Neslon Schwartz and Julie Creswell write of the events leading to the financial meltdown the Fed is facing in today’s New York Times in an article appropriately titled, “Who Created This Monster?”
A few summary points:
It is beyond subprime. Wall Street created and abused derivative instruments that effectively placed liabilities off balance sheets. Even after the bailout of Long Term Capital a few years ago, regulators kept a hands off policy in regulating these complicated tools.
Old wisdom espoused by classic investment leaders like Warren Buffet and Bill Gross was swept aside by financial technocrats who were hired more for mathematical talent than market savvy and depth. Markets have a psychological component that often dictates to mere mathematical reality. Like the definition of a cynic, they could not distinguish between price and value. Ultimately the instruments became so complex no one could even figure out the price.
The risk in a financial intrument was isolated from the return and marketed separately. This was acceptable even to an Alan Greenspan who felt this was an effective method for placing risk is the best hands. This to me is a form of financial polygamy; like having one girl you can talk to and another you like to have sex with.
When banks stopped holding the loans they wrote, they lost any incentive to assure the quality of the loans. They worked for pure fees, often generous, just to originate the loan and then pass it on like a financial ‘hot potato’. Regulators are now considering making the originators and financial backers hold some portion of the loan on their books.
Complexity reigned over common sense. Greed is always to willing to hear a complicated reason why the laws of nature do not apply to ‘this opportunity.’ If it can not be explained in 10 minutes, don’t own it.
I encourage you to read the entire article.