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The Free Market Myth Dissolves into Chaos
With each new revelation of multi-billion dollar losses from the largest Wall Street firms, there has been this nagging question as to how these Masters of the Universe got stuck with these massive write-downs. Isn’t Wall Street supposed to execute trades for others; not build huge inventories of toxic, non-trading securities for themselves?
Given that these big Wall Street players now own some of our largest, taxpayer insured, depositor banks (courtesy of a legislative gift from Congress called the Gramm-Leach-Bliley Act) and the Federal Reserve is shoveling tens of billions of our dollars into some very big black holes, common sense might suggest that Congress would be holding public hearings. These hearings might shed light on how Wall Street has, under the cloak of darkness, mutated from a trading venue to manufacturing and warehousing exotic concoctions registered offshore.
So far, Congress has shown only cursory interest in the details. The Bush administration is spinning the mess as a subprime mortgage problem lest the public figure out that a $1 Trillion unregulated market has blown up under the free market noses of this administration.
Collectively losing $70 Billion in a matter of months with projections of ongoing losses climbing to as much as $400 Billion globally sounds like serious trouble to me. And, it’s very uncharacteristic of Wall Street to lose billions of its own money.
Typically, they know long before the general public that a bust is coming (because they are the ones who sowed the seeds for the bust) and dump their losses on less knowledgeable market participants, usually the small investor. Since they are now stuck with mega losses themselves, wouldn’t that have to mean that they are the least knowledgeable market participants?
Before we break out the bubbly over Wall Street finally getting a taste of how it feels to be mauled, reflect on what it might mean to average Americans if the least knowledgeable market participants own the banks that hold their savings, money market, car loan, credit card, mortgage; and these firms’ stocks are loaded up in 401(k) plans.
The first clue to the mega losses is a three letter acronym, CDO. That stands for Collateralized Debt Obligation; a financial instrument so convoluted that even veteran business writers are having difficulty getting their brains around it.
A good analogy to visualize a CDO is the episode of the sitcom Friends where Rachel tries to make an English trifle for dessert on Thanksgiving. She puts in the requisite layers of custard and jam but when she turns the cookbook page to continue the recipe for the layers, she is unaware that the pages are stuck together and she completes the dessert with the recipe for Shepherd’s Pie. The final product is an indigestible concoction of multi layers of custard, jam, ground beef, sautéed peas and onions.
English trifles are typically served in a clear glass bowl to show off the exquisite layers. Wall Street prefers opaque pottery for its CDOs.
From 2002 through 2006, big manufacturing plants run by the largest Wall Street firms, along with some smaller players, churned out CDO trifles in the cumulative amount of over $1 trillion; half of that was pumped out in just 2006.
The recipe was quite flexible. Layers (called tranches on Wall Street) could consist of student loans, credit card receivables, auto loans, commercial or residential real estate loans, subprime mortgages or corporate loans. Layers could also be highly leveraged bets on indices (Synthetic CDOs) or pieces of other CDOs (CDOs squared). Beginning in 2003, a growing percentage of CDOs were assembled with just one asset class: residential mortgages; frequently using subprime mortgages and home equity loans as the predominant collateral.
While the layers were being assembled, the pieces sat in what Wall Street calls its warehouse operation. Once the CDO was assembled in the opaque pottery bowl, only the whipped cream was showing at the top. The rating agencies, Standard and Poor’s, Moody’s and Fitch gave the indigestible concoction a AAA rating based on that whipped cream. That the rating was requested and paid for by the issuer of the CDO was no trifling matter, as future events would expose. Even as the ground beef and sautéed peas (junk debt) began to rot in the underlying layers, the concoction maintained its AAA rating. (Only in 2007, after think tanks began to expose the chicanery and markets began to seize up did the rating agencies begin to downgrade the ratings.)
Five years went by with the so-called "efficient market" stumbling around in the darkness of fantasy ratings, failing to ponder the obvious questions about these AAA instruments. Questions, such as:
How could a layered concoction of questionable debt pools, many of dubious origin, achieve the equivalent AAA rating as U.S. Treasury securities, backed by the full faith and credit of the U.S. government, and time-tested over a century of panics, crashes and the Great Depression? (Despite the political rogues that come and go in Washington, we, the American people, show an inordinate and historical willingness to suffer fools and still pay our income taxes for the greater good of our fellow citizens. It doesn’t hurt either that, in most cases, the tax is removed from our paycheck before we get it.)
How could an opaque instrument made up frequently of more than 100 hard to track pieces be safe enough for pension funds, insurance company funds and, disguised as commercial paper, stashed to the tune of over $50 billion in Mom and Pop money market funds?
How did a 200-year old "efficient" market model that priced its securities based on regular price discovery through transparent trading morph into an opaque manufacturing and warehousing complex of products that didn’t trade or rarely traded, necessitating pricing based on statistical models?
There was at least one research analyst that was more curious than Congress as to how Wall Street got stuck with these CDOs on their books:
Citigroup conference call, November 5, 2007:
Mike Mayo, Deutsche Bank analyst: "…I mean $43 billion of CDOs. And, excuse me, when were these structures established?…"
Gary Crittenden, Citigroup CFO: "…In terms of the — so the positions, the warehouse positions have obviously been accumulated over — the super senior portfolio positions have been accumulated over time. As I mentioned earlier on the call, the $25 billion that was effectively the liquidity puts really came on during the course of the summer. So this really happens in two different time periods…"
Merrill Lynch conference call, October 24, 2007:
Mike Mayo, Deutsche Bank analyst: "And how did you wind up with such a large concentration [of CDOs] in the place?…"
Stanley O’Neal, CEO [now retired]: "…Why do we have such a large position in the first place? We made a mistake. There were some errors of judgment made in the businesses themselves and there were some errors of judgment made within the risk management function and that is the primary reason why those exposures exist."
This kind of bobbing and weaving and ducking and speaking gibberish is why we need Wall Street under oath in a Senate hearing room.
The Citigroup translation goes like this: we’ve been buying the AAA-rated super senior tranches all along because we were told by the physics brainiacs that these securities were walled off from losses by over collateralization. Our pat answer for how we got $25 billion of CDOs back on our balance sheet this summer is going to be a "liquidity put." We are standing by the position that we gave our buyers the right to "put" the securities back to us without losses under certain conditions. (How that complies with securities laws banning guarantees against losses has yet to be addressed. How one can make an arms length sale of a security and still be contractually bound to take it back on the balance sheet has also not been addressed. Stockbrokers would lose their job, livelihood and licenses if they used this defense. This raises the additional question of regulatory passes for the privileged, another serious contributor to inefficient markets.)
Stan O’Neal’s answer on behalf of Merrill Lynch is, on its face, very humble and simple: mistakes were made; errors of judgment. Recent articles, however, have raised suspicions that Merrill was not only holding the AAA tranches because they thought they were safe from losses because of over collateralization, but was also making hedging bets against the very subprime debt they were selling to customers; in other words, Enronomics: heads I win, tails you lose.
The danger with Alice in Wonderland securities concocted by the invisible hand of a rigged machine, is that all it takes to start a panic is for some sober looking types in scholarly garb to step into the public square and yell "the Emperor has no clothes!"
This is exactly what happened on February 15, 2007. Joseph R. Mason, associate professor of finance at Drexel University’s LeBow College of Business and researcher Joshua Rosner, delivered a paper at Hudson Institute that laid bare the preposterous notion that one could indefinitely put lipstick on a pig (as they liked to say during the dot.com mania) and call it a AAA security. As the working paper found its way into the hands of Gretchen Morgenson at the New York Times and her article appeared three days later, the fireworks factory began to smolder in lower Manhattan, eventually igniting showy global displays throughout 2007. There was a run on a bank in London for the first time in 140 years, bankrupted hedge funds on Wall Street, insolvent mortgage lenders across the U.S., bailouts of money market funds by premier financial institutions and over a half trillion dollars of a liquidity infusion by the European Central Bank. There was also unprecedented help from the U.S. Federal Reserve in terms of cash infusions and back channel chats. But, by far, the most serious damage is the lingering distrust between the largest Wall Street trading firms which, unfortunately, also own banks. No one trusts each other’s solvency so interbank lending has seized up.
Mason and Rosner made a prophetic pronouncement in their paper:
"The growing investor acceptance of CDO structures has been supported by rating agencies’ willingness to rate these assets. Unlike other assets that rating agencies rate, these assets are subject to considerable market risk, a risk which rating agencies do not claim to be able to effectively rate…Because many buyers of senior CDOs can only hold investment grade assets they may continue to hold deteriorating and increasingly illiquid assets as long as their ratings have not been downgraded. Because the market is OTC [over the counter], investors may incorrectly value these assets in their portfolio and be forced to recognize large mark to market losses in a fast moving, liquidating market…."
J. Kyle Bass, managing partner at Hayman Advisors, framed more of the problem to the House subcommittee on Capital Markets in testimony on September 27, 2007:
I will tell you why and how regulators completely missed the epic size and depth of the problem in the credit markets today. An important concept to appreciate is that each securitization is essentially an off balance sheet bank…However, the securitization market has no Federal and State banking regulators to monitor its behavior. The only bodies that provide oversight or implicit regulation are the NRSROs [rating agencies] — bodies that are inherently biased towards their paymasters, the securitization [Wall Street] firms.
Without sufficient oversight, this highly levered, unregulated, off balance sheet securitization market and its problems will continue to have severe ramifications on global financial markets.
Efficient markets need transparency and alert cops on the beat. Why is that so difficult to achieve? Because opacity and rigged markets produce the desired goal of enriching the one percent who now own 44% of the wealth of the nation. This one percent, in turn, keeps Congress on a short leash by holding the purse strings to campaign funding.
Wall Street is a two-sided market. The Wall Street firms’ losses were another party’s profits. Until we know where and how these profits were booked and the details of how the losses occurred, we are choosing to be the idiots of crony-capitalism. We are choosing to hand our country over to the robber barons.
PAM MARTENS worked on Wall Street for 21 years; she has no securities position, long or short, in any company mentioned in this article. She writes on public interest issues from New Hampshire. She can be reached at email@example.com