Capitalism for the C_Os, Socialism for the Rest of Us

*This article lost some formatting when I pasted it into this blog. Read the original version here*

In 2004 I had written some articles on financial engineering 101, accounting and accountability, official fudging of data, and why management needs to treat financial statements with respect, which were published on PrudentBear.com. I later followed up this theme with an article in July 2005 titled “Assessing the Demand for Residential Real Estate” that, in hindsight, was prescient. The present article reflects on the actions taken by public and private sector leaders to navigate the current financial maelstrom, and revisits the thesis put forth in the earlier articles that integrity is being tested - that of buyers, lenders, builders, investors, public officials, and the public at large.

Back in 2005 the CEOs of some residential construction companies were on television’s “financial news” programs taking about their companies and emphasizing the following two points.

1. This time, the housing market is not as sensitive to increases in interest rates as in the past, especially since the rates are at historically low levels. The point being emphasized is that the rates can go higher (another 200 basis points?) before having a significant impact on home sales.
2. The housing market is all about SUPPLY and DEMAND.

The fall-out in the financial sector and in the broader economy from the financial innovations of the past five years, especially in housing and associated financial industries is apparently far from over. I had written in 2005 that “…the magnitude of the unfulfilled demand for housing combined with financial new product development can keep the current housing boom going for a few more years. However these new financial products have yet to stand the test of the vagaries of the environment- an economic downturn or an interest rate spike or other events that may cause lenders to pull in the reins. To understand the magnitude of the impact of a constrained lending environment it is useful to look at the sharp decline in prices of telecommunications stocks in 2001-2002 as investors became more risk-averse. Some companies went bankrupt and those left holding the bag (like the author) did not receive any bailout from the government…..Part of the bet is that with the scale of liabilities of the mortgage industry, especially the GSEs, the Fed and the government will bail out the financial sector from any disasters, shifting the burden to the public. As alluded to by others, ‘character’ is being tested - that of buyers, lenders, builders, investors, and the public at large.”

Now, let us examine the actions by the Federal Reserve Bank (the Fed) to “grease” the liquidity wheel over the past year. Some of the steps taken by the Fed are listed blow.
1. It has lowered the Fed Funds Rate from 5.25% in Aug 2007 to 2% by the end of April 2008, the fastest ramp down in rates since 1990.
2. It has provided numerous offerings of $75 billion, $50 billion and $30 billion in 28-day credit through the Term Auction Facility, or TAF. According to the Fed, TAF auctions are very similar to open market operations, but conducted with depository institutions rather than primary dealers and against a much broader range of collateral than is accepted in standard open market operations (Italics are by the writer). With a wink and a nod, this shifts the risk to the public.
3. It has lowered the rate on discount-window loans to banks.
4. In March, it started a series of repurchase transactions with terms of roughly 28 days and cumulating to up to $100 billion. Primary dealers could deliver as collateral any securities eligible in conventional open market operations. Additionally, the Federal Reserve introduced the Term Securities Lending Facility (TSLF), which allows primary dealers to exchange less-liquid securities for Treasury securities for terms of 28 days at an auction-determined fee. Recently, the Federal Reserve expanded the list of securities eligible for such transactions to include all AAA/Aaa-rated asset-backed securities. Given the cloud hanging over the ratings agencies, this is again a blatant shift of the risk and the burden to the public.
5. It bailed out Bear Stearns by lending $29 Billion to JPMorgan Chase and taking on Bear Stearns assets. This was done, in the words of Chairman Ben Bernanke, “to prevent a disorderly failure of Bear Stearns and the unpredictable but likely severe consequences for market functioning and the broader economy.” The Fed can normally only lend through its discount window to banks. Under Section 13-3 of the Federal Reserve Act, added in 1932, it can lend to “individuals, partnerships, or corporations” with the approval of not less than five governors, provided “such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions.” Now investment banks can relax with the knowledge that the fed can bail them out anytime, anyplace.
6. It used its emergency power to create the Primary Dealer Credit Facility (PDCF) which allows primary dealers to borrow at the same rate at which depository institutions can access the discount window, with the borrowings able to be secured by a broad range of investment-grade securities.

As Dwight Cass and Jeffrey Goldfarb note in an article titled “Why is the ‘Discount’ Free?” in the Wall Street Journal (June 12, 2008), the option given by the Fed to the banks, investment banks and the brokers to access the discount window at the lowered rate has value. But the Fed is giving this option (or insurance) for free. Any ordinary person will not get any insurance without a premium. Some criticism has been leveled against the Fed for encouraging ‘moral hazard’ with these steps, implying that it will embolden banks and dealers to take greater risks with the assurance of a Fed bail-out. However it is instructive to look at how these companies were led to the current state by their allegedly hardworking officers, the C_Os, particularly the CEOs.

Five Year Cumulative Compensation for the CEOs of a sample of Financial Institutions
2003 to 2007

Company	CEO(s)	Salary+Bonus 2003-2007	Total Compensation 2003-2007	Average per year 2003-2007
Merrill Lynch	Mr. O'Neal and Mr. Thain	$ 64,341,923	$ 226,474,013	$45,294,803
Countrywide Financial	Mr. Mozilo	$ 68,907,774	$ 137,505,901	$27,501,180
Bear Stearns	Mr. Cayne	$ 51,932,623	$ 128,056,532	$25,611,306
Citigroup	Mr. Prince and Mr. Pandit	$ 33,427,344	$ 113,758,846	$22,751,769
Fannie Mae	Mr. Raines and Mr. Mudd	$ 14,347,931	$ 63,357,081	$12,671,416
Freddie Mac	Mr. Syron	$ 15,054,231	$ 59,565,891	$11,913,178

Data from SEC filings and company reports
Notes:
• The salary plus bonus is the “direct cash” part of the compensation received by the CEOs.
• Upon his departure from Citigroup in November, Mr. Prince left with approximately $68 million, while Mr. O'Neal collected about $161 million after he stepped down in October at Merrill Lynch.
• Countrywide's Mozilo was to collect a windfall of $115 million dollars after his firm agreed in January to a sale to Bank of America. After facing criticism he generously offered to forfeit $37.5 million in payments tied to the deal.
• John Thain, who became the CEO of Merrill Lynch on Dec. 1, 2007, got a package of $83 million.
• Morgan Stanley CEO John Mack received a total of $41.7 million for 2007.
• Mr. Pandit, appointed as CEO of Citigroup in December 2007, received about $165.2 million in connection with the sale of Old Lane Partners to Citigroup. He received an additional $2.7 million in the roughly six months he served as head of Citigroup's investment bank and alternative investments group. In January, he was given a sign-on grant of stock and performance-based options worth over $48 million.

Each one of the above institutions has taken write-downs of billions of dollars and shrunk its balance sheet. According to Reuters, banks and other financial institutions globally have written down more than $400 billion of assets during this financial crisis. Recently, Lehman wrote off $3.7 billion in assets in its second quarter. Merrill Lynch has written off more than $30 billion in assets over the past year. Citigroup took $14 billion in write-downs in the first quarter of 2008, on top of $18.1 billion in the previous quarter. Despite these write-downs it is difficult to gauge the true extent of damage and the fair value of remaining assets. Some, if not all, of these institutions still have off-balance sheet investments and associated liabilities. It is also not clear if these institutions have determined the fair market value of the items remaining on the asset side, as the investment vehicles have become quite complex and difficult to assess, or are simply not marketable under current conditions. As an example, there is a difference of $1.1 billion between the value Lehman Brothers Holdings assigned to some assets in its first quarter conference call and what it reported in its subsequent quarterly SEC filings (Wall Street Journal, June 12, 2008). Additionally, the financial crisis wrought by these institutions has created major shocks throughout the economy and wreaked havoc on many people’s lives.

How did the ‘system’ reward this rather ‘capital’ performance? The CEOs cleaned up handsomely for driving and encouraging financial innovation, for deceptive and often fraudulent business practices, for exploitation of the ‘buyer beware’ maxim, and for other unsavory and unethical practices. In their world of capitalism, there is no ‘downside risk’ other than forfeiting some future potential earnings at that particular institution. Even the Government Sponsored Entities (GSEs) have become rotten to the core like their non-GSE peers. None of these leaders have paid back, or have been asked to pay back, their winnings from this rigged ‘heads I win tails I win some more’ coin tosses. The public is forced to bail out the institutions - socialism is thrust upon it.

Of course, the buck does not stop with the CEOs but goes right into the palms and pockets of the elected ‘lead’ers. Lawmakers up on Capitol Hill are finalizing the so-called 'Credit Suisse Plan' plan to bail out the banks and the borrowers, not with the politicians’ or the bankers’ money but with the hard-earned money of the taxpayers. The New York Times describes the bill and the Washington Post explains how this bill came about. Key aspects of the plan are listed below.
• It allows qualified mortgage holders to refinance into more affordable, 30-year fixed-rate loans with a federal guarantee.
• First-time buyers receive a refundable tax credit of up to $8,000, or 10 percent of the value of a home, on purchases of unoccupied housing.
• Fannie Mae and Freddie Mac, the government-sponsored mortgage finance giants, can purchase loans up to $625,000 from lenders. The previous limit was $417,000. This will allow lenders to make more reckless mortgages.
• The bill allocates $150 million towards counseling for borrowers to prevent foreclosure.
• In a foreclosure, lenders lose 40 to 60 percent of the loan. Under this bill the tax payers picks up the tab as long as the lenders agree to reduce the principal balance of loans to roughly 85 percent of each property’s current value.
• Nearly $4 billion in grants to communities with high foreclosure rates to buy and rehabilitate vacant properties.
The public should hold President Bush and his administration accountable for reckless encouragement of an “ownership society.” He stated in 2003 that "This Administration will constantly strive to promote an ownership society in America. We want more people owning their own home. It is in our national interest that more people own their own home. After all, if you own your own home, you have a vital stake in the future of our country." The White House website brags about home ownership in President Bush’s Record of Accomplishments. The very first highlight is that “The US homeownership rate reached a record 69.2 percent in the second quarter of 2004. The number of homeowners in the United States reached 73.4 million, the most ever.” It should be updated to reveal that in the first quarter of 2008, the homeownership rate was 67.8% and declining. In the fourth quarter of 2000, homeownership was 67.5%. By the time President Bush leaves office, the rate could well be below what he inherited. In the meantime he accomplished the wonderful feat of creating an ownership society – transferring wealth to the wealthy.

When leaders including C_Os and elected leaders combine this gross exhibition of looting with lavish posthumous paydays (see the Wall Street Journal article titled ‘Companies Promise CEOs Lavish Posthumous Paydays’) they define modern capitalism. The question is how long will the public continue to practice the socialism that supports this generosity towards the capitalists? As an educator, it is becoming almost impossible to impart ethical behavior to students in light of this behavior. However, even under these dark ominous clouds it is fascinating to listen to Muhammad Yunus, the Nobel Peace Prize winner and founder of Grameen Bank discuss micro-finance during his interview with Paul Solman (Online Newshour, PBS).

Paul Solman: “And so there will be enough investors in the world to invest in these funds to make them continue to operate, even though they're not as profitable as they could be?”

Muhammad Yunus: “It was not profitable at all, non-loss, non-dividend companies. That's what the social business is all about. So you came here to do good. It's a clean idea.”