The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble (47 page)

Meanwhile, America’s largest mortgage finance companies, Fannie and Freddie, had so much water in their lungs it was announced that it would take at least $25 billion of the public’s money to save them. Possibly $300 billion.Were it up to us, we would have left them on the beach.

Instead, the U.S. Senate bent down and pressed its blubbery lips onto those gaping traps of the mortgage twins, gurgling into them a corrupt breath of life. Since the two held one out of every two mortgages in the nation, in effect, Congress was nationalizing the U.S. housing stock itself. Henceforth, citizens would pay not only their taxes to the government, but their mortgage payments too.

At a speech in Vancouver, James Kunstler seemed positively delighted. Finally, gasoline over $4 a gallon was doing what generations of artistic scorn could not: destroy Fannie and Freddie’s collateral. Kunstler’s critique of American suburban vernacular architecture is that its products are not real houses at all, but “cartoon houses.”They have porches that look like real porches from a distance, but they are too narrow to sit on. They have shutters, too, nailed to the wall, making them completely useless.They may have “picture” windows—looking out on nothing—or no windows at all. And they wouldn’t exist at all were it not for cheap credit and cheap gasoline.
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Of course, the same may be said of America’s—and Britain’s—entire economies during the previous 20 years.The loose credit that built cartoon houses also constructed cartoon economies; they looked like real economies, but they were essentially perverse, consuming wealth rather than creating it.

For proof, you had only to look at Fannie and Freddie. Here were two companies that appeared to be helping Americans own houses. But since they were created, homeowners’ equity—that portion of the house actually owned and paid for by the homeowner—fell from 70 percent to below 50 percent . . . to a record low in the fourth quarter of 2008 of just 44 percent. By mid-2008, nearly 9 million Americans had zero or negative equity—and house prices were still falling.

How came this to be? The answer was simple.The looney-tune approach to finance radiated to all points of the economy. People pretended that they earned more—spending more and more money to buy more and more goods and services, while wages did not really increase. Then, they bought houses—believing the roofs over their heads were investments, rather than consumer items.With no down payment, no proof of income, and zero interest loans, for most of the new buyers, home ownership began as a dangerous conceit. And now that the roofs were caving in, it was a staggering burden.

The “consumer economy” was always a mockery. No serious economist ever suggested that you could get richer by consuming wealth. But that didn’t make consumerism unpopular.The more people consumed, the more GDP went up. GDP measured output, not wealth creation; but who could tell the difference? Besides, spending made people feel as though they were getting richer.

Then, whenever the consumer threatened to come to his senses, the feds rushed to “stimulate” him—by giving him more of what he least needed: more credit. More spending kept the cartoon economy running—allowing the consumer, the businessman, and the speculator to add to his burden of debt. In 1971, when the United States went off the gold wagon, household debt was less than 50 percent of GDP. By 2008, it was almost 100 percent.
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Even the rentiers were bamboozled by their own cartoon claptrap. Stocks rose from 1982 to 2000, fell heavily to 2002, and bounced back. But for the previous 10 years, shareholders had gotten little for their effort. In July of ’98, the London index, the FTSE, hit a high of 5,458. In July of 2008, it fell to 5,625. And in America, if stock prices were quoted in gallons of gasoline, the Dow would take the driver no further in 2008 than it did 40 years before.

The cartoon capitalists did it all backwards; they were supposed to exploit the workers, not be exploited by them. But while investors were going nowhere, corporate managers and Wall Street hustlers were getting rich.The two bozos running Fannie and Freddie, for example, pocketed about $32 million between them in 2007—a year in which the companies lost almost $5.2 billion—not to mention the losses to shareholders. And on Wall Street, managers paid out $250 billion in bonuses in the four years leading up to the credit crunch. The firms declared a profit and paid bonuses when the bets were made; they didn’t wait to see how they turned out. Thus did the big banks and big brokers become capitalists without capital, dependent on the gullibility of investors to keep them in business. And when investors began to wise up, they turned to the public for capital support.

What kind of scam was this? It may look like capitalism from a distance. But this was not real capitalism; this was cartoon capitalism—run by clowns, who sold freak investments to chump investors, and encouraged the lumpen householder to ruin himself.

Where did he go wrong? The question probably crossed his mind, perhaps even when he mounted the scaffold on January 21, 1793. The Bourbons had been the most successful family in Europe. They had ruled Europe’s biggest and richest country since Henry IV. And now they were on thrones all over Europe. But in the language of the City, Louis 16th blew himself up. He was supposed to be an absolute monarch. Ah . . . there was the dynamite! He believed it. He had surrounded the Parliament with troops and turned the country against himself. And now, he had absolutely no control over anything. Not even the power to save his own skin.

Poor Louis! He already had the bag over his head. And the blade at his neck. He must have felt like the dumbest man in France.

Dick Fuld must have felt pretty dumb too. His firm had survived the Civil War, the Railroad Bankruptcies of the late nineteenth century, the Bankers’ Panic of 1907, the Crash of ’29, the Great Depression,World War II, the Cold War; Lehman Bros. had outlasted spats, prohibition, and disco music. But it couldn’t keep its head through the biggest financial boom in history.

John Edwards claimed the title of the “dumbest man in America” when the press got wind that he was two-timing his wife and running for president at the same time. But in 2007-2008, Edwards had more competition every day. In January of 2007, the financial industry put a value on Lehman Bros.—a company it knew well—of $48 billion. On September 15, 2008, the bid went to zero.Then came more disquieting news: The world’s largest insurance company, AIG, was failing. Martin Sullivan had run it into the ground, said the analysts. It needed an $85 billion bailout.

There was no one there to bail out Louis when he needed it. France was not too big to fail; it was too big to bail out. And everything had been going so well! When Jacques Turgot was Controller-General, he was getting rid of the internal customs barriers, lifting price controls, and abolishing the trade guilds and the corvee (the system of forced labor used to build roads). The political system was being reformed, too, evolving towards a parliamentary democracy.

But along came those plucky Americans to stir up trouble.They sucked France into war with Britain. France supplied money, materiel, and troops—landing 5,000 soldiers in Rhode Island and ultimately winning the war by blockading Lord Cornwallis at Yorktown.

“The first shot will drive the state to bankruptcy,” Turgot warned the king. He was almost right. By 1786, the French were in desperate straits, with half the population of Paris unemployed and a national debt equal to 80 percent of the GDP. The French were counting on the Americans to begin repaying their $7 million in loans, but the United States was broke, too. And soon, French credit was so bad, the king could no longer borrow from the moneylenders in Amsterdam nor even from his own creditors in Paris. Having borrowed too much, Louis no longer had any room to maneuver. All he could do was to march up the scaffold steps like a real monarch.

Nearly two hundred years later, the heads rolled on Wall Street. But who was the dumbest? Surely Dan Mudd and Dick Syron at Fannie and Freddie were still in the running. Even with the deck stacked in their favor (they borrowed money more cheaply than their competitors because everyone knew the government wouldn’t let them go under), they couldn’t stay in the game. Finally, as expected, the feds had to step in and bail them out.

The previous 15 years had been too kind to finance.Wall Street was essentially a debt monger; and in the boom, nobody didn’t want to borrow. Financial profits soared. Since 1980 the profits of the U.S. financial sector as a portion of GDP went up 200 percent. Industry owners and managers could have taken their money off the table and retired to Greenwich. But on the back of this outsize success grew a monstrous hump of self-delusion; the masters of the universe began to believe their own grotesque guff. The financial markets were perfect, said the academics. All-knowing and all-seeing, they wouldn’t make a mistake! The chiefs at the big financial firms must have thought they supped with the gods themselves; they had the paychecks to prove it.

Of course, some Wall Street bosses were more cunning than others. In selling itself to Bank of America, for example, Merrill Lynch dodged the scaffold; but it becomes a ward of the state, almost like Fannie and Freddie before they were taken over completely.

The old regime on Wall Street was dominated by just five large investment companies. In just a few weeks, in the fall of 2008, their debt bombs blew up . . . and the entire, independent investment banking industry disappeared.

The financial industry was widely criticized. But it was just doing what it always does—separating fools from their money. What was extraordinary about the Bubble Years was that there were so many of them. There is always smart money in a marketplace . . . and dumb money. But in 2007 there were trillions with no brains at all.What other kind of money would pay Alan Fishman $19 million for three weeks’ work helping Washington Mutual go bust?

But behind the dumb money were some of the smartest people in the world—with bogus statistics, the claptrap theories, and the swindle science.

“Six Nobel prizes were handed out to people whose work was nothing but BS,” says Nassim Taleb, author of
The Black Swan
. “They convinced the financial world that it had nothing to fear.”

The theorists convinced themselves of two things that everyone knew were untrue. First, that “economic man”—the man they were supposed to know so well—had a brain but not a heart. He was supposed to always act logically and never emotionally. But there was the rub, right there; they had the wrong guy. The second was that you could predict the future simply by looking at the recent past. If the geniuses had looked back to the fall of Rome, they would have seen property prices in decline for the next 1,000 years. If they had looked back 700 or even 100 years, they would have seen wars, plagues, famines, bankruptcies, hyperinflation, crashes, and depressions galore. Instead, they looked back only a few years and found nothing not to like.

If they had just looked back 10 years, says Taleb, they would have seen that their “value at risk” models didn’t work. The math was put to the test in the Long Term Capital Management (LTCM) crisis, and failed. Their models went sour faster than milk.Things they said wouldn’t happen in a trillion years actually happened while Bill Clinton was in still in the White House.

In the real world, Taleb explains, things are stable for a long time. Then, they blow up. Then, all the theories and regulators prove worthless. These blowups are inevitable, but unpredictable . . . and too rare to be modeled or predicted statistically. “And they are almost always much worse than you expect,” says Taleb.

THE BRIGHT SIDE OF THE BREAKDOWN

But who could honestly say he wasn’t enjoying the financial crisis? It unhorsed cavalier fund managers; it turned the masters of the universe into servile waiters; it made Nobel Prize winners look like morons. The rich, the proud, the pompous, the vain, the incompetent—surely there was a God, an “invisible hand,” giving them all a whack on the head!

And there were the regulators, too! Under their very noses the biggest scams in history went unnoticed. America’s Securities and Exchange Commission (SEC) alone—to say nothing of the countless other cops on the financial beat—had 3,371 employees playing the piano in 2006. If you can believe it, not a single one of them noticed what was going on in the back room. Even after rummaging through Bernard Madoff ’s back office twice in three years, they still didn’t know.They must have been like pets watching an orgy, with no idea what to make of it, but wagging their tails and vaguely wanting to get in on the action.

In two days just before Christmas, 2008, Madoff ’s managed accounts were thrown into a “spiral of horror” said one fund manager.Tipped off by his own sons, the feds went to Madoff ’s apartment. They graciously asked if there was perhaps a misunderstanding. No, replied Madoff, “there was no innocent explanation.”
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Soon, the press . . . investors . . . regulators . . . were all howling for Bernie Madoff’s head. But he was a hero to us. He did the world a great favor, giving us all a remarkable and vivid lesson in investing, in pyramid schemes, in the markets, and Wall Street. As a result of such eye-opening instruction, Bernie Madoff will save more investors more money than the SEC ever will. They’ll think twice before giving money to friends to invest for them. They’ll raise their eyebrows and their doubts when someone promises them consistent, high rates of returns.

The feds charged Madoff with running a $50 billion Ponzi scheme. Charles Ponzi took money from investors and then used their money to pay out profits to earlier investors. As long as the new money kept coming into the system, it worked like a charm. So what’s the difference between Madoff ’s Ponzi scheme and the scheme run by Wall Street—in which all the investment houses, the rating agencies, the mortgage companies, Fannie Mae, Freddie Mac and the regulators themselves were all complicit? As long as new money was coming into the system, who complained?