The Great Deformation (101 page)

By the time of the Wall Street meltdown it was all over but the shouting, and Lighthouse did file for bankruptcy in June 2009. What the latter process revealed was the true essence of bubble finance. A court-ordered appraisal showed that the hotel company assets were worth just $2.8 billion, or only 35 percent of the $8 billion purchase price.

What this finding meant was that Extended Stay America was not worth even the $4.1 billion of secured mortgage debt which had financed the deal. The entire $3.3 billion in the mezzanine tranches was purely bottled air, and yet it was the latter which had financed Blackstone's famous $2.1 billion payday on the eve of its IPO.

THE ROAD NOT TAKEN:

WHY THE WALL STREET CASINO LIVES ON

Drastically overpriced debt is eventually smacked with painful losses on the free market, but not on a Wall Street served by compliant central bankers.
When the Bernanke Fed bailed out Bear Stearns in March 2008, for example, it was sitting on tens of billions of impaired or worthless assets.

Among this financial sludge was $1.1 billion of the undistributed Extended Stay paper. Accordingly, the taxpayers of America through their central bank became the owners of busted bonds which, on the margin, had funded nearly half of Blackstone's legendary profit on the sale to Lightstone.

In this saga of low-rent hotel rooms the evils of bubble finance are starkly revealed. It demonstrates vividly how the mega-LBO frenzy of the second Greenspan bubble escalated income and wealth to the top 1 percent, or in this case the top 0.0001 percent. But even more importantly it documents why Washington's frantic bailouts after September 15, 2008, were so misguided and counterproductive.

The time was long overdue for a classic liquidation of the massive credit bubble which had built up since the 1980s. A generation of speculators who rode it to the peak needed to be unhorsed once and for all. And it could have been easily achieved: Bernanke only needed to ignore the Cramer rant which echoed throughout the canyons of Wall Street in August 2007 and, instead, order the Fed's open market desk to sit firmly on its hands.

So doing, the Fed would have engaged in the right sort of “accommodation.” It would have facilitated Wall Street's desperate need for a financial housecleaning, just as J. P. Morgan did with such sublime effect in October 1907.

By staying out of the Treasury market the Fed would have permitted short-term interest rates to soar, thereby laying low the financial meth labs all along Wall Street. Their toxic inventories would have been dumped into the market at fire sale prices; they would have had no choice because trading desks would have been faced with crushing double-digit funding rates in the repo and wholesale money markets—rates which would have been rising by the hour and threatening to soar to terrifying levels. That is how panics ended in historic times, and that's why speculation did not become deeply embedded and institutionalized as it has in the age of bubble finance.

The result would have been a bonfire of speculative paper that would not have been forgotten for a generation. Every single investment bank, including Goldman, Morgan Stanley, and the embedded hedge funds at JPMorgan, Citibank, and Bank of America would have been rendered instantly insolvent and dismembered under court and FDIC protection. Speculators would have denounced the Greenspan Put for decades to come. No banking institution reckless enough to make $100,000 bridge loans against $35,000 hotel rooms would have reemerged from the conflagration.

Just as importantly, the bonfires would have largely burned out in the canyons of Wall Street. The nonfinancial businesses of Main Street would have been largely unscathed for four principal reasons.

First, after having already massively inflated its debt, from $4 trillion to $11 trillion during the fifteen years ending in 2008, the business sector needed to liquidate borrowings, not go into hock even further. A period of high interest rates and scarce new debt availability would have been economically therapeutic.

Secondly, at that moment in time viable and solvent businesses did not need cheap debt to finance productive assets. Huge sectors of the US economy centered on commercial real estate, retailing, hospitality, and other forms of discretionary consumer spending were already vastly overbuilt. A period of high-cost debt, therefore, would have dramatically reduced the rampant malinvestments of the Greenspan bubbles and forced businesses to fund only high-return projects out of internal cash flow or expensive long-term debt.

Thirdly, high interest rates would have shut down the multitrillion flow of new debt to financial engineering. As previously shown, buybacks, buyouts, and takeovers contribute little to real business productivity and growth of national wealth, and mostly serve to scalp economic rents from Main Street and channel them to the top 1 percent.

Finally, thousands of drastically overleveraged business like Extended Stay America would have been forced into bankruptcy but they would have nevertheless continued to function under court protection. More importantly, they did not need Wall Street to reorganize their finances. Several trillions of business debt that had been incurred to fund LBOs, stock buybacks, and corporate takeovers could have been repudiated by debtors in bankruptcy court and replaced by simplified, equity-based capital structures.

Businesses thus freed from the yoke of Wall Street–originated debt would have emerged from
Chapter 11
and have been controlled by the knowledgeable businessmen and skilled employees who had operated them all along. The American economy would thereby have embarked on the road to definancialization. Real economic productivity, investment, innovation, and growth based on honest free enterprise might have again become possible.

Instead, after the Lehman event, the madcap money printing of the Bernanke Fed and the bailout frenzy of the Paulson Treasury Department stopped the Wall Street cleansing in its tracks. The only thing that changed was that the remnants of the “departed”—Bear Stearns, Merrill Lynch, Lehman, Wachovia—were recycled back into the even greater girth of the
“reprieved”—Goldman, Morgan Stanley, JPMorgan, Bank of America, Barclays, Citigroup, and Wells Fargo.

The system which finally failed in September 2008 was actually reincarnated in even more destructive aspect. The Bernanke Put was far more insidious than the Greenspan Put because it refused to permit even a 10 percent correction in the stock averages before pumping a new round of juice into Wall Street.

Likewise, the carry trade became an even more one-sided gift to speculators: risk assets could now be funded in the wholesale money markets for virtually nothing, while hedge fund operators were solemnly promised by the monetary central planners that their cost of carry would be frozen at nearly zero for years on end.

BLACKSTONE DOUBLE DIP

But the worst effect was that the Wall Street machinery and principal participants in the financial engineering régime were soon back in business. This cardinal reality was made starkly evident in the court papers issued upon Extended Stay America's discharge from bankruptcy in May 2010. The hotel company's proud new owner was, well, the Blackstone Group. And to underscore that speculators had returned to the scene of the prior strangulation, as it were, its partner in the deal was the John Paulson hedge fund.

The ever gullible financial press was wont to characterize this outcome as a triumph of capitalism; that is, the mobilization of flexible private equity capital to reorganize and recapitalize a failed business enterprise. But that was dead wrong because the Blackstone-Paulson partnership didn't recapitalize anything. What it did, instead, was utilize the same cadre of Wall Street lawyers and bankers to shrink and shuffle the busted debt paper from the Lightstone deal into a new deck of about $3.5 billion of notes, bonds, and preferred stock.

The second Blackstone deal, therefore, brought only trivial amounts of actual fresh equity—a couple hundred million—to the table. The Blackstone-Paulson investors essentially performed the same old trick that had become standard fare before the Wall Street crisis: they bought another call option on a debt-laden enterprise that was leveraged at 10:1.

Whether the resulting 50 percent haircut on the total capitalization, from $8 billion to about $4 billion, was the right value for the 76,000 aging hotel rooms in the Extended Stay portfolio would be determined by real-world events. But the underlying facts were not encouraging: the financial deformations that had led to Extended Stay's boom, crash, and rebirth had produced a giant malinvestment in the overall hotel sector.

In fact, the ultimate indication that the Wall Street playpen known as the US hotel sector is not on the level lies in a startling statistic: there are 13.2 million hotel rooms in the world, and 5.6 million of them are located in the United States. Thus, with 4 percent of the global population we have 42 percent of the hotel rooms.

The American economy is drastically overhoteled in part because a significant swath of its labor force has become nomadic. Some of this may be attributable to new-style traveling tech workers and old-style traveling salesmen. But mainly it is due to a drastic policy-induced deformation. The Fed's massive creation of dollar liabilities drove tradable goods production to the mercantilist “cheap labor” regions of the Asian rice paddies. At the same time, it fueled an orgy of real estate development and construction on the “cheap land” precincts of the sun and sand belts at home.

As previously explained, at least 10 million tradable goods jobs had been off-shored during the Greenspan era, meaning that jobs had become scarce where people used to live (Flint, Michigan). At the same time, the debt-fueled boom in the Sunbelt—health care, retirement communities, resorts and leisure, and endless construction of new housing developments, shopping malls, and other commercial real estate projects—happened on the margin, where people didn't yet live (Ft. Myers, Florida).

Not surprisingly, the extended-stay hotel segment, where business travel accounts for 75 percent of room night demand, grew like Topsy during the two Greenspan bubbles. It provided a way station for nomadic workers and populations in transit. As in the case of all malinvestments, however, the music eventually stops when the speculative bubble which finances them implodes. That has now happened, thereby causing the ranks of nomadic finance, construction, leisure industry, and retail and consumer service workers to significantly diminish.

Accordingly, the extended-stay hotel segment remains overbuilt and overvalued a half decade after new construction peaked. Yet the Fed's ZIRP (zero interest) policy perversely thwarts the free market's curative capacities to punish speculation and liberate assets from the encumbrance of excessive debt. Instead, it perpetuates the “extend and pretend” illusion that the debt is money good because it encumbers an asset that is vastly inflated in value.

ECONOMIC SUFFOCATION BY BERNANKE'S RENTIERS

In effect, Bernanke is the godfather of the debt zombies. His radical interest rate repression campaign has not created much new lending, but it has disabled and overridden the free market's capacity to liquidate bubble-era
credit. Instead of taking the drastic debt write-downs which are warranted, banks and other lenders have been enabled to pursue the “extend and pretend” route; that is, extending maturities on debt that can never be repaid while booking it at par because borrowers stay current on interest payments.

The low interest rates on bubble-era debt, as well as post-crisis restructured debt, are laughable by all historic standards. Banks should be reserving heavily against the maturity cliffs ahead, but are not being required to do so owing to the utter folly emanating from the Eccles Building; namely, the Fed's fatuous promise that one day it will be able to “normalize” interest rates without triggering a debt-impairing conflagration on Wall Street and another plunge on Main Street.

So by not taking the deep reserves required, Wall Street banks are (again) reporting phony profits. Indeed, led by JPMorgan they are massively reversing out reserves they had previously taken in order to goose their earnings and levitate the value of executive stock options. And phantom banking profits are only the surface issue.

The real economic problem is that by keeping properties and businesses encumbered with too much restructured and rescheduled zombie debt—as was evident in the so-called restructuring of Extended Stay America by Blackstone and Paulson—free cash flow is siphoned off to pay what are essentially unearned rents. These ill-gotten receipts are collected by Keynes's famous rentiers who nowadays are called PMs (portfolio managers) at fixed-income funds.

Stated differently, bubble-era properties and companies are being bled to death by uneconomic interest payments and thereby precluded from reinvesting in plant, equipment, technology, new products, human resources, and all the other ingredients of sustainability. After a decade as a debt zombie, therefore, the typical commercial property will have lapsed into a state of terminal decay and the typical operating business will have become a hollowed-out cipher.

None of this would have been a surprise to pre-Keynesian-era economists because they knew that credit inflations are tricksters. They fund artificial demand which gives rise to secondary and tertiary waves of additional demand, usually to build new infrastructure and production capacity that ends up redundant when the bubble pops.

This crack-up boom cycle so well known to the ancients was vividly at work in the extended-stay hotel segment. At the peak of the bubble, nomadic workers in construction, finance, and real estate were actually creating part of their own demand; that is, they were filling rooms that
justified even more construction. Yet developers couldn't fill up rooms with their own workers indefinitely, nor could the Fed permanently extend the speculative building mania in commercial real estate.