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The Great Shakeout


Given that these bonds were proprietary to the firms that issued them, the brokers could charge their clients a huge premium—as much as twenty times the fees they might take for Treasuries or even big corporate bonds. Those markups were perhaps the most profitable streams of revenue these firms have ever seen. A so-so salesperson could make $2 million to $3 million easily selling this paper; a good broker could bring down twice that. All the brokerage houses, led by Lehman, Merrill, and Bear Stearns, jumped into this game, usually with sketchy due diligence and nary a thought of what would happen if homes fell in value. As the housing boom went on and on, and home prices refused to quit, the brokerages dramatically lowered their lending standards to get ever-higher rates for their bonds and generate even-better returns for their customers.

But then the chickens began coming home. The Fed started what proved to be an inexorable rise in interest rates, and the housing market cooled. The borrowers, legions of whom had used adjustable-rate mortgages, began defaulting at record rates. Even though only a small percentage of homeowners actually defaulted when all was said and done, those defaults set off alarm bells that led the major bond-rating agencies to downgrade the mortgage-based bonds. That caused a kind of mortgage-bond reflux. In essence, the billions in mortgage-backed loans were called all the way back up the borrowing chain, and no one had the cash to cover them because they were too heavily leveraged. It was that chain reaction that effectively caused Bear, then Lehman and Merrill, to succumb or merge. AIG, the insurer of much of this kind of paper, could no longer guarantee its worth, either.

Has Wall Street fulfilled Marx’s long-held assumptions about capitalism? Are we all communists now? … What nuked Merrill and Lehman was human error …

All of those firms had one thing in common: They had no deposit base they could use to buy up all of this deflated inventory. They weren’t, alas, banks, like Hudson City; they were just brokers, renting money at ever higher prices to finance their own increasingly worthless investments. Without exception, all of these firms thought they could ride the housing cycle right through rather than dump these bonds, albeit for huge losses. Fortunes were lost (theirs and other people’s) in vain attempts to hold on for a home-price appreciation that never came. The federal government has now lent or spent almost a trillion dollars propping up this mortgage edifice even as institutions worldwide have taken more than a half a trillion in losses on the paper. The storm has overwhelmed almost everyone and everything in its path, Katrina-like, and despite the stock market’s encouraging response to the government’s most recent moves to address the crisis, on Friday, others may yet drown. At the very least, Wall Street will emerge forever changed.

How was all of this allowed to happen? Where were the regulators, the agencies that rate these bonds, the early warnings to the investors that maybe this paper was more dangerous than the brokerages let on? First, not only was there no regulation to speak of at any level—federal, state, or local—but the much-worshipped Alan Greenspan and current Fed chairman Ben Bernanke actually encouraged this kind of securitization even as they raised rates ever higher, seventeen times, to stop the very house-price appreciation these securities depended on to be viable. They shared the Republican ideology that promoted homeownership for everyone—including those who couldn’t afford it—and minimal market regulation.

Second, the ratings agencies, like Standard & Poor’s and Moody’s, blew the call. Failing to take the new risky lending practices into account, they just assumed that as long as employment held up—job losses had always been the trigger for defaults—the mortgage-backed bonds were good. Third, on the off chance of a possible rash of defaults, the issuers purchased insurance from outfits like AIG to make good on potential losses. We now know from the government’s seizure of AIG this past week that the world’s largest insurer could never pay off on all of those policies without selling everything that wasn’t nailed down, which is exactly what the new company, bought by you, courtesy of the Federal Reserve, will now have to do.

So, back to the big questions: Is this the end of Wall Street? What does it mean for the broader economy? And what about all that nationalizing?

First, let’s take Wall Street. The good news is, there’s almost no one left to go belly up from the mortgage mess. The bad news is, I said “almost.” A couple of firms are working their way through the storm, for the time being anyway, with their heads above water. Morgan Stanley intelligently slashed its mortgage operation ahead of the others, but still lost billions on mortgage-related trading, and was forced into merger talks with Wachovia last week. Morgan Stanley was also said to be in talks with the Chinese state to shore up ts capital base. Citigroup is mired with who-knows-how-much toxic paper, but because of its worldwide deposit base and salable assets, it hopes to be able to cover the losses and rebuild capital over time. The financial jury’s still out on those companies, although a merger or major cash infusion would certainly make Morgan Stanley safer than it was.


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