Searching for the cause of the crisis on Wall Street | By Nelson D. Schwartz and Julie Creswell | Published: March 24, 2008
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Even though Gross, 63, is a market veteran who has lived through the collapse of other banks and brokerage firms, the 1987 stock market crash and the near meltdown of the Long-Term Capital Management hedge fund a decade ago, he said the current crisis feels different - in both size and significance.
The U.S. Federal Reserve has not only taken action unprecedented since the Great Depression - by lending money directly to major investment banks - it also has put taxpayers on the hook for billions of dollars in questionable trades that these same bankers made when the good times were rolling.
"Bear Stearns has made it obvious that things have gone too far," said Gross, who planned to use some of his cash to bargain-shop. "The investment community has morphed into something beyond banks and something beyond regulation. We call it the shadow banking system."
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On Wall Street, of course, what you do not see can hurt you. In the past decade, there has been an explosion in complex derivative instruments, like collateralized debt obligations and credit default swaps, that were intended primarily to transfer risk.
These products are virtually hidden from investors, analysts and regulators, even though they have emerged as being among Wall Street's most outsized profit engines. They do not trade openly on public exchanges, and financial services firms disclose few details about them.
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"Not only did Wall Street have so much freedom, but it gave commercial banks an incentive to try and evade their regulations," Frank said. When it came to Wall Street, he said, "we thought we didn't need regulation."
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"In reality," Greenberger added, "it spread a virus through the economy because these products are so opaque and hard to value." A representative for Greenspan said he was preparing to travel and could not comment.
A milestone in the deregulation effort came in the autumn of 2000, when a lame-duck session of Congress passed a little-noticed piece of legislation called the Commodity Futures Modernization Act. The bill effectively kept much of the market for derivatives and other exotic instruments off-limits to agencies that regulate more conventional assets like stocks, bonds and futures contracts.
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Regardless, with profit margins shrinking in traditional businesses like underwriting and trading, Wall Street companies rushed into the new frontier of lucrative financial products like derivatives.
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Timothy Geithner, a career civil servant who took over as president of the New York Fed in 2003, was trying to solve a variety of global crises while at the Treasury Department. As a Fed president, he tried to get a handle on hedge fund activities and the use of leverage on Wall Street, and he zeroed in on the credit derivatives market.
Geithner brought together leaders of Wall Street companies in a series of meetings in 2005 and 2006 to discuss credit derivatives, and he pushed many of them to clear and settle derivatives trading electronically, hoping to eliminate a large paper backlog that had clogged the system.
Even so, Geithner had one hand tied behind his back. While the Fed regulated large commercial banks like Citigroup and JPMorgan, it had no oversight on activities of the investment banks, hedge funds and other participants in the burgeoning derivatives market. And the industry and sympathetic politicians in Washington fought attempts to regulate the products, arguing that it would force the lucrative business overseas.
Geithner declined an interview request for this article.
In a May 2006 speech about credit derivatives, Geithner praised the benefits of the products: improved risk management and distribution, as well as enhanced market efficiency and resiliency. As he had on earlier occasions, he also warned that the "formidable complexity of measuring the scale of potential exposure" to derivatives made it hard to monitor the products and to gauge the financial vulnerability of individual banks, brokerage firms and other institutions.
When increased defaults in subprime mortgages began crushing mortgage-linked securities last summer, several credit markets and many companies that play substantial roles in those markets were sideswiped because of a rapid loss of faith in the value of the products.
Two large Bear Stearns hedge funds collapsed because of bad subprime mortgage bets. The losses were amplified by a hefty dollop of borrowed money that was used to try to juice returns in one of the funds.
All around Wall Street, dealers were having trouble moving exotic securities linked to subprime mortgages, particularly CDOs, which were backed by pools of bonds. Within days, the once-booming and actively traded CDO market - which in three short years had seen issues triple in size, to $486 billion - ground to a halt. ...
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