Authors: Charles Ferguson
Or consider Stan O’Neal. He had been CEO of Merrill Lynch for four years by the end of 2006, and had pushed Merrill aggressively into subprime securities. In 2006 O’Neal’s
take-home
compensation was just over $36 million, of which $19 million was in cash. But this was not his
total
compensation. To avoid taxes, much of his compensation was deferred, to
be paid upon retirement.
In 2006 Merrill Lynch had revenues of $33.8 billion and pretax earnings of $9.8 billion. In January 2007 Merrill paid its annual bonuses—just under $6 billion, of which one-third went to
people involved in mortgage securities. Dow Kim, the head of Merrill’s fixed-income unit and therefore in charge of subprime securitizations, received $35 million. As late as the second
quarter of 2007, ending 30 June, Merrill Lynch was still profitable, reporting earnings of $2.1 billion. But as with Bear Stearns, in the middle of 2007 the bubble started to deflate. In the very
next quarter, the third quarter of 2007, Merrill reported a net loss of $2.6 billion caused by over $8 billion in losses on subprime loans and securities. Then the company went off a cliff. For the
full year 2007, Merrill’s revenues declined by 67 percent and it lost $8.6 billion. It would subsequently lose much, much more, nearly all of it stemming from decisions made while
O’Neal was CEO. So what was Stan O’Neal doing during the third quarter of 2007, when Merrill Lynch was falling apart?
He was playing a lot of golf. In the last six weeks of the third quarter, O’Neal played twenty rounds of golf, sometimes with his mobile phone
switched off. Usually
he played on weekends, but not always. Shortly afterwards, as Merrill’s condition drastically worsened, O’Neal made unauthorized overtures to other banks regarding a potential merger.
This, finally, led Merrill Lynch’s board of directors to fire him.
Except they
didn’t
fire him. They allowed him to resign, thereby enabling him to collect an additional $161 million, representing deferred compensation and severance—$30
million in cash, $131 million in stock. Nor has Mr O’Neal been banished from the business world; after leaving Merrill, he was invited to join the board of directors of Alcoa, on which he now
sits. In fact, he also sits on two committees of Alcoa’s board. Which ones? Audit and governance. Rewards for a job well done.
Finally, consider Robert Rubin. As Treasury secretary, Mr Rubin oversaw the elimination of the Glass-Steagall separation between investment banking and consumer banking. This change greatly
benefited Citigroup; and shortly after leaving the Treasury, Mr Rubin became Citigroup’s vice chairman. At Citigroup, Rubin displayed moments of disconnection from both reality and ethical
standards: In 2001, acting on Citigroup’s behalf, he had called his former colleague Peter Fisher at the Treasury Department, asking Fisher for help in preventing Enron’s credit rating
from being downgraded, very shortly before Enron went bankrupt. (Citigroup was a major Enron creditor, and was later fined for helping Enron conceal its losses.)
During the bubble, Rubin pressed Citigroup to take on more risk, even after being warned of the increasing dangers and dishonesty of housing loans and mortgage-backed securities. He does not
seem even to have been aware of his company’s financial structure and obligations. In his testimony before the FCIC, Rubin said that it was only post-crash that he learned about
“liquidity puts”, the contract provisions by which Citigroup was obligated to repurchase CDOs if they lost money or couldn’t be sold. These agreements with the structured
investment vehicles (that Citigroup itself had created) added over $1 trillion to Citigroup’s real balance sheet, and caused billions of dollars in losses during the crisis. It’s too
bad that Rubin didn’t read the footnotes
in his own company’s financial statements, for he might have noticed the puts and raised an alarm.
31
After a decade at Citigroup, during which he was paid over $120 million, Rubin resigned under pressure in January 2009. But this does not seem to have interfered with him much. He remains
cochairman of the Council on Foreign Relations; is still a member of the Harvard Corporation, the small group that is effectively Harvard’s board of directors; and both he and his son were
active in the Obama transition team, helping to select a
new
batch of policymakers. (Who turned out mostly to be the
old
batch, recycled; but we’ll get to that later.)
Unquestionably, none of these men made a deliberate decision to destroy their firms. But, equally unquestionably, personal incentives and personal risk focus the mind in a way that golf and
bridge generally don’t. These people had way too much money
outside
of their companies to care as much as they should have about what was going on inside them. But the psychological
atmospherics were just as important as the direct incentives. They became corporate royalty, with all the absurd arrogance, disconnection from reality, ego poisoning, and cults of personality
thereby implied.
However, there were others—most famously, Goldman Sachs—who didn’t allow the temptations of helicopter golf to cloud their thinking. These very disciplined people therefore
made money not only from the bubble, but also from the
collapse
. We will now consider them, and the implications of their behaviour for financial stability, in looking at the warnings, the
end of the bubble, the crisis, its impact, and government responses to it. It is not a pretty, or reassuring, picture.
CHAPTER 5
S
OME NOTICED THE BUBBLE
quite early. In 2002 a prominent hedge fund manager, William Ackman, discovered that one of
the largest bond insurers, MBIA, was actually a house of cards. It had a AAA credit rating (naturally), but was leveraged at over eighty to one, had started to write insurance on risky mortgages,
and used questionable accounting methods. Ackman bought CDSs on MBIA, later adding bets against the other major bond insurer, Ambac, as well. Ackman then started an aggressive public campaign to
discredit MBIA via meetings with the rating agencies, the media, and the SEC. The rating agencies ignored him, of course. The SEC then spoke with MBIA, which responded that Ackman was spreading
false rumours. In fact, MBIA persuaded the SEC to investigate
Ackman,
who, in the end, turned out to be completely right. (After several years losing money while waiting for the bubble to
burst, Ackman finally made serious money from his bet.)
In 2004 Robert Gnaizda, a housing and financial policy analyst who ran the Greenlining Institute, a housing NGO, began warning Alan
Greenspan personally. Gnaizda, who met
with Greenspan and the Federal Reserve Board once or twice a year, had noticed the proliferation of toxic, highly deceptive mortgages. He provided examples, and urged Greenspan to finally use his
power under the HOEPA legislation to rein in mortgage lending. Greenspan wasn’t interested.
But the first truly serious, public warning of systemic danger came in 2005, at the Federal Reserve’s conference in the resort of Jackson Hole, Wyoming, where the world’s most
prominent central bankers and economists gather annually. The 2005 conference was Alan Greenspan’s last one as chairman of the Federal Reserve, and everyone was supposed to admire and
celebrate his brilliant record. But Raghuram Rajan, then the chief economist of the International Monetary Fund, rained on the parade by delivering a brilliant, prescient, scary paper.
1
The audience included Alan Greenspan, Ben Bernanke, Tim Geithner, Larry Summers, and most of the Federal Reserve Board.
Rajan’s paper was titled “Has Financial Development Made the World Riskier?” And his answer was yes. After some introductory comments, Rajan said: “My main concern has to
do with incentives.” Rajan discussed the new compensation structures that dominated the financial system, making risk taking so deliciously profitable: “These developments may create
more financial-sector-induced procyclicality than the past. They also may create a greater (albeit still small) probability of a catastrophic meltdown” (page 6).
On page 25, he describes a scenario nearly identical to the destruction of AIG by Joseph Cassano’s unit: “A number of insurance companies and pension funds have entered the credit
derivatives market to sell guarantees against a company defaulting. . . . These strategies have the appearance of producing very high alphas (high returns for low risk), so managers have an
incentive to load up on them. Every once in a while, however, they will blow up. Since true performance can be estimated only over a long period, far exceeding the horizon set by the average
manager’s incentives, managers will take these risks if they can.”
And then, on page 31: “Because they [banks] typically can sell much
of the risk off their balance sheets, they have an incentive to originate the assets that are in
high demand and, thus, feed the frenzy. If it is housing, banks have an incentive to provide whatever mortgages are demanded, even if they are risky ‘interest-only’ mortgages. In the
midst of a frenzy, banks are unlikely to maintain much spare risk-bearing capacity.”
Three pages later: “Linkages between markets, and between markets and institutions, are now more pronounced. While this helps the system diversify across small shocks, it also exposes the
system to large systemic shocks.”
Starting on page 44, Rajan discusses how to curtail the dangers posed by the new system: “Perhaps the focus should shift to ensuring investment managers have the right incentives” .
. . “Industry groups could urge all managers to vest some fixed portion of their pay . . . in the funds they manage” . . . “In order that incentives be to invest for the long
term, the norm could be that the manager’s holdings in the fund would be retained for several years.”
When Rajan finished delivering his paper, Greenspan and most of the audience reacted with sullen, defensive silence. But not so Larry Summers. At the time, Summers was president of Harvard
University, while also consulting to a hedge fund, Taconic Capital Advisors. One year later, after being forced to resign, he became a consultant to D. E. Shaw, a $30 billion hedge fund, which, in
2008, paid Summers $5.2 million for one day per week of work. Both hedge funds used precisely the incentives that Rajan was warning about in his paper—managers kept 20 percent of annual
profits but had no liability for losses.
With his trademark casual arrogance, Summers stood up to put Rajan in his place. If you want to read all of his response, it’s on the website of the Kansas City Federal Reserve Bank. Some
quotes from Summers’s remarks:
“I speak as . . . someone who has learned a great deal about the subject . . . from Alan Greenspan, and someone who finds the basic, slightly Luddite premise of this paper to be largely
misguided.
“We all would say almost certainly that something . . . overwhelmingly
positive has taken place through this process [of financial innovation].
“While I think the paper is right to warn us of the possibility of positive feedback and the dangers that it can bring about in financial markets, the tendency toward restriction that runs
through the tone of the presentation seems to me to be quite problematic. It seems to me to support a wide variety of misguided policy impulses in many countries.”
But Wall Street insiders already understood what Summers seemed to say he didn’t. When did they know there was a really serious bubble, and that they could game it? Many of the clever ones
knew it by about 2004, when, for example, Howie Hubler at Morgan Stanley first started to bet against the worst subprime mortgage securities with the knowledge and approval of his management. But
you can only make money betting
against
a bubble as it unravels. As long as there was room for the bubble to grow, Wall Street’s overwhelming incentive was to keep it going. But when
they saw that the bubble was ending, their incentives changed. And we therefore know that many on Wall Street realized there was a huge bubble by late 2006, because that’s when they started
massively betting on its collapse.
Here, I must briefly mention a problem with Michael Lewis’s generally superb financial journalism. In his highly entertaining and in many ways informative book
The Big Short,
Lewis
leaves the impression that Wall Street was blindly running itself off a cliff, whereas a few wild and crazy, off-the-beaten-track, adorably weird loners figured out how to short the mortgage market
and beat the system. With all due respect to Mr Lewis, it didn’t happen like that. The Big Short was seriously big business, and much of Wall Street was ruthlessly good at it.
To begin with, a number of big hedge funds figured it out. Unlike investment banks, however, they couldn’t make serious money by securitizing loans and selling CDOs, so they had to wait
until the bubble was about to burst and make their money from the collapse. And this they did. In addition to Bill Ackman, already mentioned, other
major hedge funds
including Magnetar, Tricadia, Harbinger Capital, George Soros, and John Paulson made billions of dollars each by betting against mortgage securities as the bubble ended. It appears that just those
five hedge funds made well over $25 billion, and possibly over $50 billion, shorting the mortgage bubble, and all of them worked closely with Wall Street in order to do so. In fact, as we shall
soon see, their bets against the bubble appear to have been extremely helpful in allowing Wall Street to
perpetuate
the bubble.
And as we’ve just seen, many people on Wall Street had huge financial incentives to keep creating and selling junk until the very end, even if it meant knowingly destroying their
employers. Without question, thousands of Wall Street loan buyers, securitizers, traders, salespeople, and executives knew perfectly well that it would end in tears, but they were making a fortune
while it lasted, with no individual ability to stop the bubble and very little to lose when it ended.