The Sellout

Charles Gasparino, “The Sellout (How Three Decades of Wall Street Greed and Govt Mismanagement Destroyed The Globnal Financial System), Harper Collins, 2009, 499 Pages
The Sellout traces the roots of the current financial services crisis to its roots in the late 1970s when Wall Street switched to a new business model predicated on taking enormous risks. Of course these risks were with other peoples money as the financial institutions went public and abandoned the partnership business model. The pay incentives led to business models embracing more and more risk. The profits are privatized and the risks are socialized. We saw this in 1984, 1987, 1998, 2002, and 2007. A risk manager at a financial institution is a joke; much like the auditing clowns of the SEC or similar funny people at the rating agencies. Pay incentives have created this. Now bring in the government: Fannie and Freddie and all that is missing is the background music. The book tells a good story; the total erosion of Wall Street’s dominance of the world financial markets.

Even though the feared global economic meltdown has apparently been avoided, the costs are still high. Two investment banks blown-up (Bear Stearns and Lehmans), a third forced into a merger, billions of dollars in shareholder value destroyed, and a huge destruction of the wealth of average Americans—trillions of dollars lost as housing prices fell and the Dow Jones Industrial Average fell from its October 2007 high of 14,000 to 6,500 in March 2009.

My Notes:

Pg. 14: As the big Wall Street firms converted from private partnerships to public companies in the 1980s, they were gambling no longer with their own money but with that of public shareholders, and literally overnight the bets got bigger and the use of borrowed funds, known as leverage, grew and grew.

Pg. 154: In 1999 the Republican Congress and the Clinton administration enacted the Gramm0-Leach-Bliley Financial Services Modernization Act, which killed the depression era Glass-Steagall Act that had created a formal separation of investment banks and commercial banks.

Pg. 232: One of the ironies of the bubble Fannie and Freddie helped created through their guarantees and purchase of subprime loans is that it made housing less affordable, not more so.

Pg. 432: Paulson felt he had no choice about bailing out Fannie and Freddie. If Fannie and Freddie were allowed to default, the Chinese government, which held not only U.S. Treasury debt but also debt of the GSEs, would have questioned whether the U.S. government might someday default on its Treasury debt. That type of systemic risk could begin to shut the U.S. government out of the credit markets.

Pg. 492: In addition to the implosion of three major investment banks, a number of commercial banks, the automobile industry, and countless other businesses, more than $13 trillion in household wealth was destroyed by the end of 2008, according to the most recent statistics released by the Fed. Globally, some estimates place the decline at close to $50 trillion.

Pg. 496: Recommendations:
• Just get rid of the SEC. Why would any SEC examiner crack down on Merrill’s excessive risk taking or think twice about auditing Bernie Madoff’s trading records if he or she might want to work for Merrill or Madoff down the road?
• Abolish the rating agencies or change the business model in which the watchdogs are paid by the municipalities, the corporations, and, in the case of mortgage bonds, the investment bankers doing the deals that they are rating. Any business that rates a CDO as the equivalent of a U.S. Treasury bond should not exist as a business in the first place. In any event, the SEC is only authorized to bring civil cases, not criminal cases.
• The pay and reward system for financial institutions must change. The CEOs of Merrill, Lehman, Bear Stearns, and nearly every firm created a system in which risk taking was rewarded to the extreme and losses rarely penalized, except if you consider being fired a stiff penalty, which it isn’t as most traders are simply rehired by other firms. A real penalty might include some kind of mandatory clawback provision, wherein the decision makers—those ordering the risk taking at the CEO level and just below—are penalized for massive losses by having to return their huge salaries, bonuses, and golden parachutes.
• I would add: Insurers of financial instruments, such as AIG, must be brought under strict Federal control. They are now controlled by the States who are just not up to the job. Also, bring back the separation of investment banks and commercial banks; when Citi had been allowed to combine investment banking with commercial banking it was really mixing mortgage bond trading with savings deposits and any losses would be shouldered by average people. Finally, mortgage standards requiring 20% down payments must become the standard and total debt payments of mortgage holders must not be allowed to exceed 30% of gross earnings.

Addenda:
Asset Backed Securities Index (ABX Index): Launched in January 2006, this index serves as a benchmark for the subprime mortgage-backed securities market. ABX contracts are commonly used by investors to speculate on or to hedge against rising defaults in securities backed by subprime loans.
CDOs: are supposed to be the ultimate in risk reduction. They are bonds packed with other bonds made up of mortgages, car loans, credit cards, high-yield securities, and anything that allows the risk of defaults in one class of debt to be offset by others.