Bear Stearns Hedge Funds Collapse and Goldman Reaches the Top

The following is an excellent excerpt from the book “ALL THE PRESIDENTS’ BANKERS: The Hidden Alliances That Drive American Power” by Nomi Prins from Chapter 19 titled “The 2000s: Multiple Crises, the New Big Six, and Global Catastrophe” from page 405 and I quote: “Bear Stearns Hedge Funds Collapse and Goldman Reaches the Top – The problem with rating as triple-A trillions of dollars of flimsy assets was that when some faltered, others followed. The whole industry was concocting and leveraging securities, passing them around like hot potatoes. It was only a matter of time before some insider got scalded. The first major burn was at Bear Stearns.
Two Bear Stearns funds had been created in 2003 and 2006 to buy and leverage triple-A and double-A assets, mostly CDO securities ranked as high credit quality by the rating agencies (to which banks paid fees for such evaluations). To raise money to buy these securities, they, like many other such funds, borrowed from eager big-bank suppliers. Thus, banks created junk and subsequently lent money to purchase it, creating a modern version of the Ponzi scheme.
By early 2007, the Bear funds were imploding, their demise hastened by participants extracting money as quickly as they could and by banks pressing them with margin calls—requiring more cash as collateral for loans they had originally provided to buy the securities in the funds. By the time the funds collapsed in June 2007, investors had lost around $1.8 billion.
The chain reaction unleashed by the collapse of Bear’s funds echoed that of the interconnected trust collapses in the late 1920s and during the Panic of 1907. But it was worse on two accounts: first, the advent of derivatives added layers of darkness; and second, Bear had bought components of the same deals that other investors bought, so when it had to sell them to raise money for the margin calls, it forced the price of related securities downward. Many of these were already being downgraded or defaulting, but Bear’s move caused their values to plummet even faster. All the bank players got hit, some worse than others.
As a result of Citigroup’s hemorrhaging positions, on November 4, 2007, at an emergency board meeting, Prince wasn’t dancing—he was resigning. He said, “Given the size and the nature of the recent losses in our mortgage-backed securities business, the only honorable course for me to take as chief executive officer is to step down.” He had bagged “$53.1 million in salary and bonuses in the previous four years, and left with a $99 million golden parachute.
Robert Rubin was named acting chairman. Earlier that week, Merrill Lynch CEO Stan O’Neal had also been booted out for similar reasons. He was replaced by former Goldman Sachs copresident John Thain. Thus, former Goldman leaders briefly sat atop three of the largest US financial firms as well as the Treasury Department, the National Economic Council, and the Office of Management and Budget.
As the crisis was building, Geithner continued to cultivate relationships with key bankers. From mid-2007 through late 2008, he attended multiple lunches and meetings with senior execs from Goldman Sachs and Morgan Stanley at swanky Manhattan locales and private corporate dining rooms. He even dined at the home of Jamie Dimon.
Geithner’s relationships with Citigroup’s elite were particularly tight and long-standing. Aside from having worked in the Treasury Department for Rubin, he was also close to former chairman Sandy Weill and had even joined the board of one of Weill’s nonprofit organizations in January 2007. At one point, Weill had approached Geithner about taking over Prince’s CEO spot. But at the New York Fed, Geithner had the capacity to do far more good for Citigroup. Citigroup would need him by late 2008.
Dimon Conquers the Bear – The markets and much of the media remained oblivious to the chaos churning within the banks. On October 9, 2007, the Dow closed at 14,164, an all-time high. All the signs the bankers worried about—rising defaults, the combustion of Bear Stearns hedge funds, the insane levels of leverage within an around securities, the “shitty” deals, and the “game of thrones” among bank CEOs—hadn’t broken the broader population’s concept of economic security. Yet.
Then, on December 21, 2007, Bear Stearns posted a loss of $1.9 billion, its first quarterly loss in its eighty-four-year history. The breaking point had arrived.
As the inevitable storm approached, Dimon—as many bankers before him did when they sensed domestic conditions in jeopardy—shifted to the international arena to beef up alliances. In January 2008, he hired former British prime minister Tony Blair as a senior analyst. Blair declared JPMorgan Chase “at a cutting edge of the global economy.” This was shortly after Northern Rock, a British bank, collapsed, causing scores of depositors to circle the bank waiting to extract their money, in shades of past panics.
Three months later, Bear Stearns was facing its demise. Dimon sensed a lucrative domestic opportunity and decided that JPMorgan Chase would buy it, but only it didn’t have to take on the risk of Bear’s toxic asset portfolio. Paulson and Geithner fashioned a solution. The Fed would lend about $29 billion against Bear’s crippled mortgage holdings, effectively shielding JPMorgan Chase from the related risk.
Thus on April 3, 2008, with the Fed now acting in an investment banking capacity as both a financing agent and facilitator of a private bank merger, Dimon acquired Bear Stearns, with its $360 billion in assets, under a quasi-government guarantee. He later told a congressional committee, “We viewed that as an obligation of JPMorgan as a responsible corporate citizen.” An obligation, to be sure, that the government backed and that enabled Dimon to extend his bank’s prime brokerage business, catapulting JPMorgan Chase to third place, behind competitors Goldman Sachs and Morgan Stanley, in the lucrative business of servicing hedge funds.
While Dimon’s “benevolence” did nothing to contain the bloodletting, Paulson attempted to reassure the public: “It’s a safe banking system, a sound banking system.” He said, “Our regulators are on top of it.”
Lehman Brothers Goes Bankrupt – By the summer of 2008, 158-year-old Lehman Brothers was staggering. Though many Wall Street firms were highly leveraged and exposed to junky subprime assets, Lehman was another extreme case. On September 10, it announced a $3.9 billion loss for the third quarter, the worst result in its history. The end was near.
As Bush later wrote, “There was no way the firm could survive the week-end. The question was what role, if any, the government would play in keeping Lehman afloat. The best possible solution was to find a buyer for Lehman, as we had for Bear Stearns. We had two days.”
Bush got most of his information about the unfolding crisis from Paulson, who informed him of two possible buyers: Bank of America and the British bank Barclays. London regulators rejected the idea of a Barclays purchase of the whole firm, through Barclays did buy one of Lehman’s units, its New York headquarters, and two data centers for $1.75 billion. Bank of America bought Merrill Lynch instead. Lehman was out of options.
Richard Fuld Jr., Lehman’s CEO, begged regulators to convert his investment bank into a bank holding company in order to provide access to federal funding. But as the New York Times reported, “Geithner told him no.” Fuld’s alliances weren’t as tight as those of his surviving compatriots. He filed for bankruptcy on September 15, 2008.
Nearly a week later, the Fed granted Goldman and Morgan Stanley approval to be designated bank holding companies. It didn’t hurt that Blankfein had been a member of the New York Fed’s advisory panel since 2004. Or that he had worked for Paulson.
“We believe that Goldman Sachs, under Federal Reserve supervision, will be regarded as an even more secure institution,” Blankfein stated. But in reality, this was a highly self-serving way to retain power, with Fed and government backing.
Ken Lewis’s Big Mistake – Ken Lewis rose through the ranks of Bank of America after joining North Carolina National Bank—the predecessor to NationsBank and Bank of America—in 1969. By April 2001, he was chairman, CEO, and president of Bank of America. Lewis acquired Fleet Boston in April 2004, MBNA in January 2006, and ABN Amro North America in October 2007. He had accumulated $110 million in compensation.
That wasn’t enough, though, so he decided to buy Countrywide Financial, a comparatively small acquisition announced at $4 billion in January 2008. This was a huge mistake, as Countrywide CEO Angelo Mozilo left Bank of America with a fraud- and lawsuit-infested cesspool of a firm. Even the Fed questioned its massive thousand-basis-point credit spreads at the time, which followed an 85 percent drop in Countrywide’s value over the preceding year. But that didn’t stop the Fed from approving the merger on June 5, 2008. The “go big or go home” mentality prevailed at the chief regulator.
Three months later, on September 15, 2008, the day Lehman went bust, Lewis made an even bigger mistake—buying Merrill Lynch in a $50 billion all-stock deal. Bank of America stock was trading at $33.74; three months later, when the deal closed, it has fallen to $5.10.
Paulson later admitted to pressuring Lewis to acquire Merrill, at one point threatening that if he backed out, it could result in “government-imposed changes” in the bank’s management—in effect, Lewis’s removal. He used the power of his public office to press a private company into a deal that would bring years of chaos. The move represented a new kind of alliance between Washington and Wall Street, a full-fledged investment banking advisory role from the Treasury that was more about financial than political expedience, more about saving certain banks than stabilizing the country.
The merger proved fortuitous for Paulson’s old number-two, Merrill Lynch head John Thain, who was spared the bankruptcy proceedings that befell Lehman. From September through December 2008, many conversations took place among the interested parties. Thain and Paulson spoke twenty-one times. Lewis got through thirty-five times. But Lewis couldn’t stop the merger.
After the merger, Bank of America received $230 billion in bailout subsidies—and $150 million in SEC fines. It would also fork out a record $42 billion in various legal settlements for the pain it caused people over the next five years, with more pending.
Lewis’s decision to pay bonuses to Merrill execs, including Thain’s former Goldman Sachs recruits and others, while Bank of America was getting government bailouts fell under intense scrutiny. The matter festered for two years. A March 17, 2009, House Committee even requested Merrill Lynch’s records regarding the $3.62 billion in bonuses agreed to before the merger.
The incident lingered, and on December 31, 2009, Lewis announced his resignation. Brian Thomas Moynihan took his place. Moynihan proved adept at political alliances and had visited the White House thirteen times by February 2012.
Goldman Trumps AIG – Insurance goliath AIG stood at the epicenter of an increasingly interconnected financial world deluged with junky subprime assets wrapped up with derivatives. Its financial products department had insured nearly half a trillion dollars of them for the big banks. When Fitch, S&P, and Moody’s downgraded AIG’s rating on September 15, 2008, it catalyzed $85 billion worth of margin calls.
The firm would not only fail, Paulson warned Bush, but it would bring down major financial institutions and international investors with it.” Paulson’s fearmongering convinced President Bush: “There was only one way to keep the firm alive: the federal government would have to step in.”
Blankfein and Dimon were the only CEOs Geithner called to discuss AIG’s condition on the morning of September 15. Paulson also appeared to have had Blankfein on speed-dial. Between March 2008 and January 2009, the men spoke thirty-four times, mostly during the AIG incident.
The next day, the New York Fed authorized a loan of up to $85 billion to AIG (the size of its margin calls by the big banks) in return for a 79.9 percent equity interest. On October 8, it provided an additional $37.8 billion in liquidity against securities. Total AIG’s subsidies reached $182 billion.
The main US recipients of AIG’s bailout were strongly allied firms: Goldman Sachs with $12.9 billion, Merrill Lynch with $6.8 billion, Bank of America with $5.2 billion, and Citigroup with $2.3 billion. Some foreign banks that has trading relationships with them, including Societe Generale and Deutsche Bank, got about $12 billion each. Barclays got $8.5 billion, and UBS got $5 billion.
Lehman crashed. Merrill and AIG were saved in two different ways. The selective bailout behavior echoed that of the Panic of 1907, when the big New York bankers let the Knickerbocker Trust Company—with which they had fewer personal and financial ties—tank but got the government involved to help save the American Trust Company. The bankers with the strongest political alliances needed AIG to survive. And it did.
Bankers’ Bailouts and Citizen’s Pain – On September 18, 2008, Bush told Paulson, “Let’s figure out the right thing to do and do it.” He later wrote, “I had made up my mind: the US government was going all in.”
The Big Six firms (and marginally other institutions) were subsidized by a program designed by Bernanke, Paulson, and Geithner. The trio deemed the bailout and bank subsidization as a matter of public interest, essential steps to divert a Great Depression. But the main recipients were the big bankers, not everyday Americans, who were unable to renegotiate their mortgage loans as easily as the bankers received backing.
An initial rejection of the bailout package provoked a 778-point drop in the Dow on September 29, 2008. Paulson had dramatically gotten down on one knee three days earlier to beg Democratic house speaker Nancy Pelosi to get her party to pass the bailout. Congress bowed to this chief banker on behalf of all his former colleagues and compatriots, an approved a $700 billion congressional bank bailout package. The Troubled Asset Relief Program, also known as TARP, was part of the emergency Economic Stability Act of 2008, signed by Bush on October 3. considered by much of the media and congress as the total bailout, it comprised just 3 percent of the full bank bailout and subsidization program. According to Bush, “TARP sent an unmistakable signal that we would not let the American financial system fail.”
The market rose after the intervention was announced, as it had temporarily done in October 1929. But his time, intervention came from the government—not from the bankers. The Dow shot up 936 points, the largest one-day rise in stock market history. The euphoria would be equally illusory and temporary.
As it had during the days of the original Big Six, the bankers’ unruliness had crippled the real economy. By October 30, 2008, US real GDP fell at a 0.3 percent annual rate, the second negative quarter in a row. Housing prices plummeted. Foreclosures and unemployment escalated.
Over the next few months, Bank of America, Citigroup, and AIG needed more assistance. And over the year, the Dow lost nearly half of its value. At the height of the bailout period, $19.3 trillion of subsidies were made available to keep (mostly) US bankers going, as well as government-sponsored enterprises like Fannie Mae and Freddie Mac. The Big Six received a combined $870 billion in bailouts, not including multitrillion-dollar subsidies from various Federal Reserve lending facilities and other guarantees.
But first, an election loomed.
Obama: The Preferred Choice of Bankers – Bankers believed Democratic Barack Obama would help them more than his opponent, John McCain—particularly at Goldman Sachs, Obama’s largest corporate contributor for the 2008 election. Contributors Goldman Sachs and JPMorgan Chase ranked sixth and seventh, respectively, throughout Obama’s political career. Plus, Obama had Robert Rubin in his corner. According to investigative journalist Greg Palast, billionaire Penny Pritzker had introduced then Senator Obama to Rubin at a Chicago “ladies who lunch” event. Later, Rubin opened the “doors to finance industry vaults’ for Obama. Obama raised more than three times as much from the banking and finance industries during the 2008 campaign as McCain.
In classic Democratic Party fashion, Obama promised to rein in Wall Street forces and their risky practices” while taking their contribution money. (Republicans tend to take the money without such promises.) Obama won in a decisive victory. Bankers would visit the White House more frequently than they did when his predecessor was in office, and his administration, in partnership with the Federal Reserve, would continue subsidizing bankers while talking up the importance of jobs creation.
At the end of 2008, liquidity remained tight and bankers still couldn’t move their worst assets. So on December 16, 2008, the Federal Reserve cut rates to an all-time low of 0 percent, down from 1 percent and 0.25 percent earlier in the year, thereby initiating Bernanke’s zero-interest rate policy. No American catastrophe since the Fed was created had evoked such a policy. Even during World War II, rates didn’t remain as low for as long; his was a true reaction and capitulation to financial warfare.
On January 9, 2009, shortly before Obama took office, Rubin announced his retirement from Citigroup. In a letter to Citigroup CEO Vikram Pandit, Rubin wrote, “My great regret is that I and so many of us who have been involved in this industry for so long did not recognize the serious possibility of the extreme circumstances that the financial system faces today. At the time, Citigroup was existing on $346 billion in various federal subsidies, including a $301 billion asset guarantee and $45 billion of TARP. Rubin remained cochair of the Council on Foreign Relations.
Upon taking office, Obama called Wall Street bankers’ $18.4 billion in 2008 bonuses “shameful.” “There will be time for them to make profits, and there will be time for them to get bonuses,” he said at an Oval Office appearance. “Now’s not that time. And that’s a message that I intend to send directly to them. The message might have gotten lost in translation. For 2009, cash bonuses rose 17 percent over 2008, to $20.3 billion, on the back of Washington-created, taxpayer-provided subsidies, despite a crippled economy.”


LaVern Isely, Overtaxed Independent Middle Class Taxpayer and Public Citizen and AARP Members


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