Monday, September 22, 2008

US Economic Crisis Bulletin: Goldman, Morgan Stanley to Become "Regulated Banks"; Capitalism in Convulsion, etc.

Goldman, Morgan Stanley to become regulated banks

By Krishna Guha in Washington
September 22 2008 07:34

Goldman Sachs and Morgan Stanley, the last surviving big investment banks on Wall Street, have become regulated banks.

In a statement issued at 9.30pm Sunday, the Federal Reserve said it had approved their applications to become bank holding companies, subject to regulation by the Fed.

During the transition period, the Fed will make loans to both entities and to the broker-dealer subsidiary of Merrill Lynch against collateral acceptable for posting either by a bank or a securities firm.

The Fed will also lend to Goldman, Morgan and Merrill’s London-based broker dealer subsidiaries directly.

The Fed approval is subject to a five-day waiting period for potential antitrust issues.

The move in effect spells the end of the investment banking industry as a separate sector, leaving behind only small boutique securities firms. In doing so, it ends the decades-old division of the US financial industry into two halves, which dates back to legislation passed after the Great Depression.

It follows the collapse of Bear Stearns, sold to JP Morgan in March, and Lehman Brothers, which filed for bankruptcy protection last week.

It means that both Goldman Sachs and Morgan Stanley will be subject to bank capital requirements, which will be phased in over a transition period.

As banks, the move will greatly expand their ability to take deposits from savers, thus reducing their reliance on funding in the short-term repo market.

In a statement, Goldman said: “We view regulation by the Federal Reserve Board as appropriate and in the best interests of protecting and growing our franchise across our diverse range of businesses.”

Lloyd Blankfein, chairman and chief executive, said: “While accelerated by market sentiment, our decision to be regulated by the Federal Reserve is based on the recognition that such regulation provides [our] members with full prudential supervision and access to permanent liquidity and funding.”

Morgan Stanley said in a statement that it had sought the change in status in order to provide “maximum flexibility and stability to pursue new business opportunities as the financial marketplace undergoes rapid and profound changes.”

Copyright The Financial Times Limited 2008

Capitalism in convulsion: Toxic assets head towards the public balance sheet

By John Plender
September 19 2008 19:25

In the space of just two momentous weeks, the landscape of global finance has been dramatically transformed. President George W. Bush’s administration has mounted a multi-billion-dollar rescue of the financial system at the cost of inflicting severe damage on the US model of free-market capitalism.

Heavy costs will be inflicted on the American taxpayer, who is now subsidising Wall Street – and indeed financial institutions around the world – in a bail-out of unprecedented size.

The sequence of events that led to this extraordinary socialisation of finance began with the de facto nationalisation of Fannie Mae and Freddie Mac, the bankrupt government-sponsored mortgage lenders at the heart of the US housing finance system. There followed a rise in the cost of insuring against default in the world’s most powerful economy. On some independent estimates, the overall response to crisis could take the outstanding US public sector debt from readily manageable status to a level comparable with such fiscally stretched countries as Italy and Japan.

Concern about the creditworthiness of the US is nonsensical, according to Charles Goodhart of the London School of Economics. It has nonetheless surfaced, along with worried punditry about the dollar’s role as a reserve currency.

Then came the absorption of Merrill Lynch by Bank of America and a bold decision by Hank Paulson, US Treasury secretary, to allow Lehman Brothers, the fourth largest US investment bank, to go to the wall. This constrasted with the government orchestrated rescue of the smaller Bear Stearns by JPMorgan Chase earlier this year.

The disappearance of these two Wall Street securities giants raised questions about the durability of the independent model of investment banking. Shares in the two independent survivors, Morgan Stanley and Goldman Sachs, were quickly savaged by short-sellers. In the UK, such short-selling is alleged to have been what pushed HBOS, the country’s biggest mortgage lender, into its shotgun marriage with Lloyds TSB.

Still more startling was news that the Federal Reserve was advancing $85bn (€59bn, £47bn) of taxpayers’ money to AIG, the world’s biggest private insurer. Thanks to its role in the global market for credit insurance, AIG was so interconnected with other financial institutions that its bankruptcy would have been catastrophic for the whole system.

Yet despite the rescue, the festering lack of trust that has dogged the banking system since August last year worsened after this move. On Wednesday, the interest rate on one-month US Treasury bills turned negative, bearing the astonishing message that investors would rather lose money on government paper where repayment was certain than invest in money market funds. The climactic point had been reached where nobody trusted any credit other than the government’s.

In such circumstances, experience teaches that central banks have to lend freely. In the event, the Federal Reserve injected $180bn into the markets, while other leading central banks said they were taking co-ordinated measures to help short-term dollar markets.

To round off the week, Mr Paulson announced discussions with political leaders to create a government-sponsored vehicle to take on toxic assets created during the bubble, prompting a manic stock market bounce.

The paradox in this remarkable tale is that extreme illiquidity exists in a world awash with the excess savings of Asia and the petro-economies. Russia illustrates the point. Thanks to the oil windfall, it sports high economic growth, the third largest foreign exchange reserves in the world and low public sector debt. Yet Moscow stocks are collapsing and trust in the financial system has eroded to the point where overstretched Russian investment banks are starved of funds and threatened with bankruptcy.

This is what happens when an overleveraged global financial system unwinds. Borrowing is being forcibly reduced across the world after the greatest credit bubble in history. It amounts, says David Roche of Independent Strategy, a research boutique, to a “tectonic shift from leverage to thrift as the means of financing growth and the concomitant dramatic reduction in global imbalances such as the US current account deficit”.

The reality is that the financial system has been operating as if it were an off-balance-sheet vehicle of the government. Private-sector companies and individual bankers have been making huge profits in the bubble. Their risk appetite has been enhanced by previous bail-outs and, in the case of Fannie and Freddie, by the government’s implicit guarantee. Yet their market pricing does not reflect the potential cost to the system of their own collapse.

This inability to handle externalities has again been apparent in the markets over the past two weeks as speculators have engaged in short-selling strategies against AIG and the investment banks in the US and HBOS in the UK. This threatens the financial system because the rating agencies respond to the consequent falls in share prices by cutting credit ratings, so jeopardising the victims’ ability to fund the business.

Once again, property has been at the heart of a financial debacle, in spite of the assurances of central bankers that a nationwide fall in US house prices was an impossibility. Yet the peculiarity this time lies in property being wrapped in complex financial products that few could understand.

When investors go outside their areas of competence, trouble follows. Walter Bagehot, the 19th-century economist who defined the rules for central bank management of financial crises in his book Lombard Street, said: “Common sense teaches that booksellers should not speculate in hops, or bankers in turpentine; that railways should not be promoted by maiden ladies, or canals by beneficed clergymen ... in the name of common sense, let there be common sense.”

The twist in the current decade is that even bank boards and bank executives have failed to understand complex mortgage-backed banking products, as have central bankers, regulators and credit rating agencies.

In this off-balance sheet Alice in Wonderland world, the most absurd feature has been a reward system that has granted huge bonuses to those who peddled toxic mortgage-related products and does not permit much of the money to be clawed back now that the going is bad. Almost as absurd has been the degree of leverage racked up by investment banks.

As Michael Lewitt, the Florida-based money manager, puts it: “Allowing investment banks to be leveraged to the tune of 30 to 1 is the equivalent of playing Russian roulette with five of the six chambers of the gun loaded. If one adds the off-balance-sheet liabilities to this leverage, you might as well fill the sixth chamber with a bullet and pull the trigger.”

So what stage in the the crisis have we reached? Bagehot quoted the banker Lord Overstone’s description of the progress of an unstable cycle thus: “quiescence, improvement, confidence, prosperity, excitement, overtrading, CONVULSION [Bagehot’s capitals], pressure, stagnation, ending again in quiescence”.

Over the past two weeks we have experienced convulsion. Yet it ought to be possible to avoid stagnation, because the authorities are following the prescriptions of Hyman Minsky, the economist whose work Stabilizing An Unstable Economy best explains the dynamics of this crisis.

Minsky saw fiscal activism by big government, alongside last-resort lending by central banks, as the modern way of coping with financial distress. That is now taking place. In effect, the US government is replicating what happened in the private banking system earlier in the crisis, when institutions were obliged to take entities they had created, such as structured investment vehicles and conduits, back on to their balance sheets as funding dried up.

Having implicitly guaranteed Fannie and Freddie and underpinned the operations of irresponsible bankers at AIG and elsewhere, the US government is putting bankrupt institutions back on to the public sector balance sheet via nationalisation. Now, Mr Paulson’s proposal for the system’s toxic assets has the makings of a turning point.

What will the banking landscape look like after this saga? Much depends on the regulatory response. At the very least, tougher capital requirements will be imposed, which could mean the banking system reverts to a lower-risk, utility-like function. Yet one of the most important questions concerns the independence of central banks.

If central banks have to be recapitalised, as seems likely, politicians may want to extract a price that diminishes their operational independence. That could have damaging consequences. For a central point of Minsky’s thesis is that fiscal activism and last-resort lending set the stage for serious inflation.

That, together with an increased burden on future generations of taxpayers, could be the cost of the last two weeks’ frantic efforts to stave off deflation and keep some semblance of the Anglo-American model of capitalism afloat.

The writer is an FT columnist and chairman of Quintain

Copyright The Financial Times Limited 2008

Big Pay for Big Bosses Under Fire


The U.S. government's massive intervention in the financial industry may also bring new limits on executive pay.

As the U.S. Treasury asks Congress for about $700 billion to bail out troubled financial firms, key Democratic lawmakers including House Financial Services Committee Chairman Barney Frank and Senate Banking Committee Chairman Christopher Dodd say they want the bill to include curbs on what executives can earn.

Speaking on C-SPAN on Sunday, Mr. Frank blamed the mess in part on a "perverse incentive" that encouraged executives to take huge risks in exchange for multi-million-dollar payouts, and said he'll ask for compensation guidelines for companies that want money, to make sure that doesn't happen in the future.

The bailout puts a harsh spotlight on the millions of dollars earned by the leaders of failed firms like Fannie Mae and American International Group Inc. -- and fuels long-running calls to temper those paydays. Martin Sullivan, who was ousted as CEO of AIG in June, was promised an exit package valued at the time at around $47 million; his successor Robert Willumstad, who was asked to step aside by the government last week, was due $22 million when he left.

But in one sign of the shifting attitudes, Mr. Willumstad over the weekend informed his successor Edward Liddy he would not accept the severance, which had been guaranteed in his contract. In an email, Mr. Willumstad said it wouldn't be right for him to keep the money when so many shareholders and employees had lost money.

Last week, housing regulators said the former CEOs of Fannie Mae and Freddie Mac would not be paid millions of dollars in severance owed them under their employment contracts, although they would still be eligible for pension payments. The Treasury seized control of Fannie and Freddie earlier this month.

The compensation curbs could provoke a political dispute. Treasury Secretary Henry Paulson said Sunday he didn't want the compensation curbs added to the bailout bill, which could delay its passage. Appearing on Fox News Sunday, Mr. Paulson said there had been "excesses" of executive pay, adding, "Pay should be for performance, not for failure." But Mr. Paulson said such changes should be considered separate from, and after the bailout bill.

Shareholder activists who have long sought to curb executive pay excesses also are seizing on the financial crisis to push their agenda. "It's a huge, incomprehensible sum of money," says Richard Ferlauto, head of corporate governance and pension investment at the American Federation of State, County and Municipal Employees, one of the most vocal lobbyists for executive pay reform. "If they're asking for money, we're asking for structural reform that will prevent abuses in the future."

Mr. Ferlauto says AFSCME will push harder for legislation that will require public companies to put executive compensation packages to a shareholder vote, as well as laws that would make it easier for investors to nominate independent directors to corporate boards. The shareholder vote, also known as "say on pay," passed the House of Representatives earlier this year, but has not been considered in the Senate. Presidential candidates Barack Obama and John McCain both support the measure.

Mr. Ferlauto says the union is also lobbying for caps on "deferred compensation" -- the common practice of letting executives postpone receipt of millions of dollars in pay until after they retire, thus reducing their tax bills.
Write to Phred Dvorak at

September 21, 2008

Proposed Bailout Could Set a Record

New York Times

WASHINGTON — The Bush administration on Saturday formally proposed a vast bailout of financial institutions in the United States, requesting unfettered authority for the Treasury Department to buy up to $700 billion in distressed mortgage-related assets from the private firms.

The proposal, not quite three pages long, was stunning for its stark simplicity. It would raise the national debt ceiling to $11.3 trillion. And it would place no restrictions on the administration other than requiring semiannual reports to Congress, granting the Treasury secretary unprecedented power to buy and resell mortgage debt.

“This is a big package, because it was a big problem,” President Bush said Saturday at a White House news conference, after meeting with President Álvaro Uribe of Colombia. “I will tell our citizens and continue to remind them that the risk of doing nothing far outweighs the risk of the package, and that, over time, we’re going to get a lot of the money back.”

After a week of stomach-flipping turmoil in the financial system, and with officials still on edge about how global markets will respond, the delivery of the administration’s plan set the stage for a four-day brawl in Congress. Democratic leaders have pledged to approve a bill but say it must also include tangible help for ordinary Americans in the form of an economic stimulus package.

Staff members from Treasury and the House Financial Services and Senate banking committees immediately began meeting on Capitol Hill and were expected to work through the weekend. Congressional leaders are hoping to recess at the end of the week for the fall elections, after approving the bailout and a budget measure to keep the government running.

With Congressional Republicans warning that the bailout could be slowed by efforts to tack on additional provisions, Democratic leaders said they would insist on a requirement that the administration use its new role, as the owner of large amounts of mortgage debt, to help hundreds of thousands of troubled borrowers at risk of losing their homes to foreclosure.

“It’s clear that the administration has requested that Congress authorize, in very short order, sweeping and unprecedented powers for the Treasury secretary,” the House speaker, Nancy Pelosi of California, said in a statement. “Democrats will work with the administration to ensure that our response to events in the financial markets is swift, but we must insulate Main Street from Wall Street and keep people in their homes.”

Ms. Pelosi said Democrats would also insist on “enacting an economic recovery package that creates jobs and returns growth to our economy.”

Even as talks got under way, there were signs of how very much in flux the plan remained. The administration suggested that it might adjust its proposal, initially restricted to purchasing assets from financial institutions based in the United States, to enable foreign firms with United States affiliates to make use of it as well.

The ambitious effort to transfer the bad debts of Wall Street, at least temporarily, into the obligations of American taxpayers was first put forward by the administration late last week after a series of bold interventions on behalf of ailing private firms seemed unlikely to prevent a crash of world financial markets.

A $700 billion expenditure on distressed mortgage-related assets would roughly be what the country has spent so far in direct costs on the Iraq war and more than the Pentagon’s total yearly budget appropriation. Divided across the population, it would amount to more than $2,000 for every man, woman and child in the United States.

Whatever is spent will add to a budget deficit already projected at more than $500 billion next year. And it comes on top of the $85 billion government rescue of the insurance giant American International Group and a plan to spend up to $200 billion to shore up the mortgage finance giants Fannie Mae and Freddie Mac.

At his news conference, Mr. Bush also sought to portray the plan as helping every American. “The government,” he said, “needed to send a clear signal that we understood the instability could ripple throughout and affect the working people and the average family, and we weren’t going to let that happen.”

A program to help troubled borrowers refinance mortgages — along with an $800 billion increase in the national debt limit — was approved in July. But financing for it depended largely on fees paid by Fannie Mae and Freddie Mac, which have been placed into a government conservatorship.

Representative Barney Frank, Democrat of Massachusetts and chairman of the House Financial Services Committee, said in an interview that his staff had already begun working with the Senate banking committee to draft additions to the administration’s proposal.

Mr. Frank said Democrats were particularly intent on limiting the huge pay packages for corporate executives whose firms seek aid under the new plan, raising the prospect of a contentious battle with the White House.

“There are going to be federal tax dollars buying up some of the bad paper,” Mr. Frank said. “They should accept some compensation guidelines, particularly to get rid of the perverse incentives where it’s ‘heads I win, tails I break even.’ ”

Mr. Frank said Democrats were also thinking about tightening the language on the debt limit to make clear that the additional borrowing authority could be used only for the bailout plan. And he said they might seek to revive a proposal that would give bankruptcy judges the authority to modify the terms of primary mortgages, a proposal strongly opposed by the financial industry.

Senator Charles E. Schumer, Democrat of New York, who attended emergency meetings with the Treasury secretary, Henry M. Paulson Jr., and the Federal Reserve chairman, Ben S. Bernanke, on Capitol Hill last week, described the proposal as a good start but said it did little for regular Americans.

“This is a good foundation of a plan that can stabilize markets quickly,” Mr. Schumer said in a statement. “But it includes no visible protection for taxpayers or homeowners. We look forward to talking to Treasury to see what, if anything, they have in mind in these two areas.”

Ms. Pelosi’s statement made clear that she would push for an economic stimulus initiative either as part of the bailout legislation or, more likely, as part of the budget resolution Congress must adopt before adjourning for the fall elections. Such a plan could include an increase in unemployment benefits and spending on infrastructure projects to help create jobs.

Some Congressional Republicans warned Democrats not to overreach.

“The administration has put forward a plan to help the American people, and it is now incumbent on Congress to work together to solve this crisis,” said Representative John A. Boehner of Ohio, the Republican leader.

Mr. Boehner added, “Efforts to exploit this crisis for political leverage or partisan quid pro quo will only delay the economic stability that families, seniors and small businesses deserve.”

Aides to Senator Barack Obama of Illinois, the Democratic presidential nominee, said he was reviewing the proposal. In Florida, Mr. Obama told voters he would press for a broader economic stimulus.

“We have to make sure that whatever plan our government comes up with works not just for Wall Street, but for Main Street,” Mr. Obama said. “We have to make sure it helps folks cope with rising prices, and sparks job creation, and helps homeowners stay in their homes.”

Senator John McCain of Arizona, the Republican nominee, issued a statement saying he, too, was reviewing the plan.

“This financial crisis,” Mr. McCain said, “requires leadership and action in order to restore a sound foundation to financial markets, get our economy on its feet, and eliminate this burden on hardworking middle-class Americans.”

If adopted, the bailout plan would sharply raise the stakes for the new administration on the appointment of a new Treasury secretary.

The administration’s plan would allow the Treasury to hire staff members and engage outside firms to help manage its purchases. And officials said that the administration envisioned enlisting several outside firms to help run the effort to buy up mortgage-related assets.

Officials said that details were still being worked out but that one idea was for the Treasury to hold reverse auctions, in which the government would offer to buy certain classes of distressed assets at a particular price and firms would then decide if they were willing to sell at that price, or could bid the price lower.

Mindful of a potential political fight, Mr. Paulson and Mr. Bernanke held a series of conference calls with members of Congress on Friday to begin convincing them that action was needed not just to help Wall Street but everyday Americans as well.

Republicans typically supportive of the administration said they were in favor of approving the plan as swiftly as possible.

Senator Mitch McConnell of Kentucky, the Republican leader, said in a statement, “This proposal is, and should be kept, simple and clear.” The majority leader, Senator Harry Reid, Democrat of Nevada, said that the bailout was needed but that Mr. Bush owed the public a fuller explanation.

Some lawmakers were more critical or even adamantly opposed to the plan. “The free market for all intents and purposes is dead in America,” Senator Jim Bunning, Republican of Kentucky, declared on Friday.

It is far from clear how much distressed debt the government will end up purchasing, though it seemed likely that the $700 billion figure was large enough to send a reassuring message to the jittery markets. There are estimates that firms are carrying $1 trillion or more in bad mortgage-related assets.

The ultimate price tag of the bailout is virtually impossible to know, in part because of the possibility that taxpayers could profit from the effort, especially if the market stabilizes and real estate prices rise.

Lehman Can Sell to Barclays

A federal bankruptcy judge decided early Saturday that Lehman Brothers could sell its investment banking and trading businesses to Barclays, the big British bank, the first major step to wind down the nation’s fourth-largest investment bank.

The judge, James Peck, gave his decision at the end of an eight-hour hearing, which capped a week of financial turmoil.

The deal was said to be worth $1.75 billion earlier in the week but the value was in flux after lawyers announced changes to the terms on Friday. It may now be worth closer to $1.35 billion, which includes the $960 million price tag on Lehman’s office tower in Midtown Manhattan.

Lehman Brothers Holdings Inc. on Monday filed the biggest bankruptcy in United States history, after Barclays PLC declined to buy the investment bank in its entirety.

Reporting was contributed by Jeff Zeleny from Daytona Beach, Fla., and Michael Cooper, Carl Hulse, Stephen Labaton and David Stout from Washington.

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