End of an era
By jsavit on Sep 24, 2008
There's a saying attributed to the banker J. P. Morgan: One morning, asked what the market would do, he responded "The market will fluctuate". That has certainly happened in the last weeks and months with the credit meltdown. The financial services world is turned upside down, with major houses like Merrill Lynch and Lehman Brothers being acquired at fire sale prices or going under, and the remaining major players (Goldman Sachs, Morgan Stanley) transforming themselves from investment banks to bank holding companies, subject to increased regulatory requirements but operating at lower risk. The investment banking world is turned upside down. This is the antitheses of the incredibly leveraged market that caused this crisis.
I have a personal perspective on this. I worked for years at Merrill Lynch, leaving in 2000 to join Sun (with customers, I would joke that I either had gone to the Dark Side, as a vendor, or left the Dark Side of being on Wall Street. Just a joke, guys...). In fact, I tangentially worked mortgage backed securities - a formerly obscure term that now is a household name, and not for the best reasons (I was responsible for systems that ran MBS applications and "research", and occasionally got involved in coding).
MBS are not fundamentally bad. If you have a pool of mortgages, you can "securitize" it and treat it like a bond or other category of debt instrument. It has a cash flow from monthly payments, ties to interest rates, has coupon values. Just like bonds, you can sell the debt as a negotiable instrument. On its face, a useful thing. So far, so good.
But they have tremendous risks and are very unstable. I know of an individual trade that cost $350M when a trader took a bad bet on interest rates. A few years later another firm had a $250M loss in similar circumstances. To say this is risky business is an understatement - even before the advent of "liar loans".
Part of the problem is how hard these instruments are to understand and to price. If you can't price it correctly, how can you be sure you are not selling at a loss, or buying something that is worthless. Instruments that are priced on the basis of hundreds of hours of computer time don't permit that., and they are very sensitive to things like interest rates (a small change in rates can greatly change the value of the MBS). Even the analysts didn't understand how the instruments worked. It's said of the late Dennis Weatherstone, head of JP Morgan (the bank, not the person, and now JP Morgan Chase), that he would give teams 3 attempts to explain a new instrument they wanted to sell. If they couldn't explain it satisfactorily in 3 tries, he wouldn't let them bring it to market. A wise policy that was not followed enough.
That was then, and now things got worse.
Cheap credit pumped up house prices so the underlying financial object was divorced from reality. Lack of regulation in this market permitted liar loans and very aggressive sales practices. Traders are fantastically compensated ("riches beyond the dreams of avarice") for making deals - whether or not the paper they are selling is of any value. That's somebody else's problem, just as it was when the Latin American debt that banks sold 20+ years ago melted down. Somebody else pays the piper. The ratings agencies fell down on the job and rated junk as AAA+. (let's not even get into different "tranches" and collateralized debt obligations).
The derivative markets run (or ran, I should say) with negligible regulation - there is no counter balance to prevent these fairly predictable crises. Couple incredible incentive to sell stuff that is hard to understand, and is based on inflated priced base assets, and you have a recipe for disaster. Count on the (unregulated) hedge funds as the mechanism by which institutions buy insurance against defaulted loans (this is where firms like AIG come into the picture), and the hole gets dug even deeper.
Clearly, the repeal of Glass Steagall, and the lack of transparency and regulation to prevent NINJA and other under-capitalized loans (which decreased the underlying values beneath the MBS), and the unfortunate swing to excessive deregulation contributed to this mess. We had the party, or at least, some individuals on the Street did, and now we all have to have the hangover.
Once upon a time, JP Morgan (the person, not the company) could save the US economy on his own influence (and money). Things have gone far beyond that this time - no single individual or firm is big enough to save the day (I hope Warren Buffet's move this week putting $5B of his own money in the markets at Goldman is a good sign - it certainly shows leadership), and the government will have to bail out Wall Street at a tremendous cost - if it works at all. The idea that the "wisdom of the markets" unfettered by regulation is best way to run the world is now officially dead.
Early 20th century stock market was a crapshoot because the equity markets had no regulatory oversight (and many other reasons beside). Regulation saved Wall Street then. Now cheap money for issuing debt and a similarly lax debt and derivatives market has done the same thing in early 21st century. Let's see if we can fix this in similar manner.
In the meantime, some of the major houses on Wall Street are gone, by their own hand. Charlie Merrill would not be happy to see what happened to his company, that once "brought Wall Street to Main Street", and was a great engine of wealth creation. It's sad.