Wall Street Greed and Delusion

Derivatives (complex financial instruments) are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.

“Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years.”

Warren Buffet (2003)

After seeing Michael Lewis on both 60 Minutes and The Charlie Rose Show last week, I had to read The Big Short: Inside the Doomsday Machine, the just released book by Lewis about the subprime mortgage disaster. Lewis is a fabulous story teller, and I cannot recommend this book enough.

He tells how the subprime mortgage market was created, who benefited, who lost, the cons, the dupes and the dopes and “how some of Wall Street’s finest minds managed to destroy $1.75 trillion of wealth in the subprime mortgage markets” and created the worst financial crisis since the Great Depression.

Essentially billions of dollars were lent to people who had very little chance of ever paying it back. And Wall Street firms earned billions of dollars creating, packaging and betting on complex financial instruments whose raw material was the risky mortgage loans they created. And that was just the beginning.

Tremendous leverage (using borrowed money to magnify possible returns) increased the risk of destroying entire firms.

Lewis follows a few very colorful individuals who gradually figured out just how corrupt the entire risky mortgage system was. These investors made billions by betting against the subprime market by selling short.

Note that “selling short” is an entirely legal transaction, but generally considered a high risk one that involves betting against something, i.e. a stock, bond, or currency, for example, which isn’t “actually” owned by the investor. Selling short requires astuteness, foresight, excellent timing and staying power. Being “right” too soon can be both nerve wracking and very costly, because until the market agrees with your assessment, you are at risk of losing a great deal of money. (Disclosure: I do not sell short.)

In reading Lewis’s gripping story, I alternated between nodding my head in recognition of the self-serving greed that categorized Wall Street to shaking my head in disbelief that Wall Street bankers could have been so deluded that they ended up believing their own lies, I mean “models.” As I read, I found myself laughing out loud more times than I can count – truly, Lewis has a way with words.

To give you some background info, in the “old” days, a bank lent money to a home buyer and they held the mortgage. The bank was very serious about getting repaid, so before they agreed to fund the loan, they did some rather basic things like verify the borrowers’ creditworthiness, check their employment and salary history and retain an appraiser to assess the value of the property being bought. A good credit history, a stable job and a property value that would support the loan were enough incentive for banks, back in the “old” days, to grant a loan request.

But when banks started selling the mortgage to a Wall Street firm who repackaged the loan and then sold the package to investors, the incentives became very different. It was like the Wild West before the Marshall came to town to establish law and order.

The acronym IBGYBG came into being. The brokers who made more money than they ever imagined said, “I’ll be gone, you’ll be gone” so let’s not worry about the suckers who will probably lose their homes or the gullible institutions that bought the crappy investments in the purposely opaque financial instruments. And it was easy to rationalize the sleazy behavior, because, after all, it was possible that this will all work out, if home prices keep rising. That was a big IF.

It was really a mammoth legal Ponzi scheme, or as Lewis called it a “mass delusion.”

The individual character’s stories are fascinating, but I will not try to summarize them. Instead, here are some observations that emphasize the need for fundamental financial regulation of Wall Street firms.

1. No one goes to Wall Street investment banks to make the world a better place. “Greed on Wall Street is assumed – almost an obligation. The problem was the system of incentives that channeled the greed.”
2. People see what they have an incentive to see. Wall Street employees, managers and CEOs had an incentive (i.e. huge bonuses – surely, you’ve heard about them) not to see the truth.
3. When Wall Street firms were partnerships and the principals had their own money at risk, they had a sane long-term approach to their business operations. When these same firms became publicly traded corporations, risk was transferred to the shareholders. But, of course, huge bonuses were paid to successful traders based on one year’s results. In the short term, traders had every incentive to take large risks. “Heads I win, tails someone else loses, perhaps some time in the future.”
4. The fixed income (bonds) world dwarfs the equity (stocks) world in size. The stock market is transparent and heavily policed. On the other hand, “bond salesmen could say and do anything without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation – one reason why so many derivatives had been derived, one way or another, from bonds.”
5. The world of mortgage-backed securities (pooled investments backed by mortgages) and derivatives (financial instruments created by Wall Street) were intentionally difficult to understand, so no one even bothered to try. The book describes the nature of asset-backed securities, tranches, collateralized debt obligations, credit default swaps, etc. You, dear reader, can safely skip those portions if you want to. The horse is already out of the barn.
6. It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic at Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?
7. While there may have been some criminal behavior, in the end, group think, mass delusion and incompetence were more important factors. Wall Street firms did not understand the money-making machine they had created or the risks they had taken.
8. When lenders ran out of customers who would qualify for a normal mortgage, they dreamt up new ways to lend to people who could not afford to pay the old fashioned way. Hence the introduction of “interest-only negative-amortizing adjustable-rate subprime mortgages.” Translation: you don’t have to pay any principal or any interest on your new mortgage; we’ll just keep adding that to the amount you owe.
9. Amazingly enough, Wall Street firms convinced bond ratings agencies (Moody’s, S&P) to give such garbage a Triple A rating. That credit rating agencies are “educated” by and paid by the issuers of the bonds is quite a conflict of interest! And it still exists.
10. Lewis asserts that today “nobody believes that Wall Street knows what it is doing.” He understands why Goldman Sachs and Morgan Stanley, for example, want a say in how they are regulated. He wonders why anyone would listen to them.

Conclusion

The greed and miscalculation of Wall Street firms caused the near collapse of the world economy. Governments around the world felt forced to commit trillions of dollars to resuscitate the banks.

Regulation of firms and people which have fundamentally the wrong incentives will not be easy. Regulatory reform of institutions that are too well connected to fail will not be easy. Change is never easy. But it is absolutely essential or we will all be at risk of a repeat performance of the last financial crisis. Without reform, the investment banking system can crash again, taking with it jobs, savings and U.S. tax payer dollars.

Greed and Stupidity

Last week, I had lunch with an old friend who told me that he was very upset because he had lost so much money on his investments. He said that he was of two minds about the people who caused his pain. On the one hand, he wanted to forgive them, but on the other hand, he wanted to get even. Both, perfectly natural feelings. Of course, the problem with the revenge approach is the he did not know exactly whom to blame. Like many people, he really didn’t understand how we got into this economic mess in the first place.

Well, as previous posts have discussed, it’s a complicated tale in that there are a lot of culprits and more than enough blame to go around, including lax government regulation, unscrupulous mortgage brokers and mortgage lenders, overoptimistic rating agencies and everyone who thought real estate prices could only go up. But focusing on the banking system tells a large part of the story.

Recently, David Brooks wrote a column, Greed and Stupidity, which references some very good articles and contrasts the two theories of why and how bankers screwed up. Here are some relevant quotes regarding the two explanations – greed and stupidity.

What happened to the global economy? We seemed to be chugging along, enjoying moderate business cycles and unprecedented global growth. All of a sudden, all hell broke loose.

There are many theories about what happened, but two general narratives seem to be gaining prominence, which we will call the greed narrative and the stupidity narrative. The two overlap, but they lead to different ways of thinking about where we go from here.

The best single encapsulation of the greed narrative is an essay called “The Quiet Coup,” by Simon Johnson in The Atlantic.

Johnson begins with a trend. Between 1973 and 1985, the U.S. financial sector accounted for about 16 percent of domestic corporate profits. In the 1990s, it ranged from 21 percent to 30 percent. This decade, it soared to 41 percent.

In other words, Wall Street got huge. As it got huge, its prestige grew. Its compensation packages grew. Its political power grew as well. Wall Street and Washington merged as a flow of investment bankers went down to the White House and the Treasury Department.

The result was a string of legislation designed to further enhance the freedom and power of finance. Regulations separating commercial and investment banking were repealed. There were major increases in the amount of leverage allowed to investment banks.

The second and, to me, more persuasive theory revolves around ignorance and uncertainty. The primary problem is not the greed of a giant oligarchy. It’s that overconfident bankers didn’t know what they were doing.

Many writers have described elements of this intellectual hubris. Amar Bhidé has described the fallacy of diversification. Bankers thought that if they bundled slices of many assets into giant packages then they didn’t have to perform due diligence on each one.

Benoit Mandelbrot and Nassim Taleb have explained why extreme events are much more likely to disrupt financial markets than most bankers understood.

To me, the most interesting factor is the way instant communications lead to unconscious conformity. …Global communications seem to have led people in the financial subculture to adopt homogenous viewpoints. They made the same one-way bets at the same time.

Jerry Z. Muller wrote an indispensable version of the stupidity narrative in an essay called “Our Epistemological Depression” in The American magazine. … Banks got too big to manage. Instruments got too complex to understand. Too many people were good at math but ignorant of history.

The Remedies

The greed narrative leads to the conclusion that government should aggressively restructure the financial sector. The stupidity narrative is suspicious of that sort of radicalism. We’d just be trading the hubris of Wall Street for the hubris of Washington. The stupidity narrative suggests we should preserve the essential market structures, but make them more transparent, straightforward and comprehensible. Instead of rushing off to nationalize the banks, we should nurture and recapitalize what’s left of functioning markets.

Both schools agree on one thing, however. Both believe that banks are too big. Both narratives suggest we should return to the day when banks were focused institutions — when savings banks, insurance companies, brokerages and investment banks lived separate lives.

We can agree on that reform. Still, one has to choose a guiding theory. To my mind, we didn’t get into this crisis because inbred oligarchs grabbed power. We got into it because arrogant traders around the world were playing a high-stakes game they didn’t understand.

Conclusion

I agree with Brooks’ belief that the main cause of our economic meltdown was stupidity – not understanding the real risks in using “outsized” leverage to buy risky assets. On the other hand, investment bank managers were receiving “outsized” bonuses based on short-term results, and the long term risks and ramifications was someone else’s problem.

Who says we have to choose between greed and stupidity?

CNBC Financial Advice

Last week Jon Stewart of the Daily Show ridiculed the usefulness of financial predictions made on some CNBC shows.  Stewart exposed the theatrics and general silliness of many CNBC commentaries, not to mention the shameful sucking up to CEOs.

Remember that the Daily Show is on Comedy Central, so have a good laugh. This is not meant to be fair and balanced.

Yes, CNBC has had some very good interviews with the likes of investor Warren Buffet, author John Bogle and PIMCO executive and author Mohamed El-Erian. But remember that many CNBC shows are essentially infotainment; they are meant to keep you watching so that CNBC can sell ads.

By the way, keep watching the show to see a humorous but also enlightening interview with New York Times columnist Joe Nocera.

Financial Crisis for Beginners

I recently had dinner with my cousin who said, “I don’t understand how the economy was fine for so many years and now it isn’t fine. How did this happen? I don’t understand.”

Well, this is much too complicated a subject to discuss over just dinner, but I would imagine that many people feel the same way and are asking the same question as my cousin. “Why?”

Besides this blog, which has quite a few posts on this topic, I recommend checking out The Baseline Scenario, a web site whose tagline is “What happened to the global economy and what we can do about it.”
The founder of The Baseline Scenario is Simon Johnson, 46, currently a professor at the Massachusetts Institute of Technology’s Sloan School of Management. Previously, he was chief economist of the International Monetary Fund. Peter Boone and James Kwak also contribute to the site’s articles and posts.

Johnson is interviewed and quoted frequently, both in the mainstream media and on the internet. He has published many, many opinion pieces and articles on the global economic situation and possible solutions. He also writes for the New Republic and has been interviewed on NPR radio and the Charlie Rose program. Whew! It’s exhausting just following him around on the Internet!

In my opinion, The Baseline Scenario web site is so much more than just a simple blog. Rather, it’s a free online lesson on macro, monetary, and global economics.

The section, Financial Crisis for Beginners, quite effectively lessens the confusion. It covers pretty much everything, from old-fashioned bank runs to new-fangled credit default swaps. There are also very informative and helpful articles such as The Federal Reserve for Beginners and Interest Rates for Beginners. You’ll also find links to a thought-provoking article and radio interview, National Debt For Beginners.

Worth noting is the Japan’s Lost Decade article. While many economists, analysts and financial writers compare our current economic situation to the Great Depression, The Baseline Scenario suggests that “in many ways, a more relevant comparison may be the Japanese ‘lost decade’ of the 1990s, when the collapse of a bubble in real estate and stock prices led to over a decade of deflation and slow growth.”

It’s quite amazing that a single web site, and one ubiquitous observer, can have such an impact on the national debate. I highly recommend that you follow the articles and posts at The Baseline Scenario.

P.S. This is my 100th post. For some reason, this is supposed to be significant.

How Citigroup Got Into Trouble

“Risk comes from not knowing what you’re doing.” – Warren Buffett.

In previous posts (here and here), I wrote about the poor job some investment banks did in risk management and how they ended up “owning exotic securities, derivatives, pieces of paper backed by pools of assets. They did not understand these securities any better than the people they sold them to.

An article in today’s New York Times, The Reckoning – Citigroup Pays for a Rush to Risk, by Eric Dash and Julie Creswell goes behind the scenes to explain just how bad things were. What is fascinating is that the article names names, i.e. the people who were trading the securities and the risk managers, who failed to rein them in.

Of course, top management was ultimately responsible for the debacle.  Looking back, one question comes to mind, “What were they thinking?” The authors answer that question.

Here are extensive quotes from the article.

In September 2007, with Wall Street confronting a crisis caused by too many souring mortgages, Citigroup executives gathered in a wood-paneled library to assess their own well-being.

There, Citigroup’s chief executive, Charles O. Prince III, learned for the first time that the bank owned about $43 billion in mortgage-related assets. He asked Thomas G. Maheras, who oversaw trading at the bank, whether everything was O.K.

Mr. Maheras told his boss that no big losses were looming, according to people briefed on the meeting who would speak only on the condition that they not be named.

For months, Mr. Maheras’s reassurances to others at Citigroup had quieted internal concerns about the bank’s vulnerabilities. But this time, a risk-management team was dispatched to more rigorously examine Citigroup’s huge mortgage-related holdings. They were too late, however: within several weeks, Citigroup would announce billions of dollars in losses.

Normally, a big bank would never allow the word of just one executive to carry so much weight. Instead, it would have its risk managers aggressively look over any shoulder and guard against trading or lending excesses.

But many Citigroup insiders say the bank’s risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers eager to increase short-term earnings — and executives’ multimillion-dollar bonuses — failed to rein them in, these insiders say.

Today, Citigroup, once the nation’s largest and mightiest financial institution, has been brought to its knees by more than $65 billion in losses, write-downs for troubled assets and charges to account for future losses. More than half of that amount stems from mortgage-related securities created by Mr. Maheras’s team — the same products Mr. Prince was briefed on during that 2007 meeting.

Citigroup’s stock has plummeted to its lowest price in more than a decade, closing Friday at $3.77. At that price the company is worth just $20.5 billion, down from $244 billion two years ago. Waves of layoffs have accompanied that slide, with about 75,000 jobs already gone or set to disappear from a work force that numbered about 375,000 a year ago.

While much of the damage inflicted on Citigroup and the broader economy was caused by errant, high-octane trading and lax oversight, critics say, blame also reaches into the highest levels at the bank. Earlier this year, the Federal Reserve took the bank to task for poor oversight and risk controls in a report it sent to Citigroup.

The bank’s downfall was years in the making and involved many in its hierarchy, particularly Mr. Prince and Robert E. Rubin, an influential director and senior adviser.

Citigroup insiders and analysts say that Mr. Prince and Mr. Rubin played pivotal roles in the bank’s current woes, by drafting and blessing a strategy that involved taking greater trading risks to expand its business and reap higher profits. Mr. Prince and Mr. Rubin both declined to comment for this article.

For a time, Citigroup’s megabank model paid off handsomely, as it rang up billions in earnings each quarter from credit cards, mortgages, merger advice and trading.

But when Citigroup’s trading machine began churning out billions of dollars in mortgage-related securities, it courted disaster. As it built up that business, it used accounting maneuvers to move billions of dollars of the troubled assets off its books, freeing capital so the bank could grow even larger. Because of pending accounting changes, Citigroup and other banks have been bringing those assets back in-house, raising concerns about a new round of potential losses.

To some, the misery at Citigroup is no surprise. Lynn Turner, a former chief accountant with the Securities and Exchange Commission, said the bank’s balkanized culture and pell-mell management made problems inevitable.

“If you’re an entity of this size,” he said, “if you don’t have controls, if you don’t have the right culture and you don’t have people accountable for the risks that they are taking, you’re Citigroup.”

Questions on Oversight

Though they carry less prestige and are paid less than Wall Street traders and bankers, risk managers can wield significant clout. Their job is to monitor trading floors and inquire about how a bank’s money is being invested, so they can head off potential problems before blow-ups occur. Though risk managers and traders work side by side, they can have an uncomfortable coexistence because the monitors can put a brake on trading.

That is the way it works in theory. But at Citigroup, many say, it was a bit different.

David C. Bushnell was the senior risk officer who, with help from his staff, was supposed to keep an eye on the bank’s bond trading business and its multibillion-dollar portfolio of mortgage-backed securities. Those activities were part of what the bank called its fixed-income business, which Mr. Maheras supervised.

One of Mr. Maheras’s trusted deputies, Randolph H. Barker, helped oversee the huge build-up in mortgage-related securities at Citigroup. But Mr. Bushnell, Mr. Maheras and Mr. Barker were all old friends, having climbed the bank’s corporate ladder together.

Because Mr. Bushnell had to monitor traders working for Mr. Barker’s bond desk, their friendship raised eyebrows inside the company among those concerned about its controls.

After all, traders’ livelihoods depended on finding new ways to make money, sometimes using methods that might not be in the bank’s long-term interests. But insufficient boundaries were established in the bank’s fixed-income unit to limit potential conflicts of interest involving Mr. Bushnell and Mr. Barker, people inside the bank say.

Indeed, some at Citigroup say that if traders or bankers wanted to complete a potentially profitable deal, they could sometimes rely on Mr. Barker to convince Mr. Bushnell that it was a risk worth taking.

Risk management “has to be independent, and it wasn’t independent at Citigroup, at least when it came to fixed income,” said one former executive in Mr. Barker’s group who, like many other people interviewed for this article, insisted on anonymity because of pending litigation against the bank or to retain close ties to their colleagues. “We used to say that if we wanted to get a deal done, we needed to convince Randy first because he could get it through.”

Others say that Mr. Bushnell’s friendship with Mr. Maheras may have presented a similar blind spot.

“Because he has such trust and faith in these guys he has worked with for years, he didn’t ask the right questions,” a former senior Citigroup executive said, referring to Mr. Bushnell.”

According to a former Citigroup executive, Mr. Prince started putting pressure on Mr. Maheras and others to increase earnings in the bank’s trading operations, particularly in the creation of collateralized debt obligations, or C.D.O.’s — securities that packaged mortgages and other forms of debt into bundles for resale to investors.

Because C.D.O.’s included so many forms of bundled debt, gauging their risk was particularly tricky; some parts of the bundle could be sound, while others were vulnerable to default.

“Chuck Prince going down to the corporate investment bank in late 2002 was the start of that process,” a former Citigroup executive said of the bank’s big C.D.O. push. “Chuck was totally new to the job. He didn’t know a C.D.O. from a grocery list, so he looked for someone for advice and support. That person was Rubin. And Rubin had always been an advocate of being more aggressive in the capital markets arena. He would say, ‘You have to take more risk if you want to earn more.’ “

It appeared to be a good time for building up Citigroup’s C.D.O. business. As the housing market around the country took flight, the C.D.O. market also grew apace as more and more mortgages were pooled together into newfangled securities.

From 2003 to 2005, Citigroup more than tripled its issuing of C.D.O.’s, to more than $20 billion from $6.28 billion, and Mr. Maheras, Mr. Barker and others on the C.D.O. team helped transform Citigroup into one of the industry’s biggest players. Firms issuing the C.D.O.’s generated fees of 0.4 percent to 2.5 percent of the amount sold — meaning Citigroup made up to $500 million in fees from the business in 2005 alone.

Even as Citigroup’s C.D.O. stake was expanding, its top executives wanted more profits from that business. Yet they were not running a bank that was up to all the challenges it faced, including properly overseeing billions of dollars’ worth of exotic products, according to Citigroup insiders and regulators who later criticized the bank.
 

In 2005, as Citigroup began its effort to expand from within, Mr. Rubin peppered his colleagues with questions as they formulated the plan. According to current and former colleagues, he believed that Citigroup was falling behind rivals like Morgan Stanley and Goldman, and he pushed to bulk up the bank’s high-growth fixed-income trading, including the C.D.O. business.

Former colleagues said Mr. Rubin also encouraged Mr. Prince to broaden the bank’s appetite for risk, provided that it also upgraded oversight — though the Federal Reserve later would conclude that the bank’s oversight remained inadequate.

Once the strategy was outlined, Mr. Rubin helped Mr. Prince gain the board’s confidence that it would work.

After that, the bank moved even more aggressively into C.D.O.’s. It added to its trading operations and snagged crucial people from competitors. Bonuses doubled and tripled for C.D.O. traders. Mr. Barker drew pay totaling $15 million to $20 million a year, according to former colleagues, and Mr. Maheras became one of Citigroup’s most highly compensated employees, earning as much as $30 million at the peak — far more than top executives like Mr. Bushnell in the risk-management department.

In December 2005, with Citigroup diving into the C.D.O. business, Mr. Prince assured analysts that all was well at his bank.

“Anything based on human endeavor and certainly any business that involves risk-taking, you’re going to have problems from time to time,” he said. “We will run our business in a way where our credibility and our reputation as an institution with the public and with our regulators will be an asset of the company and not a liability.”

Yet as the bank’s C.D.O. machine accelerated, its risk controls fell further behind, according to former Citigroup traders, and risk managers lacked clear lines of reporting. At one point, for instance, risk managers in the fixed-income division reported to both Mr. Maheras and Mr. Bushnell — setting up a potential conflict because that gave Mr. Maheras influence over employees who were supposed to keep an eye on his traders.

C.D.O.’s were complex, and even experienced managers like Mr. Maheras and Mr. Barker underestimated the risks they posed, according to people with direct knowledge of Citigroup’s business. Because of that, they put blind faith in the passing grades that major credit-rating agencies bestowed on the debt.

While the sheer size of Citigroup’s C.D.O. position caused concern among some around the trading desk, most say they kept their concerns to themselves.

“I just think senior managers got addicted to the revenues and arrogant about the risks they were running,” said one person who worked in the C.D.O. group. “As long as you could grow revenues, you could keep your bonus growing.”

To make matters worse, Citigroup’s risk models never accounted for the possibility of a national housing downturn, this person said, and the prospect that millions of homeowners could default on their mortgages. Such a downturn did come, of course, with disastrous consequences for Citigroup and its rivals on Wall Street.

Even as the first shock waves of the subprime mortgage crisis hit Bear Stearns in June 2007, Citigroup’s top executives expressed few concerns about their bank’s exposure to mortgage-linked securities.

In fact, when examiners from the Securities and Exchange Commission began scrutinizing Citigroup’s subprime mortgage holdings after Bear Stearns’s problems surfaced, the bank told them that the probability of those mortgages defaulting was so tiny that they excluded them from their risk analysis, according to a person briefed on the discussion who would speak only without being named.

Meanwhile, regulators have criticized the banking industry as a whole for relying on outsiders — in particular the ratings agencies — to help them gauge the risk of their investments.

“There is really no excuse for institutions that specialize in credit risk assessment, like large commercial banks, to rely solely on credit ratings in assessing credit risk,” John C. Dugan, the head of the Office of the Comptroller of the Currency, the chief federal bank regulator, said in a speech earlier this year.

But he noted that what caused the largest problem for some banks was that they retained dangerously big positions in certain securities — like C.D.O.’s — rather than selling them off to other investors.

“What most differentiated the companies sustaining the biggest losses from the rest was their willingness to hold exceptionally large positions on their balance sheets which, in turn, led to exceptionally large losses,” he said.

In fact, some analysts say they believe that the $25 billion that the federal government invested in Citigroup this fall might not be enough to stabilize it.

Others say the fact that such huge amounts have yet to steady the bank is a reflection of the severe damage caused by Citigroup’s appetites.

“They pushed to get earnings, but in doing so, they took on more risk than they probably should have if they are going to be, in the end, a bank subject to regulatory controls,” said Roy Smith, a professor at the Stern School of Business at New York University. “Safe and soundness has to be no less important than growth and profits but that was subordinated by these guys.”

photo credit: TheTruthAbout…

How Wall Street Became a Giant Hedge Fund

 “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” – Warren Buffett (2003).

Some people are placing the blame for our current financial crisis squarely on the shoulders of greedy Wall Street financiers. They have a valid point. At least part of the problem can be attributed to greed. How and why greed undid some of the great financial institutions is best told by a Wall Street insider.

“Andy Kessler is a former hedge fund manager turned author who writes on technology and markets.”

His article, The Demise of a Giant Hedge Fund - The old Wall Street is dead. Long live the new Wall Street, appeared in the October 13, 2008 The Weekly Standard.

Wall Street is really just a compensation scheme. Firms generate sales, and employees get half the money. Yes, half. The rest, after expenses goes to shareholders. Sweet deal.

By 2002, Wall Street firms, despite being flush with huge balance sheets of capital to generate returns with, were no longer making money in their bread and butter business of stock and bond trading, investment banking, and money management. The one group making money were these weird guys with math Ph.D.s creating exotic securities, derivatives, pieces of paper backed by pools of assets, maybe airplane leases, or home mortgages. The neat thing about derivatives is that no one but the person who created them knows what they’re worth, so you can sell them at huge markups. Woo-hoo. Mammoth departments were created all over Wall Street to securitize everything that moved. With the Fed forcing low interest rates in 2002-2004, the higher the yield the better.

Subprime home mortgages, because of higher risk (ooh, don’t say that word), had high yields and moved to the top of the list. When not enough of these loans could be bought from banks, firms like Bear Stearns and Lehman set up entire loan-origination subsidiaries, and in true Wall Street style were aggressive and rose to the top of the market-share tables. If you want to know why Wall Street CEOs made so much, it wasn’t from trading your 1,000 shares of Apple stock.

Still, those profits weren’t enough. Their customers were making great money buying Wall Street’s derivatives. But why should banks and pension funds and hedge funds have all the fun? What a perfect use for all that capital on their huge balance sheets and cheap financing from low interest rates. Wall Street, en masse, started buying all these high yielding derivatives for their own account. They ate their own dog food, if you will.

…all of a sudden, Wall Street is no longer a business of traders or stock brokers or investment bankers, it’s a giant hedge fund. And they have no idea what they are doing. None. I ran a hedge fund for a lot of years and learned rather quickly that if a trade was too good, if everyone was doing the same trade, then I should absolutely turn around and run for the hills. But no one on Wall Street did. The spreadsheets flashed green. Risk was a four-letter word best not said in polite company.

Wall Streeters became hedge fund cowboys and loved the spoils, until a tiny little downturn in housing sent everyone rushing to get out of the pool at the same time. Deleveraging a balance sheet leveraged at 30 to 1 is not easy or pretty when everyone is doing it along with you. And this is not the customer panic-selling and paying fees to Wall Street, it’s Wall Street doing the selling, pushing prices into the irrational range and turning companies belly up overnight.

Is this the end of Wall Street? More like the start of a new one. At the end of the day, Wall Street is not about the names on the door, it’s about the people inside. There were great people at Lehman and Enron, Bear Stearns and AIG. Those who have a nose for making money will join other firms, or hedge funds, or start their own shop. Still, I’m pretty sure that half of those employed on Wall Street in 2007 will be doing something else by January.

And the new Wall Street? There’s only one direction. It’s back to basics. Not quite back to the old white shoes-blue blood partnerships of the past but certainly that business model. With a lot less capital, sit on the edge of the stock market and provide access to capital for the next set of great companies. Take ‘em public, bank ‘em, and grow with ‘em. It may not be as exciting as the last few years, but it beats getting dumped in the East River.

My Conclusion

In the end, greed was a big factor, but so was a complete failure to manage risk, properly. Top management at some investment banks, supposedly intelligent people, essentially bet their whole company on a strategy that amounted to putting too many eggs in one basket. They ending up owning “exotic securities, derivatives, pieces of paper backed by pools of assets.” They did not understand these securities any better than the people they sold them to.

And because there was no transparency or regulation, the investment bankers could take on as much risk as they wanted to. So they used way too much leverage. They simply took more risk than they had the ability to take. These bets were very profitable, until things went the wrong way. And, because they used such a large amount of borrowed money, there was just no margin for error.

And when many on Wall Street tried to “deleverage” at the same time, i.e. they all tried to sell at once, there was no one on the other side of the trade. There were not enough buyers, so there was no liquidity, just when it was most needed.

See the quote at the top of this post.

To be continued …