Posted on 11/01/2009 9:46:34 PM PST by bruinbirdman
[Excerpt]
"Sometimes our technology, in creating these securities, outpaces our ability to cope with them." That's what Larry Fink told the New York Times in May 1987 when asked about Howie Rubin's trading disaster. In the past, Fink would have made that statement to a reporter and then celebrated with his team the fact that one of his competitors, particularly one like Merrill Lynch, which he saw as a pesky upstart in the field he aimed to dominate, was now being nailed with massive losses.
But Fink wasn't celebrating, because, much like Howie Rubin, he had just gotten his first real education in risk. And like Rubin, Fink and his team thought they had it all figured out. In the second quarter of 1986, Fink had made an opposite bet from Rubin--all of his research pointed to higher interest rates and a reduction of prepayments from mortgage holders, and he was having one of his best runs.
With that in mind, Fink began gambling even more with esoteric Collateralized Mortgage Obligation strips, and, like Rubin, he would end up losing big. Unlike in Rubin's case, the full extent of the losses wasn't immediately apparent. When the Rubin fiasco became public, Fink and his team thought they had their position hedged--meaning that they utilized a classic technique to reduce losses by making an offsetting trade, thus minimizing the losses that had beset Rubin.
But, as Fink was about to discover, his hedges were losers as well. His former boss Tom Kirch now worked for Fink and was attending an executive committee conference in Carmel, Calif., enjoying the beautiful northern California weather in the quaint town where Clint Eastwood was mayor.
During a break, Kirch went back to his hotel room and received an urgent message to call the First Boston trading
(Excerpt) Read more at forbes.com ...
as i recall the gov was telling us they had put safeguards in place so it would never happen again........hahaha
It is bad when a make believe world is interrupted by reality. 90% of the crap sold to investors today is VERY, VERY risky derivative based stuff that few, if any, retail customers understand. Yet, they buy because its going up. It will not end well for America...
This is why everybody--even many on the Left--want the banks to be subject to the 1933 Glass-Steagall Act again, which would effectively shield bank assets from the ups and downs of the stock market. Note that both the 1929 and 2008 stock market crashes had horrifying consequences because when the market crashed, it took bank assets along with them.
Which, by the way, was the purpose for the Glass-Steagal Act in the first place!
The one crucial nugget that he, and many managers/bankers/traders made again this time was to be found here:
“There was almost no price at which Fink could unload his positions. First Boston was stuck, and so was he. Fink had received not just his first real education in risk but also a lesson in how Wall Street really worked.”
These clowns in the late 80’s and again in this debacle, forget that there is risk in limited liquidity. When the turds hit the turbine blades, people want to be in cash or something really, really liquid, like short-duration Treasury bills. Something on which you can get a bid day or night, in US markets or offshore markets, so if there is a need to shift one’s positions, you can do it.
This was part of the problem in the late 80’s, and it is a huge problem again now. It was the problem in the auction rate securities markets, it is the problem with CDO’s, it is the problem with various derivative contracts, etc.
What is most strange about this fascination by Wall Street and The City with illiquid instruments is this: the long-term trend of markets is to make trading easier, faster and more of a commodity over the long term. All attempts at creating one-off or specialized instruments almost always are swimming upstream of the long-term flow. I learned this having been in the hay market in ag - there are no futures on hay, on any exchange, in any market. Why? Because hay isn’t a commodity. There’s good hay, bad hay and supreme quality hay - there’s grass hay, grain hay, alfalfa hay, mixes of all of the above, pea hay, soybean hay, peanut hay, you name the legume, at some point someone has tried to cut it for hay.
This results in a cash-only, private-contract market. This is opposed to markets like wheat, corn and soybeans, where there are standards the crop must meat - X% moisture, Y pound per bushel volume, delivered to registered commodity terminals, etc. You can buy and sell contracts and futures on commoditized grains all day long - because these crops have been made into a commodity.
In mortgages, the trend has been to create “conforming” mortgages, which when bundled are easily securitized. Fannie/Freddie have been doing this since the Depression, and until recently, it worked pretty well.
So when the debt markets started creating these idiotic, almost illiquid CDO’s, CDO-squared, etc - they were, in effect, twisting their own rope from hemp grown by dubious lenders and mortgage brokers, tying it into a hangman’s noose and then either sticking their own heads through the noose or selling positions for other fools to stick their heads through a noose. And when the noose started getting a little snug, they decided that the way to solve that problem was to stand on a wobbly chair (ie, lever up).
This is the same thing, repeated over and over again throughout history with investments - and is one of the reasons why debt deflations and the really painful credit collapses often involve real estate (whether commercial, ag or residential) - because when the crap hits the fan in real estate valuations, real estate is, always has been, and likely always will be, very illiquid.
I would add one more issue to your point:
G-S 1933 also put a firewall between banking and insurance.
Now we have an insurance company (eg, AIG) getting into the banking sector through unregulated derivatives, and in effect, exposing the assets of an insurance company to the banking sector, which is exposed to the markets in the ways which you detail. In effect, all the firewalls are gone.
We need to stovepipe the investment banks, commercial banks and insurance companies to prevent flash-over from happening again.
1) Reimpose the full aspects of the 1933 Glass-Steagall Act to effectively protect bank assets from the ups and downs of the stock market.
2) Increase the minimum margin requirements for trading in stock and commodity futures from 5% to somewhere between 15% and 20%.
3) Require REAL liquidity backing to trade in derivatives, hedge funds and credit default swaps.
4) Re-write the Sarbanes-Oxley Act to better balance the need for IPO's against better accounting report requirements.
I have no time frame for these particular derivitives. This article sets it about 1986.
Warren Buffet puts the big shift at the time the big brokers went public. Before, they bet their own (partners') and private clients' money. After they went public, the risk was on the shareholders. The shareholders, of course, only make money after the partners took their fees, but took all the risk.
These broker IPOs started about 1987 or so. [And GS was the last of them to do it?] This is the big reason they wanted to void Glass-Steagall, so they could get their hands on bank deposits?
Long Term Capital was the first institution [hedge fund] to supposedly have global meltdown exposure. It was private. When it went bust however, Greenspan put the screws on the brokers and banks responsible for providing the seed loans that were leveraged and made them pony up hundreds of millions to cover LTC?
yitbos
The article mentions CMO’s, which were one of the first packaged mortgage instrument outside the Freddie/Fannie secondary market. They weren’t all that liquid, and whatever protection that might have been used on them in the 80’s was even less liquid.
When LTCM went down, it was (again) due to the deadly combination of leverage and illiquid instruments, particularly with exposure to Russian debt markets.
Buffett’s choice of the timeframe is right (when they started going public in the 80’s), but identified only one of the reasons I think are behind this. The article makes an oblique reference to one of the other issues that is responsible here, and I think that is an over-reliance on computer modeling of risk on Wall Street. Before computers (or computing cycles) were cheap, portfolio analysis was based much more in business instinct and common sense, and much less on computer models. Computer models, as we all know, are GIGO - garbage in, garbage out. Or as is more the case now, “selective data in, selective projections out.” The [over] reliance on computer modeling has seduced Wall Street pro’s into thinking that they have risk completely quantified and accounted for, when the truth is far different.
Another problem in the late 80’s was that the computers used at brokerages were overwhelming the exchanges. At some points in ‘87, the exchanges were running a half-hour behind in filling orders. Here’s some additional information in a paper by the Fed:
http://www.federalreserve.gov/Pubs/FEDS/2007/200713/200713pap.pdf
Agree with all your points, with a NB that for we retail investors, margin requirements in most stocks now runs 50% (and 100% on small, under-capitalized stocks) in equities, 10% on commodities contracts.
These margin limits should be enforced on everyone equally. There were hedge funds coming into the 2008 crash that were levered up 15:1 and higher, and i-banks that were levered up to 30:1 and higher. Set the limit at 10% for everyone, more for illiquid instruments, the way the stock exchanges have done for thinly traded, low-cap stocks.
Additional points:
5) Eliminate all dark pools. All equities, options and futures (and options on futures) trades are to be made on exchanges open to all investors. Eliminate ICE, et al.
6) Enforce delivery rules to prevent naked shorting. Make the penalties for inability to deliver very high.
7) Restrict CDS contracts to a sum total of the amount of debt outstanding, require that anyone writing a CDS have capital or debt instrument to deliver/settle the trade. No more naked CDS contracts.
8) Reform accounting for banks. Eliminate “level 3 asset” accounting and mark-to-mythology. Everything has to be marked to market. If the complaint is that there is no market, that should be a clue that the instrument should probably not exist or it shouldn’t be on a bank balance sheet. Banks, when originating debt issues, should be required to “eat their own cooking” — ie, they should not be able to make a bunch of loans, bundle them up and get them completely off their own books and “sell the problem.” All banks originating debt should be required to keep a certain proportion of the issue - say, 15%, until the debt is repaid by the borrower.
Lastly, we should change the model and compensation methods used by the credit rating agencies of S&P, Moody’s and Fitch’s. From here on in, buyers of debt pay for ratings, issuers don’t pay.
Indeed! There were some grand financial threads here at FR from 2006 on concerning just such quants and their "standard deviations".
The only quant we hear about these days is "quantitative easing". Ah, ha, ha. YIKES!!!
yitbos
self ping
Our elites grow up and do well in INSTATUTIONS. Little hot houses of order, that produce human orchids. Ask Robert Mcnamara about elites, computers and illiterates in black pajamas and regular infantry uniforms. Ask the now dead Russian nobility about Marxist reading mobs, or also now dead German generals against the slob Russian Armies.
The Federal Reserve is yet going to drag us all down, or blow us all up. Or both.
Cut a fat hog in the fanny for a long time off that one.
Maybe Canadians are just not dumb enough to invest in tons of crap mortgages (or they have no CRA breathing down their necks). I just can't see G-S being a silver arrow for the U.S. financial industry. The one big difference I can find is that Canada actually enforces its security regs/laws. Financial regulation in the U.S. has gotten as ridiculous as "gun control" laws -- a million laws you'll never see enforced.
What's your take on why Canada has far less financial regulation, but sounder banks?
Very good recommendations
Barney Frank heads an important committee and here is the derivites regulation bill they passed
http://www.marketwatch.com/story/key-committee-oks-post-crisis-derivatives-bill-2009-10-15
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