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Can Capitalism And Hubris Breed Crazy Times? You Can Bank On It

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By JOHN HELYAR Bloomberg News

The Tampa Tribune

Published: September 18, 2008

There is just one problem with the genius of capitalism. From time to time, it veers off into barking madness.

We are in the midst of just such a time. This is a week when Lehman Brothers Holdings has gone bankrupt, Merrill Lynch & Co. has been bought and American International Group is panhandling for $85 billion.

While Ben Bernanke frantically pumps Federal Reserve money into banks ($50 billion in overnight reserves), Treasury Secretary Hank Paulson frantically bails out banks. (Well, except for you, Lehman. Sorry about that; Bear Stearns Cos. had the first-failer advantage.)

There's no clear way out of this mess. Brilliant as he is, Paulson seems to be out of ideas. A Master of the Universe as chairman of Goldman Sachs Group, he has become a Master of Disaster at Treasury.

It's a good deal clearer how we got here. Wall Street went off and did what Wall Street does best. It takes a good idea and overdoes it to such excess that it becomes a very bad idea.

Nothing new about that. In the late 1980s, the Street was infatuated with leveraged buyouts. The fever was fueled by junk bonds, that creation of Drexel Burnham Lambert whiz Michael Milken, giving acquirers access to cheap debt and making LBOs so profitable.

The frenzy peaked 20 years ago next month, when RJR Nabisco Chief Executive Officer F. Ross Johnson tried to take his company private. That sparked a six-week bidding war for RJR Nabisco as every Wall Street chief was avid to land history's biggest LBO.

Winning While Losing
Kohlberg Kravis Roberts & Co. won - sort of. The firm financed much of its $25 billion purchase with junk bonds. The market for this paper soon tanked under the weight of junk-bond defaults (mostly from failed LBOs) and Drexel's bankruptcy. KKR had to pull off a huge refinancing of RJR debt to redeem the junk bonds before they reset at usurious rates.

Market fevers are always broken by such sobering events, and the broader economy suffers along with the Wall Street perpetrators. The recession of 1990-1991 was a hangover from 1980s excesses.

And that was a mere tropical depression compared with the storm generated by today's overleveraged markets.

There are some big differences between the go-go autumn of 1988 and the "oh no" September of 2008, none of them good.

What created this boom, and worsened the bust, was the changed business model of Wall Street. These firms are transactional creatures - executing trades, structuring deals. Unfortunately, the margins in their traditional businesses had been squeezed by online and international competitors.

So creative investment bankers decided to develop a new business, securitizing and trading existing assets. The asset of choice was mortgages. After all, Fannie Mae and Freddie Mac had already created markets. All that needed to be done was add some profitable wrinkles and rock 'n' roll.

Mortgage securitization was at first a godsend for an industry reeling from the dot-com bust and the Sept. 11 shocks. The more America's housing market boomed from 2002 to 2006, the frothier this market became.

It only became bigger when mortgage originators such as Countrywide Financial Corp. started doing a lot of business with previously unqualified customers. They issued subprime mortgages, whose adjustable-rate terms and other gimmicks kept initial payments low.

Dizzy On The Carousel

The boom market for housing meant defaults were low. The onerous back-end payments on these mortgages never came due. Joe Sixpack could refinance or could relocate to the next new subdivision - they were everywhere! - and the subprime merry-go-round just kept spinning.

Wall Street mortgage wizards could convince investors, and themselves, of the great liquidity and low risk of this market.

They didn't have to work too hard at it. Federal Reserve Chairman Alan Greenspan was a cheerleader for nontraditional mortgages, and he kept interest rates at a minuscule 1 percent.

Yes, the model worked great, right up until the housing boom ground to a halt. The subprime carousel did likewise soon thereafter. People would learn how illiquid these assets were and how toxic this enterprise could be.

It was astonishing, just how many people were swamped by the tsunami that spread across the subprime cesspool: employees of firms such as Bear Stearns and Lehman, which will disappear from the face of the Earth; shareholders in a vast array of banks, who have seen $16.5 trillion of market value wiped out; and, of course, the homeowners themselves.

Fitch Ratings estimates as much as 45 percent of the holders of option-adjustable mortgages (meaning payments were optional) will default. This will surely lead to an age of reregulation, if our presidential candidates are to be believed, and well it should.

The sweeping deregulation of U.S. banking was the great enabler of overleveraged, overly ambitious bankers.

The repeal of the Glass-Steagall Act in 1999 allowed commercial and investment banks to merge and created synergies of incompetencies. Instead of doing what they did well - making loans and doing deals, respectively - they combined forces to do various things badly.

The wreckage they have left is as ugly as anything Gustav or Ike left behind.

The lessons to be learned are just emerging, but here's an early one: Firms taking big risks may not be able to survive without a big deposit-taking base of support. The winners in this debacle, to the extent they exist, are commercial banks. JPMorgan Chase & Co. picked up the pieces of Bear Stearns; Bank of America Corp. snapped up Merrill Lynch.

And here's another lesson that's hardly new, but Wall Street apparently has to repeatedly relearn: Hubris kills.

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