Wall Street’s system deeply perturbed—like clockwork

ARTICLE: “New York Tries Taming Credit-Default Swaps: State to Regulate Certain CDS Pacts as Insurance Deals,” by Serene Ng and Liz Rappaport, Wall Street Journal, 23 September 2008

EDITORIAL: “The End of Wall Street,” Wall Street Journal, 23 September 2008.

FINANCE AND ECONOMICS: “Is there a future? The loneliness of the independent Wall Street bank,” The Economist, 20 September 2008.

ARTICLE: “Some Investment Banks May Prosper: Smaller Companies Are Likely to Survive Despite Hard Times,” by Craig Karmin, Wall Street Journal, 23 September 2008.

THE FINANCIAL CRISIS: “Walls Come Down, Reviving Fears of a Falling Titan,” by David Enrich and Damian Paletta, Wall Street Journal, 23 September 2008.

ARTICLE: “A Chance To Find Balance,” by Michael Mandel, BusinessWeek, 29 September 2008.

ARTICLE: “Aftershocks Beyond The Street,” by Michael Orey, BusinessWeek, 29 September 2008.

ARTICLE: “Short-Sale Ban Spreads Around Globe: Australia, Taiwan, Netherlands Join Push to Keep Investors From Betting on Decline,” by Kara Scannell, Wall Street Journal, 22 September 2008.

THE FINANCIAL CRISIS: “Leaders Seek Global Response to Financial Crisis: At U.N. Gathering, France, Brzail Call For More Oversight,” by Jay Solomon, Wall Street Journal, 24 September 2008.

FINANCE AND ECONOMICS: “Beware falling BRICs: Emerging countries are not the havens some people thought,” The Economist, 20 September 2008.

NUMBERS: “Global Markets, Frightened Investors,” by Tara Kalwarski and David Foster, BusinessWeek, 29 September 2008.

ARTICLE: “Sovereign Funds: Twice Shy,” by Emily Thornton and Stanley Reed, BusinessWeek, 29 September 2008.

ARTICLE: “Japanese Banks Roaring Up Wall Street,” by Allison Tudor, Wall Street Journal, 23 September 2008.

The simplest explanation of CDSs that I’ve found yet (top article):

Credit-default swaps are privately negotiated contracts that act like insurance and protect investors against a default on bonds and loans that they own. Swap buyers make regular payments to sellers, which in turn agree to make large payouts if defaults take place.

So when Morgan Stanley declares “the world had changed,” and the WSJ calls that the “understatement of the year,” you’ll have to excuse their myopia.

It used to be that banks and investment firms were together. In the pre-1929 regulatory environment, that was pretty dangerous, so after the big collapse that helped trigger the Great Depression, there was a new law (Glass-Steagall) that forced those operations to separate, meaning the House of Morgan split into J.P. Morgan, the bank, and Morgan Stanley, the investment bank.

Glass-Steagall was repealed in 1999 (Gramm-Leach-Bliley), triggered by Citicorp’s announced merger with Travelers Group, meaning commercial and investment banks could once again be housed in single firms.

What happens with the “fall” of Wall Street now is nothing more than the disappearance (for now) or the remaining independents, but they seemed to be going away anyhow. First Boston (Steve’s old shop) was gobbled by Credit Suisse back in 1988, then Salomon Smith Barney went to Travelers, later consumed by Citicorp. In 2000, PaineWebber went to UBS, J.P. Morgan went to Chase, and Donaldson, Lufkin and Jenrette went also to Credit Suisse. AG Edwards disappears inside Wachovia in 2007, and Bear Stearns went to J.P. Morgan a few weeks back.

What happened last week was the last three big independents disappeared: Merrill Lunch to Bank of America, and Goldman Sachs and Morgan Stanley convert to commercial holding banks. Lehman simply goes bankrupt.

Let me be clear here: the function of investment banking does not disappear, just the large-scale independent form (meaning, separate from a commercial bank). To me, it’s a bit hyperbolic to call that the “end of Wall Street,” because Wall Street existed before Glass-Steagal and it continues to exist after Gramm-Leach-Bliley. Phil Gramm’s dreams of being Secretary of the Treasury—even if McCain wins—probably died last week, but not Wall Street.

What will change is that commercial banks that also do investment banking are likely to be more conservative—not exactly a bad thing given our last decade or so of spending beyond our means as a nation.

Also, venture capitalists don’t exactly disappear, nor does private equity hedge funds, nor do angle investors. In short, we still possess a lot of ways, including stock markets, to directly connect savers and entrepreneurs—unlike the vast majority of the rest of the world.

So please, no TEOTWAWKI fear-mongering.

Independent investment banks on Wall Street disappear (don’t be surprised if Goldman and Morgan Stanley convert back someday) for now, but as the Economist points out, “universal banks” (marrying investment banking and deposit-taking) were already in the ascendant—globe-spanning behemoths befitting this frontier-integrating age of globalization. Bear and Merrill disappeared into just such banks, and will continue to operate there. Meanwhile, Citicorp looks at the future with some bullishness—its model is supreme.

America is nervous, so sayeth the Economist, because the universal model is viewed with some real suspicion here. Nonetheless, last week constituted the real-world, complete repeal of Glass-Steagall.

But not all investment banks disappear. The ones that remain are just smaller, like Pipe Jaffray, Raymond James Financial (big enough to name the Tampa Bucs football stadium), Jeffries Group (where I’ve spoken) and others.

According to the WSJ:

Some analysts suggested that these boutique investment banks resemble in some ways the businesses that Goldman and Morgan Stanley had 25 years ago, when they were much smaller private partnerships.

Indeed, many experts expect a lot of the fired investment bankers to seek out new employment at these boutiques, so maybe growth will be in their future now that the asteroid killed off the big dinosaurs? Okay, that’s a bit harsh. Real point here is that old growth forest cleared and maybe new ones will grow in their place—again, not the end of the world.

As the BusinessWeek piece points out, this System Perturbation can produce a lot of new, more balanced financial thinking, spurring investment in education, infrastructure and R&D (somebody, call Tom Friedman!), so in combination with high energy prices, this is also perhaps a very good thing.

Absolutely, in the short run, there will be tighter credit everywhere and that’s dangerous to globalization’s spread. Other states realize this, thus the quick additional efforts around the globe to stop the short-selling on financial stocks, and the calls from smart-enough leaders (Sarkozy, Lula) for more sensible regulation (arguably speaking more to the inter-market flows, which are truly less regulated than investments in any one mature economy).

The real danger over the long run is a lot of rich countries taking money off the table and threatening the capital needs of the rising great powers. The Economist, presaging my latest insert into Great Powers, remarked “so much for decoupling,” in light of the market shocks felt in places like Russia, China, Argentina, etc., following last week’s tumult on Wall Street. As the mag warns, “investors may be changing their minds about emerging markets.”

As the BusinessWeek charts show, much of their decline came on the drop in commodity and energy prices a few weeks ago, only to be accelerated further by Wall Street’s woes.

But here’s the key difference: one thing for the advanced West to curtail appetites and another for the rising East to curtail expectations. Lower your calories is one thing, but lowering your sights is quite another.

But that cautiousness can cut both ways: the sovereign wealth funds that showed up last year to rescue Wall Street in the opening round of these crises aren’t showing up this time, taking a clear wait-and-see attitude. They pumped in about $60 billion, only to see $14B go away quickly.

One oddity: Japanese investors are back, looking aggressive and hungry. Not party to much of the excesses of the last decade as they were still recovering from their own party in the 1980s (quite the hangover), they now scour for bargains. What a wonderful world.

In the end, all the recent talk about how the U.S. would never mend its ways without a crash proves both true and false: Wall Street heaves but the rest of our economy does not—for now. If the rescue package does its main trick of restoring confidence, then maybe—just maybe—we get our cathartic cleansing without too much damage.

But clearly, new rules are coming, both for our markets and how the world’s markets increasingly connect to one another.

So definitely score this one as a major System Perturbation. Hardly unexpected, since people have predicted it for years, and not the collapse some foresaw, because this is not the 1930s, but still one big enough to leave most of us woozy and scared, and perhaps big enough to wipe out whatever benefit McCain got from Russia and Palin.

Comments

[farhad]

Dr Barnett,a paradim and the theory of prophet Milton Friedman andthe school of Chicago has come to die;the selfregulating and the invisible hand of the market to correct itself has failed,as it failed inChile(the first place Milton Friedman tried) Argantine & elsewhre,andeversince late 1970's(74-75)they applied his economic theories in US.Somebody 150 years ago predicted;that the conflicit between the demand and supply(in fact the supply is there,but there is not enough affective demand and the system gets sachurated)causes them to turn to certain measures that makes it harder for future obsticles & makes the ground work for bigger meltdowns.with out going to period of 1877,1907,1929 and explain what historically beenhappening,just looking at 1998-99,the burst of the .com bubble which Greenpan action seemingly recovered from it,it caused it to become a bigger crisses of today(which they estimate the debts runto $500 trillion,of course not known publicly yet).if the meltdown of 1929 stock market took till 1958 to recover(30 years mostly by WWII),imagine what this one going to do,the book;THE U TURN,explains the switch they made from new deal of John m Kings to Milton Friedman's nightmare of today.I believe Obama wants to do somting like Frank Roosevelt's new deal, but like you said we are notin 1930's(unless we have another global war),it is too late.

[stuart abrams]

I think somebody should start printing up bumper stickers that say, "Don't Blame Me, I Voted For Henry Clay." In many ways, all of this can be traced back to Jackson's war against the Bank of the United States, which essentially set the US on a very unique financial course in which you had state-chartered, minimally-regulated banks with no central bank. In addition, you have a legal system that is highly biased in favor of debtors. In essence, we still have this basic structure today - we think of the Fed as a central bank, but it really isn't one in the sense that they exist in most countries. This system encouraged capital flows and helped fuel the rapid economic development of the US, but it has always been highly prone to crises. Glass/Steagall tried to deal with that problem, but it created a system that was at heart artificial - notably, virtually no other country in the world had anything that resembled Glass/Steagall. This wasn't a problem until globalization begins to kick in in the '70s, and US financial institutions find themselves at a distinct competitive disadvantage. We start to chip away at Glass/Steagall with the creation of high-yield debt instruments in the '80s (junk bonds), which produces the S&L debacle and the financial crises of the late '80s. Ultimately, the commerical banking lobby out-muscles the securities lobby and Glass/Steagall ends in '99. However, everybody forgot that at core, we still have the financial system that Old Hickory created in 1833, and another crisis was inevitable. We need a new Bretton Woods conference to establish a new world financial order for the 21st Century, in which the US will be forced to adopt a financial system more like the rest of the world.

[Louis Heberlein]

Major domestic and probably global economic transformation is now underway without public or investor votes. Where will the investor moneys be focused now that the 'easy' virtual financial products evaporate? I think it will go to more tangible and useful investments.

An old classic model of economies noted a pyramid with agriculture and raw material production at the base, manufacturing next, marketing and sales next, and the financial network on top. The caveats for the model were that all levels needed to coexist, and had to be nurtured prudently by the financial group.

A later model used concentric circles with the financial network at the center, and the agriculture and raw material level on the rim. Participants in the outer rims could share profits and help each other invest based on promised returns. But their players would get capital faster from contracts with players on the inner circles. It would cost more, but give them a chance for a competitive edge.

Adam Smith believed a free competitive market without state authorized monopolies and oligopolies would be most efficient and efficient and fair economic growth.

Later developments, including technologies, caused countries like America to limit the size and mix of business ventures; e.g., a huge financial companies could not cooperate to buy out and dominate the oil industry.

Without 'evidence' that those restraints were necessary, proponents of innovative finance convinced us to abandon or reduce those restraints. The eventual 'Emperor has no clothes' discovery about much of the virtual financial economy products gives us the opportunity for transformation.

Just remember the capital assets for the financial pyramid top, or center circle, originated from the efforts of the folks at lower pyramid levels, or outer circles. FDR urged us to overcome the fear that could paralyze the folks with those tangible activities. But we must also remember that the financial part of the models are mainly important to the extent they support the overall system.

Lets make a lot of copies of that Jimmy Stewart movie.

[Louis Heberlein]

A low key, but important aspect may be the 'validation' of Islamic beliefs that Western type interest loans are corrupt practices designed to exploit the public and small businesses rather than share risk/reward in their ventures.

It may show up on a few web sites, but it can be much more important in how it is used to teach Islamic theory and practices to young people. So, the perceived social virtues involved in America's resolution of this 'crisis' from its creative virtual financial system may be important in reaching those Gap societies.

The TV presentations of ideologues insisting we just let the public and small businesses suffer from their unwise choices can reinforce Islamic positions that our society is run by cruel bastards.