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Excerpted from THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA by David A. Stockman by arrangement with PublicAffairs, an imprint of the Perseus Books Group. Copyright © David A. Stockman, 2013.

CHAPTER 2

FALSE LEGENDS OF DARK ATMS AND FAILING BANKS

When the great financial bubble finally burst in September 2008, AIG's credit default insurance was shockingly exposed as bogus. Given this evidence of utterly reckless and massive speculation, the Fed was handed, as if on a platter, one final chance to restore a semblance of capital market discipline.

By that late hour, however, the Fed was not even remotely interested in financial discipline. The Greenspan Put had now been superseded by the even more insidious Bernanke Put. In defiance of every classic canon of sound money, the new Fed chairman had panicked in the face of the first stock market tremors in August 2007 (see chapter 23), and thereafter the S&P 500 had become an active and omnipresent transmission mechanism for the execution of central bank policy. Consequently, after the Lehman event the plummeting stock averages had to be arrested and revived at all hazards. Accordingly, the bailout of AIG was first and foremost an exercise in stabilizing the S&P 500.

The cover story, of course, was the threat that a financial contagion would ripple out from the corpus of AIG, bringing disruption and job losses to the real economy. As has been seen, however, there was nothing at all "contagious" about AIG, so Bernanke and Paulson simply peddled flat-out nonsense in order to secure Capitol Hill acquiescence to their dictates and to douse what they derisively called "populist" agitation; that is, the noisy denunciation of the bailouts arising from an intrepid minority of politicians impertinent enough to stand up for the taxpayer.

But this hardy band of dissenters—ranging from Congressman Ron Paul to Senator Bernie Sanders—was correct. Everyday Americans would not have lost sleep or their jobs, even if AIG's upstairs gambling patrons had been allowed to lose their shirts. Still, the bailsters peddled a legend which has persisted; namely, that in September 2008 the nation's financial payments system was on the cusp of crashing, and that absent the bailouts American companies would have missed payrolls, ATMs would have gone dark, and general financial disintegration would have ensued. But this is a legend. No evidence has ever been presented to prove it because there isn't any.

Had Washington allowed nature to take its course in the days after the Lehman collapse on September 15, the only Wall Street furniture which would have been broken was the potential bankruptcy of Goldman Sachs and Morgan Stanley, the two remaining investment banks. Needless to say, the utterly myopic investment banker who was running the US government from his Treasury office wasted not a second ascertaining whether the public interest might diverge from Goldman's stock price under the circumstances at hand.

According to his memoirs, Secretary Paulson already "knew" on the very morning Lehman failed that the last two investment banks standing needed to be rescued at all hazards: "Lose Morgan Stanley, and Goldman Sachs would be next in line—if they fell the financial system might vaporize and with it, the economy."

Tendentious and sophomoric would be a more than generous characterization of that apocalyptic riff. Yet groundless as it was, the fact that Paulson and his posse treated it as truth is deeply revealing. It underscores the extent to which public policy during the bubble years had been taken captive by the satraps and princes seconded to the nation's capital by Wall Street. Such self-serving foolishness would never have been uttered in earlier times, not even by the occasional captain of industry or finance who held high financial office.

Certainly President Eisenhower's treasury secretary and doughty opponent of Big Government, George Humphrey, would never have conflated the future of capitalism with the stock price of two or even two dozen Wall Street firms. Nor would President Kennedy's treasury secretary, Douglas Dillon, have done so, even had his own family's firm been imperiled. President Ford's treasury secretary and fiery apostle of free market capitalism, Bill Simon, would have crushed any bailout proposal in a thunder of denunciation. Even President Reagan's man at the Treasury Department, Don Regan, a Wall Street lifer who had built the modern Merrill Lynch, resisted the 1984 bailout of Continental Illinois until the very end.

Once the Fed plunged into the prosperity management business under Greenspan and Bernanke, however, the subordination of public policy to the pecuniary needs of Wall Street became inexorable. No other outcome was logically possible, given Wall Street's crucial role as a policy transmission mechanism and the predicate that rising stock prices would generate a wealth effect and thereby levitate the national economy.

Not surprisingly, the Goldman Sachs "occupation" of the US Treasury coincided almost exactly with the Fed's embrace of financialization, leverage, and speculation as crucial tools of monetary management. Its legates in Washington during this era, Robert Rubin and Hank Paulson, never once agonized over violating free market rules. They simply assumed that the good of the nation depended upon keeping the Wall Street game up and running.

Nor did the Goldmanites have even the foggiest appreciation of why the old fashioned guardians of the public purse, like Bill Simon, had been so resolutely anti-bailout. To his great credit, Simon appreciated the insidious effects of bad precedent and rightly feared that once the floodgate was opened crony capitalism would flourish. He also understood that every crisis would be portrayed as a one-time exception and that once officials started chasing market-driven brush fires, the policy process would quickly degenerate into analytics-free, seat-of-the-pants ad hocery and would frequently even border on lawlessness.

In fact, that is exactly what happened in the signature bailout episodes during Goldman's occupation of the Treasury. The $20 billion bailout of the Wall Street banks during the 1994 Mexican peso crisis orchestrated by Secretary Rubin was not only unnecessary, but was done against overwhelming opposition on Capitol Hill. In the end, the American taxpayer was thrown into the breach by Treasury lawyers who tortured an ancient statute governing the Economic Stabilization Fund until it coughed up billions for a bailout of Mexico and its Wall Street lenders. In so doing, Rubin simply thumbed his nose at Congress, implying that the greater good of Wall Street trumped the democratic process.

Likewise, the entire Paulson-led campaign to bail out Wall Street during the September 2008 crisis was an exercise in pushing the limits of existing law to the breaking point. Lehman was not bailed out mainly because Washington officials had not yet found a loophole by the time of its Sunday-night filing. But as the crescendo of panic intensified, the Treasury and Fed miraculously found enough legal daylight by Tuesday to rescue AIG.

Throughout the ordeal Paulson and his posse viewed themselves as glorified investment bankers, empowered to use any expedient of law and any drain on the public purse that might be needed to ensure the survival of the remaining Wall Street firms. Rampaging around the globe and browbeating bankers and governments alike on behalf of their half-baked merger schemes, they defiled the great office of US Treasury Secretary like never before.

GOLDMAN AND MORGAN STANLEY: THE LAST TWO PREDATORS STANDING This was a blatant miscarriage of governance. As will be seen, at that late stage of the delirious financial bubble which had overtaken America, Goldman Sachs and Morgan Stanley had essentially become economic predators. Their bankruptcy would have resulted in no measureable harm to the Main Street economy, and possibly some gain. It would have also brought the curtains down on a generation of Wall Street speculators, and sent them packing in disgrace and amid massive personal losses—the only possible way to end the current repugnant régime of crony capitalist domination of the nation's central bank.

Goldman and Morgan Stanley helped generate and distribute hundreds of billions in toxic assets—mortgage-backed securities and CDOs based on subprime mortgages—that were now resident on the balance sheets of a wide gamut of Main Street institutions like corporate pension funds and insurance companies, along with institutional investors spread all over the planet. The TARP and Federal Reserve funds that were pumped into Goldman and Morgan Stanley, however, did nothing to ameliorate the huge losses being incurred by these gullible customers.

Instead, the Washington bailouts rescued the perpetrators, not the victims; that is, the bailout benefits were captured almost exclusively by the Wall Street insiders and fund managers who owned the common stock and long-term bonds of these two firms. Yet it was these punters who deserved to take punishing losses. It was they who enabled Goldman and Morgan Stanley—along with Bear Stearns, Lehman, and the investment banks embedded inside Citigroup and JPMorgan—to grow into giant, reckless predators.

As will be seen in chapter 20, only twenty-five years earlier these firms had been undercapitalized white-shoe advisory houses with balance sheets which were tiny and benign, but now their designation as "investment banks" reflected an entirely vestigial nomenclature. They had long ago morphed into giant ultra-leveraged hedge funds which happened to have retained relatively small-beer side operations in regulated securities underwriting and M&A advisory services.

The preponderance of their fabled profitability, however, was generated by massive trading operations which scalped spreads from elephantine balance sheets that were not only preposterously leveraged (30 to 1) but also dangerously dependent upon volatile short-term funding to carry their assets. Indeed, perched on a foundation of several hundreds of billions in debt and equity capital, these firms had become voracious consumers of "wholesale" money market funds, mainly short-term "repo" loans and unsecured commercial paper. From these sources, they had erected trillion-dollar financial towers of hot-money speculation.

On the eve of the financial crisis, Goldman had asset footings of $1.1 trillion and Morgan Stanley had also passed the trillion-dollar mark. Much of their massive wholesale funding, however, had maturities of less than thirty days, and some of that was as short as a week and even overnight. When Bear Stearns hit the wall in March 2008, for example, it was actually rolling over $60 billion of funding every morning—until, suddenly, it couldn't.

It goes without saying that these highly liquid wholesale funding markets were dirt cheap because lenders had no rollover obligation and were often fully secured. It is also obvious that on the other side of their balance sheets, these de facto hedge funds held assets which were generally more illiquid, longer term, and subject to credit and market value risk, and which therefore generated substantially higher average yields.

Due to this "duration" and "credit" mismatch, the profit spread per dollar of assets was considerable, and when harvested a trillion times over, total profits were enormous, reaching $18 billion (pre-tax) at Goldman during the year before the crisis. Since this amounted to a half million dollars of profit per employee (including secretaries and messengers) the potency of carrying a giant balance sheet on the back of cheap wholesale liabilities was self-evident.

Yet here is where the foundation of overvalued debt and equity capital came in. There were limits on the extent to which the assets of these giant "investment banks" could be funded on wholesale money. Even the frothy markets of 2008 would have viewed a balance sheet consisting mainly of slow, illiquid assets funded preponderantly with short-term liabilities as a house of cards. So the investment banks' foundation of permanent capital, in fact, was the vital linchpin beneath the whole Wall Street edifice.

Thus, Goldman's balance sheet at the time of the crisis boasted long-term debt and preferred stock of $220 billion and common stock of $60 billion, even as measured by its depressed share prices that week. Likewise, Morgan Stanley had $190 billion of long-term debt and preferred stock, and $25 billion of common stock at the current market prices of its shares. Taken together then, the last two investment banks standing rested on a half-trillion-dollar base of long-term capital.

During the boom years, this long-term capital had earned handsome returns in the form of interest and dividends, with the common stock, the most junior capital, also experiencing substantial price appreciation. Goldman's share price, for example, had peaked in late 2007 at nearly $250 per share, a level five times its May 1999 IPO price.

Yet in the matter of investments, as in the opera, it's not over until the fat lady sings. The crucial economic purpose of each firm's capital was to function as a financial shock absorber. During times of heavy economic weather, therefore, senior wholesale lenders would be spared from any losses incurred on impaired asset accounts; losses would be absorbed by the firms' more junior, permanent capital—the common equity first and ultimately the long-term debt as well.

As events unfolded in the fall of 2008, these shock absorbers were brought into play. In very short order, they had proved wanting when Lehman filed for bankruptcy and Merrill Lynch was carted-off to Bank of America on a financial stretcher. Both firms had failed because their permanent capital had been inadequate to shield the losses, thereby rendering them insolvent.

In the days after September 15, the shock absorbers of the last two investment banks left standing, Goldman and Morgan Stanley, also failed the test. Their most illiquid asset classes—such as securitized mortgages, CDOs, commercial real estate securities, and corporate junk bonds— declined in market value by between 20 percent and 50 percent during the meltdown. Even when blended with holdings of low-risk government bonds and blue chip corporate securities, the blow to capital was devastating, and they would not have survived the ordeal on their own.

THE HEALTHY RUN ON THE WHOLESALE MONEY MARKET—INTERRUPTED In fact, as the financial meltdown gathered momentum after Lehman failed on September 15, Goldman, and especially Morgan Stanley, became the victims of a violent "run on the bank" by wholesale lenders, which in classic fashion lost confidence in the value of their collateral. Yet that "run," so much deplored by Washington officialdom, was actually a good thing— the market's mechanism for flushing out the bad assets that had piled up on Wall Street balance sheets.

Under the circumstances, these firms had no choice but to rapidly liquidate assets, even at fire sale losses, in order to generate cash to redeem the short-term funding which was coming due in a great tidal wave. Such was their just desert for engaging in the age-old folly of borrowing short and hot, and investing long and illiquid.

Had economic nature been allowed to take its course, the resulting massive destruction of capital value at the two remaining investment banks would have been profoundly therapeutic. It would have demonstrated conclusively that the combined $500 billion of long-term debt and equity capital which had been issued by Goldman and Morgan Stanley over the previous decades had been vastly overvalued and was far more vulnerable to catastrophic loss than the trend-following money managers who owned it had understood.

While the financial party fueled by the Fed's interest rate repression and "put" under risk assets roared, the Wall Street business model thrived: issuance of overvalued debt and equity enabled it to scalp gargantuan profits from balance sheets bloated with cheap wholesale money. The speculative mania on Wall Street was thus well and truly fostered in the misguided conference rooms of the Fed's Eccles Building.

When the crash came, however, the inflated prices of the Goldman and Morgan Stanley equity and bonds had come under withering attack. The fund managers who owned them should have suffered massive losses, been fired by their firms, and become an example for an entire generation of money managers, steeling them for years to come against another Wall Street swindle of such hazardous aspect.

But Paulson and Bernanke body-checked the free market before the grim reaper could complete its appointed rounds. So doing, they gave credence to the lame whining of Wall Street executives who claimed they were victims of nefarious short-sellers. But that was pettifoggery. They were actually the victims of just plain sellers: investors and traders who had belatedly recognized that the capital securities of these giant hedge funds would be soon swamped in a tidal wave of losses.

Absent Washington's bailout interventions, Goldman's stock price would likely have proven to be worth far less than its $60 book value, if anything at all. Certainly it would not have been worth even close to the ballyhooed "bargain price" of $115 per share paid by Warren Buffet (only after Uncle Sam pitched a safety net under the market) or the $250 per share it had reached during the bubble peak.

As it turned out, Washington's intervention with TARP and the Fed alphabet soup of liquidity programs stopped the wholesale bank run in its tracks. It accomplished this by the very simple expedient of replacing the hundreds of billions of private wholesale funding—short-term commercial paper and overnight repo funding—which had gone into hiding with freshly minted Federal Reserve credit. And it was this instant, cheap funding do-over which was the ultimate evil of the bailouts.

In truth, the "run" in the wholesale funding market was the market's homemade remedy for purging the speculative fevers which had overtaken Wall Street. At the time of the meltdown, the evaporation of wholesale funding was a curative agent, forcing Goldman, Morgan Stanley, and other leveraged hedge funds, including those such as Lehman and Merrill Lynch which had already been rendered insolvent, to liquidate their vast inventories of toxic assets at prices far below book value.

Moreover, this liquidation process exhibited an exceedingly precise focus that was completely inconsistent with Washington's spasmodic arm waving about "contagion." Specifically, the asset fire sales were not coming from the old-fashioned "whole loan" books (loans made to homeowners but never securitized by Wall Street) of the nation's eight thousand commercial banks and thrifts. This was because the response of conventional deposit banks to deteriorating mortgage performance was to boost loan loss reserves, not dump mortgage paper on the open market.

By contrast, the housing and real estate–based assets held by the Wall Street "investment banks" consisted preponderantly of securitized mortgages and related synthetic and derivative instruments. The book value of these "assets" had been artificially inflated from the get-go, based on implausibly optimistic default assumptions with respect to the underlying mortgage pools.

Moreover, these pools had also been drained of value time and again by the fee extractions taken at each step along the route to securitization and sale. This sequence of fee scalping included mortgage origination, packaging of these loans into mortgage-backed securities, repackaging of MBSs into CDOs, and even further repackaging of CDOs into CDOs squared.

As a consequence of the "run" in the wholesale funding market, however, this whole misbegotten edifice was being rectified. The toxic securitized mortgages and derivatives were being marked down to realistic value. Likewise, the wholesale funding market was being taught a harsh lesson on the consequences of the type of reckless lending which had permitted tiny investment banks to grow into trillion-dollar giants.

At the same time, the prices of investment bank capital securities were experiencing shocking declines, as illustrated by Goldman's stock price dive from $200 per share to less than $50 in a matter of months. In short, the dangerous business model on which these ultra-leveraged hedge funds were based was being purged from the financial system. Indeed, Lehman and Merrill were already down, and Goldman and Morgan Stanley were on the ropes.

Mr. Market was thus on the cusp of being four-for-four in eliminating these dangerous ultra-leveraged gambling operations. Unfortunately, Chairman Bernanke and Secretary Paulson drastically misconstrued this healthy run in the wholesale banking sector. Not only did they view it as a threat to the Fed's wealth effects model of monetary central planning, but they also saw it as a replay of the Great Depression–era bank runs.

As will be seen in chapter 8, however, it was nothing of the kind. Contrary to Chairman Bernanke's faulty and self-serving scholarship, the famous bank runs of 1930–1933 were not the result of monetary policy mistakes by the Fed after 1929. Instead, they were the ineluctable consequence of the wartime and postwar debt booms from 1914 to 1929 and the vast crop of insolvent borrowers which they fostered.

Likewise, Washington's massive intervention in September 2008 could not thwart a Great Depression 2.0 because the collapse of Wall Street could not have caused one. There had been no economic Armageddon looming, only a long cycle of debt liquidation, shrinking living standards, and austerity— or exactly the outcome we have experienced anyway.

The contemporary situation was nothing like the early 1930s because the United States was now a massive international debtor and importer. That condition was the opposite of the American economy's posture in 1929 when it had been the era's massive creditor, exporter, and industrial producer; that is, the US back then had played the role belonging now to the red capitalists of China.

At the end of the day, the 2008 financial panic had originated in the canyons of Wall Street; it had actually been contained there during the peak weeks of the crisis, as toxic assets were liquated and wholesale funding was withdrawn; and it would have burnt itself out there had Washington allowed the markets to have their way with errant speculators. Instead, a handful of panicked officials led by Bernanke and Paulson drove Washington into a momentary hysteria, causing it to throw the American taxpayer and the Fed's printing press into the wrong breach. So doing, they stopped a bank run that was needed and perpetuated two giant financial predators which were not.

THE MAIN STREET BANKS WERE NEVER IN DANGER There was no logical or factual basis for the incessantly repeated claim of Washington high officials that Wall Street's losses would spill over into the nation's $12 trillion commercial banking system and from there ripple outward to infect the vitals of the Main Street economy. Owing to the composition of its asset base, the Main Street banking system was never remotely at risk, and it had no need for capital infusions from TARP.

The actual evidence shows the "run" on the wholesale money market was almost entirely confined to the canyons of Wall Street. During the heat of the fall 2008 crisis, there were no runs on the nation's eight thousand commercial banks and thrifts, save for a handful of clearly insolvent higher fliers like Indy Mac and Washington Mutual. Nor would there have been one in the absence of TARP and the Fed's aggressive Wall Street bailout actions.

The carnage on Wall Street in no way weakened the deposit guarantees of the Federal Deposit Insurance Corporation (FDIC) which reassured mom and pop that they did not need to get in line at their local bank branch. The vast bulk of assets held by the commercial banking system were either invested in safe US Treasury debt and government-guaranteed mortgage securities or whole loans to home owners, businesses, and developers which were carried on their "banking books" rather than in "trading" accounts.

There was no reason to fear a contagion of fire sale liquidations of these types of assets or a resulting flight of retail depositors. Even if the national economy plunged into recession, the commercial banking system would experience rising loan loss reserve provisions and weakened profitability. Yet this impact would play out over quarters and years, not in immediate, huge, headline-making loss events which would catalyze public fears about the safety and soundness of their local banks.

There was actually a striking note of irony in the contrast between the relatively safe commercial banking system and the bonfires on Wall Street. As it happened, the mortgage securitization machine had functioned like a giant financial vacuum cleaner, sucking the worst of the subprime and exotic mortgages off the balance sheets of local community lending institutions and into the billion dollar securitization pools assembled on Wall Street.

The main channel for this process, the nonbank mortgage broker industry, was a Wall Street instrumentality of cheap money. By the time of the final housing boom in 2003–2006, in fact, the mortgage broker channel was originating 75 percent of all mortgages. When the financial crisis came, Main Street banks were sound because, ironically, they had been driven out of the high-risk mortgage business by Wall Street and its mortgage broker agents.

When the Greenspan Fed drove short-term funding costs in the wholesale money markets down to 1 percent by the spring of 2003, it enabled Wall Street to finance massive "warehouse credit lines" to local mortgage brokers and bankers. Stocked up with Wall Street money, the latter did not need retail deposits or capital and, instead, operated as fee-based agents and were therefore free to issue risky loans. They worked out of makeshift offices and did not need vaults, tellers, or drive-through windows. With no skin in the game, they were driven entirely by mortgage production volume (see chapters 18 and 19). When the great Wall Street investment houses—including Bear Stearns, Lehman, Goldman, and Morgan Stanley along with the wholesale banking departments of JPMorgan, Citigroup, and Deutsche Bank—became aggressively involved in financing the local mortgage bankers, brokers, and boiler rooms, the planking for the subprime mortgage fiasco was laid. The Wall Street houses were able to access nearly unlimited amounts of low-cost wholesale funding by means of the commercial paper and repo markets and recycle it through their "warehouse lines" to local mortgage bankers and brokers. Unfortunately, the sudden availability of these multibillion-dollar warehouse lines proved to be a financial poison in the world of home finance, not the socially beneficent "innovation" claimed by investment bankers.

Needless to say, the new army of mortgage brokers put into business by these Wall Street credit lines had not spent decades building up a franchise in local home mortgage markets, thereby acquiring the skills in prudent underwriting and borrower selection on which long-term survival in the home mortgage business inherently depends. But they did know how to organize turbo-charged boiler-rooms which cranked out prodigious numbers of new mortgages.

These new mortgage brokers also had the capacity to grow by leaps and bounds. They had quickly discovered that salesmen currently pitching Amway products, aluminum siding, and used cars could become fully functioning mortgage bankers in a matter of days and weeks. This was especially the case after the government-sponsored enterprises Fannie Mae and Freddie Mac and the big Wall Street banks introduced online computerized underwriting.

Like the operators of McDonald's drive-through windows, brokers simply tapped the screen and another serving of home mortgage loans would instantly appear. Brokers then obtained the money for loan disbursements to homeowners simply by drawing down their warehouse lines until enough volume was achieved to facilitate a block sale of freshly minted mortgages to their Wall Street partners. The latter then completed the securitization and distribution process, harvesting generous fees and markups at each step along the way.

At the peak of the housing boom, outstanding warehouse lines offered by the top Wall Street houses soared to several hundred billion dollars. These huge credit lines constituted an efficient financial superhighway to transport truckloads of sketchy mortgages from Main Street America directly to Wall Street.

Needless to say, the operators of these fly-by-night mortgage-stamping machines were not "bankers" in any traditional sense of the word—they had no skin in the game. Wall Street actually even went further, hiring traditional banks to write subprime and other riskier mortgages. It then periodically bought all the resulting loans on a wholesale basis, meaning that what remained of George Bailey's Savings and Loan was enlisted in the rinse-and-repeat style of mortgage lending as well.

Accordingly, the residential loan books of the commercial banking system were surprisingly clean, even as the securitized mortgage meltdown gathered force in the fourth quarter of 2008. At that point, total commercial bank assets were $11.6 trillion. Yet only $200 billion, a tiny 1.7 percent of total assets, consisted of "toxic assets"; that is, private-label mortgage-backed securities of the type originated by the Wall Street securitization machine and which were now plummeting in value.

Furthermore, these minor holdings of toxic private-label mortgage assets were dwarfed by commercial banking system investments of nearly $1 trillion in Fannie Mae and Freddie Mac mortgage-backed securities. These "agency" backed mortgage securities had always been considered blue chip credits and a close imitation of Treasury bonds, and had officially become "risk free" upon the US government's nationalization of Freddie and Fannie.

From a big-picture perspective, then, the nation's hinterland banks had played a pretty good hand of mortgage finance poker. First, they had sold off most of their subprime originations to the Wall Street securitization machine. Next, they largely avoided reinvesting in the garbage securities Wall Street crafted from these subprime loan pools. And finally, they backfilled their investment accounts by buying mortgage securities wrapped with Uncle Sam's money-good insurance via the Freddie and Fannie guarantees, not the bogus kind sold to Wall Street and the European banks by AIG.

WHY THE MAIN STREET BANKS WERE MONEY GOOD The commercial banks had retained on their own balance sheets about $2 trillion of residential mortgages and home equity lines of credit. But these mortgages were overwhelmingly of prime credit quality and had stayed on the books as "whole loans," rather than having been sliced and diced into tradable securities. So as the economy tumbled into recession and average home prices plunged by 35 percent, any elevation of losses would be charged to loan loss reserves and written off over years, not sold at fire-sale prices on Wall Street's crashing market for securitized paper. The commercial banking system was not vulnerable to a panic, just a slow multi-year resolution.

In short, the GSE securities plus the whole mortgage loans added up to $3.2 trillion in housing assets, but the Freddie–Fannie (GSE) paper was money good and the whole loans were higher quality and were backed by substantial loan loss reserves required by regulators. So the Main Street commercial banking system was surprisingly well insulated from the putative financial "contagion" on Wall Street.

Much the same can be said for the remaining $6 trillion of non-home mortgage assets which sat on commercial bank balance sheets at the time of the crisis. About $1.6 trillion of this was low-risk revolving and term credit to business and industry known as "C&I (commercial and industrial) loans."

Most of these business loans occupied the senior slot, or the highest payment ranking, in borrower capital structures and usually had a first lien on the operating assets of the borrower's business. So the risk of loss was modest, and the prospect of a C&I loan meltdown was essentially nonexistent. In fact, the truly risky business credit, $1.5 trillion of then-outstanding unsecured and subordinated debt, was all in junk bonds, and nearly all of these were owned by institutional investors and mutual funds, not banks.

The story was much the same in the case of the commercial real estate loan books of the Main Street banks; that is, loans on office buildings, strip malls, retail properties, and housing land acquisition and development. Once again, nearly half of the $3 trillion in outstanding commercial real estate debt had been sold to Wall Street, where it had been securitized and packaged into commercial mortgage-backed securities (CMBSs). By the time of the crisis, these hot potatoes were languishing unsold on Wall Street balance sheets or stuffed into the portfolios of pension funds and insurance companies, but they were no longer in the loan books of the Main Street banking system.

The commercial banking system had retained about $1.7 trillion of whole loans in the various commercial real estate categories, but there was little risk of a selling contagion. Most of these loans were "interest only" with a five- to ten-year bullet maturity, meaning that it would take years for borrowers to run out of cash and default on interest payments when failed strip malls and unfinished subdivisions eventually became foreclosures. That prospective slow bleed-off was irrelevant to the bonfires which raged on Wall Street in September 2008.

Indeed, busted commercial real estate loans have accounted for most of the five hundred bank closures conducted by the FDIC in the years since the crisis. Yet all of these shutdowns were orchestrated over weekends with such clockwork precision that hardly a single retail depositor anywhere in the nation was ever alarmed. Unlike Wall Street's hot money funding, Main Street loan portfolios were bedded down with high-persistency deposits. Losses would be realized over time through the bleeding cure, not a fire sale.

The remaining $2 trillion of assets on the commercial banking systems balance sheet as of October 2008 were not even remotely exposed to contagion risk. About $1 trillion of this total consisted of credit card, auto, and other consumer loans that were well secured with collateral and provisioned with deep loss reserves. The other $1 trillion consisted overwhelmingly of US Treasury securities and investment grade corporate bonds.

The workout in the commercial banking sector, therefore, has turned out to be a slow-motion write-down, not a red-hot meltdown of the type which afflicted Wall Street. There was no basis for a retail bank run and never would have been one in the absence of TARP.

This outcome was readily ascertainable in September 2008, by means of a cursory examination of the collective balance sheet of the nation's non–Wall Street banking system. There was absolutely no reason for panic about the financial "contagion" spreading to Main Street banks. Nor was there any excuse for suspending the normal rules which required the FDIC to close failed banks and to completely wipe out debt and equity security holders.

THE URBAN LEGEND OF SKIPPED PAYROLLS AND DARK ATMS Another false vector of the contagion story centered on the panic in the money market mutual fund sector and the resulting drastic shrinkage of the commercial paper market. It was from this chain of events that the urban legend arose about ATMs going dark and business payrolls being skipped. In truth, the commercial paper market had become a giant bubble and needed to be cut down to size, but the implication that this necessary unwind had brought the payments system to the verge of collapse was not even remotely accurate.

In fact, after Congress courageously voted down the first TARP bill, the orchestrators of the bailout, Chairman Bernanke and Secretary Paulson, cynically deployed these payments freeze horror stories to spook congressmen and other policymakers into falling in line. As Senator Mel Martinez recalled their pitch, "I just remember thinking, you know, Armageddon . . . if these guys in the middle of it . . . believe this to be as dark as they are painting it, it must be pretty darned dark."

Senator Martinez's recollections reveal the true contagion: it was the contagion of fear which two panic-stricken men, Bernanke and Paulson, spread through the nation's capital like wildfire during the hours after the Lehman failure. Yet nothing like the financial nuclear meltdown alleged by Washington officialdom ever occurred or threatened.

The heart of the false panic was rooted in the money market mutual fund sector. Total short-term deposits at the time of the crisis had reached a big number: $3.8 trillion. So an honest-to-goodness "run" by investors would have been scary indeed. It turns out, however, that the "run" amounted to little more than a circular movement of cash among different money market fund types, with virtually zero impact on the Main Street economy.

As it happened, roughly $1.9 trillion, or half of total money market deposits, were held in a category of fund which invested exclusively in US Treasury and agency debt or tax-exempt muni bonds. During the entire period of the Wall Street crisis, this "governments only" segment of the money market fund industry experienced no losses or investor liquidations whatsoever.

By contrast, the other $1.9 trillion was in "prime" funds. In addition to investing in safe government securities and bank CDs, the prime funds were also permitted to hold commercial paper, thereby slightly enhancing interest rate yields compared to purely government funds.

During the several weeks after the Lehman failure about $430 billion, or slightly less than 25 percent of deposits, fled the "prime" fund half of the industry. This flight was triggered when the largest and oldest of these funds, the Reserve Prime Fund, announced that it "broke the buck" owing to the fact that about $750 million of its $60 billion in assets had been invested in Lehman commercial paper. Yet obscured in the hubbub was the fact that the resulting losses were tiny—just 3 percent of assets. In reality, breaking the buck was a money fund marketing pratfall, not the precursor to Armageddon; it amounted to a modest wake-up call disabusing investors of the industry's phony claim that money market accounts were absolutely safe and immune to loss.

So the unexpected shock from the Reserve Prime Fund's breaking the buck triggered a "run" on the prime funds of significant magnitude during the week or two after September 15. Yet according to the Financial Crisis Inquiry report, most of this so-called flight money did not get very far; that is, 85 percent, or $370 billion, of this outflow simply migrated to what were perceived to be safer "government only" money market funds.

In truth, the "run" was almost entirely within the money market mutual fund sector, with the debit going to the "prime" funds and the credit to the "government" funds. Indeed, this migration frequently involved nothing more than investors hitting the send button! They simply moved their deposits between these two types of accounts at the same fund management company.

Bernanke, Paulson, and the other bailsters focused exclusively on the gross outflow from the prime funds and waved this $430 billion bloody shirt incessantly. Needless to say, they did not bother to tell Congress that only a net amount of $60 billion, or 2 percent of total assets, had actually left the money market fund industry during the three weeks before the October 3 TARP vote.

Nor did they mention that most of the $60 billion which did leave the money market sector had gone into CDs and other bank deposits, and that none had ended up in mattresses. Moreover, all of this data was published in real time by the Investment Company Institute, so it should have been evident to policy makers, even in the heat of the crisis, that the circular flow from "prime" funds into "government only" money funds and banks (which got the $60 billion) posed no threat whatsoever to financial system stability.

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