Market Meltdown: Thoughts on Shadows, Secrets, and Shells
After reading Francine Hardaway, Dave Winer and Steve Gillmor today, it occurs to me that we are not under any obligation to accept the Bush Administration’s claim that their way is the only way out, or hand off incredible power to the Secretary of the Treasury with absolutely no understanding of how that power is to be used or how it will cure the problem.
Further, many have pointed out that the proposed bailout plan does not put a cure on the underlying disease that brought us to this place — out of control credit and lending practices locked inside an invisible, or shadow, banking system. As many other smarter people than I have pointed out, there is no instant cure for our financial market mess; there are too many players, too many vines branching out, and too many unknowns. But let’s start with mortgages as a place to dig our feet in.
The mortgages that are rocking the financial industry are still secured by real estate. The homes are, for the most part, still worth something, and when the market rebounds (which it will, just like it has many times in the past), they will regain their value. At the moment, many of these foreclosed homes (and office buildings, and parking lots and whatever else…) are vacant and waiting for someone to buy them. So we have a bunch of unoccupied homes that are bank-owned and worth less than what was loaned by the bank to purchase them.
Then, thanks to the repeal of Glass-Steagall and subsequent removal of the firewall between investment companies and banks, we have these mortgages bundled into funds by the banks’ subsidiary broker-dealer (wholly owned by the bank holding company, of course), and sold to individual investors as “prudent investments”, intended to spread the risk among many. In theory, it’s great, because evidently no one foresaw the entire industry turning belly up at once and leave those investors holding the bag. As Morgan Stanley and Goldman Sachs become full-fledged bank holding companies tomorrow by decree of the Federal Reserve, the Glass-Steagall firewal evaporates forever.
What we have isn’t a meltdown of the traditional banking system. It’s a meltdown of the shadow banking system, the behind the mask, unnamed industry that relies on short-term credit to reap big profits which are plowed back into investments in commercial paper.
In 2007, the founder and CIO of PIMCO wrote the following:
Financial institutions fell for the ruse, and now we all suffer the consequences. Defaults are rising, the dollar’s sinking, and — good Lord! — even Google’s (Charts, Fortune 500) stock price is going down. Something must really be wrong.
It is. What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.
My Pimco colleague Paul McCulley has labeled it the “shadow banking system” because it has lain hidden for years, untouched by regulation, yet free to magically and mystically create and then package subprime loans into a host of three-letter conduits that only Wall Street wizards could explain.
And in March, there was this excellent description of the shadow banking system:
On Wall Street, of course, what you do not see can hurt you. In the past decade, there has been an explosion in complex derivative instruments, like collateralized debt obligations and credit default swaps, that were intended primarily to transfer risk.
These products are virtually hidden from investors, analysts and regulators, even though they have emerged as being among Wall Street’s most outsized profit engines. They do not trade openly on public exchanges, and financial services firms disclose few details about them.
Used judiciously, derivatives can limit the damage from financial miscues and uncertainty, greasing the wheels of commerce. Used unwisely – when greed and the urge to gamble with borrowed money overtake sensible risk-taking – derivatives can become Wall Street’s version of nitroglycerin.
Bear Stearns’s vast portfolio of these instruments was among the main reasons for the bank’s collapse, but derivatives are buried in the accounts of just about every Wall Street company, as well as those of major commercial banks like Citigroup and JPMorgan Chase. What is more, these exotic investments have been exported all over the globe, causing losses in places as distant from Wall Street as a small Norwegian town north of the Arctic Circle.
For years, this has been the shell game fueling Wall Street while ordinary folks just try to get through the day and pay their bills. Credit has been the currency driving the markets, and as it proved lucrative for US investors, so too did it prove lucrative for foreign investors. As I understand it, 41% of US Treasury bonds are owned by foreign investors. Call me naive, but it seems to me that the addiction to credit isn’t just on Wall Street, it’s in Washington, too.
As I wrote last Sunday, our war in Iraq is being fueled by issuance and purchase of US Bonds. Only US citizens aren’t the only ones buying them. As more debt is piled on more debt, we run the serious risk of having our margins called by the likes of China, Saudi Arabia, and others. In the meantime, the UK markets grow shakier by the minute, and we are all placed at risk of losing what little savings we’ve managed to accumulate, while Lehman executives share 2.5 billion in bonuses, courtesy of Barclays Bank, who skimmed the cream off the soured milk that was a respected investment bank.
Glenn Greenwald echoes my own thoughts on this:
What is more intrinsically corrupt than allowing people to engage in high-reward/no-risk capitalism — where they reap tens of millions of dollars and more every year while their reckless gambles are paying off only to then have the Government shift their losses to the citizenry at large once their schemes collapse? We’ve retroactively created a win-only system where the wealthiest corporations and their shareholders are free to gamble for as long as they win and then force others who have no upside to pay for their losses. Watching Wall St. erupt with an orgy of celebration on Friday after it became clear the Government (i.e., you) would pay for their disaster was literally nauseating, as the very people who wreaked this havoc are now being rewarded.
More amazingly, they’re free to walk away without having to disgorge their gains; at worst, they’re just “forced” to walk away without any further stake in the gamble. How can these bailouts not at least be categorically conditioned on the disgorgement of ill-gotten gains from those who are responsible? The mere fact that shareholders might lose their stake going forward doesn’t resolve that concern; why should those who so fantastically profited from these schemes they couldn’t support walk away with their gains? This is “redistribution of wealth” and “government takeover of industry” on the grandest scale imaginable — the buzzphrases that have been thrown around for decades to represent all that is evil and bad in the world. That’s all this is; it’s not an “investment” by the Government in any real sense but just a magical transfer of losses away from those who are responsible for these losses to those who aren’t.
Which brings me to my point, such as it is. If a bailout of Wall Street is inevitable for our own protection, I want it on my terms. If I have to finance it, I want to do it in a way that’s going to benefit ME, the taxpayer. I want a return on my investment, not more taxes to service the debt owed to China.
Let’s start by making a citizen’s margin call. We actually do have clout, because it’s our 401(k) and pension money fueling the new investments that keep the pyramid on track as we move forward. Let’s tell the government we will make our investments in US bonds which may only be owned by US citizens, earmarked only for the purpose of retiring debt to foreign investors.
Let’s also insist that we don’t act with haste on any bailout of Wall Street. Any emergency measures taken at this time should be just that — emergency measures, for a very short period of time (3-6 months, maximum), while a longer-term plan which includes full disclosure, appropriate sanctions, and full recovery efforts of whatever assets and profits are left to recover.
Finally, there can be no — I repeat, NO — blank check granted for this bailout. No power without oversight, no action without proper accountability and recourse. None. Because it’s worth remembering this important fact, again courtesy of Glenn Greenwald:
What’s most vital to underscore is that the beneficiaries of this week’s extraordinary Government schemes aren’t just the coincidental recipients of largesse due to some random stroke of good luck. The people on whose behalf these schemes are being implemented — the true beneficiaries — are the very same people who have been running and owning our Government — both parties — for decades, which is why they have been able to do what they’ve been doing without interference. They were able to gamble without limit because they control the Government, and now they’re having others bear the brunt of their collapse for the same reason — because the Government is largely run for their benefit.
Lest you doubt, let me remind you that Jeb Bush served as a financial consultant to Lehman from 2007 on. Here’s an added bonus:
Sitting behind McCain was former Gov. Jeb Bush, who was hired a year ago by Lehman Brothers as a financial consultant. As governor, Bush served on the three-member State Board of Administration that agreed to let the state’s retirement fund buy a series of mortgage-backed securities from Lehman Brothers that turned out to be troubled. The subsequent steep drop in value prompted a $9 billion run on the fund last December by local governments who had invested their money in the SBA managed fund. Lehman also manages two funds for the SBA, which is also heavily invested in some Lehman securities.
All I can say to that is that the good people of Florida should really think hard before electing someone Jeb and George endorse, if they hope to keep what little retirement savings they have left.