Magazine | May 17, 2010, Issue

Shadow Bailouts

The Democrats punish Wall Street with promises of endless money

‘This is structured finance!” shouts Enron executive Andy Fastow, waving his arms wildly at a circling herd of hungry velociraptors with glowing red eyes. “This is what it looks like!” That’s from Enron on Broadway, and it’s not half bad, but anybody who knows anything about theater knows that the real action is downtown: Everybody will be watching the case of Securities and Exchange Commission v. Goldman Sachs, now playing at the U.S. District Court for the Southern District of New York, which promises to be a sideshow spectacle that will make Enron’s finance follies on Broadway look like a high-school production of Our Town. However entertaining a Goldman Sachs prosecution might be, the show America should be watching is the one in Washington: the kabuki politics of Sen. Christopher Dodd’s financial “reform” bill, a piece of legislation that will enshrine backdoor bailouts into U.S. law for the foreseeable future.

Washington does not want to talk about that bill in any great detail right now, which is one possible explanation for the fact that the SEC decided to go after Goldman Sachs on a 3–2 party-line vote — unanimity is the norm for such an action — and with a case that even most of the hardcore Goldman-haters on Wall Street think is pretty weak. As with the sausage-filler details of the stimulus and health-care bills, Democrats do not want Americans getting a real good look at what’s in the financial-reform bill before it becomes law. Neither does Wall Street. Instead, we’ll be talking about Fabrice Tourre, the Goldman spreadsheet jockey at the center of the SEC’s complaint. So, Fabulous Fab, get ready for your closeup — and maybe a long minimum-security vacation in the Enron suite.

The Goldman case doesn’t sound like the stuff of high drama, even in the SEC’s own words: “The marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS.” As dramatic perorations go, that’s not exactly quietus-making and bare bodkins. And, though clean-minded men always are tempted to think the very worst of Goldman Sachs, it’s not blazingly obvious that the Broad Street Bully got itself sideways with Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, or Exchange Act Rule 10b-5. But they say a decent prosecutor can get an indictment on a ham sandwich, and Goldman’s Tourre looks set to join Michael Milken and Martha Stewart on the rogues’ gallery of people the feds made into lunchmeat for the crime of getting rich while being a jackass.

#page#Tourre refers to himself as “the fabulous Fab” in cringe-inducing e-mails,  and jokes that he “managed to sell a few Abacus bonds to widows and orphans that I ran into at the airport.” He describes his financial work as “pure intellectual masturbation” and boasts of “standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstruosities!!!” (Misspelling and ludicrous third-person usage in original.)

On Wall Street, you don’t go to jail for breaking the law — the law is what you can get away with — you go to jail for being an embarrassment to Wall Street. Fabulous Fab is 31 years old and looks like a young man who has consumed nothing but organic Vermont dairy products his entire life: soft and pale. It’s a happy thing for him that the worst thing he’s facing is kiddie jail, a book deal, and a demotion from banker to consultant, if he even gets that: His bosses are not throwing him to the wolves — not yet. Goldman gives every indication that it is girding its loins, preparing to cry havoc and let slip the dogs of war. Given that Goldman girds its loins with $1 million Treasury bills, this should be a long and entertaining show indeed. And that may be the point: It is a red herring, a distraction from the fact that congressional Democrats, the Obama administration, and the big Wall Street players are colluding to make the present system of ad hoc and ad infinitum bailouts permanent, codified in law, with practically no accountability in Washington and no oversight from our elected representatives.

That’s because the Dodd bill creates a system of shadow bailouts. Example: The bailout of insurance giant AIG wasn’t really a bailout of AIG — AIG is a dead corporation walking, and everybody knows it. Rather, it was a bailout of all the firms that would have taken losses if AIG had gone into bankruptcy. The Dodd bill’s defenders protest that the bill will end bailouts, but it will only hide them. That’s because firms that might have been sent tumbling into insolvency by a failure elsewhere in the financial system — by a repeat of the Lehman Brothers fiasco, for instance — will be protected by the Dodd regime from default and bankruptcy. And Congress will be protected from having to go on the record supporting such actions in each case. The Dodd bill is a blanket backdoor-bailout authority.

Much too much has been made of the $50 billion resolution fund and the levy that financial firms would pay to fund it. Senator McConnell abominated it as a “bailout fund,” but he was paying attention to the wrong pot of money: That $50 billion is a little ladle-load of cashola compared with the buckets of schmundo that the Dodd bill will make available for indirect bailouts and endless support of troubled businesses — financial and non-financial firms alike. Case-by-case interventions may be out, but the bill would allow — in fact, appears designed to ensure — bailouts for the creditors of troubled firms. Under the Dodd bill, Wall Street firms (or unions, or sovereign-wealth funds, or anybody else with the right political connections) who are exposed to losses on failing financial companies will be able to collect significantly more money than they would be able to under normal bankruptcy procedures. That is the bailout.

#page#We’ve seen this before, of course. The AIG bailout, for instance, amounted to bailout of Goldman Sachs and other banks that had a lot of AIG exposure and would have had a harder time being made whole in bankruptcy court than they did under Washington’s management. The Dodd bill instructs that the government shall “ensure that unsecured creditors bear losses in accordance with the priority of claim provisions” in the existing law — but how well has that worked out in the past? What legal authority did the Obama administration have to upend the normal priority of claims in the bailout of General Motors, a corrupt deal that saw secured creditors forced to take substantial losses while unsecured creditors received a better deal than they were legally entitled to — all because those unsecured creditors were the union bosses who put Barack Obama into the White House? That wasn’t just a bailout of GM; it was also a bailout of the UAW. That’s the kind of bailout regime that the Dodd bill will make permanent: the indirect bailout.

Part of the problem is that, instead of creating an independent FDIC-style entity to handle resolutions, the Dodd bill would give that power to the FDIC itself. This is a bad idea for lots of reasons: The FDIC is effective because it basically does one thing and does it well, under narrowly defined rules with relatively little latitude for political gamesmanship. The Dodd bill will interfere with the FDIC’s ability to focus on the one thing it does well and task it with doing other things it is apt to do poorly. We don’t mind bailing out ma-and-pa depositors when a bank goes feet-up, because keeping those deposits guaranteed adds greatly to the stability of the banking system and the economy, encourages savings and capital formation, and does so at a remarkably low cost to the nation. But the investors in Goldman Sachs structured-finance deals aren’t very much like plain-vanilla bank depositors. Bailing them out is not going to be cheap, and it should not be a priority.

One Capitol Hill critic of the Dodd bill calls it an “FDIC wish list for aggrandizing its power,” but even FDIC chief Sheila Bair cannot deny the underlying purpose of the bill: effecting bailouts. “The construct is you can’t bail out an individual institution — you just can’t do it,” Bair says. But . . . ? “In a true liquidity crisis, the FDIC and the Fed can provide system-wide support in terms of liquidity support — lending and debt guarantees — but even then, a default would trigger resolution or bankruptcy.” Right, a major bank default would trigger resolutions or bankruptcies across the financial sector — and the FDIC and the Fed will be given a very large toolbox full of levers and pulleys to prevent such a default from occurring in the first place.

Lawrence Lindsey, former director of the National Economic Council, says that the Dodd bill would represent the end of “Too Big to Fail” — but not in the way we might have hoped: “How could any firm actually fail when all of its debt could be guaranteed by the Treasury, the Fed could print money to assist it, and just in case, there was $50 billion sitting around to reassure nervous creditors that they would be repaid regardless what contract or bankruptcy law said? . . . Needless to say, the large Wall Street firms aren’t complaining; they will permanently benefit from having lower borrowing costs thanks to these provisions, the same way Fannie Mae and Freddie Mac enjoyed implicit guarantees.”

And that leaves us with the Divine Dodd, standing in the middle of all these complex, highly leveraged, exotic political trades he created without necessarily understanding all of the implications of those monstruosities. I hear that Treasury bonds are big with the widows and orphans.

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