Friday, May 5, 2017

Crony Capitalism, American Style - By Milton Ezrati

With highway accidents, the greatest carnage always attracts the most onlookers. So, too, with the 2007-08 financial crisis and its aftermath. Each review of those events paints an increasingly ugly picture of crass cronyism. Two administrations, one Republican and the other Democratic, claim only the most noble, disinterested motives for their actions, but everything done has conspired to protect established financial power and advantage it against competition. Collusion and cronyism dominated the buildup to the crisis and informed Washington’s otherwise seemingly ad hoc response. Now, Dodd-Frank has enshrined the inequitable practices in law.
Whatever the sins of bankers and investors, Washington orchestrated the mess from the beginning. For years, the federal government insisted that banks direct their mortgage lending increasingly toward the dubious credits referred to as sub-prime. Under the 1992 Housing Community Development Act the two government agencies that support the mortgage market -- the Federal National Mortgage Association (FNMA), known as Fannie Mae, and the Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac -- denied lenders support unless they made more and more loans to sub-prime borrowers. By the early years of this century, these agencies would only participate if half the loans involved were of this dubious character.
Because this insistence put lenders in a precarious financial situation, it required collusion from others in Washington. Regulators turned a blind eye to the risk such lending imposed on bank balance sheets. They looked the other way when banks used exotic derivatives to pass that risk off to others. When regulators did worry, they encouraged banks to package the bad loans into securities and sell them on capital markets. Other authorities facilitated the process by allowing credit-rating agencies to give these questionable securities attractive rankings.
When, despite these arrangements, this house of cards began to come down in 2007, Washington sprang into action. It said it wanted to protect the financial system. No doubt it did. It also had two other objectives: to conceal its role in creating the problems and to protect the established firms that had previously cooperated. Instead of sanctioning the firms and individuals who the government said were at fault, the authorities put billions of taxpayer dollars at risk to rescue them. Hurried legislation under Republican President George W. Bush and his Treasury Secretary Henry Paulson raised $700 billion of government funds for what the administration called the Troubled Asset Relief Program (TARP). It bought from these lenders the “distressed assets” that Washington had previously insisted they acquire, at least those that these institutions had not yet unloaded onto unsuspecting investors. Under President Barack Obama, the Federal Reserve took over the rescue effort, extending such transfers literally into the trillions of dollars.
Even as the government rescued the bankers, it blamed them for all that had gone wrong. President Obama showed superior finger pointing skills. He and the rest of Washington justified rescues to those that they held blameworthy by claiming a primary need to save the financial system. It is hard to argue with such priorities. Still, it is strange that, for all the animus the government showed, no prosecutions have occurred even now long after the crisis had passed and financial markets have recovered. Most of the managements of established financial firms remain in place to this day, as do their boards of directors, where turnover has been less than 10 percent from before the crisis.
If this behavior does not at least hint at cronyism, there is more. It surely is telling that Washington in its crisis management chose to ignore a previously successful model. Back in the 1980s, the nation found its financial stability threatened from reckless mortgage lending by a class of financial institutions then called saving and loan associations (S&Ls). To deal with that crisis, Washington created the Resolution Trust Corporation (RTC), which, in a kind of controlled bankruptcy, took over failing S&Ls, removed their managements and boards, immediately sold off their viable assets, and kept the questionable ones with a eye to working them out over time. Every failing firm was treated the same way. Markets stabilized as this systematic approach quickly relieved panic.  
Instead of opting for such an orderly approach, Washington in 2008 proceeded in a much less coherent manner. It treated each troubled firm in a different way. When, for instance, the investment bank Bear Stearns showed signs of trouble, the Fed arranged its forced sale to J. P. Morgan. Later, as the crisis gained momentum, government gave lavish loans to Citibank and a few others. Official Washington allowed another investment bank, Lehman Brothers, to go bankrupt but actually took a majority ownership stake in the insurer, AIG. If its goal was to save financial markets from a destructive panic, this was precisely the wrong way to proceed. A coherent, transparent approach, like a reconstituted RTC, would have gone a lot further to convince investors and other financial players that the authorities were in control. The ad hoc approach followed during this more recent crisis surely contributed to panic by raising in all a strong suspicion that official Washington had no clear idea of how to deal with the pressures of the moment.
It is only fair to ask why Washington in 2007-08 never even considered a reconstituted RTC. Several have in fact asked raised this point, including William Seidman, who had served on the old RTC. None in authority have even tried to answer. Could it be that the RTC’s evenhanded, if tough approach failed to serve an agenda that Washington preferred to hide? After all, an RTC approach would have penalized formerly cooperative managements and boards. Those few senior executives who lost their positions received lucrative severance packages, something an RTC arrangement would have forbidden. What is more, an RTC-like approach would have treated all troubled firms equally. This time the Fed and others in authority preferred to treat firms according to a clear crony-like hierarchy.  
Take the experience of Bear Stearns. When it became apparent in March 2008 that the firm was having trouble finding the liquidity to meet its obligations, no one in authority considered a rescue. The Fed explicitly rejected using its term-lending facility to help. Instead, it forced Bear Stearns to sell itself to JP Morgan at a bargain price of $10.00 a share, well off the stock’s high of $133.20 a share hit during the previous year. What is even stranger is that the authorities, while denying Bear Stearns a dime, advanced Morgan the bulk of the purchase price in the form of a loan that the Fed said it would forgive should Bear’s assets go bad.
Fed Chairman Ben Bernanke never fully explained why he and the authorities seemed determined to destroy Bear Stearns while fashioning a sweetheart deal for Morgan. His most direct response revolved around technicalities, itself a strange thing to emphasize in an environment full of unprecedented official action. Of course, he could not say that Morgan was a member of a cooperative establishment while Bear was not, had in 1998 refused to join a Fed-organized bailout of the well-connected hedge fund, Long-Term Capital Management or that Bear, as The New York Times noted at the time, was notoriously considered “an outsider that defied its more mainstream rivals.” Maybe the authorities have less questionable motives. If so, no one from the Fed has stated them.
AIG was also always considered an outsider. When it got in trouble later that year for guaranteeing some of the dubious mortgage-backed securities, the government, while extending loans to Citibank and others, insisted on an 80 percent ownership stake in AIG. Then, under management led by the New York Federal Reserve Bank, the firm paid full value on assets owed to those paragons of the financial establishment, Goldman Sachs, Deutsche Bank, and Societe Generale, even though these firms announced that they expected a loss. Though the Government Accountability Office pointed to “inconsistencies and contradictions” in the New York Fed’s explanation for its decision, the investigation, as with so much else from that time, ended there with questions left open.
All this dubious behavior occurred under the Bush administration, but, as if to announce the bipartisan nature of Washington’s crony system, the Obama administration passed Dodd-Frank. This huge and far-ranging piece of financial reform legislation advantages established firms at the expense of others. By imposing a raft of compliance and reporting requirements on all financial firms, it disproportionately burdens smaller companies. While explicitly imposing disadvantages on smaller firms, Dodd-Frank offers larger players an additional and particularly valuable competitive edge by designating them “too big to fail.” To be sure, the law requires those so designated to jump regulatory hurdles not required of others, but it compensates them with an implicit government guarantee against failure. It is no surprise that more than one fifth of the nation’s community banks have shuttered since Dodd-Frank became law.
There is no smoking gun. There seldom is when government and industry collude to their mutual benefit. Still, a pattern of cronyism emerges, one sufficient to raise questions among voters and businesses about where government priorities lie.
Mr. Ezrati is a writer living in New York. His latest book is Thirty Tomorrows and describes how the world can cope with the challenges of globalization and aging demographics. See more of his writing at