaron’s contributions, organization, and constant urgings forward are the prime reason this book got to the publisher on time in December 2008. It’s been said a book is done when the manuscript is torn from its writer’s hands, and Aaron made sure that when that date came, what was being torn was something readable.

Much of this book involves dollar amounts, dates, data, and numbers. Staying on top of that would not have been possible without a crack research team, and I was fortunate to have worked with three of the best: Eugene Ashton-Gonzalez and William J. Miller were terrific, and my research intern, Ariel Katz, deserves special praise for her insights. She graduates from business school in May 2010, and some lucky company should snag her right away. Special thanks also go to Marion Maneker, for his gentle shoves in the right direction and his insights into the world of publishing.

Jeanne Glasser at McGraw-Hill was uniquely patient in dealing with writing a book about live events as they happened. When that publisher took issue with my criticisms of Standard & Poor’s (a division of McGraw-Hill), Jeanne fought hard for the book. That the book in your hands ended up at John Wiley & Sons—and Jeanne at FT Press and Wharton School Publishing—tells you something about character. And I would be remiss if I did not add that Lloyd Jassin, my literary agent, went above and beyond the call of duty throughout. As you might imagine, this was not the typical book deal.

Speaking of which: I am thrilled to be published by Wiley. The people there were especially excited about this project. It was a pleasure working with Kevin Commins and Meg Freeborn and the rest of the Wiley crew.

Perhaps this is an acknowledgment first, but I have to give a shout out to Google Docs—the collaborative editing process would have been a bear without it. We had so many different versions of each chapter floating around before we started using it. G-Docs made staying on top of the latest changes and edits a breeze. Chalk one up for cloud computing.

On a personal note, my wife showed infinite patience during this lost year of writing Bailout Nation. If it wasn’t for her, this book would never have been finished. (Go for a walk! You’re babbling again! Stop procrastinating! And for goodness’ sake, will you take a shower already!)

I must also express my gratitude to my partners at FusionIQ, Kevin Lane and Mike Conte, who gracefully allowed me to take many days off to finish this beast and to close the door to my office to bang out a few more pages during the workweek.

Many additional authors colored my worldview, and much of what you read is due to the prior work of Roger Lowenstein, Richard Bookstaber, Tom Metz, Paul Desmond, Stephan Mihm, Satyajit Das, Robert J. Shiller, Robert F. Bruner and Sean D. Carr, Reginald Stuart, and Ed Gramlich. Their writings influenced what you now hold in your hands, and if it’s any good, it’s because I stole only from the very best.

Introduction

Bailout Nation

Owe the bank $100, that’s your problem. Owe the bank $100 million, that’s the bank’s problem.

—J. P. Getty

We like to think of the United States as a rugged country of determined, self-reliant individuals. The iconic image is the American cowboy. You can picture him on a cattle drive, watching warily over his herd. All he needed to get by were his wits, his horse—and his trusty Winchester.

This idealized vision of America is fading fast, rendered moot by present-day cattle rustlers. The new gauchos ride not on the range, but on the financial vistas. Instead of herding cattle, they rope derivatives, wrangle financial instruments, and round up paper wealth. The differences between the modern-day cowboy/bankers and the ranch hands of the old West are many, not the least of which is monetary—today’s banker/rustler makes a whole lot more money than the frontiersmen did in the past.

But there is another crucial difference between the two—the “individualist” part. The newfangled herdsman may look rugged, but he sure as hell ain’t independent. The modern cowpoke has become way too reliant on a different sort of cavalry: Uncle Sam—and all the taxpayers that support him.

How did we go from being a nation that revered the idea of the self-reliant broncobuster into something else entirely? What turned us into a nanny state for well-paid bankers?

How did the good ole U.S. of A. turn into a Bailout Nation? That is what this book is about.

It’s easy to understand why bailout is such a dirty word in the American financial vernacular. There are many reasons, but I want to focus on the three biggest ones.

First, there is something inherently unjust about some people getting a free ride when everyone else has to pay his or her own way. We Americans are always willing to lend a hand to someone down on their luck, but that is not what the current crop of bailouts is about. This is the government financially rescuing people despite—or perhaps because of—their own enormous recklessness and incompetence.

This inequity is especially galling to those of us who work in the financial markets. Wall Street has long been a brutal meritocracy. Success is based on skills and smarts and the relentless ability to identify opportunity while simultaneously managing risk. All of the people I know who work on the Street—whether in stocks, bonds, options, or commodities—have a strong sense of fair play. “Eat what you kill” is the classic Wall Street attitude toward risk and reward, profit and loss.

There are, however, those market players who fail to live or die by their own swords—but then expect to be rescued by others from their own folly. They embody a fair-weather belief in the free market system, somehow thinking it applies only during the good times. This is a high form of moral cowardice, and it is rightly despised by those who play fairly and by the rules.

Since the turn of the twenty-first century, well-connected, moneyed interests have managed to keep all of their profits and bonuses during good times, but have somehow thrown off their risk and the results of their own bad decision making onto the public taxpayers. “Privatized gains and socialized losses” is hardly what capitalism is supposed to be.

Second, the process of how some groups get rescued by the government, while others are left to flounder, is in and of itself suspect. The cliché that “no one should see how laws or sausages get made” is especially true when it comes to bailouts. The political mechanisms—and the dollar amounts involved—are especially egregious. Why? In all modern cases, they are done quickly, on an emergency footing. There is often little or no debate. Transparency has been nonexistent. Many observers not only object philosophically to the concept of bailouts, but are particularly offended by the ham-fisted way they are foisted upon the public. Nearly everything has been done on an ad hoc basis, with little thought and less planning. Who has time for strategy or long-term thinking when we have trillions of dollars to spend?

Third, and finally, there are the costs. If we have learned anything about bailouts over the past hundred years, it is that each rescue attempt is more costly than the one that preceded it. This is usually true in terms of the immediate expenditure, but even more so in terms of the long-term damage done to the financial system. As of February 2009, the costs have raced past $14 trillion. That is an unprecedented sum of money, greater than any other single government expenditure in the nation’s history (see Table I.1).

Table I.1 Cheaper to Clean Up After?

SOURCE: Data courtesy of Bianco Research

Beyond the actual out-of-pocket expenses lies the dangerous hazard of corporate bailouts. The government’s largesse encourages greater and greater reckless speculation. The ordinary liability and risk that is supposed to go with investing and business ventures seem to have disappeared. A grotesque distortion of normal capitalist incentives is formed. When a sector of the economy expects to be rescued by the government, it loses the healthy fear of financial failure. This leads directly to excessive speculation and reckless behavior—a condition known as moral hazard.

Historically, excessive greed, recklessness, and foolish speculation were punished by the market. Speculators lost their capital, their reputation, and their influence. (Back in the day when skyscrapers had windows that opened, some even lost their lives.) Their pools of cash migrated to people who handled risk in a more intelligent fashion. This is—or perhaps was—the great virtue of capitalism: Money finds its way to where it is treated best. Capital gravitates to those who can balance risk and reward, and who can obtain positive investment results, without blowing up. It’s no coincidence that the largest venture capital firms, the biggest hedge funds, and the longest-lasting private trusts know how to manage risk. They preserve their capital. They have a healthy respect for losses, and strive to keep them manageable. They do not, as so many have done recently, put all their money on a single number, spin the roulette wheel, and hope for the best.

The present system has lost its auto-correcting mechanism. As economist Allan Meltzer noted, “Capitalism without failure is like religion without sin—it just doesn’t work.” While the profit motive is alive and well, with rewards potentially in the billions of dollars for some, there is no corresponding and offsetting risk of enormous loss. Any system that allows profits to be kept by a select few but expects the loss to be borne by the public is neither capitalism nor socialism: It is the worst of both worlds.

Government intervention thwarts this migration of capital. Instead of the relentless efficiency of the marketplace—I call it the back of Adam Smith’s invisible hand—we have instead politically expedient shortcuts that bypass this process. In the end, this results in a misallocation of capital, and an embracing of risk and short-term motives that leads to utter recklessness. Hence, the mortgage broker who fudges the loan application, the bank that looks the other way to process it, and the fund manager that ultimately buys this crappy paper are all focused not on sustainable, long-term returns, but on the quick buck. As we will see, the implications for the broader economy have been dire.

The modern era of finance is now defined by the bailout. Systemic risk has become the buzzword du jour. History teaches us that these bouts of intervention to save the system occur far more regularly than an honest definition of that phrase would require. Indeed, systemic risk has become the rallying cry of those who patrol the corridors of Washington, D.C., hats in hand, looking for a handout. As we too often learn after the fact, what is described as systemic risk is more often than not an issue of political connections and politics. Perhaps a more accurate phrase is economic expediency.

The past generation has seen increasing dependence on government intervention into the affairs of finance. Industrial companies, banks, markets, and now financial firms have all become less independent and more reliant upon Uncle Sam. This is no longer a question of philosophical purity, but rather a regular occurrence of politically connected corporations—and their well-greased politicians—throwing off the responsibility for their failures onto the public. Any sort of guiding philosophy or ideology regarding free markets, competition, success, and failure seems to have simply faded away as inconvenient. No worries, the taxpayer will cover it.

Some people—most notably current Federal Reserve chairman Ben Bernanke and former chairman Alan Greenspan—seem to feel that it is the responsibility of governmental entities such as the Federal Reserve or Congress to intervene only when the entire system is at risk. The events since August 2007 have made it clear that this is a terribly expensive approach. Perhaps what the government should be doing is acting to prevent systemic risk before it threatens to destabilize the world’s economy, rather than merely cleaning up and bailing out afterward. An ounce of regulatory prevention may save trillions in cleanup cures.

The United States finds itself in the midst of an unprecedented cleanup of toxic financial waste. As of this writing, the response to the credit crunch, housing collapse, and recession by various and sundry government agencies had rung up over $14 trillion in taxpayer liabilities, including bailouts for Fannie Mae and Freddie Mac, General Motors and Chrysler (twice, and soon to be three times), American International Group (AIG) (four times), Bank of America (three times), and Citigroup (three times). It has forced capital injections into other major banks, and government-engineered mergers involving once-vaunted firms Bear Stearns, Goldman Sachs, Morgan Stanley, Merrill Lynch, and Washington Mutual (see Table I.1). It has led to the Federal Deposit Insurance Corporation (FDIC) receivership, nationalization and sale of Washington Mutual (now in the hands of JPMorgan Chase), and Wachovia, flipped over the course of a weekend to Wells Fargo.

Yes, that’s $14 trillion (plus)—about equal to the gross domestic product (GDP) of the United States in 2007. And as 2008 came to a close, even more industries caught the scent of easy money: Automakers, home builders, insurers, and even state and local governments were clamoring for a piece of the bailout pie.

The implications of this are significant. The current bout of bailouts—the banks and brokers, airlines and automakers, lenders and borrowers in the housing industry—will have significant, long-lasting repercussions.

So far, they have turned the United States into a Bailout Nation.

And that’s just the beginning.

Part I

A BRIEF HISTORY OF BAILOUTS

Source: By permission of John Sherffius and Creators Syndicate, Inc.

Chapter 1

A Brief History of Bailouts

“The ultimate result of shielding men from the effects of folly is to fill the world with fools.”

—Herbert Spencer, English philosopher

America’s relationship with bailouts has been a complex and nuanced affair. It has evolved gradually, morphing through var ious phases over time. The United States has had several distinct bailout eras, and each has seen an incremental shift in the attitudes toward government rescues. Philosophically, the country has moved from finding the mere idea of a government intervention to any corporation abhorrent, to begrudgingly accepting interventions as a rare but necessary evil. Since the late 1990s, bailouts have been embraced around the world as a near-normal responsibility of government to save the financial markets from themselves. Most recently, a backlash has been building against bailouts as a reward for dumb and irresponsible behavior.

Let us consider an earlier period in U.S. history—the nineteenth century to the pre-Great Depression era. The popular attitude toward both governments and corporations was very different at that time from today. Government was much smaller, and was not seen as a lender of last resort to either banks or industry. A general suspicion of corporate entities was commonplace among the populace, and there was a near-adversarial relationship between the government and the larger corporate interests.

The federal government’s involvement in companies in the nineteenth century was more as an incubator than a rescuer. There wasn’t much in the way of venture capital funding then, and a few start-ups sought and received modest amounts of government assistance. Railroad and telegraph firms were given easements and rights of passage, facilitating the government’s desire for expansion into the West. Later on, telephone companies also enjoyed government largesse. Eminent domain was used to purchase properties for the benefit of companies as varied as mining, cattle ranches, railroads, and telegraph firms. In each of these early examples, the government’s cash outlays were quite modest, and often facilitated a broad public good.

Rather than betting on any single company, the government found it to be in its own interest to jump-start a sector and then allow a brutal Darwinian competition to take place. Ultimately, that left standing only a few survivors as the rest of the industry fell by the wayside. Automobiles, computers, electronics—history is replete with examples of the U.S. government staying out of the way of a competitively developing industry. The government left these companies to follow their own natural life cycle via the mechanics of the free market. In Pop! Why Bubbles Are Great for the Economy, Dan Gross details the thousands of railroads, telegraph companies, automakers, and Internet companies that boomed and then eventually went bust.1 In most industries, this process leaves behind a valuable infrastructure for subsequent companies to build upon. This was Joseph Schumpeter’s “creative destruction” at work.

The groundwork for modern bailouts was laid in the early twentieth century, when in 1913, the Federal Reserve System was created. As we will see in a later chapter, this had major implications a century later. As originally envisioned, it was imbued with only modest monetary and fiscal powers. Eventually, these powers were expanded dramatically.

The next phase took place in the 1930s and 1940s, between the Great Depression and World War II. The widespread economic turmoil and political discontent forced the government to engage in a series of economic stimuli designed to generate jobs, income, and economic activity. While some political historians have described this as a bailout, it was not directed toward any specific corporation or economic sector. The public works programs of the Depression era were designed to impact the entire economy, stimulate growth, and reduce the 25 percent unemployment rate.

The latter years of this second era preceded World War II. The U.S. steel industry had previously enjoyed a booming decade in the 1920s, but had collapsed during the economic crisis. The United States, anticipating the possibility of its entry into World War II, recognized the importance of a viable industrial manufacturing sector. Without a healthy steel industry, the country would’ve been hamstrung in its attempts to build ships, tanks, planes, and other tools of warfare. The munitions industry also received much of Uncle Sam’s largesse, as did the metals companies and the rubber industry. Indeed, the ramp-up to World War II saw an enormous amount of government assistance to companies that were war-related.

Were these truly bailouts? It’s hard to call any nation’s national defense buildup in wartime a true bailout.

After World War II, the United States entered a long period of economic expansion. The building of suburbia, the automobile industry’s enormous growth, the expansion of major cities, and the entire postwar baby boom led to salad days for corporate America. There was no further government involvement in corporate America until the rescue of Lockheed Aircraft Corporation in 1971.

What made the Lockheed bailout so pivotal was its status as the first public bailout of a major corporation—and only that corporation. The Lockheed rescue became the blueprint for most future bailouts over the next half century.

The rescue of Lockheed in 1971 ($250 million) led to loan guarantees for Penn Central in 1974 ($676.3 million in loan guarantees), which paved the way for the $1.5 billion rescue of Chrysler in 1980 and then Continental Illinois Bank in 1984 ($1.8 billion loss). This led to the original mother of all government insurance payouts—the savings and loan (S&L) crisis of the early 1990s (total taxpayer cost: $178.56 billion), which led to the stock market rescue of 2000, and so on. Each bailout has had negative consequences, and the repercussions have often led to the next bailout. Each negative impact seems to have the perverse effect of making future bailouts less surprising and more tolerable—and therefore more likely.

The Federal Reserve’s attempted rescue of the credit markets in August 2007 ultimately led to the $29 billion rescue of a single firm—the investment bank Bear Stearns in March 2008. The Fed not only was rescuing Bear Stearns but, indirectly, JPMorgan Chase, the largest derivatives counterparty of Bear Stearns. More important, the Fed was also protecting its original decision to rescue the credit markets. The housing bailout package of July 2008 rationalized the interest rate policies of the early 2000s, and led indirectly to the nationalization of Fannie Mae and Freddie Mac, which not only cost $200 billion, but put more than $5.5 trillion worth of debt back on the books of the U.S. government. Then came the takeover of AIG ($173 billion and counting), the $700 billion Troubled Assets Relief Program (TARP), which featured the forced injection of $250 billion into the nation’s largest banks. November 2008 brought another $20 billion capital injection into Citigroup (total $45 billion) and guarantees for $250 billion of its toxic assets. Bank of America also saw its cash injection upped to $45 billion and guarantees of $306 billion on its toxic assets. There was $30 billion for the automakers. 2009 saw a $75 billion rescue for homeowners, and a $770 billion dollar economic stimulus plan.

Perhaps it’s best to stop calling these numbers “astronomical.” A better term might be “economic numbers”—dollar amounts so vast they dwarf time and space. When you are tossing around those kinds of numbers, what is another $800 billion program for mortgage-backed securities and credit-related assets? And as long as we still have some checks left, we might as well do a government-engineered takeover by JPMorgan Chase of Washington Mutual. The government tried to do the same with Citigroup and Wachovia, but Wells Fargo swooped in with a higher offer, suggesting that even in Bailout Nation, private capital still has its place.

As a nation, we went from never bailing out anyone to somehow finding a seemingly inexhaustible supply of bailout candidates.

I can’t wait to see what the hell is gonna happen next month.

Chapter 2

The Creation of the Federal Reserve, and Its Role in Creating Our Bailout Nation

I am a most unhappy man. I have unwittingly ruined my country. Agreat industrial nation is controlled by its system of credit. Our systemof credit is concentrated. The growth of the nation, therefore, and allour activities are in the hands of a few men. We have come to be one ofthe worst ruled, one of the most completely controlled and dominatedGovernments in the civilized world.

—President Woodrow Wilson1

As much as I tried to steer clear of writing a history of central banking, it was all but impossible. Any examination of bailouts in the United States would be incomplete if the role of the Federal Reserve System were omitted. I will endeavor to keep it brief and relatively painless.

It is crucial to understand the role of the Fed, and how it has radically expanded over time, if you are to have any hope of comprehending the modern era of Bailout Nation. Since March 2008, so many different financial bailouts have been funded directly by the Fed—into investment banks, government-sponsored enterprises (GSEs), brokerage firms, money market funds, even the overall stock market—that we could not discuss bailouts intelligently and avoid mentioning the Fed. It is front and center in this mess.

The role of emergency fixer was not part of the Fed’s original mission statement. At the end of the eighteenth century, prior to the creation of a central bank, currencies from as many as 50 nations were circulating in the United States. A single currency, backed by a strong authority, was needed to maintain some semblance of order. For any young and growing country, this was a necessity.

As originally conceived, the central bank had a narrow task. It was brought into existence for eminently reasonable and defensible purposes: to establish financial order, to allow for the creation of needed credit for the country, and to resolve the issue of the fiat currency (money that has value by virtue of the government declaring it has value).

From those relatively modest monetary and fiscal powers, the Federal Reserve has evolved into something that would be unrecognizable to its founders. Under the guise of economic expediency, the Fed has grabbed power, dramatically widening the areas of its responsibility. Since the 1990s, the Federal Reserve System, a private corporation registered in the State of Delaware, has behaved as though it were in charge of anything economic—moderating the swings of the business cycle, maintaining interest rates, supporting the value of depreciating assets, even intervening in the stock market.

During the economic collapse and credit crises, there was a distinct lack of financial leadership in the United States. With President Bush’s approval rating at historic lows, the White House showed little inclination to face the storm. As the many crises began heating up in 2007, the leadership vacuum was apparent. It was into this empty space that the Fed inserted itself, seizing more and more authority. It wasn’t so much a power grab as a reluctant filling of the void. Steve Matthews, writing for Bloomberg, observed, “What started as a meltdown in the market for subprime mortgages has turned into a worldwide credit and economic crisis. Bernanke, now the Fed chairman, has responded with the most aggressive expansion of the Fed’s power in its 95-year history.”2

Paul Volcker, the well-regarded former Fed Reserve chair, was aghast at how much authority the central bank had claimed as its own. Following the Fed-financed shotgun wedding of Bear Stearns and JPMorgan Chase, he told The Economic Club of New York: “The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.”3

The Federal Open Market Committee (FOMC), the Federal Reserve’s principal tool for implementing monetary policy, has even gone so far as to state that its charge includes preventing “panic” in the markets, a far cry from its official dual mandate of price stability and full employment.

None of these duties were ever part of the Fed’s charter.

The fourth time’s the charm: The institution we know as the United States Federal Reserve is actually the fourth attempt at creating a central banking system in the United States.

To truly appreciate how a limited facilitator of banks evolved into the most powerful central bank in the world, we need to understand a bit of its history. All three previous attempts at creating a central bank in the United States were met with equal measures of concern and controversy. Thomas Jefferson, the principal author of the Declaration of Independence, argued that since the Constitution did not specifically empower Congress to create a central bank, doing so would be unconstitutional. “Banking establishments are more dangerous than standing armies,” Jefferson famously declared, and went on to say:

The central bank is an institution of the most deadly hostility existing against the Principles and form of our Constitution. I am an Enemy to all banks discounting bills or notes for anything but Coin. If the American People allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the People of all their Property until their Children will wake up homeless on the continent their Fathers conquered.4

The change from the Jeffersonian view toward the Federal Reserve to the modern public’s attitude is nothing short of extraordinary.

Like Presidents Jefferson and Wilson, the American people genuinely feared giving this much power to a group of unelected, unaccountable private bankers. The fairly blasé response to the Fed’s current expansion of its authority—and trillions in new Fed credit lines—is rather surprising. In light of the antipathy and worry previous central banks had historically evoked, the power grab by the Bernanke Fed and Treasury Secretaries Paulson and Geithner are all the more remarkable. Other than gold bugs and economists from the Austrian school, the public response has been tepid.

The first attempt at creating a central bank was made in 1791. The new nation needed a depository for the levies and taxes it collected, and the government required a way to take short-term loans to fill temporary revenue gaps. A simple fiscal institution was created and called the First Bank of the United States. But just to be safe, it had a 20-year charter, which expired in 1811.

Without the existence of a central lending authority, the War of 1812 left the underfinanced nation with a “formidable debt.”5 Private banks issued an ever-increasing amount of notes, leading to a serious bout of monetary inflation. The need for some form of a central bank was readily apparent. Thus, the Second Bank of the United States was chartered in 1816, five years after the demise of the First Bank. It had more funding and therefore greater influence than its predecessor. While both banks were controversial, it was the Second Bank of the United States that was perceived as especially threatening. It became so powerful that “many citizens, politicians, and businessmen came to view it as a threat to themselves and a menace to American democracy.”6

When the Second Bank’s charter lapsed in 1836, there was hardly an appetite for a Third Bank of the United States. But as the young nation grew, its finance and banking system grew haphazardly. Lacking a coordinating central authority, the first hundred years of the country’s financial development became a patchwork of private banks, notes, and currencies. Many individual states issued their own legal tender, and private banks had the authority to commission engravers to design banknotes. Insurance companies, railroads, import and export firms, and others all had a similar ability. The anarchy that ensued made the dozens of foreign currencies circulating in the republic’s early days look almost organized. In A Nation of Counterfeiters, Stephen Mihm writes:

By the 1850s, with so many entities commissioning banknotes of their own design (and in denominations, sizes, and colors of their own choosing), the money supply became a great confluence of more than 10,000 different kinds of paper that continually changed hands, baffled the uninitiated, and fluctuated in value according to the whims of the market. Thousands of different kinds of gold, silver, and copper coins issued by foreign governments and domestic merchants complicated the mix. Such a multifarious monetary system was not what the framers of the Constitution had intended.7

And those were just the legal currencies, notes, and specie. Counterfeiting was fairly commonplace. Estimates were that as much as 10 percent of all currency in circulation was fake.8

Beyond forgery, bank runs were common, and bank failures occurred with increasing regularity. It was apparent that the financial system, left to its own devices, could not function properly. It was operating—quite literally—in the Wild West.

The nation’s third foray into central banking came about with the National Currency Act (1863), later amended to the National Banking Act (1864 and 1865). This legislation provided for the creation of nationally chartered banks. Requirements included stringent capital minimums, lending limits, and regular bank examinations by the Office of the Comptroller of the Currency. Near-modern banking regulation and supervision thus came into existence.

Although these national banking acts were a significant improvement over the previous regulatory regime, eventually they too proved inadequate. Currency growth was tied to the bond market, not the broader economy. For a rapidly growing young nation, this proved insufficient. An inelastic currency and nonexistent national reserve system led to wild swings in the economy, with oscillating periods of booms and busts. Depressions became a surprisingly common cyclical phenomenon.

These “early experiments in central banking,” as the Federal Reserve Bank of Boston called these pre-twentieth-century attempts, were almost quaint in comparison to modern times. The Boston Fed explained:

As the American economy became larger, more urban, and more complex, the inelastic currency and the immobile reserves contributed to the cyclical pattern of booms and busts. These wide gyrations were becoming more and more intolerable. Financial panics occurred with some frequency, and they often triggered an economic depression. In 1893 a massive depression rocked the American economy as it had never been rocked before. Even though prosperity returned before the end of the decade—and largely for reasons which this nation could not control—the 1893 depression left a legacy of economic uncertainty.9

How did we end up with such a powerful central bank if the country was originally so opposed to one? After those first three attempts failed, we need to fast-forward to the Panic of 1907. In its aftermath, we find the genesis of the modern Federal Reserve Bank.

As so often happens, a long stretch of cyclical growth led to a boom, bust, panic, and renewal. Rapid industrial growth was the key to the recovery from the depression of 1893. Soon, twentieth-century America was booming. From the mid-1890s to 1906, the nation’s annual growth rate was 7.3 percent. 10

How did the country go from prosperity to panic? It would take a complete book to explain (I recommend Bruner and Carr’s The Panic of 1907). In brief, the San Francisco earthquake revealed trouble beneath the surface of the nation’s finances. The massive scope of the damage impacted financial activity around the world. Relief funds were sent to help resolve nearly $500 million in damages caused by the quake and the ensuing fires. London, Germany, France, New York City, and other financial centers saw significant capital migrate westward.

But it was primarily in London, the capital of the British Empire and the financial center of the world, where the monetary problem gestated. Insurance companies were shipping enormous amounts of gold to San Francisco as policies were paid out. As a result, the money supply in England was becoming inordinately tight. With capital scarce, bankers in the United Kingdom decided to do something about it. Printing presses and helicopters were not a ready solution in 1906; instead, the Bank of England raised rates from 3.5 to 6 percent to attract capital. Soon after, other European banks followed. Money flows to where it’s treated best, and after the rate hikes, lots of money found its way back to England.

Consider this modern example of how the more things change, the more they stay the same. In October 2008, after its banking system was devastated by the credit crunch and investment losses, Iceland’s central bank hiked its rates to 18 percent for the same reason the Bank of England did a century earlier: to attract capital.

To those who regularly advocate for the dismantling of the Federal Reserve, perhaps the previous tale may prove instructive. Unless all nations agree to do so simultaneously, the dissolving of a central bank amounts to the economic equivalent of unilateral disarmament.

In the United States in 1907, there was no such comparable mechanism to compete with the Bank of England. While the promise of great riches attracts capital during a boom, liquidity flees once the boom turns to bust. The legacy of economic uncertainty tracing back to the 1893 depression, combined with America’s acute need to attract capital, set the stage for what came next.

In 1908, Congress was desperately searching for an answer to the ongoing financial crises. Its response was to create the National Monetary Commission, a panel studying potential solutions to the nation’s monetary problems. It took five years of political maneuvering, public debate, and legislative proposals to decide whether the United States should have a central bank, and what that bank should look like. It would take yet another book to explain precisely how the Federal Reserve was created in 1913 (and G. Edward Griffin’s The Creature from Jekyll Island11 is the Fed hater’s standard tome).

For the purpose of understanding how the United States became a Bailout Nation, we need only note that the Federal Reserve System was indeed created, granted extraordinary powers, and set loose upon the world. As we will see, the results of this act will have unforeseen consequences that were not remotely imagined back in 1913.

Chapter 3

Pre-Bailout Nation (1860-1942)

Capitalism is not really the best word to describe this arrangement. (The term was coined in the late 19th century as a way to describe the ideological opposite of communism.) Some decades later, people began to use a better term, “the American system,” in which the government involved itself in the economy primarily to develop what we would now call infrastructure—highways, canals, railroads—but otherwise let economic liberty prevail. I prefer to call this spectacularly successful arrangement “financial democracy”—a largely free system in which the U.S. government’s role is to help citizens achieve their best potential, using all the economic weapons that our financial arsenal can provide.

—Robert J. Shiller1

The United States as a Bailout Nation is a relatively new phenomenon. In the early and middle parts of our history, the country did not engage in rescue operations of corporations; speculators who got into trouble were on their own.

Government assistance was more likely to be made available during the birth pangs of a new industry—not during a single company’s death rattle.

Venture capital firms were nonexistent in the nineteenth century. The early days of the republic did not have the equivalent of a Sand Hill Road. Sometimes Congress was called upon to fund start-ups and new technologies. Classic examples can be found in the expansion of the nation’s railroads westward and in the development of the telegraph industry. Both of these industries found a coaxable benefactor in Washington, D.C., and received a helpful push from taxpayer subsidies. Commercialization of the first telegraph line was jump-started by congressional funding; railroads received land grants and other forms of enabling assistance to help them expand westward.

The government’s preference was to fund industries that would facilitate the nation’s physical expansion, stimulate infrastructure development, and aid economic growth. Once these industrial sectors were up and running, however, they were left to succeed or fail on their own. How charming! How quaint! What a novel idea!

Inventors and entrepreneurs were a key part of this process. The telegraph industry began when Samuel F. B. Morse, the inventor of the Morse Code, managed to wrangle $30,000 of taxpayer money out of Congress in 1844. He was credited with establishing the first telegraph line between Washington, D.C., and Baltimore.2

So too began the railroad industry. Government grants in 1850 provided lands to Illinois, Mississippi, and Alabama in aid of the Illinois Central Railroad, along with the Mobile and Ohio Railroads. Illinois Central obtained these subsidies through the efforts of a young country lawyer by the name of Abraham Lincoln. The Illinois Central Railroad later repaid the favor by helping Lincoln get elected president in 1860. Perhaps it wasn’t such a favor after all; once in office, Lincoln signed land grants to railroads totaling more than 150 million acres of public land. Of the five transcontinental railroads of the day, four of them owed their existence to these enabling subsidies.

The life cycle of all new industries is the same: New technologies experience a period of rapid growth. The opportunities attract competitors. The new industry expands rapidly and soon makes lots of money. This attracts further competition: more companies, people seeking jobs in these growth areas, and even more capital and greater investment. Fresh competition helps the industry develop and mature. Eventually, the boom reaches the point where overinvestment and excess capacity become endemic, leading to brutal price competition and shrinking margins. Strong firms survive while most of the weaker companies fail. Those with poor management, insufficient capital, or inferior technology soon find themselves on the wrong side of Darwin’s law. This is a cycle that repeats over and over in the system of free market capitalism.