Life After Debt, Part II – Weapons Of Mass Destruction

In Part I, I discussed an internal Clinton-era memo in which US Treasury department officials considered the consequences of paying off our national debt, by 2012.

The most frightening ironies of the ‘Life After Debt’ memo are the alternative vehicles the author proposed to replace US Treasuries.

As a finance professional, reading the memo carefully, I almost chocked on my morning coffee at the proposals coming from the bowels of Treasury.  It was like reading a 1930s memo proposing the invention of a nuclear bomb, as that would ensure the end of all future wars.

First, the author considers FNMA and FHLMC (more commonly known as Fannie Mae and Freddie Mac) agency debt as securities for the conduct of monetary policy instead of US Treasury debt.  Since the companies were AAA-rated, fast-growing and as rock-solid as the US housing market (!), this was not an entirely crazy idea at the end of 2000.  Obviously, with the receivership of Fannie Mae and Freddie Mac in 2008, we know in hindsight that a Federal Reserve balance sheet filled with agency debt would have meant a complete catastrophe wrapped in a shit sandwich.  Although it had become an increasingly important staple of Wall Street bond issuance for the prior decade, agency debt from Fannie and Freddie became deeply distressed in the Summer of 2008, and would have ripped a limitless black hole in the Federal Reserve balance sheet.  Needless to say it’s a good thing that did not happen.

But the second suggested vehicle for absorbing impending federal surpluses is the real problem.  The author introduces “[N]ew, very low-risk securities constructed from a pool of private debt securities.”

Knowing what we know now, we should be thankful this idea never took off.  I’ll quote the memo for a fuller description and then explain what the author was getting at:

 Such securities would be packaged in a way similar to mortgage-based securities currently issued by Government Sponsored Enterprises like Freddie Mac and Fannie Mae, but would not be as liquidity constrained and would be better diversified against certain market risks.  To package the new instrument, a financial institution could buy a set of high-quality corporate bonds.  It would then offer to sell a coupon bond called the Triple-A Plus bond that pays a fixed annual interest rate for the life of the bond.  The Triple-A Plus Fund would put up its equity capital and take on the default risk of the underlying corporate bonds.  Although not completely risk-free, bonds like the Triple-A Plus bond would entail very little credit risk and would be close substitutes for Treasury securities.  With the advent of such an instrument, liquid and transparent markets should develop, given the value of just such a low-risk security to both private markets and the Fed.

Now, I take great interest in the author’s plan, because it is both prescient, up-to-date for its time, and in hindsight, incredibly stupid.  This theoretical super AAA bond was in the process of being perfected by Wall Street at the time of his writing.  It would have been constructed by pooling a diversified portfolio of high quality corporate bonds, and then offering a fixed rate to the holder who takes on the very-low probability of default.  My sense is the author must have heard of this financial innovation through a conversation with Wall Street structuring professionals, and he then attempted to apply it to solving the problem of what instrument the Fed could use for investments instead of US Treasurys.

 

The author is right that there was no liquidity constraint on this type of instrument, which is another way of saying, Wall Street could make in infinite amount of it.  The author also correctly notes that “the value of such a low-risk[1] security to both private markets and the Fed” would lead to the creation of extraordinary amounts of this debt instrument.  Finally, and most importantly, the author was also right that the assets were “not completely risk-free,” although plenty of quantitatively sophistical investors believed them to be risk-free up until the period of 2007 and 2008, when they were shown to be financial “weapons of mass destruction.”  The “Super-senior” AAA CDO, comprised of a portfolio of low-risk corporate bonds, was a particular innovation of Goldman Sachs’ mortgage desk where I worked in the years following this memo.

 

AIG Financial Products (AIG FP) considered the “Super-senior AAA CDO assets riskless, and the income derived from it to be free money.  It was precisely these instruments, described by the author at the Treasury department, perfected in the following years by Goldman Sachs to the specifications of its client AIG FP, that sent AIG into government receivership in 2008.  We can be thankful again that the Federal Reserve didn’t buy these products from Wall Street, as attractive as they sounded in the memo.

 

Up Next: Life After Debt Part III – Check out the “Where Are They Now?” file



[1] !!!!

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Life After Debt, Part I – Bizarro World Debt Crisis

Join me, if you will, in examining a time capsule from November 2000.  A junior economist, burrowed deep in the cubicles of the US Treasury Department, wrote a never-published memo to his bosses about a major problem facing the financial markets titled, ‘Life After Debt.’  How would markets react to the imminent pay down of all our Treasury debt?  Projections at the time showed the stock of US Treasury bonds would be completely paid off by 2012.[1]

Meaning, no more government debt.  Federal government debt, totally paid off.

Produced in the final weeks of the Clinton administration, the paper never got published.  No problem a little more than a decade later, as we know, since this alternative reality never came true.  Not even close.

National Public Radio’s Planet Money Program made the unpublished memo available a while ago, but it deserves further study.  To read it today opens up the Bizarro World of US national debt, a world a decade ago when our biggest problem seemed to be the issue of disappearing federal deficits and the problem of parking future federal surpluses.  Our US Treasury officials lay awake wondering at night – how will we ever invest our untold billions of surplus future tax receipts?  How can we avoid dismantling Wall Street’s bond market infrastructure?  How can we not crowd out private investments with excess government surpluses?

This is Bizarro World indeed, given the downgrade of United States sovereign debt risk by S&P, the seeming impossibility of producing an annual balanced budget, and the ever-increasing load of national debt.

If September 11, 2001 marked a new era in the United States’ relationship with national security and existential threats, the end of 2000 marked a turning point in our relationship with fiscal responsibility.  Concerns before then strike us now as oddly naïve, as if from a different generation from our own, despite their proximity to today.  Reading this memo with our present day lens is funny, but not in the ‘ha-ha’ way.  More like the laugh-instead-of-crying kind of way.

The Treasury department author worried about three negative consequences of buying back all US Treasuries, specifically the elimination of

a) A risk-free benchmark for pricing risky assets,

b) A fully articulated yield curve for market signaling, and

c) A key instrument of the Federal Reserve for conducting Monetary Policy

As a bond guy by training I will acknowledge that US Treasuries fulfill these roles very nicely, and the author conscientiously consids how to address changes over time in these three key areas.  Markets would indeed have to adjust to a new regime if US Treasuries slowly disappeared.  I can’t fault the economist for considering the important consequences of such a big changes in US markets.

In addition, as you read the memo carefully and the side notes by the author and editor, you see that they understood that overall reducing or eliminating the Federal Debt was a good thing, but that the risks and costs of doing so should be anticipated, understood, and debated.  This understanding works fine as a theoretical exercise deep in the heart of the Treasury Department cubicles.  But one does get the decidedly uncomfortable feeling that concern for structurally important institutions such as US Treasury dealers and bond investors would take precedence over the general welfare improvement inherent in paying down indebtedness.  This preference isn’t spelled out, but it is implicit.

I do not mean to imply the author is complicit in defending Wall Street bond dealers and their investors, per se.  But I do read the memo and want to violently reach back in time and throttle anyone who gave up our best, once-in-a-generation opportunity, at national solvency.  We seem so far from it now that the detached consideration of the ‘pros and cons’ of paying off the national debt reads as cruel historic irony.

As a country we’re the Megaball Multi-State winner from 2000 who, ten years later, declared bankruptcy.  We took the lump sum lottery that we won and blew it on a speculative Las Vegas condo investment, flashy speedboats, and a few too many wars of choice in the Middle East.

Instead of building national wealth, we now we have deficits as far as the eye can see, to pay off the wars, as well as social safety net programs that are, demographically speaking, unsustainable.

But I digress.  It’s worth reading the memo to check out the choices under consideration in 2000 for parking our impending windfall of federal surpluses.  The details are funny, but again, not in the ha-ha way.

 

Up Next…Part II – Weapons of Financial Mass Destruction



[1] Back in 2000, I fully expected to be writing this blog in 2012 from my hovercraft.  Life is cruel sometimes.

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Now, Alanis, For Something Really Ironic

There’s comedy, there’s high comedy, and then there’s Wall Street Journal Op-Eds.  Phil Purcell writes this morning about the opportunity to cure “Too Big To Fail.”  He urges shareholders to split our mega-banks into smaller, more manageable entities.

Since I happen to agree strongly with that goal, I naturally sat up straighter at the breakfast table, ignored the screaming two-year-old[1] and gripped my cereal spoon a little tighter, all the better to pay attention to Purcell’s piece.

But Purcell crusades Wall Street Journal style, so I should have been prepared for his giant helping of unreflective Jell-O.  He served up a plate of 1950s thoughts, masquerading as a new idea.[2]

Ah, where to begin?  Let’s start with the fact that Purcell himself created one of the Too Big To Fail behemoths, leading Dean Witter’s acquisition of Morgan Stanley in 1997.  He then headed the combined firm before being pushed out in 2005.  All the ‘synergies,’ all the ‘costs savings,’ all the ‘shareholder value’ he made happen with that exciting merger?  He’s awfully quiet about that now.  I’m not saying he’s apologetic, as he mostly certainly is not.  Just quiet.

At the point in his Op-Ed where he notes that Morgan Stanley Dean Witter had to be bailed out by taxpayers in 2008, Purcell ought to contritely note his part in the creation of a massive Too Big To Fail bank.[3]  But he’s not about to apologize for the unholy mess that he engineered, to his personal benefit, capped off at the end by a $113.7 million[4] exit package.[5]  The fact that he brought a perfectly nice retail brokerage (Dean Witter) under the same roof as an M&A and trading powerhouse (Morgan Stanley) resulted in an opportunity for private gain for him by the time he left in 2005, and public liabilities for us taxpayers in 2008, just three years later.  But that’s not his concern, and that obviously goes unmentioned.

What he is very concerned with, however, is shareholder value.  Purcell rightly points out that investors discount the share prices of firms that could not survive the 2008 crisis without a taxpayer bailout.  Shareholder value, I agree, is a worthwhile concern.  Not the primary concern when it comes to TBTF, but still, a valid concern.

Purcell proposes that shareholders advocate a break-up of the giant banks.  Nevermind the fact that shareholders have close to zero effectiveness [6] [7] when it comes to managing big governance issues of publicly owned corporations.  The only folks who have the power to choose to break up their own big public firms are the ones in the CEO seat.  Few CEOs willingly shrink their own kingdoms.  It just doesn’t happen that way.[8]

Purcell’s main recommendation is to split the TBTF banks into smaller entities, so that client-oriented firms “should be spun off to give the value to shareholders,” while high growth financial-service companies should be owned privately.  You know, by private equity companies.  And here’s the weird thing you’ll be shocked by:  Purcell, strangely enough, runs a private equity firm that purchases high growth financial service companies!  What a happy coincidence!  He’s just here to help.

So, to sum up:  We should combine financial firms into Too Big To Fail banks from 1998 to 2008, as it will greatly enhance the probability of extraordinary CEO pay from a shareholder-owned company, and never mind the taxpayer bailout to follow.  In 2012, we should break up these same banks to sell them to your private equity business?  Again, you don’t even mention the taxpayer bailout or the policy implications of the government welfare underlying your fortune?

Thanks for your thought leadership through the years, Mr. Purcell.  My two year-old is more selfless than you.  Now why is she crying again?



[1] My wife made me include that detail.  Not sure why.  Wives work in mysterious ways.

[2] “Mr. Romney!  Mr. Romney!    A Telex just came in for you, and I had the secretary make you a carbon copy!  Mr. Purcell accepts your offer of Treasury Secretary in the new administration!”

[3] Is it too much to ask that we get a little Japanese-style begging of forgiveness from guys like Purcell?  Just a deep bow and a contrite apology – I really think it would go a long way.

[4] Read about it here.  There’s a great passage at the end of the NY Times coverage, in which Purcell’s departure and golden parachute kicks off a competitive feeding frenzy of private enrichment at the top of Morgan Stanley, headed then by John Mack.  A compensation consultant calls it “an ‘ice cream war’ between children, where one wants as much as the other. ‘Except that, in this case,’ he said, ‘somebody seems to have got the whole ice cream factory.’”  Oh, the good old days.

[5] If you have a strong appetite for self-serving crap, can I interest you in Phil Purcell’s Wikipedia entry?  Which he clearly wrote himself?  He’s not well-known enough to have anybody come in and edit his entry and add a dose of realism, although Wikipedia notes that the page probably needs some editing.  (Meaning, there’s only been one author of the post, Purcell himself.)

[6] The “Shareholder Democracy” aka “Say on Pay” Movements exist in the minds of a few business school professors.  But they’ve had no noticeable effect on the business world.

[7] The exception to the rule being a few well-known hedge fund agitators like Daniel Loeb, Bill Ackman, or the wily veteran Carl Icahn.

[8] Mubarak, Saleh, Gaddafi, and Assad used to get together at pool parties and laugh at the relative accountability and haplessness of American financial CEOs Pandit, Moynahan, Dimon, and Blankfein.  Now Blankfein’s all like, “Shoe’s on the other foot now, bitch!  They can’t make me leave!”

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Book Review: Boomerang – Travels in the New Third World

Back in College, in social science classes, we learned never to rely on cultural explanations.  Professors excised culturally deterministic phrases from our analysis: “The Spanish society tends to…The African American culture explains…Inevitably, Catholic norms led to… ”

Cultures change, as does our view of them, the intellectual posits, and culture drops out as a powerful explanation in the long run.

In Boomerang, Michael Lewis raises up national culture as the key lens to understanding the European Debt crisis.  This makes for poor social science and weak financial insight, but like anything from Michael Lewis’ pen, wildly entertaining reading.

Lewis sets up the central conceit of Boomerang as follows: When the lights go out and nobody is looking, what do people do?  In the financial context, he means specifically that when easy credit flowed into Europe between 2002 and 2007, what national character trait explains how the people of Iceland, Greece, Ireland, and Germany reacted, respectively?  The first three nations blew massive holes in the balance sheets of their national banks and governments, while the Germans remained prudent, and more specifically, anal.

Icelanders, we learn, transformed themselves in one decade from risk-taking fisherman to free spending hedge funders.  Easy credit from abroad allowed their testosterone-driven inner-Viking to bust loose from any prudence or fiscal constraint.

Greeks bring an every-man-is-an-island-unto-himself, as well as a deep distrust of one another, to their financial lives, resulting in a nation of tax cheats who assume all citizens cheat on their taxes.  The government cannot raise revenues as a result.

The Irish moved from abnormally impoverished (in the European context) to abnormally enriched over the course of the decade.  Their seemingly acquiescent round-trip back to relative poverty fits in with what Lewis describes as an unwillingness to communicate their troubles to anybody else.  They nationalized their insolvent banks, needlessly in Lewis’ view, in a brutal financial move that kept their troubles deeply repressed.

Lewis saves his most memorable images for the German national character.  Their coprophilia[1] apparently explains why German investors prefer a clean-seeming AAA-bond investment that contains steaming toxic subprime bonds bundled inside.  Lewis hires an overeducated chauffer to drive him to the Hamburg Red Light district.  She then proceeds to list a steady stream of phrases using the German  scheisse in everyday German conversation.  Somehow

None of this helps explain how Greece will resolve its national debt problems or whether Germany will, yet again, approve ECB loans to bail out its less thrifty southern European brethren.

Lewis’ Big Short from the previous year managed to be simultaneously entertaining and informative about toxic CDOs and the traders who loved to short them.  In Boomerang, he mostly settles for entertaining cultural sketches, albeit with limited financial insight.  But given that Lewis writes about financial characters for a living better than almost everybody else does what they do for a living, it’s still fun.  If Europe is going to experience financial Armageddon, can’t we also laugh a little?[2]

 

Please see related post, my review of Michael Lewis’ Liar’s Poker.

As well as related post, my review of Michael Lewis’ The Big Short.

And Michael Lewis’ The Undoing Project

 

Please also see related post, All Bankers Anonymous Book Reviews in one place.


[1] You’d better go look that one up.  I’ll wait right here….Ok, all set then?  Great, let’s move on.

[2] This seems as good a time as any to break out the old saw: “Heaven is where the police are British, the cooks are French, the mechanics are German, the lovers are Italian and it is all organized by the Swiss.  Hell is where the police are German, the cooks are English, the mechanics are French, the lovers are Swiss, and it is all organized by the Italians.”

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Greek Government Formed Today, Will Soon Crumble

European credit crisis watchers cheered the end of the nerve-wracking Greek electoral cycle, with a coalition government sworn in that does not seek further debt repudiation or a sudden break with the Euro, its European creditors, and the European Central Bank

A look at electoral results, however, suggests this government may be set to fail very quickly.   As a well-connected Greek businessman pointed out to me last night,[1] voter apathy indicates huge dissatisfaction with the choices of leadership in Greece.

The big winners were the absentees.[2]  If you look at the results you have 39% did not vote.  Which, for the US, is nothing alarming but in Greece we usually have absentees under 5%.  It’s a real conclusion that people have lost all confidence in politics and politicians.

He then explained that the peculiar Greek parliamentary system means the leading coalition can form a government with only a fraction of eligible voters in support.

You have about a third of the people who voted for the Conservative party and they’re going to form the coalition government.  Which is a joke!  Because of the way the electoral system works, the first party gets a bonus of 50 seats in the parliament.  So you have a government that now has a majority with less than 40% of the votes which represents 24% of the voters…Now that’s not really a democracy.

It’s also an indicator of a weak coalition position.  On top of that, fully a third of the electorate that did vote for the left-wing candidate will seek only to obstruct the new government.

Here’s the people who will do everything they can to block everything.  They’d rather die and create a mess than accept reality.

This is not a hopeful situation when what Greece needs, and what Europe needs, is unprecedentedly strong leadership.  Given the hard choices ahead, it’s unlikely the coalition government can hold power for the next year.[3]



[1] Audio interview to follow as soon as possible

[2] Meaning, abstention from voting

[3] My prediction, not my friend’s prediction.

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Psychoanalyze the Banker

An interview with a psychologist who mostly works with folks in the finance industry reminds me of, well, a lot of things I’ve seen.  The psychologist points out the insecurities inherent in many trading jobs, as well as the problem of working in the industry and then hitting your 30s.  Inevitably there’s the reference to CEO as psychopath which is a bit overdone but in any case it’s worth a read.

One highlight:

About a quarter of my clients are corporate but not finance.  Is there a difference?  They are all incredibly tough and everyone says their motivation is money.  But when you drill down into what’s driving people in the corporation world, other motives come to the surface.  With people in finance, it really is money, I find.

Here’s another good one:

This is what’s intriguing about the current financial crisis so far…where are the thought leaders indicating the path to a new phase in our economic evolution?  Who will augur in the growth moment from this crisis?  I don’t see new ideas coming to the fore.

And then, on leaders in the finance world:

They present themselves as to the outside world as posh and erudite and sophisticated; as supermen.  But they are just like you and me, with similar needs and fears.  We shouldn’t fall for their spiel.

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