One wants to ask the Wall Street wizards who comprise the talent pool for the
incoming administration, "If you so smart, how come you ain't rich no more?"
Manhattan's toniest private schools, harder to get into than Harvard, quietly
are looking for full-tuition pupils now that the children of sacked Wall Street
bankers are departing for public schools in cheaper suburbs. Harvard University
president Drew Faust has warned of budget cuts to come due to "unprecedented
losses" to its US$39 billion endowment.
Shares of Citibank, the current firm of Bill Clinton's treasury secretary
Robert Rubin, last week traded at less than a tenth of their year-earlier
market price and may require yet another federal
bailout. [Citigroup will have more than $300 billion of troubled mortgages and
other assets guaranteed by the US government under a federal plan to stabilize
the lender after its stock fell 60% last week, Bloomberg reported today,
November 24. Citigroup also will get a $20 billion cash infusion from the
Treasury Department, adding to the $25 billion the bank received last month
under the Troubled Asset Relief Program. In return for the cash and guarantees,
the government will get $27 billion of preferred shares paying an 8% dividend.]
Rubin, a transition advisor to president-elect Barack Obama, was mentor to
Treasury secretary designate Timothy Geithner. Even Goldman Sachs, the
thoroughbred trading machine that gave us Treasury Secretary Hank Paulson as
well as Rubin, is trading at a fifth of its peak value.
These facts came to mind while reading David Brooks' November 21 New York Times
panegyric to Obama's prospective cabinet, which gushes, "Its members are twice
as smart as the poor reporters who have to cover them, three times if you
include the columnists." Brooks added, "... as much as I want to resent these
overeducated Achievatrons ... I find myself tremendously impressed by the Obama
transition."
Has Brooks checked the markets? The cleverest people in the United States, the
Ivy-pedigreed investment bankers, have fouled their own nests as well as their
own net worth, and persuaded the taxpayers to bail them out. If these are the
best and the brightest of 2008, America is in very deep trouble.
The one-trick wizards of Wall Street had one idea, which was to ride the trend
and pile on as much leverage as credulous investors and crony regulators would
allow. It has gone pear-shaped, and those who didn't cash out early along with
the cynics are poor. Fortunately for them, Obama will let them play with the
budget of the US federal government for the next four years.
Failed financiers run the Obama transition team. It used to be that the heads
of great industrial companies got the top Cabinet posts. Now it is the
one-trick wizards. After George W Bush fired former Treasury Secretary Paul
O'Neill, who had run Alcoa, the last survivor of the species was Vice President
Dick Cheney, the former CEO of Halliburton. Obama's bevy of talent comes from
finance. American industrialists have become figures of ridicule, like the
pathetic chief executive of General Motors, Rick Wagoner, begging for a
government loan.
Stocks rallied on November 22 on reports that Obama would give the Treasury
post to Geithner, the New York Federal Reserve Bank president and the architect
of the biggest bailout in history. He doubled the size of the Federal Reserve's
balance sheet to more than $2 trillion, through the purchase of such risky
assets as the commercial paper of near-bankrupt American auto companies. That
is in addition to the Treasury's $700 billion bailout plan. Investors like the
idea of trillion-dollar transfers from public funds to private companies.
Former Treasury secretary Rubin "was an architect of the [Citibank's]
strategy," the New York Times reported on November 23. "In 2005, as Citigroup
began its effort to expand from within, Mr Rubin peppered his colleagues with
questions as they formulated the plan. According to current and former
colleagues, he believed that Citigroup was falling behind rivals like Morgan
Stanley and Goldman, and he pushed to bulk up the bank's high-growth
fixed-income trading, including the [structured credit] business. Former
colleagues said Mr Rubin also encouraged [former Citibank CEO Charles] Prince
to broaden the bank's appetite for risk, provided that it also upgraded
oversight - though the Federal Reserve later would conclude that the bank's
oversight remained inadequate."
A case in point is the reported implosion of the Harvard and Yale endowments.
For years, these giant funds were held up as proof that superior intelligence
was the ticket to excess returns. During the 10 years through 2007, Harvard and
Yale produced compound annual returns of 15% and 17.8% respectively, far better
than the market, the average endowment or the average hedge funds - only to
blow up in 2008 by frightful proportions not yet released.
According to a recent study [1], the "super endowments" sailed past their peers
by loading up real estate, commodities, and "private equity", precisely the
sectors that underwent necrosis this year. Private equity is the subprime
version of corporate finance, acquiring non-public companies with a minimum
down payment and the maximum of debt.
David Swenson, the legendary manager of the Yale Endowment, learned one trick:
buy on dips in the equity market with all the borrowed money he could get. The
alumni network on Wall Street made sure that the university endowments were
first in line for the hottest deals. That worked until 2008. We do not know how
far the private equity holdings of Harvard and Yale have fallen, but the traded
equity price of the Blackstone Group, a leading private equity firm, is a fair
gauge. It is down from its $35 initial offering last year to only $4.65 today,
a drop of 87%. Commodities, meanwhile, have fallen by half.
For a quarter of a century, the inbred products of the Ivy League puppy mills
have known nothing but a rising trend in asset prices. About the origin of this
trend, they were incurious. The Reagan administration had encountered a stock
market in 1981 trading 50% below its the long-term trend. Reagan restored the
equity market to trend by cutting taxes, suppressing inflation and easing some
regulations. The private equity sharps were fleas traveling on Reagan's dog.
They simply rode the trend with the maximum of leverage.
Now that the stock market has collapsed, the private equity strategies cannot
repay their debt, and their returns have evaporated. Note that equity investors
spent a decade in the cold, from 1973 to 1983; it may be even worse this time.
The maturities on debt issued to finance private equity deals will come due
long before the recovery.
Over the long term, we know that the average investment cannot grow faster than
the economy, for investments ultimately are valued according to cash flows, and
cash flows stem from economic growth. Real American gross domestic product grew
by 2% a year on average between 1929 and 2007. Whence came the enormous returns
to the Ivy League? Some of them surely came from betting on the right horses,
but most came from privileged access to leverage.
One recalls Ferdinand I of Austria (1793-1875), deposed for incompetence after
the 1848 Revolution, who apocryphally shot an eagle, and said: "It's got to be
an eagle, but it's only got one head!" Ferdinand thought the two-headed bird of
his family crest was the norm, just as the pink-shirted, suspender-wearing Ivy
Leaguers thought that two-digit returns were the norm for their investments.
The same privileged access to leverage allowed the investment banks to produce
return on equity in excess of 20% year in, year out, by selling structured
products, as I explained in a recent essay (Lehman
and the end of the era of leverage, Asia Times Online, September 16,
2008). For the 10 years through 2007, American homeowners joined the party,
with returns in excess of 20% of their home equity (10% home price appreciation
more than doubles with leverage).
Investment banks were levered long the leverage, so to speak. The more leverage
the world demanded, the more Wall Street could charge for ever-more-arcane
methods of packaging leverage, and the higher the returns to leverage
providers.
That explains how a Washington political operative like Rahm Emanuel, now
Obama's chief of staff, who studied ballet rather than balance sheets, could
earn a reported $16.2 million in two-and-a-half years at Wasserstein Perella,
the mergers and acquisitions boutique. At the height of the bubble, Bruce
Wasserstein's firm sold out to Germany's Dresdner Bank for the fairy-tale sum
of $1.6 billion. Even the crumbs from Wasserstein's loaf could make a Chicago
politician rich.
Without leverage, the clever folk around Barack Obama are fleas without a dog.
None of them invented anything, introduced an important new product, opened a
new market, or did anything that reached into the lives of ordinary people.
They wore expensive cufflinks, read balance sheets, exercised regularly, sat on
philanthropic boards, and assumed that their flea's ride on the Reagan dog
would last forever.
All they knew was leverage, and now that the world is de-levering, they are
trying to put leverage back into the system. One almost can hear Mortimer Duke,
Don Ameche's charcter in Trading Places, shouting, "Now, you listen to
me! I want trading reopened right now. Get those brokers back in here! Turn
those machines back on!"
Of course, nothing excludes the possibility that Obama's team will come up with
something constructive. But there is no reason to expect a drastic change from
the crisis response of the same sort of people (starting with Treasury
Secretary Paulson) in the Bush administration. They will bail out incompetent,
failing firms and drop money from helicopters and call it a stimulus package.
And it will turn out no better than it did for the humiliated Republicans.
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