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Week of 2.27.09

Book Excerpt: "Dumb Money"

From "Dumb Money" by Daniel Gross. Copyright 2009 by Daniel Gross. Reprinted by permission of Free Press, a Division of Simon & Schuster, Inc, NY.

Chapter 1: WTF?

Last November, high-rolling developer Donald Trump's company was scheduled to pay the $334 million balance on a $640 million loan from a group of lenders led by Deutsche Bank, which had been extended to build a glitzy 92-story condominium tower in Chicago, named (what else?) Trump Tower. But sales had been slow because the city's high-end condo market was suffering from the economic downturn. Seeking an extension of the loan, Trump sued the lenders, invoking force majeure, a standard clause in loan documents that permits developers to put off completing projects if an unexpected cataclysm takes place-a flood, a strike, a riot, a mammoth sinkhole, a meteor, or "any other event or circumstance not within the reasonable control of the borrower." In Trump's view, the economy had suffered just such an event. "A depression is not within the control of the borrower," as the author of Think Big and Kick Ass in Business and Life put it.

Later the same month, former secretary of the Treasury Robert Rubin, the yin to Trump's yang-understated, publicity-ducking, with a hair shade in the normal color spectrum-was trying to salvage his declining reputation. In the 1990s, as a member of what became known as the Committee to Save the World, Rubin had helped avert a series of financial crises. The former Goldman Sachs arbitrager had spent most of this decade as a highly paid vice chairman and key adviser at Citigroup, the giant bank that has become a charter member of the Committee to Bankrupt the World. Citigroup had racked up tens of billions of dollars in losses on subprime bonds, mortgages, new instruments called collateralized debt obligations, leveraged loans, credit card loans-oh, to hell with it, pretty much every kind of debt. "In hindsight, there are a lot of things we'd do differently," Rubin said as part of a press offensive. "But in the context of the facts as I knew them and my role, I'm inclined to think probably not." After all, he told Newsweek, Citi and the financial system had suffered "the perfect storm." Rubin left Citigroup in January.

More than anybody, Alan Greenspan was the intellectual architect of this decade's economy. A good-luck mascot of two bull markets, the longtime Federal Reserve chairman had spent his career evangelizing for the Holy Trinity: low interest rates, deregulated markets, and the ability of financial innovation to insulate markets and the millions of people who depended on them from calamities. However, when he appeared before Congress in October, Greenspan expressed doubts about his theories on the magic of markets. "I found a flaw," he said. "I was shocked because I had been going for forty years or more with very considerable evidence that it was working exceptionally well." A flaw? The persistence of low interest rates-that, Greenspan assured us, made all the sense in the world-sparked a speculative orgy in securities and derivatives. These instruments, he had assured us, would help people manage risk; instead, they created systemic risk. Deregulated, free, and open markets had gone so haywire that they required massive government intervention. Pretty much everything Greenspan said about how this system was supposed to work was wrong! In fact, it is now clear that because of the way the system was designed, losses and failures could only create massive, widely distributed losses. The disaster was not a bug, but an inevitable feature of the financial operating code Greenspan had helped write.

Within a few months in the summer and fall of 2008, financial players large and small, rogues and respected elders, blue collar and white shoe, suffered a host of stunning, appalling, nauseating forces majeures, a deluge of Category 5 perfect storms. When the subprime lending industry began to go tapioca in early 2007, the authorities assured us that the financial problems were confined to the unsavory business of making high-interest loans to marginal individual borrowers. But a year later, as the presidential election careened toward its frenzied finish, the lethal virus had infected the nation's entire financial system. The government nationalized the two largest lending institutions, Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation), and effectively took control of the nation's largest insurance company, AIG (American International Group), by extending more than $100 billion in loans to the stricken company. The nation's fourth-largest investment bank, Lehman Brothers, filed for Chapter 11, triggering a gut-wrenching chain of events that forced the federal government to step in and guarantee money-market mutual funds, heretofore the safest place to stow cash this side of a mattress. Giant commercial banks, including Washington Mutual and Wachovia, effectively failed, with the Federal Deposit Insurance Corporation (FDIC) brokering their sales, at nominal prices, to larger banks. A couple dozen smaller banks simply were eaten by the FDIC, whose primary role is to insure deposits in banks and thrift institutions. In September, after a few tense weeks of negotiations and grinding market volatility, Congress approved a $700 billion bailout of the nation's financial system. But Treasury Secretary Henry M. Paulson's plan to deploy that cash to buy toxic mortgages was quickly abandoned in favor of injecting funds directly into large banks. Not to be outdone, the Federal Reserve committed $500 billion to buy mortgage-backed securities issued by Fannie Mae and Freddie Mac, and also offered to backstop commercial paper and other debt issuance by private companies.

Because foreign investors traded heavily in mortgage-backed securities, the financial agony went global. In the last quarter of 2008, staid British banks, grasping Russian oligarchs, German corporate monarchs, French finance companies, and Spanish home lenders began to falter from the most deadly infection to hit the Continent since the bubonic plague of 1348. Iceland's banking system, which had amassed foreign currency debt equal to eight times its gross domestic product, keeled over, plunging the entire island nation into bankruptcy. The potential cost (so far) to America's taxpayers? Up to $8 trillion and counting.

Meanwhile, back in the real world-the shrinking portion of the economy not controlled by the government-large companies like Linens'n Things and the Tribune Company, staggering under debt loads piled onto them by private equity buyers, went bankrupt. Hedge funds, the exclusive investment vehicles for the ultrarich that had come to dominate the money culture, began to block investors from withdrawing cash, lest the funds be forced into liquidation. A decade of rising inequality is being capped off by an oddly egalitarian moment wherein the private equity firm that owns Chrysler and the automaker's workers are suffering proportional losses. The cherry on top of this miserable sundae: in December, former NASDAQ chairman Bernard Madoff, whose investment firm had quietly racked up steady (too steady, it turns out) returns for well-heeled clients for decades, revealed that his $15 billion empire was nothing more than a Ponzi scheme. From Trump on down, it seems, everybody who thought big this century has gotten his ass kicked.

Humble observers cannot indulge in too much Trumpenfreude (joy at Donald Trump's suffering) because the damage has spread to the real economy. The financial system's failures have frozen credit, leading to plunging auto and retail sales, rising corporate bankruptcies, an upsurge in unemployment, massive deficits, and a level of unfocused economic dread not seen since the 1930s. All of which left a big stinking mess for the incoming president. "Black Man Given Nation's Worst Job," The Onion blared on November 5, 2008.

WTF? How did the Ownership Society devolve so quickly into Bailout Nation? What turned the Bush Boom-a period of low interest rates, rising asset prices, and economic growth-into Hoover 2.0? How did the crown jewel of American capitalism-our financial services industry-transform into cubic zirconium? What happened?

This brief book-a long essay that is more a chronicle of this decade's money culture than an investigation into the fetid nooks and crannies of the financial system-attempts to answer these questions. The answer is at once relatively simple and somewhat complicated.

 
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