Leverage, Derivatives And Dog Food: How Wall St. Screwed Up

from the and-what-comes-next dept

Following my post on the makings of the financial crisis, some folks noted that I didn't really discuss the issues of leverage and derivatives, and how they ended up screwing up Wall Street something fierce -- as, instead, I focused much more simply on the issue of "risk" and sort of swept those details under the rug. I'd been intending to tackle the subject this week, but it looks like Andy Kessler has already done the job for me, with an excellent description of how Wall Street went from helping people trade stocks into a bunch of cowboy hedge fund traders who didn't even realize what they were trading, but knew they were making tons of money -- so they kept borrowing to do more of it. They got suckered by their own dog food and ate until they became seriously overstuffed.
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.

It was the easy trade. Borrow at 3 percent and make 6 percent or 8 percent or 10 percent. They liked it so much, they levered up. Meaning instead of just borrowing a dollar for every two dollars of assets they owned (which by the way, thanks to the 50-percent margin requirement, is the amount of leverage that you and I are allowed to buy stocks from these same firms), they borrowed 20 to 1, 30 to 1, and even 50 to 1, if they could get away with it. And man, it was a lucrative trade. So why not?

I'll tell you why not. Because 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.
It's a good read. Kessler and I agree that a new sort of Wall Street will come out of this -- and that's for the best. Money will flow again, but there will be new opportunities for banks to get back to basics.


Reader Comments (rss)

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  •  
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    David, Oct 6th, 2008 @ 1:42pm

    Just like any ELE

    The strong survive...

     

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    the_dukeman (profile), Oct 6th, 2008 @ 1:54pm

    banks should get back to banking

    I recently saw on a documentary a financial pundit in France stating that French banks do 75% normal banking, and keep real estate as no more than 25% of their business. As a result, the French banks are in way better shape than the American ones.

     

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    Anonymous of Course, Oct 6th, 2008 @ 2:10pm

    Capital preservation

    Wouldn't an insurance plan for the banks (like
    FDIC) that protects them from loss of capital if
    the mortgage securities fail work better than
    the current plan? I think that would reduce the
    fear and loathing between banks and put some slack
    in their credit policies.

     

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    Wayne, Oct 6th, 2008 @ 4:43pm

    60 Minutes: A Look at Wallstreet's Shadow Market

    60 Minutes had a great story about this on Sunday.

    http://www.cbsnews.com/video/watch/?id=4502673n

     

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    HATING Anonymous, Oct 6th, 2008 @ 4:43pm

    @ Anonymous of Course

    You are not paying attention, which is how we got into this mess in the first place. The whole idea of packaging and selling these sub-prime mortgages together with less risky investments WAS the de-facto insurance system. The problem is, because Wall Street couldn't follow it's own simple rules (or the law), we now have $67 TRILLION dollars worth of derivatives based on $1 TRILLION of actual assets.

    The fail-out plan is literally just a drop in the bucket - full of political pork and devoid of any assistance to the American taxpayer.

    Wake up, pay attention, and at least try to understand the gist of an issue before writing so much drivel...

     

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    Anonymous Coward, Oct 6th, 2008 @ 7:08pm

    This sounds like what happened just before the Great Depression... Does no one take history in HS anymore?

     

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    Twinrova, Oct 7th, 2008 @ 3:50am

    Couldn't have said it better myself.

     

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    Twinrova, Oct 7th, 2008 @ 3:56am

    Couldn't have said it better myself.

    "Lynch America Countrywide"
    That actually made me laugh out loud.

    Sorry for the double post. Stupid enter button and my lack of coffee, in addition to the lack of an edit button.

    Anyway, I found something else I need to learn about. I've seen it pop up several times, but now I'm getting the feeling the word "derivative" isn't what I think it is.

    And for the record: I've noticed each and every one of these articles about what happened all clearly point the finger at the downturn in the housing market as the culprit for the failures. Cause and effect.

    But not a single report shows what caused the downturn in the housing market. Tell me again how the credit industry had no hand in this? Yeah, the hell it didn't.

    The timeline speaks for itself. It was just a matter of time before consumers couldn't pay their mortgage.

     

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      Mike (profile), Oct 7th, 2008 @ 7:43am

      Re: Couldn't have said it better myself.

      And for the record: I've noticed each and every one of these articles about what happened all clearly point the finger at the downturn in the housing market as the culprit for the failures. Cause and effect.


      You've got them backwards...

      But not a single report shows what caused the downturn in the housing market. Tell me again how the credit industry had no hand in this? Yeah, the hell it didn't.

      You are confusing the mortgage part of the credit market with other parts of the credit market. You seem to be lumping together a bunch of different things.

      Learn what the separate parts are before you pull out your blame finger.

       

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        Twinrova, Oct 7th, 2008 @ 12:42pm

        Re: Re: Couldn't have said it better myself.

        "You've got them backwards..."
        Got what backwards? Timelines don't lie, Mike.

        "You are confusing the mortgage part of the credit market with other parts of the credit market. You seem to be lumping together a bunch of different things."
        No, I'm not. I understand the aspect of the whole process of spreading risk around as "credit" towards those who passed monies around as much different than the "credit industry" of those handing out credit cards.

        I do not find it illogical to conclude the tactics of the credit card industry affected mortgage defaults, leading to investment credit to fall short of expectations. It was a large gamble to assume the housing market was never going to fall as it did.

        For those of you wondering how I'm making this connection, let me take you back a few years when the housing market was rising (thus, the lead up to the bailout).

        The credit industry took it upon themselves to start making changes in the way the do business. Here's what they did:
        Phase I: Eliminate the high credit/limit information when reporting to the credit bureaus.

        This was devious and some issuers are still doing this today. Here's how it works (assuming a credit card limit of $3000, $1000 balance, $25/mo payment, and never late):
        The information sent to the bureaus omitted the $3000. This forced the evaluation of the report to take the balance ($1000) and turn it into the limit, meaning, you were now "maxed out" at 100% of your credit line.

        This move forced the credit score to drop! It also affects the debt-to-income ratio used by financial institutions. This example shows a moderately good borrower turned into a high risk borrower by the simple elimination of credit information. Millions were affected by this.

        Phase II: Raising interest rates due to "competition"
        Imagine, to your shock, your 1.9% interest rate instantly increased to 23.99%. You've never been late with a payment. So why the increase?
        Simple: You had cards issued from the "competition", and the increase was to "penalize" you for having it.

        This one hits home because I was a victim of this. So were hundreds of thousands of others, judging by the information posted on the web at the time. Many people didn't get a satisfactory answer when they called. It took me 2.5 hours to get mine, and only because the guy I was talking to felt sorry for my situation.

        Phase II also included constantly changing the payment due dates on every statement to ensure borrowers would overlook it, forcing the "late payment" penalty upon them. One lady sent me in her statements, and sure enough, all 5 have a "notice" indicating the payment due date change.

        I won't even get into the dropping of the grace period many issuers enacted.

        Phase III: Lobby for bankruptcy law changes in their favor!
        Well, this certainly worked! In 2005, the new bankruptcy laws were changed and it came at a perfect time when interest rates were being raised for "no apparent reason" of good, hardworking people doing what they're supposed to do: pay their bills on time.

        Shortly after the law was changed, damn near every credit issuer raised their base principal rate from 2% to 4%. A simple $25/mo payment instantly turned into $70, and with the average family owning 4 cards, that's a massive increase in monthly payments.

        Consumers were now stuck. Most couldn't escape the credit card rates even through bankruptcy, as it was now damn near impossible to file for Chapter 7 (clear of all debt). Many bankruptcy attorneys shut their doors for good because the new law was much too complicated to work out any benefit for the consumer who was really in trouble.

        Follow the timeline closely and take a look at just when ARMs started getting widely used to get people into new homes. Strange, isn't it.

        Take this, the first increase in gas prices, rising goods prices, and increased taxation of states (varies), it's no wonder the housing market crashed.

        Here we are 3 years later and the economy sucks. Every article regarding the bailout clearly shows what happened, and when it started happening. Find this time line coincidental?

        I sure don't. You can try to find flaw or dispute this information all you want to, but it's all fact.

        The time line speaks for itself. What the market was doing during all this didn't matter because no one, and I do mean no one, could have seen the housing market crash so fast because people could no longer pay their mortgage bill.

        I continue to monitor the actions of the credit card industry because they're not regulated. When I hear of tactics used by this industry to harm the consumer, I make sure it gets out into the public, despite no longer owning any credit cards.

        I do this because I'm tired of the legalized loan sharking that occurs when people are given no choices to "fight back" when they adhered to the terms and conditions by the issuer, only to get bent over and reamed.

        Note: The Fair Credit Reporting Act (FCRA) isn't overseen by the government. It's a "checks and balances" system derived because the credit industry doesn't want government oversight, so they do it themselves to placate the government.

        Nice how that worked out, isn't it.

         

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    mic, Oct 7th, 2008 @ 11:22am

    Mike, what I like about this site is that you are usually able to follow the reasoning to the roots of the problem. As you did in excellent series of posts about the economics of non-scarce goods, where you were discussing fundamentals of economy like private ownership.

    So lets try to dig deeper also in case of economic crisis. Some people are claiming that they've found roots:
    http://en.wikipedia.org/wiki/Fractional-reserve_banking#Criticism
    http://en.wikipedia.org/w iki/Austrian_Business_Cycle_Theory

    Looks to me like logical explanation of crisis, but at the same time I am confused because it is widely ignored, so it cant be right, can it? :-)

    What do you think?

     

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      Mike (profile), Oct 7th, 2008 @ 2:02pm

      Re:

      Looks to me like logical explanation of crisis, but at the same time I am confused because it is widely ignored, so it cant be right, can it?

      Well, there's some elements of truth in there, as well as some elements of... not quite fiction, but perhaps exaggeration. The complaints against fractional reserve banking are misplaced. There's nothing fundamentally wrong with fractional reserve banking -- the problem is in how fractional reserve banking is, at times, used to effectively hide risk by making risky instruments seem not as risky.

      The whole thing with pegging money to a gold standard is silly. That is an arbitrary designation, and if it was done, you could bet that similar complex financial instruments would show up to get around it anyway, and you'd have the same problems as before, just in a different way.

      I do tend to think that central banks exacerbate the problem, but are hardly the cause of it. It's the old bath temperature issue. When things are too "cold" they turn the temperature (interest rate) up, and when things are too "hot" they turn it down. But they know less than the market does so they tend to be too slow and they tend to overreact, so you get wildly fluctuating situations that aren't good for market stabilization in normal times.

       

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