Bailout Nation (10 page)

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Authors: Barry Ritholtz

BOOK: Bailout Nation
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10.
Expected results and unintended consequences:
The bailout is put into effect sooner rather than later. It usually has some degree of curative properties, as large piles of money often do. We learn of errors and problems fairly quickly, but usually some measure of victory is declared. Minor abuses come to light—a little fraud here, some oversight snafu there. These are par for the course, and mostly ignored.
Without fail, the unintended consequences of the bailout begin working their way through the system. The repercussions are felt years and even decades later.
W
e have seen this exact pattern with the various industrial bailouts of the 1970s and 1980s, the savings and loan (S&L) crisis of the early 1990s, and the Long Term Capital Management (LTCM) crisis of 1998. More recently, the tech wreck of 2000-2003, the credit crisis, the derivatives disaster, and the housing collapse all went through similar phases.
Each of these events followed the usual progression. Indeed, all of the current bailouts are repercussions—the step 10—of previous bailouts.
And we have yet to learn the unintended consequences of the credit crunch bailout, the housing rescue plan, the American International Group (AIG), Citigroup (C), Bank of America (BAC) rescues, the General Motors (GM) loans, or the Fannie and Freddie conservatorship. We seemed to be rushing headlong through steps 1 through 9; step 10 is off in the future.
But rest assured, we will discover, as we always do, some terrible repercussions down the road. They will be substantive and substantial—and very, very expensive.
Part II
THE MODERN ERA OF BAILOUTS
Source
: By permission of John Sherffius and Creators Syndicate, Inc.
Chapter 5
Stock Market Bailouts (1987-1995)
The essential Greenspan legacy . . . is the idea that the Fed will allow nothing to go really wrong.
—James Grant, publisher of
Grant's Interest Rate Observer
1
 
 
S
o far, we have looked at various interventions—in the economy (1930s); in individual companies (Lockheed, Chrysler); and in entire sectors (banking). The next step on our path to becoming a Bailout Nation was when we went beyond any given company or sector bailout. We moved into uncharted territory when the U.S. Federal Reserve began intervening in the
entire stock market.
Of course, the Federal Reserve has indirectly impacted all markets by performing its ordinary duties: maintaining price stability and maximizing employment. The Fed engages in a variety of targeted actions, such as changing interest rates, adding or subtracting liquidity, buying and selling Treasuries. These all have an impact on the markets, for better or worse. But that impact is incidental to the operations of the Fed's normal central banking activities. The results are a by-product, not the goal of the central bankers.
Where investors—and taxpayers—should become concerned is when the Fed goes far beyond ordinary central banking operations and seeks to maintain or support asset prices. This is a slippery slope, and, as we shall see, it leads to consequences that have been utterly disastrous.
How the Federal Reserve morphed from a lender of last resort to a guarantor of asset prices is a long and tortured tale. We will skip most of the boring history, and instead focus on the era dating from the 1987 crash forward. Traditionally, the Fed's mandate has been to “foster progress toward price stability” and to “promote sustained real output growth.” For our purposes, let's call these fighting inflation and smoothing out the excesses of the business cycle.
Change came to the Fed in the form of a new Federal Open Market Committee (FOMC) chairman. Alan Greenspan took the reins in 1987, and he radically broke away from his predecessors' philosophies. Under the new chairman, FOMC policy incrementally moved toward supporting asset prices. As so often happens with these things, it began with a major disruption. In Greenspan's case, it was the 1987 market crash.
Initially, 1987 was a good year for the markets. By August, the S&P 500 had gained about 40 percent year-to-date. September was a bit rocky, sliding 10 percent from the highs—but that was to be expected. Nothing goes up in a straight line forever, right?
But then came October. Things took a turn for the worse, as the Dow Jones Industrial Average slid 3.8 percent on Wednesday, October 14. On Friday, October 16, the blue chips lost another 4.6 percent. The crash occurred on Black Monday (October 19)—when the Dow plummeted a harrowing 22.6 percent.
We can spend many hours going over all of the conditions precedent to the crash, but that is another book entirely (the interested should read
Black Monday
, by Tim Metz). While there is still academic debate over the causes of the crash, for our purposes, let's note as sufficient causal elements the combination of portfolio insurance—a derivatives product that utterly failed to work as advertised (
let's hear it for innovation!
)—a creaky New York Stock Exchange (NYSE) infrastructure, and Treasury Secretary Baker's remarks over the weekend implying we were no longer supporting the dollar.
The actual crash is a fascinating part of stock market history. Those of you who wish to become serious students of the market must familiarize yourself with what occurred. Panics may vary from generation to generation, but we learn that human nature is immutable.
It is not the crash itself, however, but rather the actions of various parts of the government that are of particular interest to us.
The response from the Federal Reserve was swift. Before the market's opening on Tuesday, October 20, the Fed issued the following statement: “The Federal Reserve System, consistent with its responsibilities as the nation's central bank, affirmed today its readiness to serve as a source of liquidity to support the financial and economic system.”
Note that the address is to the system, threatened by the large movement downward of
asset prices
. The central bank then added substantially to reserves through open market operations. Over the next two weeks, the federal funds rate fell to 6.5 percent from 7.5 percent just prior to the crash.
But the Fed's pledge was not sufficient to halt the sell-off. According to Tim Metz, author of
Black Monday
(Beard Books, 2003), there was a slight problem prior to the opening of the markets the next day: Most of the NYSE floor specialists were technically insolvent. Not only had they absorbed enormous losses during the crash, but the various bank lines of credit they used each day had disappeared. It looked like the crash was going to continue Tuesday, with the Dow off 6 percent in the morning. It wasn't until New York Federal Reserve President Gerry Corrigan jawboned banks into restoring credit lines—and somehow turned off futures information between New York and Chicago—that the mother of all Turnaround Tuesdays took place.
It is a classic example of the authority of the Fed being used to avoid what looked like a full-blown liquidity crisis.
“
. . .
the Fed's responsibilities to serve as lender of last resort was intended to reverse the
crisis psychology
and to guarantee the safety and soundness of the banking system” was how Robert T. Parry, president of the Federal Reserve Bank of San Francisco, described the Fed's actions at a University of California at Davis conference 10 years later.
2
He affirmed what the Fed saw as its proper role.
Now, it's at precisely this point in our narrative that we must stop for a moment to point out something you may not have taken the trouble to consider before. Exactly why did the Fed become in charge of psychology? The central bank was originally established to bring financial order to the early Wild West days of banking. Somehow, resolving fiat currency issues and supervising credit morphed into a far more subjective role. Michael Panzner, author of the prescient doomsday tome
Financial Armageddon
(Kaplan Business, 2007), calls it “mission creep.”
We know what happened next: Over the ensuing years, the role of the Fed crept significantly, from that of inflation fighter to market therapist, and ultimately to the guarantor of asset prices.
After the 1987 crash, Wall Streeters were relieved. Instead, they should have been concerned. They had unknowingly made a deal with the devil, one that would prove quite costly down the road. The supposedly unique Federal Reserve intervention after the 1987 crash was hardly a one-off—it became the Fed's modus operandi which continues to this day.
T
he 1987 crash laid bare many of the structural flaws of the market. During trading of the highest-ever volume on Black Monday, the market's internal plumbing had failed. Orders were not executed for hours, quotes did not update, and specialists were overwhelmed at their posts. At brokerage firms, phones rang and rang unanswered.
The mechanical functioning of the NYSE was not the result of any intelligent design. The conventions for executing equity orders had evolved on an ad hoc basis. It took the stresses of the crash to reveal the market's warts.
The President's Working Group on Financial Markets
In 1988, President Ronald Reagan issued Executive Order 12631 establishing the President's Working Group (PWG) on Financial Markets. The goal of the PWG was to “enhance the integrity, efficiency, orderliness, and competitiveness of our Nation's financial markets while maintaining investor confidence.” (Once again with the psychology.)
Twenty years later, it remains a secretive organization, one whose formalized meetings keep no minutes and whose functions are poorly understood. There is surprisingly little academic publishing on this body. Due to its secretive nature, the PWG's workings are often described in market folklore as “they,” as in “They won't let the market drop, they were in buying today.”
It wasn't until 1997 that the PWG received the name by which they are best know today: the Plunge Protection Team (PPT). That was the headline of a Sunday Washington Post article by staff writer Brett D. Fromson.
3
For our purposes, the PPT is an irrelevant footnote.
Why? First off, it is hard to imagine a secret cabal manipulating markets, deploying billions or even trillions in capital, with a nary a shred of evidence ever surfacing. The Bush White House couldn't illegally fire nine U.S. attorneys without the political motivation being discovered and a major investigation launched.
4
Could the markets be supported via massive trading, and no one anywhere would ever see proof and come forward? It's hard to imagine that big a secret being kept for so long.
Second, and more important, the PPT, well, they really suck at their jobs. If the conspiracy theorists are correct and this group is supposed to prevent market meltdowns, they are not exactly hitting the cover off the ball. The late George Carlin had a routine on American Indians' military organizational structure. They weren't bad fighters, he said, just because they started out defending Massachusetts and ended up in Santa Monica.
And so it is with the PPT. How is their fighting prowess? Well, consider that starting in 2000, the NASDAQ fell from over 5,100 to about 1,100—a plunge of nearly 80 percent in about two and a half years. And in 2008, the PPT performed even more miserably. Bloomberg reported that as of November 19, 2008, markets were suffering from “the worst annual decline in the Standard & Poor's 500 index since 1931.”
5
The carnage “dragged down every industry in the benchmark gauge and 96 percent of its stocks. Four hundred eighty-two companies slipped as the 500-stock index slumped 46 percent, poised for its biggest yearly retreat in eight decades.” And after the major indexes ended 2008 down more than 40 percent for the year, the first 10 weeks of 2009 saw the markets fall another 22 percent.
Worst annual decline in eight decades? Down another 22 percent in two months? Geez, how incompetent must a secret market-manipulating organization be before someone gets fired?

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