Friday, March 28, 2008

Bear Stearns - Crying Over Spilled Milk

Martin Wolf writes:

I greatly regret the fact that the Fed thought it necessary to take this step. Once upon a time, I had hoped that securitisation would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene. That has proved a delusion. A vast amount of risky, if not downright fraudulent, lending, promoted by equally risky finance, has made securitised markets highly risky. This has damaged institutions, notably Bear Stearns, that operated intensively in these markets.

Bear went out of business primarily because of weak/bad management. Many of the rest have problems, because Wall Street origination has a unique ability to follow the herd.

The trend toward mark-to-market and better risk management systems has been a positive development.

The ability of Wall Street to manufacture junk credit has a long history. What seems to be new, these days, is that there is a new class of investor-enabler, non-bank financials called "Hedged Funds".

In the past, the business culture of underwriting (sales for a fee) was separated from the business culture of old-line banking (lending at a spread). Glass-Steagall drew the "Chinese Wall", based on hard-won experience. Without judgment on either, it just cordoned off two cultures that didn't mix and wouldn't change. [Until idiots repealed it in 1999, tossing caution to the wind.]

Accordingly, with Bear, we discover no terra nova. Securitization will recover, at least until the next great speculation dressed-up as "sound investment". Put another way, a full-scale repeal of the credit-cycle seems unreachable.


The only exception might be that the topology now includes another category, derivatives, and the now well-worn path involved in the unexpected insolvency of a very large, highly leveraged entity, a financial super-nova, if you will, like that involving the firm with the Orwellian sounding name, Long-Term Capital Management. So far, the market hasn't come up with a solution to that problem, short of Fed intervention. (To be fair in this context, the repeal of Glass-Steagall probably has little impact, except that it went in the wrong direction altogether. Separating the underwriting of securities from the selling / attachment of "liquidity puts" might have made sense, in retrospect.)

The answer probably isn't too complex. For "Hedged Funds", it probably involves capital requirements (beyond a certain size fund) and requiring maintenance reserves of one kind or another. For derivatives, it probably involves re-thinking the structure of the OTC market in some cases as well as the ability for firms to put some contracts off balance-sheet altogether.

Just off the top of the head.

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