Duh Financial Meltdown

It's The Fault of the Brainiaks

Back when I was playing football in high school we had a hell of a team but we were very light. To give us an "edge" in our first couple of games our coach listed weights for us in the program that were exaggerated as much as 20%. He did this so other teams would be afraid of us. It worked in first three games because by the time the other team realized that we were normal we were already ahead by two or more touchdowns. In other words they accepted our financial statement on face value. The other coaches in the league got wise and so everyone else in the league was ready when we played (we were undefeated for the season so the "edge" meant nothing).

So it is with the banks and brokerages. They misstated their value or the value of their "assets" in their programs. And we dopes believed the programs without checking them out.

What really "happened" in this meltdown is societal far more than financial. In other words defective people are at fault and not badly structured markets. It's our brainiacs who are at fault. The smartest guys in the room had always been the smartest guys in the room; Masters of the Universe as it were. Guys who got 1500 on their SATs and IQs of somewhere in four digits. So the sharpies did what all sharp guys do: they all went to the same prestigious colleges (MIT, Wharton, Harvard, etc.) and they learned exactly the same stuff from professors who were clones of one another. And it came to pass that when the sharp guys graduated they all had the same tools. And they all went to Wall Street somewhere and most often ended up in the investment banking part of firms. (Typical hot wife of successful investment banker shown at left before she dumped the loser husband for a successful Mexican drug kingpin.)

So every Sharp Guy Graduate in every Investment Bank---all of them operating on their own but each equipped with the same set of tools--came up with the same answer to the age old problem of: "How do we make more money out of this shit?" They all figured out that by packaging debt instruments of various grades into bigger and bigger bundles they could create a "model" composed of so many differing debt vehicles and cross hedges that no one could look at a bundled security and tell what was happening. The results were potent, both in apparent value as well as returns. All were good enough to keep increasing the value of their holdings. So long as they had a mix of valuations that conformed to their models, all valuations and returns would hold true. All thought they could balance the higher risk of flakes with the low low low risks associated with Mr. and Mrs. Wonderful in the correct proportions so the debt packages based on "models" should show correct value. And if push came to shove they could always follow the Milkin model of trading bundles within their firms in order to build or maintain value. And of course hedge fund speculating could keep things Heaven bound forever.

But value of course is finally only what others will pay.

Anyway things rolled on with newer and newer sharp and younger guys from the same places arriving on the scene who figured that they could break up and repackage these huge "bonds" to include futures contracts on every interest rate in the world, hedge fund shares, and so on into newer and better packages, ones that contained Third World Bonds, promissory notes from Hollywood producers, and God Only Knows what kinds of other debt so their models still looked good.

Now in the "old" normal market when a debt is securitized into a bond the holder of the packaged debt instruments is assured of value because they know the exact content of the bond. If one mortgage within the bond goes south it is replaced with one of like value, so the overall pricing of the bigger debt instrument remains constant.

What went wrong is that the rules of the game had been changed and we were not informed until the refs started calling penalties. Most assumed---without checking---that bad debt was always replaced and that bonds were "safe." None of the brainiacs had a plan for replacing anything, especially "anything" like the defaulting of huge debt by Mr. and Mrs. Wonderful. When it happened it was a single huge customer who could not meet a margin call which ended up a default in one part of the world but because it was so large that hundreds of people had to "cover" by selling the brainiac bonds. And gues what? They couldn't get what they were thinking they would get and so the story rolls on. When this happened in firm #1 the scramble to "replace the irreplaceable" became a stampede of Giants, all of whom held vastly over valued debt.

The only thing wrong is systemic. There is a creed (taught to us in college) that a business must always grow or it will shrink--the stock price will fall--and a business with plummeting stock value cannot possibly pay employees the same money as one that has a soaring stock price.

A business HAS to grow. Profits have to grow.

Says who? College professors and their learned students, that's who.

It was the mass concentration on lessons of the past that had been learned in school and not in the markets that caused this meltdown as much as anything else. "All Theory and No Practical Experience" type of thing. And all the guys who had their educations end five years ago were also completely in the dark. It turned out that not even the smartest guys in the room knew what they had wrought.

Well at least 100 billion has been wrought, a sum that equals five years or more of profits and these profits will be restated for as far back as five years. It ain't over til it's over.

Competition. But before I leave this arcane subject, honesty compels me to tell you that the Great God Competition played as big a part in this "collapse" as anything. Firms MUST return competitive amounts of money on investments or lose clients, those big clients who demand higher and higher returns "or else." The "or else" means they will pick up their marbles and deliver them to your competition. So even if a firm did not do what others were doing because they were not comfortable with the risk, risk which they deemed to be extraordinarily high, they were forced to play in this highly risky market or be put out of business. Plenty of "loser firms" stayed true to the code of not ever buying a black box, meaning if you don't know everything in and about the vehicle including the trading rules, STTFO. With some of Wall Street's biggest firms on the ropes, these "loser firms" may become more than they ever wanted to be.

THE GREAT ECONOMICS BLOG, THE BIG PICTURE, HAS AN OUTSTANDING PIECE RIGHT HERE. He speculates that losses could approach $1bil. He's good and he's very scary.