Prelude to a Financial Market Crash: Part 1 - Alternative Universe

You likely have no idea of how bad this is going to get before its over. That's probably a good thing in its own way. As is said, ignorance is bliss.

At some point we will probably have to either repudiate the dollar Ponzi scheme or surrender ourselves to a regional autocracy. Either way, it will be painful, and a lot of innocent people will be badly hurt.

The warnings will not come from the insiders or your elected representatives, the media or the Administration. No one will want to tell you the truth because frankly you do not want to hear it. And they are afraid.

They will wait until it blows up, and then claim ignorance and amazement, and then try and control the 'solutions' in order to absolve their cronies and punish the innocent further.

The only way to protect yourself is to put as much distance between the US dollar financial scheme and gain as much self-sufficiency for yourself and your community as is possible. And at the right time you will have to have the courage to say "No."


Hello, Alternative Universe
Junk and chumps, pump and dump, barbarians and brokers, smoke and mirrors and other assets of our risk-positive fiscal mess
By John Sakowicz
4.23.08

This is the first of a multipart series on the state of the economy and how we got here.

There is no glory on Wall Street. There is only greed. There are no good guys or bad guys. There are only winners and losers. In fact, there are only guys like Steve Schwarzman and Pete Peterson.

In 1984, Schwarzman and Peterson got crushed like a couple of grapes under the very chubby feet of a guy named Lew Glucksman. (Everything about Lew was chubby, not just his feet.) This happened at a place called Lehman Brothers, at that time a venerable Wall Street partnership. It was a classic power struggle, but no biggie in the whole scheme of things.

Schwarzman and Peterson bounced back quickly. In 1985, they started a new firm with a shared secretary and $400,000. Their new company was called the Blackstone Group, and it is the stuff of legend to say that fortune smiled on them. Schwarzman and Peterson are now two of the richest men in the world. Since 1985, they've done over $400 billion in deals. They are arguably the leading global alternative-asset managers in the world. What's more, they invented an entirely new financial world while they did it.

Problem is, we have to live in it.

Problem Swallowing

Problem is, there are lots of problems on Wall Street. For starters, we've seen the consolidation of power and the concentration of both capital and revenue in fewer and fewer hands. The few institutions left on Wall Street—and there about 10—are now like superstores or warehouses. And the story of how they came to dominate Wall Street is very much like the story of how Costco or Sam's Club came to push mom and pop retailers off the map.

I would know. I started my career at Alex Brown & Sons, the oldest investment bank in the country, established in 1800. A guy named A. B. "Buzzy" Krongard hired me. (Buzzy later turned out to be the No. 3 guy in the CIA.) Alas, in the decade of the 1990s, the proud people at Alex Brown got swallowed up by Bankers Trust, which in turn got swallowed up by Deutsche Bank. I also worked for Colonial Management Associates, which got swallowed up by Columbia Management Group, which got swallowed up by FleetBoston, which got swallowed up by Bank of America.

I worked on the floor of the NYSE for Spear, Leeds & Kellogg, which was swallowed up by Goldman Sachs. I worked for Dean Witter, which got swallowed up by Morgan Stanley. None of the firms I worked for were small companies, what we on Wall Street quaintly call "boutiques." I worked for big companies. Yet they've all been swallowed. All of them.

Now, the 10 or so institutions that dominate Wall Street are monopolies. We've also seen the reinvention of these very same companies on Wall Street. There is now no difference between a commercial bank and an investment bank, no difference between a lender and an adviser. There is now only the monolithic Merrill Lynch or the monolithic Citigroup. Capital is concentrated in these few firms. Naturally, so are revenues. But risk, too, is concentrated. This is a big problem. Because if every deal has got to be bigger and bigger to earn fatter and fatter rewards, then these few institutions must assume greater and greater risk. And risk management is what making money is all about.

Prime Junk Chumps

The Glass-Steagall Act, enacted during the Great Depression to prevent another stock market crash by separating commercial banking from investment banking, was repealed in 1999. In today's lineup of traders, deal makers, underwriters, lenders, advisers, market makers, portfolio managers, brokers and others, it is impossible to point to the chief suspect in the defrauding of America that is now being commonly called the "subprime crisis."

The traditional institutions of commercial banks and investment banks have given way to a new set called hedge funds, private equity funds, and other alternative asset managers. Emphasis on "alternative." Schwarzman and Peterson saw the trend; this was their genius. But there is little to no regulation of alternative-asset managers.

Which brings us to the next problem: There is little to no regulation of the alternative assets that these alternative-asset managers dream up and manage.

A lot of this stuff is debt—debt that is diced, spliced, altered, reheated, topped off with nuts, whipped cream and a cherry and then packaged and repackaged to the American investor. This debt is sold not directly to the little guy, the retail investor—you and me—but to the institutional investor who is presumably acting on our behalf through pension funds, insurance companies, mutual funds, endowments and others.


In the parlance of Wall Street, this debt is "securitized." Call this debt by any name, but don't call it secure. The popular names for this debt are collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs), first widely heard last summer when the subprime market was blowing up. These CMOs and CDOs are spread across the spectrum of risk. Some are senior debt. Some are subordinated debt. Some are OK. The rest are junk. Junk as in subprime junk.

Guess who owns that debt now? You do. Through your pension plans, insurance policies, mutual funds, university and hospital endowments—you do, we do, I do.

And ever since the Federal Reserve Bank bailed out Bear Stearns, you now also own this debt as an American taxpayer. Yeah, chump, you. The losses—er, liabilities—were shifted to you.

There's more. The Fed now lends money—our taxpayer money—to all of Wall Street. The Fed lends not just to its member banks, like before the subprime mess, but it now also lends to all those reckless broker dealers out there, firms like Bear Stearns. The Fed lends your money to them through something that is called the "discount window."

And, man, is that money discounted! The Fed is giving it away. As of this writing, borrowing from the discount window hit something like $36.2 billion a day. A day.

Impossible Things

In Alice in Wonderland, the Queen says, "I believe in as many as six impossible things before breakfast."

Within the last decade, a thousand impossible things are dreamed up before dawn. Not only is there the packaging of new forms of debt, but the minting of new forms of money. Literally, new forms of money: they're called swaps and derivatives.

Swaps and derivatives trade like stocks and bonds, but most of them aren't registered securities like stocks or bonds. But swaps and derivatives aren't exactly Monopoly money, either. What are they? Ridiculously complex and esoteric. For the last decade, risk managers on Wall Street pulled their hair out, lost sleep and finally gave up trying to quantify the risk inherent in them. Yeah, they've given up. When it came to swaps and derivatives, even auditors couldn't find their ass with both hands.

And yet trillions of dollars in swaps and derivatives trade every single day in markets that didn't even exist a decade ago. For the most part, the biggest volume of swaps and derivatives don't even trade in a physical marketplace like the exchanges in New York or Chicago. The transactions are opaque because they are largely undertaken by private parties in electronic markets, most of them offshore.

Swaps and derivatives trade in a virtual market, a shadow market. A market that in the United States alone is estimated to be a $45.5 trillion market.

Here's the perspective: The size of the worldwide bond market is estimated at $45 trillion. The size of the worldwide stock market is estimated at $51 trillion. And the size of the worldwide swaps and derivatives market is estimated at $480 trillion in nominal or "face" value. That's 30 times the size of the entire U.S. economy and 12 times the size of the entire world economy.

Brokers & Barbarians

How is this possible? Advanced technologies make this market possible. Welcome to money's alternative universe. Alternative trading systems. Electronic communications networks. Central banks. Private banks. Brass plate banks. Russian Mafia banks in Cyprus. The Vatican's bank in the Cayman Islands. The Bush and bin Laden families holding hands and tip-toeing through the tulips in financial cyberspace. Digital barrels of oil in virtual supertankers in the Persian Gulf. Digital ounces of gold in virtual vaults in Switzerland. Digital bushels of corn in virtual silos in Iowa. Eurex. Euronext. The World Federation of Exchanges. A transnational community of anonymous traders who have never met and never will.

Merrill Lynch trading swaps and derivatives with Iran. Mullahs on the mainframe. Citigroup trading swaps and derivatives with Venezuela. Chavez on the craps table. UBS trading swaps and derivatives with almost anyone out there in the ethers—Christ, the anti-Christ—it doesn't matter to UBS. What matters is that traders keep liquidity coming out the yin-yang.

We've seen the emergence of a new master race on Wall Street who work hand in hand with the traders. They created this market of swaps and derivatives, and help traders manipulate this market through their own brand of highly sophisticated pump-and-dump schemes and do their damned best to keep this market secret and off the books. These are the prime brokers.

Not in keeping with their other brethren on Wall Street, either short-term traders or long-term bankers, prime brokers are the new barbarians at the gate. They augment the activities of the hedge-fund guys and private-equity guys—and then take the game to a whole other level.

Believe me when I say their interests are not aligned with your interests.

At press time, oil nears a record $117 a barrel. The dollar continues to fall. Our credit woes continue to worsen. The United States is deep in debt and still digging. We're all paying for the nation's debt addiction through both direct and indirect taxes. Our leaders, such as they are, are tracking the storm of inflation and the threat of the most serious recession since the Great Depression. Still think this doesn't have anything to do with you?

Steve Schwarzman and Pete Peterson are betting on it.

Next: Where has that Black Swan been hiding?

John Sakowicz is a Sonoma County investor who was a cofounder of a multibillion-dollar offshore hedge fund, Battle Mountain Research Group. He was assisted in research by Arianna Carisella.

Part 1: Alternative Universe

Investors Pull Out of Mutual Funds

If this trend continues, and US corporations continue to scale back on their stock buybacks, look for another slump in US stock prices this quarter. Right now the stock market is likely being sustained by hedge fund buying from resurgence in the carry trade. Once that let's up, the thinness in the equity market will be set up for an event driven plunge.

Investors pull out of mutual funds
By Deborah Brewster in New York
Financial Times
Published: April 27 2008 22:26

All but one of the 25 largest US mutual fund managers saw their long-term assets fall in the first quarter, as returns dived and investors pulled out of funds.

In the worst start to a year for more than a decade, most money managers had retail outflows, and even stalwarts such as American Funds and Vanguard suffered a drop in assets, of 6.6 per cent and 4.3 per cent respectively.

Pimco, the bond manager, was the only one to show a rise in retail assets, according to Financial Research Corporation and industry estimates. Pimco’s Total Return fund had an inflow of $9bn in the three months to March.

The trend is likely to worry economists, because it suggests the credit turmoil is hurting the confidence of mainstream investors. That, in turn, could dampen activity among consumers in the months ahead, since falling investment sentiment is often associated with muted household spending levels.

However, the fall also marks a fresh blow for the financial industry, because mutual fund managers typically make money by charging a percentage of assets – meaning that profits in the industry fall when assets decline.

Last week, a group of publicly traded asset managers announced bleak quarterly results. Affiliated Managers Group, which holds stakes in 26 mutual and hedge fund companies, reported a quarterly profit fall for the first time in five years, with outflows of $8.4bn in the quarter.

Big institutional fund groups – such as AllianceBernstein, a unit of French insurance group Axa – likewise showed asset falls.

One senior industry executive said: “This is the worst I have seen for a long time, the industry-wide outflows, and unfortunately I don’t think it is a short-term situation. The days of domestic [US] equity funds driving profits for us, that could be gone.”

Retail and institutional investors pulled $100bn from US, European and Japanese equity funds during the quarter, according to Strategic Insight.

The trend is accelerating a shift in the money management industry, as investors move away from equity funds, which have been the industry’s profit mainstay, towards either low-margin options such as short-term cash and indexed funds, or high- margin alternative investments such as hedge funds, private equity and hard assets.

Long-term assets do not include money market funds, which have seen big inflows. Several money managers, such as Fidelity, have large money market funds which are offsetting their outflows, although money market funds are low-margin products and do not provide long-term investor loyalty. Fidelity had a drop of long-term assets of close to 10 per cent for the quarter, as investors continued to pull funds from the former market leader despite a lift in performance in its funds.

How the SEC Enabled the Wall Street Credit Crisis

The bailout of Bear Stearns by the Fed was a travesty of the public trust. To say that no public money was put at risk is a misstatement of the facts.

The investment bank should have been allowed to fail in a managed liquidation, and the Fed should have opened the discount window for the commercial banks to keep them solvent on an arranged borrowing plan that minimized their profits and cut the bonuses and dividends severely. The so-called purchase of Bear by JPM is a farce.

That these banks are still paying dividends and bonuses is a crime against the public trust. Unless we reform the banking system, reinstate Glass-Steagall, and tighten capital requirements on commercial banks the looting of the US Dollar by the banks will continue.

April 27, 2008
Everybody’s Business
Wall Street, Run Amok
By BEN STEIN

YOU may well be asking yourself, as I have asked myself, how on earth did the credit crisis on Wall Street become such a catastrophe?

How did all of the mechanisms operated by the mind-bogglingly well-paid men and women of the Street go so wrong that we saw a major investment bank, Bear Stearns, essentially disappear? How did Wall Street firms of ancient lineage take such immense losses that they made banks clam up on lending — at great risk to the economy?

Weren’t fail-safe devices in place to guard against risk? Weren’t government watchdogs there to make sure that catastrophes could not happen? Weren’t ratings agencies on the job to police what was going on in the canyons of Lower Manhattan?

To paraphrase Dr. Evil in the “Austin Powers” movies: “How about ‘no,’ Scott?”

Anyone who cares about this disaster would be extremely well advised — and I’d underline “extremely” as often as possible — to read a speech on the matter that was given on April 8 by a genius investor named David Einhorn at a Grant’s Interest Rate Observer event.

Mr. Einhorn runs Greenlight Capital, a successful hedge fund. He also isn’t an infallible observer of human lapses and regulatory failures — he invested in and briefly served on the board of New Century, a subprime mortgage lender that later went bust amid accounting problems. (When I sought his response, Mr. Einhorn said he did not want to comment on New Century or on his essay.)

Yet his speech so well explains what went wrong in the financial debacle that it’s frightening. Here is my CliffsNotes version of it.

First, Maestro Einhorn points out that the fellows who run big investment banks have a strong incentive to maximize their assets and leverage themselves into deep trouble because their pay is a function of how much debt they can pile on. If they can use relatively low-interest debt to generate slightly higher returns, the firm earns more revenue and executive pay increases. Often, an astonishing 50 percent of total revenue goes to employee compensation at Wall Street firms.

NOW, you may ask, what kind of assets were they acquiring with that debt? Well, sometimes, as with Bear Stearns, the leveraged assets are mostly government agency debt, which used to be regarded as fairly safe.

Sometimes, as Mr. Einhorn notes, those portfolios also hold stocks, bonds, loans awaiting securitization, and pieces of structured finance deals. They also hold heavy exposure to derivatives that have stunning risk profiles and can produce astounding losses in bad circumstances. They might also contain real estate assets and have exposure to private equity deals.

In other words, they can hold some scary “assets.” What do they hold as capital against such risks? You would think it would be cash or Treasury bonds, wouldn’t you? But no.

Under an interesting set of rules promulgated by the Securities and Exchange Commission in 2004, called “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,” the amount of capital that had to underlie assets was reduced substantially. (Mr. Einhorn rightly says that this set of rules should have been called the “Bear Stearns Future Insolvency Act of 2004.”)

Through the act, the S.E.C. — acting as one of Wall Street’s chief regulators, mind you — also allowed such things as “hybrid capital instruments” (much riskier than cash or Treasuries), subordinated debt (ditto) and even deferred return of taxes, to be counted as capital. The S.E.C. even allowed the banks to hold securities “for which there is no ready market” as capital.

“These adjustments reduced the amount of required capital to engage in increasingly risky activities,” Mr. Einhorn says.

In response to Mr. Einhorn’s critique, an S.E.C. spokesman told me that these changes could theoretically lower capital, but that the agency has seen no evidence that that has, in fact, occurred.

But Mr. Einhorn has even more troubling observations. He says the S.E.C. also allowed broker-dealers to set their own valuations on assets and liabilities that were hard to value. And broker-dealers could assign their own creditworthiness ratings to counterparties in complex derivatives transactions when those counterparties were otherwise unrated.

In a word, Mr. Einhorn says, the S.E.C. told Wall Street to police itself to save on regulatory costs, while not bothering to “discuss the cost to society of increasing the probability that a large broker-dealer could go bust.”

A result of all this, he says, was as follows:

“The owners, employees and creditors of these institutions are rewarded when they succeed, but it is all of us, the taxpayers, who are left on the hook if they fail. This is called private profits and socialized risk. Heads, I win. Tails you lose. It is a reverse-Robin Hood system.”

And when it all went kaput during the Bear Stearns debacle, the likable chairman of the S.E.C., Christopher Cox, said that the system was fine and needed no immediate repairs. Of course, Henry M. Paulson Jr., the Treasury secretary, is calling for merging the S.E.C. with the easygoing Commodity Futures Trading Commission, in the financial equivalent of setting off a Doomsday Device.

The S.E.C. told me that all of its actions were helpful to investors and that no one could have prevented the Bear Stearns collapse because it was caused by liquidity issues, not capital issues. My respectful response is that if Bear were thoroughly well capitalized, why would liquidity issues come up at all?

There is much more in Mr. Einhorn’s speech about how dramatically understaffed the ratings agencies are in assessing risk on Wall Street and how even the biggest ratings agencies largely allowed the Street to rate itself.

The big ratings firms, according to Mr. Einhorn, do not even bother to assess the major investment banks’ portfolios because they change so often.

It looks to me as if the inmates are running the asylum. One truth, that deregulation is sometimes a good thing, has been followed down so long and winding a road that it has led to an immense lie: that deregulation carried to an extreme will not lead to calamity.

To think that people of this mind-set are in charge of the finances of the nation that is the cornerstone of world freedom is terrifying. Mr. Einhorn may well have done us a service of great value.

Ben Stein is a lawyer, writer, actor and economist. E-mail: ebiz@nytimes.com.