The Nationalization of Folly

Washington’ s takeover of Fannie Mae and Freddie Mac gained the quick support of Wall Street, who never meets a bailout it doesn’t like, and the thanks of Beijing, whose playbook it seems to be borrowing.

Months after U.S. Treasury Secretary Henry M. Paulson, Jr. reassured the world ‘s markets that “We are closer to the end of this problem than we are to the beginning,” the Bush administration this week seized mortgage giants Fannie Mae and Freddie Mac.  With that single act, the United States -long-reputed bastion of free enterprise, and led by the first MBA-trained president ever- undertook the largest nationalization of private enterprise in modern history.  It was by far the most striking culmination, at least to date, of the folly, hubris and Titanic misjudgment that has seen Wall Street, boards and regulators take a holiday from risk and reality that can now be measured in trillions of dollars in write-downs, lost shareholder value and the worst economic crisis since the Great Depression.

Like the government-sponsored Bear Stearns rescue that preceded it, this, too, is a bailout that has the fingerprints of Wall Street all over it.  Morgan Stanley played a pivotal role in advising Mr. Paulson on how the deal would be orchestrated.  In fact, all of the government’s recent interventions have been done in consultation with Wall Street’s biggest firms.

With the stroke of a pen, the decision to place the strangely named pair into a “conservatorship” removes key private sector competitors from the mortgage business that was so lucrative to Wall Street’s top banks and institutions, while at the same time ensuring a steady flow of mortgage funds into the market.  Wall Street got what it wanted again, and showed its gratitude by the Dow soaring more than 300 points in the first few minutes of trading after the decision was announced.  And the U.S. government is now the biggest mortgage backer in the world.

Reasonable men and women will differ as to whether the bailout of these institutions was wise or not.  What cannot be disputed is that it was the result of one of the most costly governance and oversight failures ever.

What brought the U.S government to this remarkable place in the history of its free enterprise system?  How was it possible that these two firms were permitted to play such a pivotal role in the economy that their stake in the mortgage market was actually measured in the trillions?  How could regulators and boards of directors have failed to such an extent that this mother of all bailouts became necessary?

I doubt that there will be much of an appetite to pursue these questions, which is exactly why, in a culture where accountability and good governance always took second place to short-term greed and self-interest -and that was on a good day-   such a calamity happened in the first place.

Over time, investors, investment bankers and executives became incredibly wealthy from Fannie and Freddie.  The two CEOs of these firms made more than $30 million last year alone.  The financial rewards from these institutions were viewed as the legitimate fruits of a fabled market-driven free enterprise system which, it is claimed, operates best when government stays out of the picture.  Naturally, these rewards were privatized.  Now that the jig is up, it is claimed by many, including a deafening chorus on Wall Street just fresh from its long running show where it was clamoring for ever lower interest rates from the Fed, that government cash is necessary to clean up the mess and stabilize the market.  The losses, which already are counted in the billions, will be socialized.  And thanks for thinking about Adam Smith.

The earth did not exactly shake from the howls of outrage heard among defenders of free market capitalism when the takeovers were announced, or from the College of Wall Street cardinals where the vice of hypocrisy rarely evokes the specter of shame.  And it is the idea that Wall Street winds up making money from either success or failure, that free enterprise or government bailout is just fine with this crowd as long as the money keeps rolling in, that is the most galling.

It is always a measure of the fundamental strengths of any system of government or economics that the spires of its principles are able to withstand the gales of expediency.  Looking at how happily the market embraced this latest government intervention, which occurred on a draconian scale heretofore typically associated with South American dictatorships, the toppled ruins on Wall Street, and in those other places where principles are expected to matter, are not a pretty sight.

The Alice in Wonderland world into which U.S. capitalism has descended, where profits were based on flaky business models, indecipherable investment vehicles and assets held together by thin air, has long had its antecedents in a similarly dysfunctional system of CEO pay.  This, too, is a world diverged from reality and common sense, where monster-size bonuses often had nothing whatever to do with performance or outcomes and where fortunes were regularly awarded by boards on the basis of shoddy results, if not outright failure.  Is it at all surprising that it was this same system that tempted CEOs to misjudge the prospects of risk and to take actions that were based on how next year’s bonuses would be affected rather than what was in the long-term interests of investors.  It is not that far a stretch from a boardroom culture where bonuses were routinely awarded even for poor performance to one that would see a pandemic creation of investment vehicles that proved to be empty in terms of value and risk consideration.

Criminal fraud at the level of Hollinger or Enron, or misfeasance such as was found at Fannie Mae when previous management cooked the books in order to push up their own pay, may not abound throughout corporate America.  But the seeds of the folly that is at the center of CEO pay and the disaster it so often heralds may well be viewed by history as having been synonymous with the disconnection of value, values and meaningful governance/oversight that has brought the economy and the American business system to this perilous point in time.

And the price tag for all of the government’s actions over the past year -the Bear Stearns rescue scam (as noted on these pages before, the Fed never really took on the $29 billon loan; it bought the collateral outright), its apparently never closing and endlessly accommodating discount window, and now this latest Wall Street bailout?  Nobody seems to know.  And few appear to be asking even during a presidential election year.  The costs seem likely just to be pushed off in one form or other, whether in the guise of soaring inflation, galloping deficits, higher interest rates or a weaker dollar, to a future generation.  The rewards of the government’s latest intrusive efforts will be privatized once more.  Their risks and the costs that lie ahead will be socialized again.

One more point of interest: the Fannie and Freddie move was met with approval by countries which hold substantial instruments of U.S. debt, including significant amounts of paper obligations on the part of these financial institutions.  China, a totalitarian state that professes communism but increasingly practices capitalism, especially praised the move by the United States, a land which trumpets capitalism but increasingly seems to practice the fine art of socialism.

In the distorted, upside down world that America’s leaders, financial wizards, regulators and directors have created, what pleases Beijing most seems only fitting.