Wednesday, December 28, 2011

The Devils Are (Still) Here

Kyle Bass said it was a must read, and that was good enough for me. All the Devils Are Here, by Bethany McLean and Joe Nocera, offers a chronological account of how Wall Street executives created, and then abused, the instruments that led to the global financial crisis of 2008. The whole alphabet soup is explained--ABCP, CDO, RMBS, SIV, etc.--as well as the motivations of the chefs cooking this toxic brew.

The scary part is this. Time and again, smart men and women (O.K., men mostly) suspended their better judgment, allowing risk to metastasize. The dereliction was so pervasive as to appear inevitable. The story told here strongly suggests, furthermore, that the dereliction is ongoing. It comes from human nature. Character breeds success, which then undermines character.

So much for the villains. How 'bout them victims? There was a veritable tsunami of dumb money sloshing through global markets in the mid-aughts. There probably still is. We know that in August 2007 some of that dumb money, about $20 million worth, leaked from the State of Maine's Cash Pool into an SIV-Lite called MainSail II, which was heavily invested in residential mortgage-backed securities (RMBS). Maine bought at the exact top of the market for such securities--the very definition of "dumb money." Within weeks MainSail II was downgraded by Moody's from Prime-1 to junk, and the vehicle's assets were frozen. By the end of August, Maine could not be sure that it would get any of its money back.

According to UMaine's Richard Borgman (who gives the blow-by-blow account here), this was not a prudent investment by the Treasurer's office. For months defaults on home loans had been rising, home prices falling, and subprime lenders failing. In July 2010 (before Maine invested in MainSail II) Standard & Poor's and Moody's had each placed hundreds of tranches of RMBS on review for possible downgrade. The handwriting was on the wall, and Treasurer David Lemoine failed to see it. In Borgman's opinion, "there was a lack of understanding of the investment and an over-reliance on ratings and the broker." One year later Lemoine made a stick-save by putting the investment back to the broker, Merrill Lynch. But for a whole year the $20 million was dead money.

Fair question: if Maine's Treasurer was in over his head in 2007, are MainePERS fund managers, with their "passive" investment style, in over their heads now? If so, a lot more than $20 million is at risk.

Toward the end of their book, the Devils authors lift a trenchant passage from Alan "Ace" Greenberg's The Rise and Fall of Bear Stearns. Greenberg was formerly CEO (until 1993) and Chairman of the Board (until 2001) at Bear Stearns and was 80 years old when the firm that he helped build went belly up in 2008. Reading this, one cannot help but think that the money is getting ready to stop one more time:

The interdependent relationships between banks and brokerages and institutional investors strike most laymen as impenetrably complex, but a simple ingredient lubricates the engine: trust. Without reciprocal trust between the parties to any securities transaction, the money stops. Doubt fills the vacuum, and credit and liquidity are the chief casualties. Bad news, whether it derives from false rumor or verifiable fact, then has an alarming capacity to become contagious and self-perpetuating.

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