Resetting the Bomb

Neil Barofsky, the Special Inspector General for the last bailout, guesses that whoever has his job this time around is going to have a lot of work. 

“There will be S&L-type frauds, absolutely ostentatious frauds,” he says, spitballing a list of potential problems in the $2 trillion Covid-19 rescue package. “I’d be looking for tens of billions of loss to fraud.”

This is unavoidable. If the rescue package signed into law by Donald Trump on March 27 had more regulatory controls — “nothing, nada, zero,” oversight is how another economist explains the existing structure — it might defeat the purpose of getting money out into the economy quickly. It seems possible the rescue was designed with such surreal logic in mind. “Fraudsters spend money, too,” is how Barofsky puts it. 

A second issue has to do with the structure of the Covid-19 relief plan. It features two main components: rescues of Main Street and Wall Street.

The headline-grabbing frauds will be found in the Main Street side, where crooks will scheme to get their hands on (among other things) $377 billion in relief intended for desperate restaurants, hardware stores, nail salons and other real-world employers. 

These will be scams the public can understand, “straight rips,” as Barofsky puts it: insiders creating dummy companies and submitting for loans, employers taking money for payroll and hiding layoffs, con artists Googling their way to successful SBA loan applications, etc. 

Nigerian-letter-type scams, in which crooks impersonate bailout agencies asking for bank info before sending relief, are already being reported across the country. Stories range from mass-texts from “CostCo” offering $110 stimulus checks, to a woman who said she was offered a six-figure Covid-19 grant from “Bill Barr” by phone. 

Those stories are bad, but the exponentially more serious potential for mischief in this new rescue is on the Wall Street side. “With the [Main Street] relief, you might see $50,000 frauds, $100,000, $4 million,” says Barofsky. “It’ll be billions on the other side.” 

There are worries from analysts about the use of bailout funds to manipulate financial markets, finance takeovers and buybacks, subsidize executive bonuses. The crisis will surely be used as a pretext to con the public into taking tens or hundreds of billions in bad investments off the books of dumb companies, in the name of “guaranteeing liquidity.” 

A larger issue is conceptual. What’s the consequence of making the maintenance of prices in financial markets a “systemically important” end in itself?

America’s executive class in the last few decades has settled into a Ponzi-like pattern: borrow, inflate, strip assets, crash, get bailed out, start over. Both the profits and the size of the bag the rest of the country is left holding get bigger with each cycle. 

In the last ten years buybacks, takeovers and other schemes made executives rich, but left companies cash-poor and leveraged to the hilt. When Covid-19 hit, corporate America could with sincerity claim it needed immediate aid to keep doors open and financial markets afloat. 

But the scope of the rescue is as massive as it is in significant part because private-sector cash that might otherwise have buffered the damage had already been stripped out of the economy. As Marcus Stanley of Americans for Financial Reform puts it, “We’re starting to routinize the process of privatizing gains and socializing losses.”   

A week of calls to anxious analysts in quarantine identified a series of related issues hanging over the rescue:

“Debt bomb.” The 2008 mess was triggered in part when companies like Goldman, Sachs issued collateral calls against billions in credit default swap contracts it held with insurance giant AIG. When the latter was unable to come up with the money, mayhem ensued, creating wide-scale losses and necessitating an AIG bailout – through which Goldman ended up being paid $12.9 billion. 

The pre-2008 economy was built on a combustible pile of mortgage debt, and bets on mortgage debt, that exploded once banks got nervous and started to call in their money. Some cleaning up of the mortgage markets was done, but Wall Street simply moved elsewhere to build new credit sandcastles, leading to an explosion of corporate debt, securitized commercial loans (CLOs), takeovers, etc.  

One new development involved “subscription lines,” a type of financing of private equity deals, the cheery name we use today for leveraged buyouts. 

When a Wall Street takeover artist wants to raise cash to buy up a company, it goes to big-dollar players – often an institutional investor like a pension fund – and elicits commitments to invest. The private equity fund then goes to a bank, which issues “subscription lines” of financing against the promise of those investors (a.k.a. the “limited partners”). 

Subscription lines have existed for decades, but their use was traditionally limited and short-term, with investors coughing up capital within 30 days. In recent years and especially since 2008, though, the scope of subscription line financing has increased, and the time to repay has also been expanding, to up to five years. 

Making takeovers easier andmore profitable for executives of the Bain Capitals of the world inspired what Barron’s in 2018 described as a “rage” for subscription line financing. This was one of many post-bailout factors inspiring the recent boom in leveraged buyouts: the years 2013-2018 saw the most private equity deals over any five year-period in American history.  

The rub is that capital on those “lines” can be called in at any time, and might be, as the Covid-19 crisis progresses. The funds themselves are also demanding that investors fulfill commitments. In California, the $17.8 billion Orange County Employees Retirement Fund said they received three capital calls over two weeks.

“Investors are terrified that banks are going to start calling the leverage on the leverage,” noted one former private equity firm executive last week. “After 2008, they didn’t defuse the debt bomb. They reset it.”

A March 19 piece by William Cohan in Vanity Fair quoted industry insiders worrying about the “scourge of interconnectivity” returning, with particular concern about debt amassed in the private equity world. A trade publication, Buyouts Insider, likewise quoted private equity investors worrying about a “nightmare scenario” in which nervous banks calling in their lines would cause a “flurry of cash going out the door.”

That situation bears watching. Private equity funds were at the center of another controversy animating Washington last week:

“Equity investors” target the bailout. After the CARES Act was signed by Trump on March 27, it looked like takeover artists might be frozen out. The problem was the “affiliation rule,” which barred businesses from receiving emergency money if they were backed by a sponsor firm controlling companies that collectively employ over 500 people. 

Thousands of businesses are controlled by leveraged buyout firms, employing as many as nine million Americans overall. The number of employed would be higher, of course, if not for the layoffs that often ensue after a private equity fund acquires a firm and begins squeezing it dry. 1.3 million Americans in the retail sector alone were laid off in this way in the last decade, according to one report. 

Companies controlled by private equity often face bigger cash crunches than non-affiliated firms, because in addition to having to make rent, payroll, and other ordinary expenses, they also owe an array of special “dividends” and fees to Wall Street masters. In times like the Covid-19 disaster, these revenue streams ostensibly dry up. But what if financiers could use bailout funds to get their vig paid?

Last Tuesday, Steve Nelson of the Institutional Limited Partners Association, a private equity group whose members include titans like Apollo and Blackstone, sent a letter to Steve Mnuchin (how do we always manage to have a Goldman-trained Treasury Secretary during these crises?). 

“We see no reason why being owned in a fund structure should result in these businesses having less access to the capital needed to keep their employees on the payroll,” Nelson wrote.

This overture was apparently rebuffed at first, but no worry: there was always congress to lobby! By late Tuesday, Nancy Pelosi was writing Mnuchin a letter explaining that “startups are the engine of America’s innovation economy” and that the thousands of firms backed by “equity investors” in the Bay Area and Silicon Valley shouldn’t be frozen out by the affiliation rule. 

The next day, Maxine Waters sent Mnuchin a different note, demanding that any aid to “equity investors” go to workers, not a “government handout for well-funded private funds.” 

Waters added, “any funds granted through this program must not be used to pay any debts or obligations to private funds, including management or consulting fees” – right on the money in terms of what one watchdog agency analyst feared these “avaricious fuckers” were after.

By the next day, House Minority Leader Kevin McCarthy was announcing that startups backed by venture capital would be eligible for bailout cash. Venture capital, which owns a stake in the growth of companies, is not the same as private equity, which controls these firms and often saddles them with fees and obligations. McCarthy said there might be future efforts to “address” private equity-owned businesses, but for now they would use “control” as a determining eligibility factor.

How this all plays out is unclear, but bet on the private equity lobby continuing to hack away until it somehow gets to the bailout money. 

Loopholes. The Main Street provision of the bill is simple in principle. If you run a small or medium-sized business, and you do your banking with an SBA-approved lender, ask your bank for money and you’re basically supposed to get it, up to $10 million. If you don’t lay off any employees, the loan is supposed to be forgiven. 

When the gates opened on the program Friday, a “frenzy” of applications led to about $3.2 billion in loans going out the door in a day, to roughly 10,000 businesses. However, there were widespread reports of problems, with some banks asking for more time – JP Morgan Chase warned customers they wouldn’t be ready – a situation that led some to wonder if banks were stalling for better conditions. 

Banks are scheduled to earn 1% to 5% to underwrite these loans, which are 100% backed by the government, a nice chunk of essentially risk-free money. If the loans are not forgiven after two months, the compensation becomes 1%. That number was 0.5% originally, but banks had the government over a barrel as the start date approached, and the rate was doubled on Thursday, just before the program opened. 

There are other battles. Wells Fargo is using the crisis to ask for relief from regulatory caps imposed after a string of scandals. Other banks are asking for a relaxation of anti-money laundering controls, higher interest rates, freedom from liability in case of fraudulent applications, and a host of other requests, many of them reasonable given the situation, but which may also have longer-term implications.

All these issues, in conjunction with the logistical problem posed by a huge rescue program being administered by the notoriously slow and overwhelmed SBA, add up to worry that money will not get to employers quickly enough, or at all. A program with similar conception after 2008, the HAMP mortgage relief plan, closed up shop after providing very limited real-world aid. That shouldn’t happen this time, but there are a lot of steps between the pile of government cash and the millions of non-finance-sector human beings who need it.

Meanwhile, money has been pouring almost unabated into the financial markets. The CARES bill included a $454 billion appropriation to Treasury, which insures a vast program of Federal Reserve asset purchases and direct loans. These, too, ostensibly have conditions, but loopholes were baked in that could accelerate pre-Covid problems.

A major issue in the post-crash era, and especially in the last few years, has been the orgy of stock buybacks and redemptions. According to Americans for Financial Reform, the biggest banks in the country have returned an obscene $265 billion to shareholders just in 2018 and 2019, which represents 110% of net income. This is another way of saying bank shareholders heading into this crisis had hovered up all of their recent cash flow and a little bit more of reserves to boot, leaving little for the very rainy day we’re now experiencing. 

It wasn’t just banks. Companies overall spent $7 trillion on buybacks between 2004 and 2014, and nearly $2.5 trillion in the years 2018 and 2019 alone. A 2018 study by the Roosevelt Institute found that Lowe’s, CVS, and Home Depot could each have given workers $18,000 raises across the board with money that was instead spent on buybacks. The restaurant industry outdid banks by spending 140% of its profits on buybacks during the same period, 2015-2017.And so on.

In recent weeks, there’s been a lot of self-congratulation among members about rules imposed in the CARES Act to prevent stock buybacks. “We ensured in the bill that any taxpayer dollars given to industry goes first and foremost to worker paychecks and benefits, not CEO bonuses, stock buybacks or dividends,” is how Pelosi put it.  

However, the rule only speaks to direct loans. There are countless other ways for companies to get money in this rescue. It appears a corporation that issued bonds and sold them into the Fed’s giganto-buying programs could take the proceeds of those sales and buy its own stock, for instance. 

Marcus Stanley of Americans for Financial Reform points out that buybacks are actually mentioned in the terms for the Fed’s new Primary Corporate Credit Facility. The Fed program offers an arrangement where certain companies (likely, the ones in serious trouble) can issue bonds without having to pay interest for a year. “A borrower that makes this election may not pay dividends or make stock buybacks during the period it is not paying interest,” the rules state.

Presumably, that means a company that issues bonds in normal fashion and sells them into the facility may pay dividends and make buybacks. “That’s how I read this, that they considered that,” says Stanley. 

There are other worries about the financial rescue. For instance, the world’s largest asset manager, BlackRock, will oversee the Fed’s new corporate bond-buying program, an arrangement that inspires gallows laughter among analysts. BlackRock sells corporate bonds under the brand name iShares, and it has some of the biggest bond-backed ETFs (exchange-traded funds), including a major one that trades under the name LQD that was in freefall in March, but rallied since BlackRock’s appointment. 

“’Conflict of interest’ is kind of a quaint 20th-century term to describe the BlackRock arrangement,” says Stanley.

Firms like BlackRock will guide hundreds of billions in Federal Reserve purchases, effectively setting prices as massive buyers in the very markets in which they operate. “The big asset managers are the choke points,” agrees another economist.  

The difference between the Trump rescue and the Bush-Obama bailouts of 2008 is that this time, we’re at least not rescuing the direct culprits behind the crash. Coronavirus isn’t the fault of Bain Capital or Citigroup or Home Depot.

What’s the same is that instead of fixing glaring structural problems, we’re once again throwing trillions at the unfairness economy, essentially guaranteeing that we’ll be right back in this same spot again soon, bailing out the next era of “record profits.” We’re resetting the bomb again.