Walking down the Failure!

James L Bradley
March – 2008

Right about now you’re either looking at the balance in your checking
account, or have done so in the past few days. If you are one of the fortunate
ones, you have a balance that will provide for you for approximately 6-
months, if your world goes sideways. If you’re not, think about it.
This short piece is only meant to give you an idea of what is happening
within the financial world of the United States, albeit “within” this activity is
affecting the financial structure of the world.
Unfortunately our free society encourages the quick and the dark, and we
now find ourselves trying to find out what pulled our economy down into the
dark, and why our leaders (political or financial) let it happen.
In looking back we find our Congress (Democratic and Republican), and
the Executive Branch pushing and pulling for “financial deregulation”, this
very strongly over the past decade. The result, large investment banks and
large brokerage firms crawled behind closed doors and created a plan that
contained a multitude of innovative schemes that today our so-called
“experts” now find very difficult to understand or unravel to a point where
they can nail down a value.
They are faced with instruments that contain complex derivative
packages, such as “collateralized debt”, “obligations”, and “credit default
swaps”, which in a sense are created to transfer “risk”. The recognized
definition of a “derivative” in the financial market is, “a financial instrument
whose value is “derived” from the value of something else”. They can be
based on commodities, equities (stocks), bonds, interest rates, exchange
rates, or indexes –in other words I or you can create a “derivatives” on the
value of a canoe anchored in Long Lost Bay, and be legal.
And get this, the products (like the canoe) are virtually hidden from
investors, analysts and regulators, and better still over the past decade these
“hidden products” have become the Wall Street’s most outsized “profit”
vehicles. Keep in mind, they “don’t” trade openly on public exchanges, and

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being within the law, financial service firms disclose “few” details concerning
their substance or lack of – it is not required.
Now try and understand this legal vehicle, let me ask this would (if you
could) buy a “pig in the poke” from a smiling little weasel (aluminum side
salesman) sporting a “Vote, and Vote Often” button – too obvious, well try
the guy in a multimillion dollar yacht with a three level house located at
Martha’s Vineyard.
Don’t get me wrong, it is written (somewhere) that used “judiciously” they
can limit the damage from financial miscues and uncertainty, and yet used
“unwisely” they have become Wall Street’s version of nitroglycerin. It kind of
reminds me of the Savings and Loan scam – but much, much bigger, the hole
has become so deep, that nations will suffer from the greed and the urge to
gamble with borrowed money for years to come.
The recent headlines of “Bear Stearns” is but the tip, in their case it is now
read that their portfolio was chucker-block full of these derivative
instruments, and this is listed as one of the main reasons for its collapse.
Following a typical instrument, let’s assume a package containing loans
on homes.
a. Lending organization has made loans on homes; the initial value of the
package is valued at $1.00 in real money, price of homes plus their
interest rate. In doing this Wall Street and the banks made it far too
easy for people with shaky credit to get a mortgage, these were known
as a “subprime” loan.
b. They take this package to a major financial institution, for $1.05, they
have realized their money loaned, plus a small profit. Investors jumped
all over themselves to obtain a piece of this fast-growing mortgage pie,
so there was plenty of money floating around to pay for these loans.
c. Now the bank or major financial house, groups the package with other
similar packages and markets it for $1.07 – the new institution is
holding a package worth $1.07 that had a “real value” of $1.00.
Financial houses cut and diced up these mortgages and sold them as
“complex” investments, finding more than eager buyers among

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 pension funds, hedge funds and more who were chasing “higher”
returns that were more than willing to “overlook” the risks.
d. As long as housing prices went up, the strategy worked – when the
deck of cards began to crumble, so did financial stability. The housing
situation set off the dominoes, where rampant defaults caused the
mortgage securities to drop dramatically, this dried up the available
money to fund a new home, as the lenders everywhere tighten up the
rules for obtaining credit.
The rules had changed in our economy, I have mentioned time and time
again that when the middle class in this country no longer have the
purchasing power, the rest of the world will feel the bite, and since most of
our manufacturing jobs have taken a hike overseas, now it comes.
It all came apart when somewhere along the chain someone pokes their
head up and demands a real value count – can’t be found! The frightening
part is that this massive scheme has spread to major institutions and brokers
across the globe whereas you’ll find derivatives buried in major commercial
banks like Citigroup, JPMorgan Chase and even in a small bank in a
Norwegian town north of the Arctic Circle.
While “home loans” to risky borrows were among the first to go bad, keep
in mind that the present situation did not stem from the housing market
alone, and all indicators today shows it will NOT end there.
Alan S Binder (former vice-chairman of the Federal Reserve) said, “The
problem has been spreading its wings and taking in markets very far afield
from mortgages, it’s a failure at lots of levels. It’s hard to find a piece of the
system that actually worked well in the lead-up to the bust.”
Naturally, the CEO of the International Swaps and Derivatives Association,
(“ISDA”) is not sitting still for all the negative publicity where Robert G Pickel
issued a statement saying, “Some people want to blame our industry
because they have a vested interest in doing so, either by making a name for
themselves or by hampering the adaptability and usefulness of our products
for competitive purposes. We believe that there are good investments
decisions and bad investment decisions, we don’t decry motor vehicles
because some have been involved in accidents.”

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 And yet, legislators on the banks of the Potomac are drumming up
detailed plans for “new” regulations, one that includes the treatment of Wall
Street banks like their heavily regulated commercial brethren. Whereas even
James Dimon (CEO of JPMorgan Chase) is leaning towards acknowledging that
maybe, “just maybe”, the new regulations are necessary.
On the 17th of March Mr. Dimon remarked, “I can’t even describe the
seriousness of that (financial regulation keeping up with the global world). I
always talk about how BAD things can happen that you can’t expect. I didn’t
fathom this event.” What?
During the 1st week of September, Charles O Prince III in a meeting with
House Financial Services Committee Rep Barney Frank (the chairman of the
committee) [two months before Prince resigned as CEO of Citigroup, amidst
nearly $20 billion in write-downs], mainly due to CDOs (Collateralized Debt
Obligations) and MDSs (Mortgage-Backed Security’s). During their discussion
he was asked about their investment vehicles and why their were not on
their balance sheet – his response was if they were it would put “Citigroup” at
a disadvantage with Wall Street investment banks, who were loosely
regulated and were allowed to take far greater “risks”.
Mr. Frank at that time finally realized just how much freedom Wall Street
had, and indeed how lightly regulated they were – mainly in NOT having to
answer to a myriad of government agencies like the Federal Reserve and the
comptroller of the currency. Mr. Frank in addition commented, “this freedom
is giving commercial banks an incentive to try and evade their regulations.”
During the late 90s Wall Street fought long and hard against any attempt
to regulate the emerging “derivative marketplace”, this again brought to our
attention by Michael Greenberger (former senior regulator of Commodity
Futures Trading Commission).
It was not like we were not warned; in 1998 the Long-Term Capital crisis
gave a strong indication of things to come to the industry of the danger of
big-bets with borrowed money, again like today the Federal Reserve Bank of
New York prevented massive damage.
When this was going on, derivatives were being praised as a “boon” that
would give the economy stability. Where in March 1999, Alan Greenspan

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(Fed Chairman) said, “these instruments enhance the ability to differentiate
risk and allocate it to those investors most able and willing to take.” He did
also acknowledge the fact that the, “possibility of increased systemic risk
does appear to be an issue that required fuller understanding,” he argued
that new regulations, “would be a major mistake.” Going on to say that,
“regulatory risk measurement schemes, are simpler and much less [accurate]
than a banks’ risk measurement model.”
Greenspan firmly felt that derivatives would spread the risk in the
economy, which spurred the comment by Greenberger, “In reality, it spread a
virus through the economy because they are so [opaque] and hard to [value].
A large break came for the derivative marketplace when Congress passed
the “Commodity Futures Modernization Act of 2000 (“CFMA”), which was
signed into law by Bill Clinton in December -2000. A large part of the Act
allowed for the creation of United States exchanges for listing a [new] sort of
derivative security, the “single-stock future.”
It also contained what is known as the “Enron Loophole”, which
exempted most over-the-counter energy trades and trading on electronic
energy commodity markets – a “loophole” that was drafted by Enron
Lobbyists pushing for a deregulated atmosphere for their “experiment.” We
know what happened with Enron, another warning ignored. Like every other
bill, (almost) it slipped through supported by Phil Gramm (Rep Senator Texas,
an chairman of the Senate Banking Committee) it was an amendment to the
large appropriations bill.
Lately Mr. Gramm (now vice chairman of UBS – Swiss investment banking
giant) could not be reached for comment, makes you wonder what he would
say seeing that his company is being hammered by ill-considered derivative
investments.
By the beginning of this decade, (according to Frank and Blinder),
Greenspan “resisted” suggestions that the Fed use its authority to “regulate”
the mortgage market or at least to “crack down” on the rampant practices
like providing loans to borrowers with little, if any, documentation. Mr. Frank
comments, “He had the authority, but he didn’t use it.”

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 Some on the Potomac, like Representative Scott Garret, Republican of
New Jersey and a member of the Financial Services banking “sub-
committee”, [rejected] the idea that loosening financial rules helped create
the current crisis. Saying that, “I don’t think deregulation was the cause, and
had we had additional regulation in place, I’m not sure what we’re
experiencing now would have been averted.” What else do you expect him
to say?
Regardless, margins were shrinking in underwriting and trading, Wall
Street firms stampeded into the new frontier of lucrative financial products
such as derivatives. Students with doctorates in physics and other
mathematical disciplines were brought on board to design the new
derivatives linked to mortgages and other products.
All this risk (being spread across the financial landscape) was not going
unnoticed, three-years-ago top executives from firms like Goldman Sachs,
Lehman Brothers and Citigroup under the handle of “Counterparty Risk
Management Policy Group II”, debated, discussed and produced a 153-pager
report with a conclusion that, “the chances of a systemic upheaval had
declined [sharply] after the Long-Term Capital bailout”. In other words, they
felt the chances of an event (of which we are going through now) was slim or
none.
They did recommend some “nips” and “tucks” around the market’s edges
– to really define and ensure that trades were cleared and settled more
efficiently, and on the other side that “secretive” hedge funds volunteer more
information abut their activities – with this they settled back in the $10,000
leather chairs and said the financial markets were more “stable” than they
have been just a few years earlier. A point that could not be argue, “Wall
Street Banks”, were fat, dumb and happy – posting record profits and
obtaining fat healthy capital cushions. Like water over the Niagara money
flowed easily, and as corporate “default” rates were practically zero – with
the few bumps and bruises occurring readily absorbed. Life was good at the
lower end of Manhattan. Especially with the new formulas and plans being
cranked out by the students of Physics and Mathematics, with their

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innovative designs that would mitigate risk, were seen as having “reduced”
the event we are now labeling as a financial cataclysm.
One individual, E. Gerald Corrigan (Managing Director Goldman Sachs,
and former New York Federal Reserve President) remarked lately, “I shudder
to think what today would look like if NOT for the fact that SOME of the
changes were, in fact, implemented.”
This “stealth” market relies on trades conducted by phone between Wall
Street desks, away from open security exchanges – in effect little is known
the value of the exchange, or who holds it – in the end, unknown to analysts,
investors and regulators – pig-in-the-poke.
Even the credit rating agencies, (which banks paid to ‘grade’ some of the
new products) assigned high ratings on many, this with only having a minor
(if at all) familiarity about the quality of the assets behind the instruments. In
fact, even the frantic people running Wall Street really didn’t understand
what they were “buying” and “selling”, this comment from Byron Wien, a 40-
year veteran of the stock market, now the chief investment strategist of
Pequot Capital, a hedge fund.
He states, “These are ordinary folks who know a spreadsheet, but they are
not steeped in the sophistication of these kinds of models. You put a lot of
equations in front of them with little Greek letters on their sides, and they
won’t know what they’re looking at.” Scary isn’t it, can you imagine the
same type of knowledge being passed on to meat inspections of the USDA?
Would you eat you next steak?
How about a man who holds a “doctorate” in economics from MIT, who
states he only has “modest understanding” of complex derivatives – where
Mr. Blinder (former Fed vice chairman) says, “I know the basic understanding
of how they work, but if you presented me with one and asked me to put a
market value of it, I’d be guessing!”
Warren E Buffet, who needs no introduction, said in 2003, that derivatives
were potential “weapons of mass destruction.” And there is another little
known player, a career civil servant who took the wheel of the New York Fed
in 2003. As Fed President, Timothy F Geithner, attempted to get a handle

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on hedge fund activities and the use of leverage on Wall Street, he focused
on the “Credit Derivatives Market”.
He brought together leaders of Wall Street for a series of meetings in
2005 and 2006, to discuss credit derivatives where he pushed many of them
to clear and settle derivatives trading electronically, in this hoping to
eliminate a large paper backlog that was clogging the system. He did this
even with one hand tied behind his back, because as stated the Fed
regulated large commercial banks like Citigroup and JPMorgan, it had NO
oversight on activities of the investment banks, hedge funds and other
players in the burgeoning derivatives market. In the battle, he ran into
industry leaders and sympathetic politicians who fought attempts to regulate
the products, holding fast to their primary argument that any regulation
would force the “lucrative” business overseas. (Where were these people of
merit when thousands of middle income jobs went overseas? – sorry I drift.)
What does all this have to do with you and I, the Joe walking down the
street, well here are some sobering thoughts.
At the end of 2007, 36 percent of the average consumers’ disposable
income went to food, energy and medical care, this 36% a bigger chunk of
income than at any time since records were first kept in 1960 – this according
to Merrill Lynch.
Eating at home (reported by the government) has increased last year, the
first time since 2001, where the National Restaurant Association says that 54
percent of restaurants reported declining traffic in January.
Parents are calling for advice on how to deal with grown children who
have moved back home – much more than reported 5-7 years ago.
How about the home foreclosures, one kickback is less trash is being left
curbside – and cities are loosing on the average $22-25 per month for pickup,
and the appliance sale business is down – if it is still clicking away people are
waiting.
Some compare what is happening today as signs of an upcoming
depression, while others maintain that the USA is just one piece of a complex
global economy, whereas 100 years ago, an American financial crisis was our
problem and because today’s merging economies will provide us with an

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extra layer of insulation. Professor Robert A Howell (Dartmouth) says,
“People are still going to eat in China and India. They’re going to be buying
clothes, cars and airplanes – so I think it’s a whole different ballgame.”
Us, well food prices are on the rise along with energy, as it did in the 70s
and then as now declining home prices brought the equity of a home down.
The dollar which did okay in 2001 recession is falling now even MORE than it
did in the early 70s (9% then on a trade-weighted basis) were according to
the Federal Reserve it fell 14% in the last 12-months.
Have we reached the bottom yet? In the 70s (if we use that as a guide)
the S&P 500 fell 35%, today it has only fell 15% since its high in Oct 2007.
Do we expect more?
Can we shop differently? Little items, such as food like no-name cereal or
crackers are much less of a deal today simply because commodity prices are
going through the roof.
It is written that nearly 90% of the CFOs of global public companies don’t
see a recovery until 2009, this according to a recent survey by Duke
University, it goes without saying that if companies are forecasting a late
recovery they will not be making any steps to build their payrolls soon,
remaining cautious with their available capital.
What now?
The infamous former Fed Chair Alan Greenspan says, “a most wrenching
crisis, it will only end when housing prices stabilize.” Seems he should have
done something back around 2001-2003?
The Fed has slashed interest rates, where it has cut the closely watched
Federal funds rate over six times since September, from 5.25% to 2.25%,
two-thirds of the cut over the past two-months. Upcoming tax rebates for
millions of people, might help a bit, but some see this as knee jerk reaction to
the government not paying attention to the situation when it started –
subprime loans. Mainstream economists “think” that something will have to
be done soon to slow down the number of foreclosures, the real cause of our
economy’s woes.

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 Myself, I believe that this time the hole is much deeper than anyone suspects and if
they do, they are treading very lightly in voicing their opinion. I also think that our
American workforce has to be dragged kicking and screaming back into the global
economy, in my opinion the people of the United States are still the premier producers, it
was our ability to produce that pushed us forward as the premier consumers in this world.
Exporting jobs might have been a short-term solution for some companies, but now these
very same companies are dancing around the May-Pole looking for their American
Consumers!
My grandmother told me many years ago, “What goes around, comes around!”

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