Yves here. Even though the Andrew Ross Sorkin book Too Big to Fail and the related movie were released years ago, they played a critical role in shoring up the party line on the handling of the financial crisis, that heroic financial regulators saved the banks and therefore the economy from collapsing. Since many readers of this site joined us after our extensive real-time and post-crisis commentary ran, this post provides a good overview of what is wrong with the official story.
By Bill Black, the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. Jointly published with New Economic Perspectives
I am watching the film Too Big to Fail based on Andrew Ross Sorkin’s book of the same name. It led me to check out the price of the used book, which has fallen to $1.02, which is low enough that I am willing to buy a copy of the book, particularly since not a penny will go to Andrew Ross Sorkin. The financial analytics displayed in the movie and the book are so poor and dishonest that I need to have a copy by my keyboard as an inspiration to keep trying to cut through the calculated dishonesty about Wall Street pumped out nearly every day in the pages of the New York Times.
The movie starts with the imminent failure of Lehman. It is an astonishingly sympathetic portrait of Wall Street, Hank Paulson, Tim Geithner, and Ben Bernanke. The movie invents a scene in which the Treasury leadership explains “in English” the causes of the crisis to the Treasury PR person. There is not a word about the three fraud epidemics that hyper-inflated the bubble, drove the crisis, and produced the Great Recession. As one expects of a Sorkin tale, it is all about personalities and “great men.” (Women are rare and powerless, even FDIC Chair Sheila Bair.) The movie and book have a patina of financial jargon that Sorkin thinks constitutes analytics, and a nearly total failure to probe the Wall Street BS about the crisis.
One odd aspect of the book and movie is that they almost (in the case of the book) totally ignore the largest financial run in history – the $300 billion run on money market mutual funds. That run was enormously important in its own right – and only staunched by the temporary provision of federal deposit insurance to the formerly uninsured industry. The run also freaked every senior financial regulator in the world. The movie ignores the run even though it caused Paulson’s fears to spike. The book’s treatment of the run is cursory and devoid of analysis.
Sorkin’s attempt to make Paulson the flawed hero and Geithner the most effective hero of the financial crisis is the primary theme of the book and movie. Sorkin presents Bernanke as a kindly grandfather. This indicates that Geithner was Sorkin’s primary source and that Paulson was a major source. Sorkin’s account suggests that Paulson had one tragic flaw and one PR flaw. The tragic flaw is incompetence. Sorkin does not directly charge Paulson with this flaw, but even the weakest factual account of the crisis displays Paulson’s incompetence. In Sorkin’s account, Paulson recurrently fails to anticipate the information he will need to make key decisions and is therefore constantly surprised by developments and unprepared to respond. Paulson, the former head of Goldman Sachs, should be a caution to everyone that believes we can only staff key government finance positions with Wall Street elites because of their unparalleled expertise.
In Sorkin’s presentation, Paulson’s PR problem stems from his obtuseness about humans. Paulson repeatedly proposes massive bailouts for the most elite banksters while providing no relief to the banksters’ victims. Similarly, he drafts a three-page bailout plan (TARP). The TARP draft exemplifies both of Paulson’s flaws. It is incompetent because it requires Treasury to make massive purchases of bad assets from the most fraudulent banksters. Putting aside, as Sorkin largely does, why this is terrible policy, Treasury cannot do it in the time required. Paulson should have known that from experience. He does not, and he does not have his staff work out the mechanics, which would have revealed that the plan would fail.
The movie does a poor job of explaining why the three-page plan revealed Paulson’s obtuseness. The movie shows him as believing that simple and short is good, and mystified by the congressional hostility to the plan. (I believe the portrayal is false and that Paulson’s design of his plan was not obtuse but, unsuccessfully, devious and malign.) The movie lost both reality and power by offering a bland summary of the plan rather than quoting its key passage that was brief – and chilling.
Sec. 8. Review.
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
Paulson’s plan was neither simple nor concise. Indeed, the Treasury “plan” had no plan. It simply said that Paulson got a blank check for $700 billion in federal funds that he could use in any fashion he wanted – and that he was exempt from the normal rules of law. It was an astonishing power grab by Paulson to be used to convey massive amounts of money to the banksters and other cronies without any of the reviews we have historically found essential to prevent abuse.
Sorkin’s emphasis on the personalities of elite bankers rather than analysis leads to a generally sympathetic treatment of the Nation’s worst banksters and an “out of history” failure to supply context essential to analytics. It is as if a problem arose in mid-2008, and Treasury was shocked that it arose. The reality is far different.
- First, Paulson led Goldman Sachs so heavily into purchasing toxic mortgage product that he endangered its survival.
Paulson had considerable experience with the fraudulent origination by lenders, the fraudulent resale of those loans by lenders in the secondary market, and the fraudulent sale of derivatives supposedly collateralized by those toxic loans in the tertiary market. The industry called (behind closed doors) the loans and the derivatives “toxic” because they were pervasively fraudulent.
- Second, Goldman purchased large amounts of credit default swaps (CDS) from AIG as “protection” for its collateralized debt obligations (CDOs).
Toxic mortgages were the (supposed) primary underlying “collateral” for most CDOs. Paulson was uniquely well-placed to prevent the crisis. Paulson was unusual in knowing that Goldman and other banks had such large claims against AIG’s CDS that AIG was insolvent.
- Third, Paulson had known for over a decade that the CDO market depended on the absurdity of the rating agencies giving “AAA” ratings to the top tranche of the CDOs despite the toxic collateral and the massive housing bubble.
Paulson knew that the top tranche of the average CDO represented 80% of the entire CDO. He knew that this meant that the top tranche had very little protection based on prioritization of rights to cash flows. This made its “AAA” rating laughable.
- Fourth, Paulson knew that CDOs had twice suffered losses so great that the CDO market collapsed.
The felon Michael Milken created the first CDOs in 1987 (FCIC Report: 129). The collateral, which proved toxic, was junk bonds. George Akerlof and Paul Romer’s 1993 article “Looting: The Economic Underworld of Bankruptcy for Profit” discusses the evidence of the fraudulent inflation of junk bond asset values by Drexel Burnham Lambert. Junk bond prices fell sharply after Milken and then Drexel pleaded guilty to felonies and the first CDO market collapsed within two years.
The second CDO market used a potpourri of overvalued, highly risky assets as the (grossly inadequate) collateral for CDOs. The CDO recipe has always been the same. You take greatly overvalued assets with ridiculously inadequate loss reserves and high credit (and sometimes interest rate) risk. The assets therefore have a relatively high nominal yield compared to safer assets that could really warrant “AAA” ratings. (The risk premium on the toxic assets, however, is too small to compensate for the greatly increased risk of the asset.) The credit rating agency then agrees to treat the bad assets as if they were great assets warranting “AAA” ratings. The pretext for this is that the CDO is “structured” to protect the top tranche, which receives the “AAA” rating. The problem with the pretext is that the top tranche is so large, and the assets are of such poor quality, that the structuring provides far too little protection against loss. The most typical bad assets used in the second CDO incarnation were mobile homes, aircraft leases, and mutual fund fees. The second CDO incarnation collapsed around 2002.
The third CDO incarnation, which used home loans as the collateral, was a vastly superior fraud scheme than its two predecessors. It was far larger and home loans had long been exceptionally safe assets. The banksters knew, however, how to understate enormously the risk of a home loan, which inevitably overstates substantially the value of the asset. Most importantly, they (and Paulson) knew that it was child’s play to get the big three rating agencies to give “AAA” ratings to toxic assets. Paulson knew that the third incarnation of the CDO scam was likely to collapse and cause far larger losses than the first two incarnations.
- Fifth, there were repeated warnings about the massive housing bubble.
Dean Baker deserves particular praise in this regard. The bubble stalled in 2006, and house prices in much of America began falling in late 2006.
- Sixth, fraudulently originated liar’s loans were the biggest single driver of the financial crisis.
Paulson had nearly two decades of forewarning about liar’s loans. The Office of Thrift Supervision (OTS) examiners in the West Region figured out that lenders made liar’s loans for fraudulent purposes in 1990, within a year of liar’s loans becoming an emerging practice among Orange County, California thrifts. We promptly began driving liar’s loans out of the industry. Akerlof and Romer’s 1993 paper contains their conclusion (and our conclusion as regulators) that only fraudulent lenders would make such loans.
The banking regulatory agencies, even under the second Prinesident Bush, warned lenders repeatedly against liar’s loans. For ideological reasons that Paulson embraced, the Bush administration refused to ban the pervasively fraudulent liar’s loans.
MARI, the mortgage lending industry’s own anti-fraud experts, warned the industry in 2006 that the incidence of fraud in liar’s loans was 90 percent. They warned also that the regulators were discouraging such loans and that the first incarnation of such loans produced substantial losses. The industry response was to increase liar’s loans.
By 2006, half the loans called “subprime” were also liar’s loans (the two categories are not mutually exclusive). About 40% of the loans originated in 2006 were liar’s loans.
Paulson also received an early warning of the second great epidemic of loan origination fraud. The appraisers warned publicly beginning in 2000 that lenders were blacklisting honest appraisers who refused the demands of lenders and their agents that appraisers inflate the value of homes. The big banks like Goldman Sachs closely follow real estate valuation information. Surveys of appraisers in 2003 and 2006 found the percentage of appraisers personally subjected to such extortion rose to 90 percent.
Paulson and Goldman also knew that once loans are fraudulently originated they can only be resold or packaged through fraudulent “reps and warranties.” They knew that secondary and tertiary markets sales of mortgage products were pervasively fraudulent.
In 2004, the FBI informed everyone that followed finance (including Paulson and Goldman) that mortgage fraud was becoming “epidemic.” They knew that the FBI was predicting that the fraud epidemic would cause a financial “crisis” unless stopped. Paulson, once he became Treasury Secretary, never followed up on the FBI warning. That made him the norm under the Bush administration. No regulator got in touch with the FBI official that issued the warning.
- Seventh, by late 2006, the mortgage banks that originated primarily fraudulent loans began to fail.
During 2007, hundreds of them failed due to their pervasive frauds. By the end of 2007, nearly every member of the entire mortgage banking industry that specialized in making nonprime loans had failed.
- Eighth, Paulson knew that the next dominoes to fall would be commercial and investment banks, and savings and loan institutions.
The underlying problem that kills banks is typically credit losses, but a liquidity crisis is the quickest killer of financial institutions. Because of their size and deposit insurance, a liquidity crisis would take longer to destroy these banks than the (uninsured and smaller) mortgage banks. Specifically, it was apparent to Paulson and his successors at Goldman by late 2006 that Fannie, Freddie, Bear, Lehman, Merrill Lynch, and AIG would fail because they would suffer massive losses on fraudulently originated mortgages and fraudulently sold CDOs. (AIG had sold massive amounts of CDS protection for CDOs that would cause it losses well in excess of its capital.) By mid-2008, huge insured savings and loans such as Countrywide and Indymac that fraudulently originated massive amounts of loans were failing or being acquired to avoid failure.
Paulson’s successor as Goldman’s leader clearly understood the danger. He began to dump the toxic mortgage products that Goldman held in portfolio, purchased on Paulson’s watch, on clients.
- Ninth, Paulson knew that regulation of the investment banks was Potemkin – because he played a key role in constructing the SEC’s fake regulation of the big five investment banks known as Consolidated Supervised Entity (CSE) program (FCIC Report: 150-155).
He knew that the investment banks combined extraordinary leverage with enormous exposure to fraudulent mortgage product. Paulson knew that Goldman was desperately seeking to reduce its loss exposure, but Bear, Lehman, and Merrill Lynch were increasing their already fatal exposures.
- Tenth, Bear failed – and almost nobody wanted to purchase it.
JPMorgan did want to buy it – but at a purchase price that Wall Street found to be exceptionally low.
- Eleventh, after Treasury assisted JPMorgan’s purchase of Bear in March 2008, everyone in finance knew that Fannie, Freddie, and Lehman were going to be the next huge entities to collapse.
Treasury chose to put only three officials in Lehman to do due diligence on its operations and collateral. That was a preposterous decision – another example of Paulson (and Geithner’s) failure to gather essential information when it could still do some good. Reviewing the collateral would have immediately apprised Paulson and Geithner of the toxic quality of Lehman’s real estate and its immense liability for the hundreds of billions of dollars in fraudulently originated mortgages that it resold to others through fraudulent reps and warranties. Instead, Paulson further ruined his credibility by asserting that there was net positive value in Lehman and that its rivals should be rushing to buy it without Treasury providing financial assistance.
Reviewing Lehman’s collateral and the claims of its creditors would have also revealed to Treasury something about Lehman that could have reduced the carnage. Treasury would have learned that Reserve Primary Fund had loaned heavily to Lehman on an unsecured basis and that when Lehman filed for bankruptcy the money market mutual fund would “break the buck.” That means its losses on its loans to the bankrupt Lehman would exceed its capital and people and firms who invested in the fund would suffer losses. Paulson knew that the fund’s primary investors were huge corporations and that “breaking the buck” would lead to immediate and massive withdrawals from the fund that would likely bankrupt it. Paulson also knew that this could lead to mass withdrawals from other money market mutual funds because the federal government does not insure such funds.
It is unlikely that Paulson would have chosen to let Lehman fail had he known these facts about the Reserve Primary Fund’s loss exposure to Lehman. The combination of the Treasury and the Fed’s failure to check Lehman’s asset quality and creditors and Paulson’s decision to let Lehman fail led to the largest run in history. Only the extension of federal deposit insurance for a considerable time until the most acute phase of the crisis ended broke the $300 billion run on money market mutual funds.
Lehman, Fannie, Freddie, and AIG all failed, and Bank of America acquired Merrill to prevent its failure within a few days of each other. Lehman’s imminent collapse drove the timing of these failures and acquisitions (as well as emergency capital infusions to the two surviving major investment banks by Mitsubishi and Warren Buffett). Lehman’s failure immediately created the $300 billion run on money market mutual funds. Financial markets globally began to cease functioning.
Sorkin’s Three Related Theses Are False
- Paulson’s (Purported) Goal of Ending Too Big to Fail
With this historical and analytical context in mind, we can analyze Sorkin’s key theses. Sorkin’s fundamental tension, and the basis for his sympathetic portrayal of Paulson, is Paulson’s (purported) desire to end federal bailouts of large failing financial institutions. The movie presents this as a noble goal for which even the New York Times praises Paulson. (We are supposed to ignore the circularity of the fact that Sorkin heavily influences that paper’s coverage of finance and the fact that Sorkin is Wall Street’s ‘sycophant-in-chief.’ We are supposed to believe that the NYT is unremittingly hostile to Wall Street and Bush’s top financial regulators, so if the NYT says anything nice about Paulson it must be a grudging admission of an inescapable and inconvenient truth.)
(Spoiler alert about the movie.) The movie’s best moment of drama is when Paulson is walking down the street shortly after Lehman files for bankruptcy and he is startled to see the stock market is not collapsing. He calls his staff in confusion and they inform him that the markets love his decision not to bail out Lehman and that the NYT praised his decision. He promptly holds a triumphal press briefing claiming credit for standing firm against pleas for a bailout and cites the stock market reaction as proof that he did the right thing. The markets, however, are already tanking by the time he cites the stability as proof of his correct call. (The movie ignores the fact that the world’s largest run is also raging by the time he, falsely, claims credit for a supposedly courageous and principled decision to refuse to bail out Lehman.)
Sorkin’s first thesis is false. First, once you allow a financial institution to become so big that its failure will cause a global crisis there are no good public policy options. Sporkin generally presents the issue as if it were an issue of toughness or principle, but that is bad analytics. If the regulator permits an unconstrained failure of a systemically dangerous institution (SDI) it will cause a global financial crisis. A global financial crisis is likely to cause a severe global recession or depression. No rational regulator creates a global recession or depression.
Second, being “tough” by permitting an unconstrained failure that triggers a global financial crisis and a severe global recession does nothing to prevent future crises. Financial crises do not occur because there were past “bailouts” of SDIs. It is important to understand what “too big to fail” (TBTF) meant when regulators used that phrase. It did not mean that bank would not fail. Regulators put TBTF banks into receivership. It meant that the federal insurance funds paid general creditors in full even if the bank was insolvent. The purpose is to avoid cascade failures. The primary unsecured creditors of huge banks tend to be other huge banks. Regulators want to avoid the failure of one massive bank triggering the failure of a string of banks.
Note that the “bailout” does not go to the shareholders or the subordinated debt holders (collectively, the “risk capital”). The typical criticism of TBTF is that the owners (shareholders) of giant banks are willing to take excessive risks because they know that if they fail the federal government will bail them out and prevent them from suffering any loss. That criticism is false, if the regulators place the failed TBTF bank into receivership or otherwise wipe out the risk capital. Paulson and Geithner seem not to have even understood the concept. They virtually never put TBTF institutions through receiverships or otherwise eliminated the risk capital as a condition of extending government assistance.
Third, elite fraud epidemics led by financial CEOs drive financial crises. CEO banksters do not want to engage in “risk.” The want a “sure thing” as Akerlof and Romer emphasized.
Fourth, Geithner, Bernanke, and Paulson did the opposite of preventing TBTF financial institutions. They took no regulatory steps to shrink TBTF banks to the point that they no longer posed a global risk when they failed. Worse, they consistently encouraged acquisitions of the largest failing financial institutions by even larger banks, making the TBTF problem far worse. There are strong reasons for believing that their explanation for their refusal to prevent Lehman’s unconstrained failure was a pretext.
Fifth, Sorkin’s book, and reality, provide the real basis for their catastrophic decision to allow Lehman’s unconstrained collapse. Conservative Republicans and Bear’s rivals criticized Paulson relentlessly on ideological, political, and ad hominem grounds after he had Treasury bail out Bear. The personal attacks portrayed Paulson as weak. These attacks deeply troubled him.
- The Purported Willingness (and Ability) of the SDIs to Fix the Crisis is False
Sorkin describes the SDIs as stepping up to the plate with their own capital to fund a resolution of Lehman through a privately funded bailout of its bad assets. The theme is the courage and responsibility of the CEOs of our Nation’s SDIs. Sorkin’s second thesis is false. The context is the meeting in which Paulson tried to play tough with the CEOs of America’s largest financial SDIs in connection with assisting Barclay’s acquisition of Lehman. Note that this acquisition would have created an even larger SDI, so it is bizarre that Sorkin pitches it as Paulson’s stand against SDIs.
Barclays was (and remains) a bad, under-capitalized UK bank. Its management led a series of massive frauds and predation on customers. No responsible regulator would ever have considered it an acceptable acquirer of anything, much less a cesspool like Lehman. The UK regulators first hinted and then told Paulson that they would reject Barclays as a purchaser of Lehman. Lehman was insolvent and in a liquidity crisis – and that is ignoring its massive liabilities for its fraudulent sales of fraudulently originated mortgages through fraudulent reps and warranties. On top of that, it engaged in other major accounting abuses to hide its losses and its liquidity crisis. In particular, its real estate was worth less than half the inflated values that Lehman had on its books.
The book and movie act as if Lehman’s insolvency and liquidity crisis were not real. They present the claim that the willingness of several CEOs to put in a billion dollars per firm would have sufficed to fill the hole in Lehman’s bad real estate assets (ignoring Lehman’s far larger liability for its fraudulent reps and warranties). The implication is that if the UK regulators had only approved Barclay’s acquisition of Lehman there would have been no crisis. The numbers do not come close to adding up. The private capital on (vague) offer (on terms that were never even sketched must less agreed to) was trivial compared to the size of the hole. AIG, Fannie, and Freddie had already collapsed. The big banks that purported to have “excess” capital demonstrated not their strength, but the grossly inadequate nature of capital requirements.
- Blaming Lehman’s Failure on the UK Regulators Is Absurd
Sorkin thesis is that that Geithner and Paulson’s frantic efforts to avert the crisis by getting Barclays to buy Lehman with private financial protection against Lehman’s terrible real estate assets were on the verge of success. The pusillanimous UK regulators pulled the rug out from under these valiant U.S. public servants by vetoing Barclays’ purchase. The UK regulators refusal to allow the purchase was bizarre because the deal was a godsend for Barclays. I have refuted each aspect of this assertion.