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?