Wednesday, July 29, 2009

Taipan Daily: Continental Illinois and the Bailout Snowball

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Wednesday, July 29, 2009
Taipan Daily: Continental Illinois and the Bailout Snowball
by Justice Litle, Editorial Director, Taipan Publishing Group

Item of note... if you find yourself hiking in New Mexico, and then suddenly discover you need to go to the bathroom, you’re in luck. The federal government has pledged $2.8 million to fix aging toilets in New Mexico national forest areas. And that’s just New Mexico.

The New York Post reports that tens of millions more in “potty pork” is being spread around the nation, to “spruce up or completely replace” unsightly restrooms. (Apparently some of these are “historic” restrooms. Did you know that such a thing even existed? I sure didn’t.)

Well, one might say, they have to spend the money on something right? Your humble editor will forego any “shovel-ready” jokes for the sake of good taste. The “potty pork” anecdote did bring to mind a slightly more serious notion, though. Consider this excerpt from a Feb. 5 NYT piece, “Japan’s Big-Works Stimulus Is Lesson”:

In total, Japan spent $6.3 trillion on construction-related public investment between 1991 and September of last year, according to the Cabinet Office. The spending peaked in 1995 and remained high until the early 2000s, when it was cut amid growing concerns about ballooning budget deficits. More recently, the governing Liberal Democratic Party has increased spending again to revive the economy and the party’s own flagging popularity.

In the end, say economists, it was not public works but an expensive cleanup of the debt-ridden banking system, combined with growing exports to China and the United States, that brought a close to Japan’s Lost Decade. This has led many to conclude that spending did little more than sink Japan deeply into debt, leaving an enormous tax burden for future generations.

Six trillion bucks, wow. That’s a lot of toilets...

So if Japan is a guide as to what not to do (see “The Zombies That Ate Japan’s Recovery” for a refresher course) then maybe stimulus isn’t the answer. So how about financial reform? Unfortunately, the one guy who really wants to reform things has been unconscionably muzzled. What can you do?

If you’re Eliot Spitzer, you can speak truth to power.

Which brings us to our second item of note... the famed former prosecutor and New York governor, fallen from grace by way of a high-class prostitute, has lost all the natural inhibitions and discretions that come with having skin in the game.

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Thus freed, and with no backs left to scratch, Spitzer absolutely let loose in an interview with MSNBC host Dylan Ratigan, calling the Federal Reserve “a Ponzi scheme, an inside job.” His remarks are worth quoting at length:

The Federal Reserve has benefited for decades from the notion that it is quasi-autonomous, it’s supposed to be independent. Let me tell you a dirty secret: The Fed has done an absolutely disastrous job since [former Fed Chairman] Paul Volcker left.

The reality is the Fed has blown it. Time and time again, they blew it. Bubble after bubble, they failed to understand what they were doing to the economy.

The most poignant example for me is the AIG bailout, where they gave tens of billions of dollars that went right through — conduit payments — to the investment banks that are now solvent. We [taxpayers] didn’t get stock in those banks, they didn’t ask what was going on — this begs and cries out for hard, tough examination.

You look at the governing structure of the New York [Federal Reserve], it was run by the very banks that got the money. This is a Ponzi scheme, an inside job. It is outrageous, it is time for Congress to say enough of this. And to give them more power now is crazy.

The Fed needs to be examined carefully.

You get ‘em, Spitz!

Long Train Runnin’

The thing is, if the Fed did in fact “blow it,” one might argue they did so a long time ago. A very long time ago... perhaps stretching all the way back to “Conti” (the Continental Illinois National Bank and Trust Company).

We’ll weave Conti into the mix with our third and final item of note for today – a reader response to last week’s piece, “This Ain't 1982.”

As an adult in '82, I swear it was followed by '83. That Continental Illinois Bank & Trust was belly-up, and in August of 1983, if memory serves, Mexico by phone, gave notice to B of A, Chase, & Citi that Mexico would default on [its] Sovereign Loans, formally. This prompted calls to Uncle Paul Volker, and that was the real turning point. That is when for real Uncle Paul turned on the spigots full blast. Because a Mexican default would formally bury the three banksters.

So 'if' 82 was [paralleled] by '09, then it reasons that 2010 is the follower of 1983. "If" 2010 is the end of the slow down and the beginning of the expansion, and the exponential debts are cleared as they were in '82, then we only need to await a major bank collapse in the US(Citi?) and a foreign country to renege on its debts(Argentina? Russia?). Then surely a heavenly profit bull cycle is at hand.

Then again "if" my auntie has balls, she would have been my uncle. Big difference, no?


[TD reader Byron D.]

Cheers, Byron, for that walk down memory lane. (No comment on your aunt.) Based on my reading of the history, I would quibble with a few small points... for instance, the Fed had been aware of the Mexico situation for quite some time, and had long been warning the out-of-control banks of the effects that tight U.S. monetary policy could have on Latin American borrowers.

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Those warnings fell on deaf ears, of course, because it seems that the towering heights of big-bank arrogance are only matched by the towering heights of big-bank stupidity. (And that’s the history talking, not yours truly.)

A bigger quibble would be with the notion that surface-level events have more of an impact than underlying conditions. Again, I would argue it was the unique set of general conditions that prevailed in 1982 – in regard to a fiscally fit, leverage-light U.S. economy – that allowed for the great bull market leverage-fest that followed. A big bank failure or country failure now might inspire déjà vu, but it wouldn’t turn back the clock on consumer debt levels, government funding requirements, or a number of other things that look radically different today.

Perhaps one could argue that emerging markets are primed for a super-run following a Western country blow-up – shoe on the other foot and whatnot – but that’s a different kettle of fish...

On a more philosophical note, one could ask an important question. Are we heading back into a familiar cycle – looping back around to someplace familiar as it were – or have we broken ground on completely new territory?

I would argue the latter. We (and by we I mean the United States here) have reached a point in history for which there is no past precedent. What’s more, everything that has happened in the past quarter century is a part of that journey... and the effects of decisions made five years ago, 15 years ago, even 25 years ago or more, are still playing out.

A Big Ugly Precedent

Take Conti for example, the top-10 bank that came a cropper in the early ‘80s. People remember the failure of the Continental Illinois National Bank and Trust Company as just
that – a “failure” – but the thing is, it wasn’t a failure. Conti didn’t actually go belly up. They got bailed out.

Conti was run by an aggressive jackass named Roger Anderson. At one point Mr. Anderson was feted for his jackass ways, winning numerous “Banker of the Year” type awards from the industry. A prominent business magazine called Conti “one of the five best-managed corporations in the country,” and the WSJ called it “the bank to beat.”

What Anderson failed to disclose is how Conti managed to sustain such rampant growth in the late ‘70s and early ‘80s. The bank did it by ramping up its dubious loan exposure, including a mountain of dodgy oil patch loans from the doomed-to-fail Penn Square, a fly-by-night Oklahoma shopping center of a bank that threw money at speculators.

The head of Penn Square’s energy lending department, William Patterson, had earned the nickname “Monkeybrains” in college, and he lived up to it with his epically stupid loan authorizations. Conti signed on to handle a billion dollars’ worth of Penn Square overflow.

Dumb decisions like these made Conti Chairman Roger Anderson a hero in the short term and a zero in the longer term. As things deteriorated from bad to worse, Anderson told investors that “We have no intention of pulling in our horns.” Then he took a forced retirement as everything went to hell. In May of 1984 a “run on the bank” began... and the Fed bailed Conti out.

The Continental Illinois bailout was inevitable, you see, because letting Conti go bust would have been disaster for the entire banking system. It would have started a chain reaction, undoubtedly pulling down other major money center banks in its wake.

After it became clear that no one else wanted it, the government itself was forced to pony up for Conti. The bank stuck around, as a private corporation with 80% government ownership, until 1994, when Bank of America acquired the carcass and put the Conti name to final rest.

Snowballs and Martingales

If the Conti story sounds familiar, it’s because we’re in the process of reliving it on an epically bigger scale. To soothe financial markets the first time around, the Fed had to give Conti $8 billion worth of emergency loans. That was a staggering sum at the time. Now, like a malevolent snowball, we’ve seen what happens as the bailout costs just keep getting bigger and bigger.

Probably the worst lesson investors took from Conti is that “too big to fail” meant “big beats small every time.” Even as the Fed swooped in to save Conti, small regional banks in unconnected states like Louisiana and Tennessee were being shut down. The message to investors (and bankers) was unintended but clear: Bigger is better. Put your money with a big bank. What’s more, small banks should strive to become big banks by whatever means possible.

The thing is, “that which can’t go on must stop” as some wise man once observed. This cycle of bigger and bigger bailouts, with ever greater lengths taken to “make it like it was before,” just can’t go on forever. It has to stop at some point. Either the government runs out of money, taxpayers run out of patience, or investors run out of faith. Right now we’re on track for some unholy combination of the three.

That’s why I don’t see us swinging back around for some glorious repeat of a bygone cycle. I think we’re still living out the effects of the past 25-year cycle, and the Fed and Treasury’s trusty martingale system – placing bigger and bigger bets, doubling down until all comes good – is on the edge of breakdown.

Warm Regards,


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