Bailout Nation (25 page)

As it turned out, the true cost of the Boskin Commission was immeasurably higher. Since the Boskin Commission's recommendations were adopted in 1999 by the Bureau of Labor Statistics, the spread between real-world inflation and official CPI the BLS reports has only grown further apart. In the current decade, the BLS has reported only modest inflation increases as actual prices of goods and services have skyrocketed.

For a while, the Boskin-influenced CPI data convinced many economists that the inflation beast really had been tamed. Soon, however, the official data became laughable. The Fed was insisting inflation was moderate as food and energy prices soared. Even more absurd was the Federal Reserve's preferred measure of inflation—the core CPI, minus food and energy costs.

Or as I prefer to call it, inflation
ex-inflation
.

What happens when we deny objective reality, purposefully misstate the economic data, and try to hide beneath a series of obfuscations and misdirection? We end up making policy based on a false view of reality. The drumbeat of bad data, and the imprimatur of legitimacy thereof, provided an undeserved credibility for the “low inflation” theme. That created a level of acceptance of elevated inflation that eventually led to several disasters. Rates were left at levels that responsible central bankers, aware of reality and concerned about inflation, would never have allowed.

The post-Boskin fantasy world made ultralow rates for extreme lengths of time more acceptable. The Boskin Commission's recommendations turned BLS data reporting into something once removed from actual inflation. Unfortunately, this gave some degree of cover to Alan Greenspan's dramatic reduction of interest rates from 2001 to 2003 down to 1 percent.

Without the commission's changes, it's hard to imagine Greenspan could have kept rates as low—and for as long—as he did. Those ultralow rates begat the boom in housing, which fed the residential mortgage-backed security (RMBS) business.

And the single biggest player in RMBSs? Bear Stearns.

Many factors led to the credit crisis—but we can draw a straight line from the silliness of the Boskin Commission to Greenspan's 1 percent federal funds rate to a surge in derivatives trading, and on to the collapse of many financial firms. Bear Stearns was the first—but it wouldn't be the last.

F
rom Boskin to Bear Stearns on to Lehman: Perhaps the most obvious of our strange connections is the number of repercussions that the Fed-engineered rescue of Bear Stearns had on other investment banks' managements, most notably Lehman Brothers.

Larger and better diversified than Bear, the 158-year-old Lehman was the second-biggest player in the RMBS market. Following the Bear bailout in March 2008, Lehman management may have assumed that the Fed and Treasury would come to its rescue if it ran into real trouble.

That misplaced reliance was a fatal mistake. But it may have begotten the strangest, least-intended consequence of all: Lehman turning down a rescue offer from Warren Buffett's Berkshire Hathaway. To date, this marks the single biggest missed opportunity of the bailout era.

After the Bear collapse, Lehman CEO Dick Fuld reached out to a few sources to round up some extra capital. Somewhat surprisingly, Buffett was receptive to taking a stake in Lehman. In 1987, Buffett had successfully rescued Salomon Brothers, but the experience had soured him on Wall Street. It was widely believed that he had sworn off owning any investment banks unless they could be had for a song.

Fuld must have been singing Buffett's tune. According to Bloomberg, Berkshire Hathaway offered to buy preferred shares that would pay a dividend of 9 percent and could be converted to common at the then-market price of $40.30.

Buffett's money was costlier than other potential investors, but it came with the imprimatur of the world's best-loved investor. That alone probably would have guaranteed Lehman's survival.

Surprisingly, Fuld spurned Buffett's offer, choosing instead to sell $4 billion in convertible preferred (7.25 percent rate, 32 percent conversion premium) on April Fool's Day; the buyers of those preferreds turned out to be quite the fools indeed.

By rebuffing Berkshire and, as Bloomberg described it, “corporate America's
Good Housekeeping
seal of approval,” Lehman likely missed its last, best chance for survival. Ironically, Buffett got the chance to make an even tougher deal with Goldman Sachs after Lehman went belly-up—a 10 percent interest rate on a $5 billion investment.

Lehman's Fuld also had other chances to raise money before the firm's bankruptcy filing in mid-September 2008. But the deals were never consummated, most notably negotiations with Korea Development Bank, which reportedly broke down over price.
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One cannot help but imagine: But for the Bear Stearns bailout, would Lehman CEO Dick Fuld have been as arrogant? One has to think he expected policy makers would give Lehman the same treatment as his smaller rival.

E
nron's lobbying for an energy derivatives trading exemption ultimately was what led to the Commodity Futures Modernization Act. The CFMA, we now know, created an unregulated shadow insurance industry. This led to all sorts of normally staid firms getting in way over their heads.

Consider the bond insurers. The Ambacs, MBIAs, and FGICs (formerly a GE/Blackrock company) of the world used to have a nice little business. They were called monolines, because they did only one thing: They wrote insurance on bonds issued by cities, states, and local municipalities. Historically, muni bonds have very low default rates; state and local governments have the power to levy taxes to make principal and interest payments, and hence rarely default. With an additional guarantee on those payments from the monolines, insured munis were granted triple-A ratings, the highest possible. The monolines' fees were the “vig” on getting those top default risk ratings. The premium more than paid for itself in reduced borrowing costs for state and local governments.

This was a lovely, low-risk business, with few defaults and a steady revenue stream. At one point in time, Ambac had the highest revenue per employee on the planet.

That situation was obviously intolerable
. So the muni bond insurers brought in the financial engineers, who decided that they should be issuing insurance on credit default swaps (CDSs)—
the premiums were so much bigger than those on boring old munis!

These firms were used to heavy oversight and supervision in the municipal bond business. In their structured finance division, regulatory oversight was nonexistent; without it, they went off the rails.

Since 2007, the stock prices of Ambac and MBIA have cratered, losing more than 90 percent. Both firms faced investigations by regulators. How a highly profitable, low-risk business stumbled into the treacherous worlds of exotic derivatives is worthy of a book itself. Tens of billions of dollars would be lost by the monoline (now duoline) insurers, and chaos in the municipal bond market ensued when the credit crunch hit in 2007-2008.

The absence of bond insurance has made borrowing much more expensive for many state and local municipalities. The increased costs of financing municipal projects—sewers, bridges, roads, schools, hospitals—have put many of these projects on hold for now. The timing couldn't be worse; the slowdown started shortly before the recession began.

When the Senate unanimously passed the Commodity Futures Modernization Act, the senators could not have foreseen the impact it would have on municipal bond underwriting and local government activity in just a few short years. That's to say nothing of the impact unregulated derivatives had on AIG.

T
he Lockheed bailout of 1971 led directly to the Chrysler bailout nine years later in 1980. Both took the form of guaranteed loans; both were in sectors and industries deemed to be indispensable.

What made the Chrysler bailout have such significant repercussions in the future was that it forestalled dealing with a ruinous employment agreement, originally signed by the major automakers and the United Auto Workers (UAW) in the 1950s. It also failed to address rising guaranteed pensions and expensive health care costs. That contract eventually would cost the Big Three hundreds of billions of dollars in both areas. The Chrysler bailout effectively kicked that can further down the road, and by 2008 GM, Chrysler, and Ford were all in shambles. And it allowed Toyota to become the world's largest automaker, employing over 300,000 people around the globe.

Had the Chrysler bailout not occurred in 1979, it is very likely the Detroit automakers would look quite different than they currently do: The UAW contract, health care and pension provisions, company management, and even the cars they design and sell would likely be very different today. In a bizarre way, we can trace Lockheed's $250 million bailout to the potential $34 billion (at least) bailout of General Motors, Ford, and Chrysler in 2008 and 2009.

I
n Chapter 11, we reviewed how a 2004 exemption to a 1975 rule governing banks' net capital ratios paved the way for the excessive risk taking at major Wall Street firms. But even that 1975 rule, which ultimately earned an “excellent track record in preserving the securities markets' financial integrity and protecting customer assets,” contained seeds of future bailouts.
⁴

The original net capital ratio rule said the value of broker-dealers' assets should be based on the credit ratings of nationally recognized statistical rating organizations (NRSROs). This ruling imparted tremendous power to firms deemed NRSROs—a designation process controversial to this day—and effectively gave the two largest firms, Moody's and Standard & Poor's, a duopoly on the rating of financial securities. (Fitch was also granted NRSRO status in 1975 but has historically played Chrysler to Moody's GM and S&P's Ford.)

As Wall Street's dependence on the NRSROs grew, so too did the power of the rating agencies. As Pulitzer Prize-winning journalist and author Thomas Friedman famously declared in 1996: