Wednesday, June 17, 2009

Bailout Nation by Barry Ritholtz

Barry Ritholtz, the extremely popular financial blogger, just released his first book, Bailout Nation. In this ambitious book, Mr. Ritholtz not only tries to analyze the most recent government bailouts but he also seeks to put these events in proper historical context.

The book begins with a history of US central banking. To make a long story short, following the Panic of 1907, the Federal Reserve came into existence in 1913. Its original mandate, to simply achieve price stability, has gradually extended over time.

After the creation of the Federal Reserve in 1913, Ritholtz pinpoints 1971 as the next year of significance. This was the year that the government first bailed out a private corporation, Lockheed Aircraft Corporation, in the form of loan guarantees. Once this precedent was set, it allowed for the bailout of Penn Central later on that year and Chrysler in 1980. A highlight of this section of the book is where Ritholtz makes a strong argument that letting Chrysler fail all the way back in 1980 might have prevented the current crisis affecting US automakers.

Following these “industrial bailouts,” Ritholtz argues that a new era of “stock market bailouts” began in 1987. Market historians will immediately recognize that 1987 was the year of the Black Monday stock market crash, where the Dow lost 22.6% in a single October day. A second important event that happened that year was the naming of Alan Greenspan as Federal Reserve Chairman. Ritholtz blames Chairman Greenspan and the Federal Reserve with reacting too strongly to prop up markets following the 1987 stock market collapse. Like with the bailout of Lockheed in 1971, the strong Fed response set a new precedent going forward. Ritholtz describes it as follows:

The Greenspan Fed created an endemic culture of excessive risk taking. The U.S. central bank created moral hazard not by targeting inflation or the business cycle, but instead by focusing on asset prices. From the squishy focus on psychology, it was merely a short hop to asset prices. After all, when prices go down, it negatively impacts sentiment, right? This was the Fed’s fatal flaw under Greenspan’s leadership. As we shall see, once those in the capital markets realized that the Fed stood ready to protect the downside via monetary reflation, all bets were off.

Following this precedent, at any hint of a stock market sell off, Chairman Greenspan would quickly come to the rescue with emergency interest rate cuts. These stock market bailouts continued until the market got carried away in the “irrational exuberance” era of the second half of the 1990s. The big moment of truth in this era came in 1998 when the Fed helped organize a bailout for Long Term Capital Management.

Once the stock market crashed following the dot-com blowup, the Fed engineered a false recovery by creating the housing bubble. Ritholtz goes into rich detail describing how and why the housing bubble was formed and then popped. The crash in housing caused the collapse of the banking system which brought about unprecedented levels of government intervention and which lands us to today: bailout nation.

By the time readers make it through the entire history of bailouts up to today they are ready for the most fun part of the book: Chapter 19, which is titled Casting Blame. Ritholtz runs down an exhaustive list of people, companies, government agencies and other entities whom he assigns responsibility for the financial crisis.

Number one on his list is Federal Reserve Chairman Alan Greenspan. Before reading Bailout Nation, my own opinion on the crisis was that no one individual, organization or law was responsible but if you had to name one and only one culprit, it was Alan Greenspan. Needless to say, I completely agree with Ritholtz on this point. Greenspan was responsible for (1) being too quick to prop up equity markets when they faltered, (2) keeping interest rates too low for too long, and (3) for not properly reigning in reckless lending by financial institutions.

For point number one, Ritholtz provides ample evidence (with excellent charts) showing how reckless Greenspan was by watching equity markets too closely.

For point two, Ritholtz covers one nearly always overlooked downside to low interest rates: individuals and institutions that seek safe investments often turn to high quality bonds. If these bonds do not meet a minimum level of return, these investors are either forced to lose ground or take on additional risk. On this subject, Ritholtz makes a compelling point on page 106:

Each fiscal year, trusts and foundations must spend or give away 5 percent of the average market value of their assets. Failing to do so leads to heavy penalties (2 percent of assets), and the possible loss of their advantageous tax status. This is why any professional money manager who is handling capital for these organizations wants to safely generate sufficient income to cover the 5 percent payout obligation. … Hence, ultralow rates caused tremendous angst and consternation among fixed-income managers. They simply could not generate the needed returns when the Fed had driven rates so absurdly low.

Ritholtz does not mention this, but this is likely why a Fed funds rate of 5.25% lead to a stock market crash. Once fund managers could again safely earn a 5% return, they moved from stocks into bonds. It makes one wonder what would happen to stocks if inflation took off and the Fed was forced to raise rates well above 5%.

For point three, Ritholtz goes in depth to show how there were obvious signs that lending practices for mortgage originations were out of control. The Federal Reserve should have stepped in to stop the madness but they seemingly encouraged the practices every step of the way.

After Greenspan, Ritholtz wags his finger at (in order) The Federal Reserve, Senator Phil Gramm, the rating agencies, the SEC and so on, covering 22 entities in all. In the end, when I take a step back and look at these vast number of failure points, I can only conclude that the housing crash and subsequent financial crisis was not some fluke or bad luck but was inevitable. My own broader conclusion on the financial crisis is that this seemingly endless number of failures at all places in government and business are simply symptoms of a country on the decline. Ritholtz never ventures into this territory, which is probably smart as a whole second book could be written about this subject.

On pages 45-49, Ritholtz lays out a ten step pattern for all financial bailouts. These steps can be found in bailouts ranging from the savings and loan crisis, Long Term Capital Management and up to the most recent bailouts. This is a very strong list that stands right next to the well known stages of financial bubbles as a quick and easy blueprint on the subject. If this book is to be remembered for anything, this ten step list should be it. Well done.

Bailout Nation ends with suggestions on fixing what ails housing, the economy and the financial industry. For this chapter, Ritholtz relies on the ideas of friends and industry gurus. Strangely, what he does not offer is his own suggestions. Sure, reading what Doug Kass and John Mauldin thinks is great but I bought Bailout Nation to find out what Barry Ritholtz thinks. His lack of personal suggestions in this section leaves the book with an incomplete feeling. If you are a regular reader of his blog like I am, you may be dumbfounded to find out that normally very opinionated Mr. Ritholtz seems to have held back his opinion on this important subject.

While large sections of the book are written in a traditional and polite manner, Mr. Ritholtz can get a bit crude in certain sections. For example, Chapter 16 is titled Dot-Com Penis Envy. One can almost sense that his first draft descriptions of Alan Greenspan and Phil Gramm included multiple f-bombs before his editor pushed back. In the end, while Bailout Nation may be slightly less entertaining in that it feels like Ritholtz pulled back in certain areas, it was probably a wise choice to maintain credibility.

In the pantheon of business books there are a handful of shining stars that stand in history as the single authority on a particular subject. When Genius Failed is the definitive resource for understanding the collapse of Long Term Capital Management. The Smartest Guys in the Room is the definitive resource for understanding the collapse of Enron. Bailout Nation is a good book but will not likely go down as the definitive resource for understanding the current economic crisis. For now, though, it is the best all in one resource available on the subject. Barry Ritholtz made a good effort at making a very complex subject accessible to novices while still maintaining enough in depth analysis to please experts. I recommend it to anyone seeking to better understand how we came to become a bailout nation.
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