As Citigroup, Merrill Lynch and other firms take write-offs of about $100 billion (and counting) due to the credit bubble, you might have had this gnawing feeling: This is familiar — I've seen this movie before. And you would have been correct. You have seen this before, and not all that long ago, either. The details are different this time, true. But the plot is very familiar: rising asset prices, increasing expectations of the market participants, which leads to over-confidence, envy, greed, risk taking and then — bang — the trend ends, and the painful correction begins.
It's a familiar, even classic, story. You could even regard this credit bubble as a sequel to the equity bubble that popped in 2000. Consider that as people began to buy up real estate regardless of the true value of some property, financial institutions were there to help. In 1995, the CDO market was in its infancy; by 2006, there was about $600 billion worth of CDOs, about 40 percent of which was backed by residential mortgages, and 75 percent of which was sub-prime, according to a study by Joseph Mason, a finance professor at Drexel University, and Joshua Rosner, of Graham Fisher & Co., a research firm.
The “sophisticated” strategy behind this boom seems to have been: Exploit the trend by issuing CDO “product” until it doesn't work anymore. By issuing CDOs, banks could load up on riskier lending strategies (and hence win more potential profit) because they could offload the risk to other investors, from banks to hedge funds. At least that's how it seems to have worked out. Investor demand for sub-prime CDOs was so hot that the interest rate spread between sub-prime and prime loans went from 2.8 percentage points in 2001, to a mere 1.3 percentage points in 2007, according to the Federal Reserve. Of course, we all know how this movie ends — badly. As with other bubbles, when valuations get out of whack, the market has a way of correcting itself.
Stephen McClellan, a former analyst with 32 years of experience, puts the fault totally at the feet of financial services companies in his new book, Full Of Bull: “[Wall Street] is structured to trade securities, perform securities transactions, distribute and sell securities as a dealer, and do corporate finance deals. Wall Street is not suited to be an investment manager, financial advisor or stock selector.”
Those are strong words, and certainly not everyone would agree with that statement. But it is the stance that many investors — even sophisticated pension plans — are going to take. Some observers say owners of CDOs will be bringing suit against CDO manufacturers in 2008, arguing they were unsuitable investments. (Australian charities and cities are arguing just such a case in a suit against Lehman Brothers.)
The courts will decide the merits of the case, of course, but no one should be surprised that a new and fancy financial vehicle was abused. Take the junk-bond market back in the late 1980s. There is nothing wrong with junk bonds, of course, and Michael Milken is to be praised, at least, for pioneering a way to get capital to promising, albeit risky, ventures. (For example, MCI, the discount long-distance phone service, might not have survived without junk.) But, alas, too much of a good thing can be corrupting: Drexel Burnham Lambert made a $522-million profit in 1986 off of junk bonds, then an all-time record for Wall Street. Milken himself was paid a $550-million bonus in that year. By 1989 it was all over: The junk-bond market melted down, taking Drexel and Milken with it. The debacle gave a disreputable air to the mergers that fueled and defined Wall Street in the 1980s.
Then the smart money gave us the Asian currency crisis in 1997 by packaging investments in emerging markets, such as closed and open-ended funds, out of proportion to what that market could support. We won't even talk about the dot-com bubble.
Irrational Exuberance
The question becomes, if Wall Street has felt the pain of “over-exuberance” before, why does it keep allowing itself to fall in love with whatever exotic investment-of-the-day crops up? The answer, of course, is profits. Wall Street firms were earning a fortune securitizing mortgages and other debt. (Merrill was rumored to have made between $400 million and $500 million in fees and other revenue on its CDO business, says one former Merrill Lynch employee.)
As we all know, people get careless when times are good. And good they were until recently. According to the Securities Industry and Financial Markets Association (SIFMA), profits for all of Wall Street came to $17.2 billion in 2006, just short of the estimated $20- billion record established in 2000. The state comptroller of New York estimates that top Wall Street brass took home $23.9 billion in bonuses in 2006 while working the CDO markets. According to SEC filings, ousted Merrill Lynch CEO Stan O'Neal left this year with $161 million in compensation and benefits despite the fact that he was at the helm of the company when it reported the worst quarterly results in its 93-year history. Citigroup's ex-CEO fared much worse, taking home just $93 million in compensation when he was pushed out of Citi.
It would seem that Wall Street executives don't have to follow the same rules about knowing the customer that registered reps do. Why would they, with record profits and bonuses at stake? They get paid, it seems, to package high-flying products like junk bonds, derivatives, CDOs, exchange traded funds, dotcom IPOs and other exotica to investors, and ride the gravy train while it lasts. Then they get paid to leave their firms while others foot the bill. (In all fairness, fad investing is not driven by the individual self-interest of top executives alone. To be sure there is always pressure from greedy investors to maximize profits.)
Here Comes The Scary Part
The Organisation for Economic Cooperation and Development has estimated that the sub-prime mortgage debacle could cost up to $300 billion to clean up. The organization estimates that 30 percent of the $890 billion still in sub-prime mortgages could go into default in 2008. While some say the government was right to intervene to lock in some mortgage rates before they reset, Tom Wiens, who serves in the Colorado State Senate, isn't so sure.
“Typically when you have the government intervene in free markets,” Wiens says, “you get a worse outcome than if you'd just let the markets take care of themselves.”
There's certainly enough money in the global economy to weather the economic storm. The question is whether investors and central bankers will let the markets have access to it. With the sovereign wealth funds of foreign governments pumping nearly $30 billion into Citi, Merrill Lynch, UBS and Morgan Stanley, some of the worry came out of Wall Street. There is growing belief that foreign investors will need to continue to bail out the U.S. financial system in 2008.
For sophisticated financial advisors, well, the turmoil creates opportunities. The more marginal producers, of course, always have a harder time bearing up under the pressure of a volatile market. But the truth is that top brass on Wall Street will probably just find some other new, bright and shiny product to sell with bigger and better profits until THAT market collapses. We know. We've seen this all before.
LESSONS LEARNED
Famous Financial Meltdowns
Drexel Burnham Lambert — 1988
The firm that created the junk-bond king and made corporate raiders look like the heroes of Raiders of the Lost Ark. Also the firm that temporarily destroyed the reputation of the junk-bond market and made corporate raiders look like evil-hearted pirates. Estimated loss: $1 billion
Crisis rating: 3
S&L Crisis — 1989
Lax regulation of standards combined with increasing liquidity for S&Ls create a housing bubble in the 1980s which eventually bursts, causing the federal government to bail out S&Ls. Estimated loss: $150 billion
Crisis rating: 8
BCCI — 1991
Murky international banking conglomerate goes bust while relying on friends in high places to keep its losses from coming to light. A state within an international financial corporation, its objective was to operate on the fringe of the global financial community, reportedly financing nefarious deals. Estimated loss: $20 billion
Crisis rating: 2
Barings Bank — 1995
Old-money bank makes new money by accounting trickery in the form of trader Nick Leeson, who covers larger and larger losses by cooking the books. Ushers in the phrase “Rogue Trader.” Estimated loss: $1.5 billion.
Crisis rating: 2
Asian Currency Crisis — 1997
Thai bhat goes bust, and spreads fear throughout the Asian Tiger economies. Some Asian leaders throw blame at George Soros. First test of the new global economy after Soviet collapse, and economy scores a solid C+. Estimated cost: $1 trillion
Crisis rating: 10
Russian Currency Crisis — 1998
Closely related to the Asian currency crisis, the Russian ruble turns to rubble one year later. Second test of the new global economy after Soviet collapse, and economy scores a B+. Starts Vladimir Putin on his path to presidential power. Estimated loss: $11 billion, plus some loose change.
Crisis rating: 6
The Dotcoms — 2001
Hype makes right in the New Era as young high-tech companies promise big in order to figure out how to make money later. A company even tries to set up a business transmitting scents over the Internet. Estimated loss: Many billions + dignity
Crisis rating: 7
CDO Market Meltdown — 2007
Wall Street decides that historically high home prices means even poor credit risks need no equity to buy a house because housing prices will always go up a lot and, hey, we can just raise their interest rates if we get in trouble. The market decides otherwise. Estimated potential loss: $300 billion
Crisis rating: 8