Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (13 page)

Most of the excitement was in New York, but the city’s demographics told a sober story. Manufacturing jobs fell from 16.8 percent in 1976 to 11 percent in 1986. The proportion of New Yorkers living under the poverty line rose from 15 percent in 1975 to 23.9 percent in 1985.
²¹

Precursor to the “Greenspan Put”

At the beginning of the 1980s, commercial banks were tottering. In the 1970s, they had plowed into the rising market: banks lent to commodity-producing countries. When commodity prices collapsed, so did the loans. Walter Wriston, chairman of Citicorp, led the charge into the Southern Hemisphere. He declared that sovereign governments never defaulted and, to prove himself correct, beggared the U.S. government to bail out Argentina, Brazil, and Mexico after Citicorp’s loans to those countries were on the edge of default.
²²
The government complied.

Commercial banks also lent without a thought toward the future in local markets that suffered when price inflation eased: agriculture and home loans. The lenders needed help, so the federal government rescued the hapless banks. Banks came to expect government coddling.

The Continental Illinois National Bank and Trust bailout is an important precursor to the American financial crack-up. Continental Illinois was the nation’s sixth-largest bank and was overloaded with oil and gas loans and neck deep in sovereign loans.
²³
On May 17, 1984, a new era of financial collectivism was ushered into being. The Federal Deposit Insurance Corporation (FDIC) decided that the nation’s (by now) ninth-largest bank was “too big to fail.” The FDIC announced a $2 billion capital injection into the holding company. The government followed with other initiatives that are all too familiar today, including $3.4 billion borrowed from the Fed’s discount window.
²⁴
The government committed itself to insuring all deposits, not merely the $100,000 deposit limit.
²⁵
In addition, it also protected creditors of the holding company.
²⁶
This and other wrinkles of the bailout are interesting precedents, too involved to discuss here. A distinction is that of treasury secretaries, then and now. In 1984, “Treasury Secretary Donald Regan blasted the plan as ‘unauthorized and unlegislated expansion of federal guarantees in contravention of executive branch policy,’” but he was ignored.”
²⁷
Today, treasury secretaries Hank Paulson (did) and Timothy Geithner (does) hand billions of dollars to the most negligent banks and brokerages.

²¹
Robert A. M. Stern, David Fishman, and Jacob Tilove,
New York 2000: Architecture and Urbanism between the Bicentennial and the Millennium
(New York: Monacelli Press, 2006), pp. 19–20.

²²
The U.S. government did so through advances from the Federal Reserve, the Treasury, the Department of Energy, and the Department of Agriculture. These sums were advanced to Brazil (among others) so that Brazil could repay its debt to Citicorp. James Grant,
Money of the Mind: Borrowing and Lending in America from the Civil War to Michael Milken
(New York: Farrar Straus Giroux, 1992), pp. 339, 341, 343.

The Citicorp and Continental Illinois bailouts happened during Paul Volcker’s term at the Fed. What would later be called the “Greenspan put” preceded the future Federal Reserve chairman. (The Greenspan put was the belief that if the markets ever stumbled, Fed Chairman Greenspan would flood the market with money, which would trancate investors’ downside risk while launching a new speculative fury.)

From a business perspective, it is unfathomable why banks, which are consistently incompetent in the lines of business in which they are authorized to transact, are continually given permission to expand and to enter new lines of business in which they lack experience.

Leveraged Buyouts and Junk Bonds

The conglomerate form of financing was dead. In the 1970s, privateequity investments, more the province of insurance companies in the past, were being managed by independent companies. Kohlberg Kravis Roberts & Co. (KKR) was a young privateequity firm in the 1970s, when the “the notion of a buyout was not well understood” (as KKR informs the public on its Web site). In 1979, Kohlberg Kravis Roberts negotiated the first
leveraged
buyout (LBO) of a public company by a privateequity firm.
²⁸
It took KKR over a year to find financing, as well it might. The idea of buying a company by loading its balance sheet with debt (the “leverage” in LBO) was new. This was the means by which the 1980s form of hostile bids for companies took wing, in conjunction with another development.

²⁴
Ibid., pp. 44–51. In turn, the FDIC took over.
²⁵
During the 1980s, financial institutions were granted the authority to cross lines of monopoly. Savings and Loans (S&Ls) lost their monopoly on home mortgages (hitherto, commercial banks had been barred from this market), and competition grew by leaps and bounds. (As mentioned in footnote 17, the S&Ls received broader authority.) Commercial bank entry broadened the residential mortgage market; the growing junkbond appetite of savings and loans, insurance companies, and mutual funds extended the ability of investment banks to underwrite more junk bonds.
²⁶
Wigmore,
Securities Markets in the 1980s
, pp. 50–51.
²⁷
Ibid.

Michael Milken’s group at the investment-banking house of Drexel Burnham (later to be Drexel Burnham Lambert Inc.) educated the world, and then dominated it, in the fertile laboratory of junk bonds.
²⁹
(Junk bonds are those that are rated below investment grade by the rating agencies.) Early buyers of Drexel’s junk bonds had acquired valuable experience in the conglomerate years—Carl Lindner of American Financial Corporation and Saul Steinberg of Reliance Insurance.
³⁰

After his initial success with “fallen angels”—companies that had fallen on hard times and been downgraded—Milken gravitated toward “new-issue” junk bonds. Drexel performed an admirable service by finding investors for some promising companies, with Turner Broadcasting and Humana being early success stories.
³¹

It was not long before the weapon (junk bonds) and the strategy (hostile bids) discovered each other. One other component was needed: a willing buyer. The mutual fund industry offered 11 junkbond funds before 1980.
³²

The early financings were responsibly packaged to permit the companies so structured to cover their debt payments out of projected earnings. By 1983, however, future annual profits (before depreciation and taxes) were projected to be 20 percent
less
than annual debt payments.
³³
The deterioration was laid out in clear terms to the buyers, but they were often buying for reasons not explained by the efficient market hypothesis. (This has been the dominant precept in finance and economics over the past few decades: that market prices reflect all known information. This is the backbone of economists’ models, the consistent failure of which would seem to deter them from constructing new models.) Barrie Wigmore, author of a seminal financial study of the period, found that this was one development he could not quantify: “How much the surge in junk bond new-issues in 1983 and 1984 was due to expanded savings and loan powers and the merger boom and how dependent it was on under-the-table incentives to money managers will probably never be resolved.”
³⁴

²⁸
Ibid., p. 303.
²⁹
Ibid.
³⁰
Ibid., p. 280. Milken did not invent junk bonds, as is often claimed. There were precedents: railroad and REIT (real estate investment trust) junk bonds.
³¹
Ibid., p. 282.
³²
Ibid., p. 283.
³³
Ibid. p. 282. Between 1980 and 1982 the ratio of earnings before interest and taxes (EBIT) divided by debt payments was about 2.0. The ratio dropped to 0.8 in 1983.

The Decade of Greed

The explosion of finance initiated a new Youth Movement. In July 1986, a
BusinessWeek
cover story quoted a Harvard Business School professor who compared Mike Milken to J. P. Morgan.
³⁵
The comparison was taken to heart: the Harvard Business School class of 1985 included 65 members who were prosecuted for securities violations.
³⁶

Some of the corporate restructuring was productive, although much was driven by the call to “align management incentives with shareholder value.” To boost shareholder value—the stock price—every quarter, financial channels combined with clever accounting were necessary. The balance sheet expanded, often through the allure of debt and buying back equity.

In 1985, Franco Modigliani won the Nobel Prize in economics. The Modigliani-Miller theorem holds that the value of a business does not decrease when its capital structure is geared toward debt (we are incorporating the efficient market fantasy dementia here.) Impatient CEOs applied the superficial gloss of this hypothesis to borrow in frightful quantities and boost profits.
³⁷

³⁴
Ibid., p. 287.
³⁵
Grant,
Money of the Mind
, p. 393.
³⁶
Philip Delves Broughton,
Ahead of the Curve: Two Years at Harvard Business School
(New York: Penguin Press, 2008), p. 157.
³⁷
Merton Miller, the other party to the theorem, was awarded the Nobel Prize in 1990.

Volcker’s Renomination

Paul Volcker’s term as Fed chairman ran until 1983. Alan Greenspan consistently supported Volcker, in public statements and private conversations. Some of Greenspan’s forecasts warned of dire times, but he was generally discussing the problems of the economy as a whole. He put at least as much blame on federal budget deficits as on problems caused by monetary policy—a money mishap that Greenspan inferred was caused by misdeeds prior to Volcker’s term. As a member of
Time
’s Board of Economists, Greenspan warned in 1981 that “towering interest rates are threatening the survival of many American financial institutions.”
³⁸
The American people blamed Paul Volcker for the high interest rates, but Alan Greenspan did not. Instead, he told
Time
in December of 1982, “The Fed is in a box.” He supported Volcker’s increasingly lonely policy by reminding readers that bond buyers thought a rapid expansion of the money supply could eventually reignite inflation (raising longterm bond rates).
³⁹
When the press was full of tattletale gossip on the acerbic relations between Volcker and the White House (specifically, Donald Regan), Greenspan told the
Times
: “It’s counterproductive and it’s unfortunate. The Fed is doing as good a job as it can do in these circumstances.”
⁴⁰
Regan was a tough cookie. Greenspan put the Fed and Volcker ahead of his own interests.

Greenspan’s campaign for Fed chairmanship was subtle. Paul Volcker’s four-year term as chairman expired in August 1983, but it appears that the White House could not make up its mind about a successor. Wall Street put pressure on the White House to reappoint Volcker. A survey of 702 business executives published in the
Wall Street Journal
on June 8 revealed that 77 percent wanted Volcker to be reappointed. In second place was Greenspan: 37 percent expressed special confidence in him.
⁴¹
With such support, he was in a commanding position to succeed Volcker, should the opportunity arise.

³⁸
Charles P. Alexander, “Will Reagan’s Plan Work?”
Time
, February 23, 1981.
³⁹
Charles P. Alexander, “The Elusive Recovery,”
Time
, December 27, 1982.
⁴⁰
Jonathan Fuerbringer, “Reagan vs. Fed: The Fallout,”
New York Times
, January 30, 1982, p. 29.
⁴¹
William Greider,
Secrets of the Temple: How the Federal Reserve Runs the Country
(New York: Simon and Schuster 1987), p. 572. The survey was by A. G. Becker Paribas.

This expression of confidence in Greenspan is notable. The comings and goings in Washington are an open book to Wall Street. When Greenspan was not speaking or attending galas, he was working the White House. His biographer Jerome Tuccille writes: “According to several White House insiders, Alan made a point of regularly massaging the people who mattered.”
⁴²
Martin Anderson told Tuccille: “I don’t think I was in the White House once where I didn’t see him sitting in the lobby or working the offices. I was absolutely astounded by his omnipresence. ... He was always huddling in the corner with someone.”
⁴³
Greenspan’s campaign made an impression on Wall Street, as did his likable disposition. A Fed chairman who gave Wall Street “the opinion you needed”
⁴⁴
and was a director of J. P. Morgan would be apt to see the world from the creditor’s perspective.

The consulting economist orchestrated a media blitz. He made television appearances on the
Tod ay
show in May 1983 and “The Editor’s Desk” on June 12, 1983.
⁴⁵
The
Times
profile (quoted earlier) appeared on June 5, 1983. The June 6, 1983, edition of
U.S. News & World Report
published an interview.
⁴⁶

Also on June 6, Volcker arranged a private meeting with Reagan. In the Oval Office, the Fed chairman told the president: “ ‘This has dragged on too long and you ought to settle it one way or the other.’” Reagan announced Volcker’s reappointment during his weekly radio broadcast on June 18.
⁴⁷
Greenspan wound down his campaign with another “From the Editor’s Desk” appearance on June 19.

Alan Greenspan: Chairman of the National Commission on Social Security Reform

Greenspan was well positioned for a senior position—not only in the White House but also with Congress. He headed a group that reformed social security. This was one of the most delicate political issues during the early 1980s. The argument went that social security was the largest government expense, and the system would be bankrupt by 1984. Social security had to be cut. Taking money away from old people does not win votes. The nation’s elected representatives did what they always do when a difficult decision needs to be made: they ran for the hills and appointed a commission.