The New Empire of Debt: The Rise and Fall of an Epic Financial Bubble (48 page)

Reports said Madoff promised investors steady 10 percent returns. How could he do that? Of course, he couldn’t. Stocks had gone nowhere for the last 10 years. The average rate of return? Zero. Promising 10 percent was clearly an exaggeration. Delivering it was surely a crime. But investors must have guessed that he was swindling his retail trading customers in order to deliver steady, above-market returns to his investment accounts. They may not have understood how it worked, but they didn’t want it to end.

Nobody is as easy to scam as a scammer, and Madoff scammed them all.

Of course, he should get the gallows; we don’t dispute it. But, often, there’s not a lot of distance between the hanged man and mob that is lynching him. The people who most wanted to see Bernie swing were the people who invested money with him. Most were very sophisticated investors.They knew perfectly well that there is no magic way to transform a zero-return market into a 10 percent return market. If they were to get 10 percent, they knew they had to take a big risk. They just didn’t know what the risk was. It turned out to be the risk that Bernie Madoff was lying.

And what about the bubble economy itself?Wasn’t it also a giant pyramid scheme with a huge, huge risk attached? It promised speculators enormous profits, but how could it deliver? It paid out money from new participants to the old participants.Without new money coming in, it would implode.

As former Citigroup CEO, Chuck Prince, put it: As long as the music was playing, they had to dance. But didn’t they know the music would stop, leaving them in an awkward and embarrassing position? Wasn’t it as obvious to them as it was to us?
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And what about the investors? Weren’t they trying to get something for nothing out of the bubble economy? And the rating agencies? They must have known that subprime debt was dangerous. Even we knew it.Why did they give it Triple A ratings? And what about the SEC? It has thousands of smart analysts, accountants, and investigators. How could they all be so stupid as to miss the biggest investment bubble in all history . . . right under their noses? And what about Alan Greenspan, who actually encouraged households to take out subprime mortgage loans? Weren’t they all in on the scam? Weren’t they all complicit?

Madoff ’s charm was that he out-foxed the foxes and out-scammed the scammers. He out-Ponzied Charles Ponzi. He out-Princed Chuck Prince. He could have taught the Egyptians how to build pyramids. In the history of high-stakes grifting, he out-did them all. A Robin Hood with Alzheimers; he stole from the rich. If he’d only remembered to give to the poor, he’d be a hero to everyone!

Besides, how hard was it to give away new houses to people who didn’t have any money, or get people who didn’t speak English to sign toxic mortgage documents? Child’s play, really. And the executives with their millions in bonuses, and humbuggers like Richard Fuld, their marks were mostly ordinary stock market investors; low-hanging fruit compared to the coconuts Madoff plucked. Rather than go after the widows and orphans, he swindled the smartest money in the world: money managed by family offices, the old Jewish money from New York and south Florida, London’s Man Group, Switzerland’s Union Bancaire Privee. He even flim-flammed the hedge funds, and took billions from his oldest and dearest friends. A real democrat, he took money from his own tribe, his own clan, and his own golf club buddies. Billions of it. Even more impressive, he did it not with hyperbole, but with relative modesty. He promised only 10 percent per year, which didn’t seem like much during the Bubble Epoque.

And now, historians look back and wonder: How could people have been so stupid? The answer is simple: In a bubble, it pays to be stupid.You buy something at a lame-brained price, and it goes up. Not only did stupidity pay, it paid well. Running a suicidal bank paid better than robbing one. Hedge fund managers got paid more than contract killers or stick-up men.

But “when the tide goes out, you see who’s been swimming naked,” says Warren Buffett.
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By the end of 2008, investors hadn’t seen the tide so low in many years; the view was nauseating, hideous. More than $30 trillion had been lost—so much that it threatened to turn the lights out on the entire world economy.

“They are in trouble in New York,” said J. P. Morgan to Bishop Lawrence.

In October, 1907, J. P. Morgan was 70 years old, and attending a church meeting in Richmond when the importance of the sacred was disturbed by the urgency of the profane. Telegraphs kept arriving from New York; they warned of a disaster. According to Dun’s Review, 8,090 companies had failed in the first nine months of 1907. Then, a failed takeover of the United Copper Company caused a panic.

“A correction is equal and opposite to the deception that preceded it,” Morgan would have said, if he’d thought of it. Since he didn’t, it falls to us.

Morgan had been around the block when it came to money. He had taken over his father’s banking business decades earlier. He’d seen panics, crashes, bankruptcies. And, now, it must have seemed that his whole life had been spent training for this one test. He returned to New York; crowds of investors looked to him to save the day. And he did. He put his own money on the line to help shore up troubled companies. He rallied friends, colleagues, and competitors to do likewise.A trust was in trouble, then the New York Stock Exchange itself, then the City of New York—one after another, Morgan brought in the financiers, came up with the money, bullied and cajoled, until the storm had passed and they could all enjoy a good drink.

And when it was over, Senator Nelson W. Aldrich, realizing what Morgan had done said: “Something has got to be done.We may not always have Pierpont Morgan with us to meet a banking crisis.”
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As it turned out, Pierpont Morgan was a ghost four years later. But in that same year, 1913, the U.S. Federal Reserve was set up to fill his big shoes. In 2009, it’s the Fed that is being tested.

Armageddon seemed to arrive in Manhattan on Monday, September 29, 2008, not just in New York, but in Moscow, Hong Kong, London, and Frankfurt, too. Germany hastened to succor bank account holders. In Rejkavik the pandemonium was so hot it seemed to melt the ice. Then, on Tuesday, plagues and locusts were loosed on the world: The U.S. stock market fell hard again. Japan was sinking into the sea. Brazil’s market was down 51 percent, year to date. Central banks were cutting rates like pulpwood. Even so, unemployment was on still the rise. Consumer spending was falling. House prices were going down.

Of course, the world improvers couldn’t sit idly when there was so much in need of improvement.They soon began intervening, in the usual clownish ways. Short selling was blamed for more accidents than alcohol. And everywhere, the authorities were getting ready for show trials, perp walks, and public hangings. Was it fair, Congressman Henry Waxman wanted to know, that Richard Fuld should be paid $480 million for his role in bankrupting the 158-year old Lehman Bros.?
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Congressman Waxman seemed to think that something needed fixing. But that just goes to show how little he appreciated the free market. Investors handed Fuld that money of their own free will; they got exactly what they deserved.The system was fixing itself.

When investors had the wind at the backs, they were ready to believe the most outrageous things: that the financial sector could get rich by lending money to people who couldn’t pay it back, and that a whole economy could flourish by luring consumers to spend more than they could afford. These hallucinations created an immense worldwide bubble of debt and dollars. But now, the wind had swung around. A huge anti-bubble was forming—equal and opposite, in true Newtonian form—a financial whirlpool marked by exaggerated thrift, debt destruction, and sweaty-palmed investors.

And where was Morgan when we needed him? Where was the Fed? Ten years before, the giant hedge fund—LTCM—had overdone it. As in 1907, according to Roger Lowenstein’s account, “Rushing for the exits . . . [traders] posed a danger not only to themselves, but to the entire world financial system.” So, the Federal Reserve Bank of New York called in the big financial houses to help with the rescue. It worked.The crisis was averted. LTCM’s positions were liquidated in an orderly way, just the way Morgan would have wanted.

But this time, the fixers were at work, but the fix didn’t seem to stay fixed. Bad positions couldn’t be unwound in an orderly manner; there were too many of them. And it was not just a handful of speculators who were getting whacked—it was half the population of the United States of America and Great Britain. Trillions of new cash and credit were being pumped in.The Fed was buying trillions worth of “assets” you would throw out of your refrigerator. Her majesty’s government became proprietor of 50 billion pounds worth of banking shares; the government of George W. Bush was preparing to enter the banking business, too. But as trillions went in, trillions more leaked out. Stock prices were still going down. Property prices were going down. Jobs were being lost. Ships were idling in port. It was not just a few investment decisions that were being corrected, in other words, it was the delusions of an empire.

“These prices make no logical sense,” said a Wall Street trader, referring to mortgage-backed derivatives at Wal-Mart-style discounts, and missing the point. Markets are not scientific. They are poetic. After the liquidity comes the liquidation. After the outsized recklessness comes the appropriate regret. After the empire come the barbarians.

“The private market has screwed itself up,” explained Representative Barney Frank, “and they need the government to come help them unscrew it.”
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(He left out the extenuating circumstance that the U.S. money supply, the shortest term lending rates, Fannie Mae, Freddie Mac, the Fed, the Federal Housing Agency, the SEC, and a whole plethora of commissions and meddlers—as well as one of out of every four dollars spent—were all under government control all along!)

On September 19, 2008, the U.S. Congress put its back to saving the empire’s financial system.

“We’re not going to Christmas tree this bill,” was how Senator Chris Dodd described how Congress would deal with Treasury Secretary Henry Paulson’s proposed bailout plan.We had never heard “Christmas tree” used as a verb. But leave it to a Washington hack to turn Christendom’s sentimental icon into a lobbyists’ grabfest. As soon as the bill arrived, the boys on the hill began decorating it, hanging baubles on every limb. They agreed on the major issues; but they were still going to take a few days to get the thing all trimmed out before it became law.The Dow shot up as investors waited for the lighting ceremony.

The plan was simple enough, but the chutzpah of it was breathtaking. He was proposing a $700 billion program, in which the government would buy up Wall Street’s mistakes—otherwise known as “cash for trash.” Henry Paulson said he had no choice: “We did this to protect the taxpayer,” said the former Goldman chief.

Everyone was getting in the act, condemning the markets and offering advice. Politicians, investors, comics . . . even the clergy.Yes, the archbishop of Canterbury said that men had put too much faith in the market, and that this faith had become a sort of “idolatry.” He thought government should be held in higher esteem, while the decisions and plans of free men should be curbed. More regulation is needed, said he, praising Britain’s ban on selling financial firms short.
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The poor Church of England had a fool as its top man. But you could hardly blame a man of the cloth for believing that markets had failed; the idea was as widespread as an STD; he probably got it the same way, that is, simply by hanging around with the wrong crowd.

Typical was this from Garrison Keillor:

[T]hat’s why we need government regulators. Gimlet-eyed men with steel-rim glasses and crepe-soled shoes who check the numbers and have the power to say,“This is a scam and a hustle and you either cease and desist or you spend a few years in a minimum-security federal facility playing backgammon.”
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Out on the prairie, one could imagine all sorts of things. But it’s not as if there were no bureaucrats on the job between 2000 and 2007. How did one imagine that these same regulators, who missed the biggest bamboozle in market history, were now going to be able to clean it up? How would a bureaucrat—charged with protecting the public’s money—recognize a scam more readily than an investor whose own money was on the line? What information does he have that is not available to the public? What theory does he follow that is unknown to investors? What meat does he eat, what wine does he drink, that prevents him from falling prey to the delusions and temptations to which all flesh is heir?

This is what Hayek termed the “fatal conceit,” that public officials—armed with the power to force people do to what they say—will do a better job of running things than people can do for themselves voluntarily. The markets had failed, or so everyone said. But what had not failed?

Neither the masters of the universe on Wall Street, nor the geniuses at the rating agencies, nor the saints at the SEC—and certainly not the poor lumpen investor—understood what was going on. None had gimlet eyes. Instead, all their eyes bulged with admiration at the financial engineers’ handiwork, and with greed at how much money they could make.

And yet the new plan put $700 billion in the hand of GS14s, clerks, hacks, and appointees. What are they supposed to do with it? Buy “assets” that Wall Street wanted to dump. How were they supposed to know what the assets were worth? If they paid too much, the government would take a big loss. If they paid too little, at least according to the dim light coming from the Christmas treers, it wouldn’t bail out Wall Street enough and the economy might sink into a deep recession. So what were these derivative contracts really worth? No one knew. Values had become like the face of God, or the meaning of “is.” They floated in the ether; they played cards with Jimmy Hoffa. But oh happy day for the public sector, that great untapped reserve of investment wisdom. Here was an opportunity to buy up those pearls that the swine on Wall Street didn’t want.