7   Corporations Turn Cannibal

William Krehm

As Adam Smith told the tale, it was almost a courtly minuet. However, as each latterly chapter unfolds under our incredulous eyes the dancers strip off decorum to become cannibals, sinking tooth into flesh of their own kind.

The New York Times (16/01, "Citigroup’s Big Loss Fuels Anxiety and Depresses Stocks" by Jenny Anderson and Eric Dash) seemed to relish the details: "Citigroup, the nation’s largest bank, reported a staggering fourth quarter loss of $9.83 billion on Tuesday and issued a sobering forecast that the housing market and the broader economy still had not bottomed out.

"To shore up their financial condition Citigroup and Merrill Lynch, rocked by the subprime mortgage debacle, were forced to go hand in hand for cash infusions from investors in the US, Asia, and the Middle East, for a total of nearly $19.1 billion.

"Citigroup’s gloomy news added to the anxiety that the mortgage crisis could plunge the economy into a recession. Compounding anxieties, the government reported that retail sales in December declined for the first time since 2002.

"Growing pessimism led to another sharp sell-off in stocks, which fell about 2 percent for the day and are now down about 6% since the beginning of 2008, the third worst start for a year since 1926."

Forgetting the Lessons Learned from the Depression and World War II

That becomes particularly disquieting, since our government has suppressed just about every thing that we learned in Depression, war and in the postwar at a staggering human cost. Since the memory of all that has been wiped clean, we are ill-prepared today to confront a more entrenched version of the same highly profitable dogmas of our enthroned financial sector.

"More bad news is coming, with Merrill Lynch expected to report sizable losses this week and major financial institutions like Bank of America retreating from their investment banking business. These moves add to concerns that financial institutions will be forced to pull back from lending at a time the economy most needs access to credit to help cushion it against a downturn.

"‘The only other time this happened in the last 100 years – financial firms going from making good profits to negative profits – was the Depression in the 1930s,’ said Richard Sylla, a professor of financial history at New York University. ‘I don’t think it will be as bad this time. The Federal Reserve is fighting the problem as hard as it can.’

"Just last week, the Federal Reserve chairman, Ben S. Bernanke, said the economy was worsening, bringing widespread hope the Fed would move swiftly to lower interest rates. Wall St.’s worsening results combined with Mr. Bernanke’s comments will certainly add fuel to the economic stimulus package being debated by the White House, Congress and the central bank.

"Citicorp’s record was caused by write-downs from soured mortgage-related securities and reserves for current and future bad loans totaling $23.2 billion. Responding to a string of dismal quarters, the banks said it would also lay off another 4,000 workers, on top of announced reductions of 17,000 employees to conserve $4.4 billion in cash annually."

Wall Street Goes to Asia Cap in Hand

"Citicorp, which earlier had raised $7.5 billion from the Abu Dhabi Investment Authority to improve its capital. Other foreign or unusual sources of new capital was the Government of Singapore Investments Authority, the Korean Investment and Citigroup’s former chairman, Sanford I. Weill. Citicorp will also offer investors about 2 billion dollars of newly issued debt securities, a portion of which will be convertible into stock.

"At the same time Merrill Lynch announced that it had issued $6.6 billion in preferred stock to the Kuwait Investment Authority, the Korean Investment Corporation, Mizhuo Financial Group, a Japanese banks and other investors, including the New Jersey Pension Fund and a Saudi Investment Fund. That is in addition to the $4.4 billion it raised in December from Temasek Holdings of Singapore.

"While the banks were able to raise record amounts of cash, they had to circle the globe to get it in two separate rounds.

"‘There is a tremendous of liquidity in the world,’ Mr. Weill said in an interview.

"Citigroup which has a large consumer lending business, sounded some warning bells on Tuesday that the American economy was turning. The bank reported sharp upticks in losses stemming from souring auto, home and credit card loans. with losses coming from the same areas being hit by real estate.

"Two-thirds of the credit card losses, for example, occurred in just five states – California, Florida, Illinois Arizona and Michigan – that have been among those hit hardest by the housing downturn. Garry I. Crittenden, the company’s chief Financial Officer, acknowledged the bank’s losses seemed to be accelerating month after month.

"Citigroup executives expect house prices throughout the country will persist, dropping on average another 6.5 percent to 7 percent.

"The news sent the company’s stock tumbling 7.3 percent, to $26.94. It has now fallen about 50% in the past year. The fear is that financial institutions will continue to take large write-downs as bad loans mount, while consumers, facing higher energy costs, falling house prices and a bleak outlook for job growth, will rein in spending even more than they already have."

Saying "Yes" but at No Altar

However, a highly entrepreneurial assortment of corporations do their harvesting in other folks’ cemeteries. The Wall Street Journal (17/01, "Financiers Reap Riches Even as Deals Wobble" by Liam Pleven and Suzanne Craig) explain the play: "To understand a root cause of the financial crisis shaking global markets, take a look at Kevin Schmidt’s pay-check.

"Mr. Schmidt arranges mortgages in Shreveport, LA. He earns his money up front, taking a percentage of each loan once papers are signed. ‘We don’t get paid unless we can say "Yes" to loans,’ his firm’s Website says.

"The problem, which Mr. Schmidt says he sees clearly: brokers have little incentive to say ‘No’ to someone seeking a loan. If a borrower defaults several months later – as Americans increasingly are doing – it’s someone else’s problem.

"At every level of the financial system, key players – from deal-makers on Wall St. and in the City of London to local brokers like Mr. Schmidt – often get a cut of what a transaction is supposed to be worth when first structured, not when it actually delivers in the long term. Now, as the bond market wobbles, takeover deals unravel and mortgages sour, the situation is spurring a reexamination of how financiers get paid and whether the incentives the pay structure creates need to be modified, This week Congress asked three prominent executives to testify about their pay packages.

"Up-front commissions and fees are well established on Wall Street. Investment banks get paid when billion-dollar deals are inked. Firms that create complex new securities are paid a percentage off the top. Rating services assess the risk of a new bond in return for fees on the front end."

On that John Thain, until a few months ago head of the New York Stock Exchange has some penetrating reflections (The Wall Street Journal, 18/01, "Merrill’s Risk Manager" by Suzanne Craig and Randall Smith). Said Mr. Thain: "The growth prospects outside the US are actually better than in the US. and there is no reason why we can’t do it profitably."

WSJ: "What shocked you the most?’

"Mr. Thain: ‘Two things. One was the lack of understanding of risk in these positions and the other was the lack of balance-sheet control. The balance sheet really got out of control and traders were able to put on positions that were way too big. And I don’t [think] there was a good understanding of mortgage markets in general, and I don’t think there was a good understanding of what the risk was.’"

From other articles on the same front page of the Money and Investing section of the same issue of the WSJ, we get to some crucial points. In a risk-ridden business, risk management came to be increasingly farmed out, as might the engineering of a production plant. But with the rapid growth of the mortgage business in all its aspects, this added ever more outside services, quite apart from the foggy if consoling reassurances that economic theory had been reduced to be the beginning of the 20th century. The end result was a well-paid commitment that the risk evaluation, and/or insurance against risk had been provided, and that covered the backs of the high executives. In relative "normal" times this filled the bill and the reliability of risk insurance. In earlier times, the insurance coverage was never seriously put to the test.

Mortgage Lending Based on Pure Faith

The assessment of the risk that is supposed to go with any insurance policy seemed to be there, as was documented by the paid invoice of the risk insurance agent. However, too much of the checking began to be farmed out including some of the more questionable credit evaluations of the subprime mortgagors. Relegating all that stuff to off-balance sheet files seemed an efficiency until it was proved to be fraud. But at the very first serious test that was proved not to have been the case.

What the rich data on this aspect of the subprime mortgage crisis in our media and parliament has still not caught with is the connection with what happened a century or more ago in the gelding of economic theory and essentially a continuation of the same technique that has brought us the subprime mortgage crisis, and its further consequences that are still pouring in.

William Krehm

– from Economic Reform, February 2008