President Obama is speaking tonight, apparently to assure us all that his administration has the financial crisis resolved. Don’t bet on it. To see why, let me take you back a couple of years.
In the fall of 2007, facing billions in losses on Merrill Lynch’s holdings of toxic assets, then-CEO Stan O’Neal approached his board at least twice to sell Merrill or merge it with a major bank — and at least twice got rejected.
Merrill was bleeding, he warned, and might not survive the huge losses on its balance sheet. The board’s response: No way.
The firm would be selling out cheaply, was the general consensus. Key board members believed that, if all else failed, Merrill would survive because the government wouldn’t let it die.
The Federal Reserve, they expected, would do what it had done for Wall Street for years — basically bail out firms that had made disastrous decisions by handing them virtually free money through low interest rates.
At least three times in the past three decades of excessive risk-taking, that’s how the Fed has helped the financial system dodge catastrophe.
As it turns out, Merrill’s board wasn’t alone in this belief. As I point out in my upcoming book about today’s financial crisis, “The Sellout,” controversial Bear Stearns CEO Jimmy Cayne took virtually the same position as the Merrill board — telling a colleague that he was waiting for a “bounce back” in the prices of the toxic debt on Bear’s books, once the Fed again pumped life into the financial system.
Lehman Bros. filed for bankruptcy a year ago tomorrow; nearly to the minute it did, CEO Dick Fuld believed the feds would come to his firm’s rescue. That would’ve been somewhat of a repeat of events in 1998, when the Treasury Department and the Federal Reserve saved Lehman by arranging a bailout of the notorious Long-Term Capital Management hedge fund because Lehman copied the fund’s moneylosing trades.
There are, of course, many villains responsible for the financial implosion that occurred around this time last year — Stan O’Neal, Jimmy Cayne and Dick Fuld chief among them for their risk-taking folly. Rep. Barney Frank and the Housing secretaries of the Clinton and Bush years, of course, believed so fervently that “owning” a home was a right that they enabled Fannie Mae and Freddie Mac to guarantee more and more risky loans for people who had no means to repay them.
And let us not forget the greedy investment bankers who sold the notion that the risk of default could be eliminated by packaging these loans into mortgage-backed securities — or the feckless bond-rating agencies that slapped all those Triple-A ratings on this debt while raking in huge fees and massive profits that have never been returned.
But the biggest villain, in my view, is that ultimate enabler of Wall Street’s greed and stupidity — the federal government, in the form of the Federal Reserve and Treasury Department.
Throughout the last 30 years of market ups and downs, the feds have bailed out the financial system by cutting interest rates to excessively low levels or, when Long-Term Capital was about to explode, by orchestrating a bailout of a hedge fund that had spread its virus throughout the banking system.
Each time, the financial bureaucrats told us the bailout was necessary to prevent total financial calamity — and that Wall Street had finally learned its lesson and wouldn’t engage in the risky practices again. Plus, they told us, the feds had learned their lesson as well — they’d be watching Wall Street’s every move.
Well, not quite. After each market implosion (in 1986-7 and 1994 and on through the 1998 LTCM crisis), Wall Street returned to risk on a larger scale — until the mother of all meltdowns swept the financial system this time last year. That crisis forced the feds to enact the mother of all bailouts — billions pumped into the banking system, with Uncle Sam becoming the largest shareholder of Citigroup, one of the world’s largest financial institutions — and declaring for the first time that the banking system officially is offlimits to failure.
It is that declaration — made by then-Treasury Secretary Hank Paulson, and followed through by his successor Tim Geithner, about protecting “systemically important” institutions — that will guarantee future excessive risk taking and yet another financial implosion. In fact, the seeds of the next meltdown are already being sown.
Goldman Sachs’ $3 billion profit in the second quarter of this year is a direct result of increased risk-taking in the bond markets. Morgan Stanley was slow to embrace this type of risk after its near collapse last year, but after losing money and being shown up by Goldman earlier this year, CEO John Mack started hiring hundreds of bond traders and salespeople to ramp up risk.
And they’re not along. Even Citigroup, a virtual ward of the federal government, is making money trading bonds and engaging in risk.
Wall Street will tell you that times have changed. One chief culprit of the financial collapse, “leverage” — borrowing to finance risk-taking activities — is way down these days, so the risk of losses spreading to dangerous levels has been minimized. Maybe so, but that won’t last — because it never does.
Study the history of Wall Street’s periodic episodes of losses, including the period after LTCM’s near-collapse. First the federal government comes to the rescue with its easy-money and interventionist bailout plans. Then there’s a period of retrenchment – after which Wall Street’s appetite for risk-taking and leverage always comes roaring back.
By bailing out the banks, the government creates an atmosphere where no risk is too small — because Wall Street always feels it has a safety net thanks to Uncle Sam.
In economic circles, the problem is known as “moral hazard.” Average Americans will call it common sense.
And common sense tells me that, given the nature of the last year’s bailout, moral hazard has been created on an unprecedented scale — setting the system up for a bigger demise somewhere down the road, when the memory of the horrible weeks following Lehman’s bankruptcy is forgotten.
It’s not just that Wall Street has a short memory — the last bailout made things worse: The federal safety net is no longer merely the promise to cut interest rates to rockbottom levels or prod firms to bail out a wayward hedge fund. After Lehman’s bankruptcy, the feds panicked and created the biggest safety net of all time.
Goldman Sachs is now a commercial bank, meaning it’s regulated by the Federal Reserve and viewed as too big to fail. Ditto for Morgan Stanley, which just hired all those traders and salesmen to take risk — and did it with the imprimatur of the federal government.
There is, of course, a simple solution to all this: Goldman, Morgan and the rest of the “banks” should either become hedge funds — with no backing from the federal government and taxpayer funds when they engage in risk — or start handing out debit cards and toasters and become real commercial banks by concentrating on signing people up for checking accounts, instead of trading esoteric bonds.
If we don’t impose such hard rules, expect a repeat of what happened last year. If history is any guide, that implosion will be bigger and more dangerous than ever before. CNBC on-air editor Charles Gasparino’s new book about the Wall Street meltdown, “The Sellout,” is due out Nov. 3.