Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (47 page)

From March 2001, the official starting date of the recession, through the end of 2004, employment fell by about 500,000. There were 1.2 million jobs lost in the private economy. (The government had gone on a hiring splurge; 700,000 additional public servants contributed to the deceivingly low half-million job losses.
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)

Official voices implored Americans to buy: “I encourage you to all go shopping more,” was President Bush’s advice five days before Christmas in 2006.
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In sum, the U.S. economy was spending (consuming) much more than it earned. This was financed by foreigners purchasing American securities and by the appreciation of U.S. assets. Foreign buying supported the dollar. The appreciation of U.S. house prices provided the cash to spend, through refinancing and home-equity loans. Financial services never had it so good.

How this arrangement worked as an economic system is a story in itself. The Seventies, Again

The process over this past decade is similar to that in the 1970s, when Volkswagen shipped the dollars it had received (from sales in the United States) to the Bundesbank. (The Chinese central bank has received the most excess dollars in the current decade, but the process is the same, so the original example is continued.)

Volkswagen sold a car in the United States. It received dollars from the buyer. The German central bank issued deutschmarks to Volkswagen in return for the dollars. In the post-2000 decade, the Bundesbank made the decision that its excess dollars would be allocated to investment in U.S. Treasury securities. Thus, by buying the U.S. debt, the German central bank funded American shoppers. When the Bundesbank bought U.S. securities, the German central bank also controlled the slide of the U.S. dollar in relation to the deutschmark.

⁴
From the month of December 2000 to the month of September 2004;
Richebächer Letter
, December 2004, p. 2.
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Richebächer Letter
, July 2004, p. 11; NIPA data.
⁶
Bureau of Labor Statistics, “Employer Costs for Employee Compensation–December 2008,” Table 1, released March 12, 2009.
⁷
Richebächer Letter
, December 2004, p. 2.
⁸
“Should Bush Tell America to Go Shopping Again?”
WSJ.com
, October 7, 2008.

A central bank may be influenced by its government. The German government had a motivation to prop up the dollar. If the dollar fell too far, Volkswagens would be unaffordable to Americans.

This same pattern of currency circulation anchored the world trade and financing system when Bernanke became Fed chairman. China was most often cited, but there were many countries exporting more goods to the United States than they received in return. Americans were buying from foreign industries, but foreigners did not buy as much from American manufacturers and service providers. This shortfall meant that American companies did not participate in these international flows. As a result, U.S. companies sold fewer goods. Domestic companies had fewer revenues, since workers were not spending their money on U.S. goods. Lower revenues of U.S. companies reduced profits and salaries. American corporations were forced to restructure in order to compete with foreign competition. Layoffs followed, and companies outsourced jobs overseas. This had been true since the 1970s.

The dollars that bought toys from the Chinese were sent by the toy manufacturer to the Chinese central bank. The toy manufacturer received Chinese currency (the yuan) from the central bank. The yuan entered the Chinese economy: the “real” economy as opposed to the financial economy.

The Chinese central bank then shipped the Chinese toy manufacturer’s dollars back to the United States. Earlier in this decade, foreign central banks recycled dollars into U.S. Treasury securities. As the current account deficit rose further, they bought agency securities (from Fannie Mae and Freddie Mac), believing the U.S. government would back these bonds should the underlying assets in the securities default (mortgage payments in San Diego, for instance). Between 2002 and 2007, almost 40 percent of the increase in Fannie Mae, Freddie Mac and other U.S. government agency securities were bought by foreign central banks.
⁹

⁹
Russell Napier, “Nationalizing America,”
CLSA Asia-Pacific Markets
, March 2008, p. 12.

When the Chinese central banks sent dollars back to the United States, investment banks and brokerage houses were on the receiving end. The banks and brokerages manufactured the securities. The dollars did not return to the “real” economy but to the financial economy. Goldman Sachs or Lehman Brothers received the dollars; the Chinese paid for securities produced by Goldman Sachs. Financial company revenues and profits rose. Securities firms hired more workers. This overseas bond trade shifted significant amounts of corporate profits in the United States toward financial institutions.

These distortions caused malignancies in the U.S. economy. From 1950 to 1980, about $1.40 or $1.45 of debt was required to produce each dollar of GDP. From 2001 through 2005, the ratio was $4.30 of debt to every dollar of nominal growth.
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Finance, rather than capital investment, generated growth.

Bernanke’s World

Ben Bernanke seemed to think that all was well. He was not concerned about the trade and finance imbalances. He was a leading missionary of a hot phrase: the “global savings glut.” He chided foreigners for saving too much. In Bernanke’s world, Americans were consuming as they should. His statement at the head of the chapter is from a “global savings glut” speech delivered in March 2005. In April, with time to revise his insight, he showed no better grasp of home economics: “[T]he recent capital inflow into the developed world has shown up in higher rates of home construction and in higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things.”
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Even today, Bernanke’s economics remain uncluttered with the possibility of too much debt. He is still a gung-ho apostle of renewing economic growth through consumer borrowing and spending.

¹⁰
Richebächer Letter
, March 2006, p. 10.
¹¹
Ben S. Bernanke, “Global Savings Glut and the U.S. Current Account Deficit,” Homer Jones Lecture, St. Louis, Missouri, April 14, 2005.

Before his chairmanship, he gave a speech entitled “The Great Moderation.” In that 2004 address, Bernanke offered interpretations of the “remarkable decline in the variability of both output and inflation” over the past two decades. He permitted the possibility that structural changes to the economy and luck may have played their role, but left no doubt that “
improved performance of macroeconomic policies
, particularly monetary policy” should receive the Nobel Prize.
¹²
[Bernanke’s italics].

Bernanke’s “great moderation” has since exploded, leaving this speech as a testament to the accumulated wisdom of central bankers. He was blind to the financial mayhem that accompanied his economic moderation. In 2008, researchers at the International Monetary Fund (IMF) identified 124 international banking crises since 1970. Four were in the 1970s, 39 were in the 1980s, 74 were in the 1990s, and 7 were after the millennium.
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The current worldwide banking crisis is not included. It would be premature to quantify it.

The Great Moderation was, in fact, the Great Distortion. The Peak

We now know that the housing bubble peaked sometime in 2005 or early 2006. Ben S. Bernanke was sworn in as Federal Reserve chairman on February 1, 2006. The brightest guys in the room thought that the excesses were about to collapse. Sam Zell, owner of Equity Office Properties, offered his opinion: “The enormous monetization of hard assets has created a massive amount of liquidity.… Together with [the rising demand for income in the developed world], these factors … are reducing the relative expectations on equity.”
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Another who saw the sun setting was Stephen Schwartzman, head of Blackstone Group, perhaps the premier buyout firm over the past two decades. He told an audience: “We have low [interest] rates, tons of money in both the private equity and debt markets.… But when it ends, it always ends badly. One of those signs is when the dummies can get money and that’s where we are now.”
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¹²
Ben Bernanke, “The Great Moderation,” speech at the meetings of the Eastern Economic Association, Washington, D.C., February 20, 2004.
¹³
Luc Laeven and Fabian Valencia, “Systemic Banking Crises: A New Database,” IMF, October 2008, p. 56.
¹⁴
From Sam Zell’s 2005 electronic Christmas card, “The Theory of Relativity,” www.
yieldsz.com; quoted in Ted Pincus, “Zell Remains Relaxed about Economy as Others
Fret,”
Chicago Sun-Times
, September 12, 2006.

However, Zell and Schwartzman misestimated. Even though the housing splurge was over, the financial economy’s credit machinery was speeding up. The nominal value of derivative contracts held by U.S.
commercial
banks (those over which the Fed has direct regulatory authority) leapt from $33 trillion at the end of 1998 to $101 trillion at the end of 2005, about the time Greenspan left office. This was roughly a 17 percent annual increase. By the second quarter of 2007, 18 months later, the nominal value had risen by 50 percent—to $153 trillion in derivatives.
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Did the credit creators take advantage of the novice? Whatever the case, Bernanke seemed unaware of the ruckus.

Finance was called upon to prevent the direst threat to Washington: a recession. Funds were directed at the most egregious commercial propositions. Wall Street funded the builders. Finding bodies to occupy the new developments would be the greatest challenge, but not now. The investment banks financed developers to increase the flow of mortgage securitization. The banks wound up owning half-finished developments in the desert, abandoned by bankrupt builders.

Likewise, banks were not, as was generally believed, selling all the mortgages they wrote. In early 2007, they held $3.4 trillion worth of direct mortgages, land development, and construction loans on their books. This was about 33 percent of commercial bank assets. Adding mortgage securities increased real estate exposure to 43 percent of assets.
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The United States was not the only economy that was vulnerable to financial excesses. In 2005, McKinsey Global Institute calculated that the ratio of global financial assets to annual world output had risen from 109 percent in 1980 to 316 percent in 2005.
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Financing fed on itself. Increasing leverage was important. The brokers and dealers had doubled their trading assets since 2000. This growth was not to help companies finance new inventions, but to leverage their balance sheets. Broker/dealers expanded their assets by $282 billion in 2005 (the largest increase in a single year), then added $615 billion in 2006.
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The carry trade was estimated in trillions of dollars.

¹⁵
Doug Noland,
Credit Bubble Bulletin
, February 25, 2006, p. 10.
¹⁶
From Office of the Controller of the Currency Quarterly Reports on Bank Derivative Activities.
¹⁷
Federal Deposit and Insurance Commission, Statistics on Depository Institutions, March 31, 2007.

The Federal Reserve creates money but does not control where it flows. The banks distribute funding through the economy where they believe it will be most profitable to them. Funding brokerage operations was very profitable. It might also have been seen as necessary, since hedge funds were buying a large proportion of derivative securities, underwritten by the banks.

Mortgage securities had grown more complex. The asset-backed or mortgagebacked bonds of the late 1990s were gathered into collateralized debt obligations (CDOs). The volume of CDOs rose from $157 billion in 2004 to $557 billion in 2006. This does not include synthetic CDOs, which rose from $225 billion in 2005 to $450 billion in 2006.
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(Synthetic CDOs are derivatives of CDOs, so they are not backed by any mortgage payments, subprime or not.)

These numbers address only a portion of the rising risk in the financial institutions and hedge funds. The leverage employed at different levels of ownership was at least as important as the poor quality of the mortgages. Gillian Tett of the
Financial Times
quoted from an e-mail sent by a banker. The banker had worked “in the leveraged credit and distressed debt sector for 20 years.” His career had never been more exciting: “I don’t think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions … with very limited capacity to withstand adverse credit events and market downturns.” The leveraged-credit specialist described the case of a typical hedge fund, two times leveraged. That hedge fund is supported by a fund of funds, which is three times leveraged. The fund of funds invested in “deeply subordinated tranches of collateralized debt obligations, which are nine times leveraged.” The result: “Thus every $1 million of CDO bonds is supported by $20,000 of end user’s capital—a 2% decline in the CDO paper wipes out the capital supporting it.”
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¹⁸
Financial Times
, June 19, 2007. Also from McKinsey: “The global stock of financial assets had reached $140 trillion.”
¹⁹
Doug Noland, “Credit Bubble Bulletin,” Prudent Bear Web site, March 9, 2007, p. 11.
²⁰
Noland, “Credit Bubble Bulletin,” February 16, 2007, p. 8; Noland is quoting from Paul J. Davies, “Sales of Risky ‘Synthetic’ CDOS Boom,”
Financial Times
, February 12, 2007.

A CDO is a theoretical financial institution. In James Grant’s phrase, it is a “paper bank, lacking walls and depositors but possessing assets and liabilities and equity.”
²²
It collects various debt obligations—bonds, bank loans, car loans, and mortgages, for instance—and sells pieces of the package to different investors. The pieces of the package carry different investment grades, from AAA on down.