News & Views from 465 California Street

Tracking the Credit Virus

Clint Reilly

For decades, Wall Street financial institutions have escaped government oversight by convincing people that even the slightest regulation would hogtie the global financial system.

Over time, the lack of oversight spawned a rogue banking system in which hedge fund entrepreneurs, mega-money managers and investment bankers were free to gamble vast sums completely unregulated. The sub-prime lending extravaganza rose from this unchecked morass.

That was before a rolling credit crisis brought staggering losses of wealth not only to big banks, but to regular homeowners across the country. With the economy reeling and in the wake of Bear Stearns’ $30 billion taxpayer bailout, much-needed government regulation is on the way.

Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson may have averted a world financial meltdown by rescuing Bear Stearns, but the results of years of unregulated, unscrupulous financial activities continue to unwind.

On April 16, The Wall Street Journal reported that Merrill Lynch was poised to report a new $6 billion to $8 billion loss that “would bring its total since October to more than $30 billion.”

The credit virus has also spread across the Atlantic, where the Swiss bank UBS declared an incredible loss of more than $35 billion. Believe it or not, UBS is the world’s largest wealth manager.

The litany of losses at Citibank, Wachovia and Washington Mutual are the tip of an iceberg that threatens to batter the nation’s economy. The potential collapse of a single international player threatens a chain of defaults that could trigger a global avalanche.

How did we get here?

Over the past decade, Wall Street began packaging loans in groups and selling them to investors as bonds. Unfortunately, they never demanded adequate underlying collateral. In many cases, they purchased the loans with funds borrowed from banks at lower rates than they earned on the sale.

Other major investors bought the bonds with borrowed money in order to earn the spread between the cost of the loan and the higher interest paid by the newly purchased bond. It seemed like easy money until two things happened.

First, when the fire started, no one wanted to buy bonds possibly containing worthless subprime mortgages. The bonds then fell in value and lenders called their loans to packagers like Bear Stearns. Owning only a stockpile of illiquid bonds, Wall Street packagers were forced to repay loans with their own capital.

The net worth of many firms evaporated almost instantly.

Second, the game of buying higher yielding bonds with cheap borrowed money and pocketing the difference collapsed when the market questioned the underlying credit of the bonds. Lenders called their loans to investors who were trapped with questionable paper that nobody wanted.

Both plays have a single tragic epilogue. The collateral for the loans used to purchase the bonds were the bonds themselves. Consequently, the collateral evaporated when faith in the bonds collapsed. Both borrowers and lenders descended into the abyss.

Because global financial institutions like UBS, Merrill Lynch, and Citibank are interlocked by mutual loans and bonds, one institution’s default will directly impact the others. Each major hedge fund, investment bank or bank is interlocked with multiple lenders and bond holders in a trillion-dollar network – threatening a devastating domino effect when funds cannot be repaid.

The possibility of American taxpayers being hit with a trillion-dollar bill demands greater federal regulation of Wall Street. The New York Times describes the role of the proposed market stability regulator: “The regulator would pass judgment on the capital levels, trading exposure and leverage of Wall Street’s most sophisticated institutions.”

And act as a watchdog to protect the interests of the average Americans who have experienced loss of home, savings and jobs as a result of Wall Street’s avarice, neglect of fiduciary duty and, yes, stupidity.

Comments (5)

  • Impossible to not consider Greenspan responsible for the present crisis. Guilty as charged!

    Posted by: Bob Lever | April 22nd, 2008 at 2:04 am

  • This harkens back to Mr. Reilly’s “Capitalism Without Values”. This week’s article should be the sister article titled “Capitalism Without Some Regulation and Compassion”.

    Posted by: Don Nguyen | April 22nd, 2008 at 3:54 pm

  • Here’s what I wonder: How many ordinary homeowners could have received bailouts from the federal government with the $29 billion sent to Bear Stearns? What if the federal government just picked up the difference between their adjustable rate loans and a 30-year-fixed? How many people could we have helped that way?

    But no. We help the haves and tell the have nots to deal with it.

    We need government regulation in the financial sector to avoid another calamity like the one we’re experiencing now. But we also need to reassess our concept of fairness and our commitment to social equality in this country. We’ve totally lost sight of it in my opinion.

    Posted by: MichoCurry | April 22nd, 2008 at 10:57 pm

  • Responsibility still rests on the shady, avaricious lender and the impatient, easily fooled subprime borrower. Now those 2 parties need to sit down and help each other solve each other’s problems. They will need the help of that “necessary evil?” of Gov’t. The Big Bad Wolf isn’t so bad all the time, is he/she?

    Posted by: Don Nguyen | April 23rd, 2008 at 11:01 am

  • “…help each other solve each other’s problems…” ??

    But-but-but….th-th-that’s SOCIALISM!!

    Bail out the sacred, holy banks and let the stupid irresponsible borrowers suffer the way they deserve to suffer, isn’t that the American Way?

    Posted by: Julian the Apostate | May 21st, 2008 at 10:11 am

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