From the November 2008 issue of Investment Advisor • Subscribe!

Spare Change

The latest of Wall Street's attempts to resist its inevitable evolution

Last fall, I heard a senior mutual fund company executive give a talk in which he warned about the impending sub-prime disaster. I wish I'd have listened more closely. This plugged in mutual fund executive, whom I've known for many years had recently returned from a trip to Wall Street and Washington D.C. where he met with investment bankers and Washington lawmakers about the growing mortgage crisis (little did we know, then).

Speaking at a wealth management conference for advisors, this proactive exec made two key points. First, the traditional mortgage business had evolved into the securities business, with lenders reselling loans as fast as they could buy them up. It had quietly become a cornerstone of the investment banks to package and sell mortgages as securities products such as CDOs, CMOs, CDOs RMBS, and the rest of the alphabet soup.

Then he got down to the problem: Rising interest rates and fears of impending mortgage defaults had caused the buyers of these mortgage-backed securities to stop buying, bringing the mortgage industry to a screeching halt. His prediction: Unless the federal government--the Bush Administration and the Congress, together--took action similar to the 1930s' Home Owner's Loan Corporation (the New Deal entity that guaranteed defaulting borrowers and forestalled massive foreclosures), we'd face another Depression-Era meltdown on Wall Street.

Pretty good call, huh? If only I'd have paid a little more attention...But I figured that as a longtime financial services industry leader, he was a little too close to the whole subprime thing, and besides, how big could the mortgage securities market be anyway? Topple Wall Street? Get real. So it was brilliant thinking like that which led to my not acting on the executive's prescient prediction, not getting out in front of this subprime disaster, and blowing what was undoubtedly my one chance at a Pulitzer Prize.

Ignore at Our Peril

Of course, I wasn't the only one who ignored this insider's sage advice: The Bush Administration and Congress come to mind. At the time of this writing, Congressional leaders and the Administration led by Treasury Secretary Henry Paulson and the Fed chair Ben Bernanke are mired in political squabbling about how best to structure a bailout package similar to the one Thornburg suggested a year ago. Although, by waiting that year, they've allowed Fannie Mae, Freddie Mac, Lehman Bros., Merrill Lynch, AIG, Morgan Stanley, and Goldman Sachs, among other firms, to require a bailing out, or a buying out, at a cost of additional billions of dollars. (As Senator Everett Dirksen of Illinois is reported to have said: "A billion here, a billion there; pretty soon it adds up to real money.")

By the time you read this, hopefully the luminaries in Washington will have crafted their response. To help you and me sort out how effective this "solution" is likely to be, I've been trying to uncover what happened in the first place. That is, I'm looking to dig deeper than the predictable drivel we've gotten from the news media: greedy CEOs, underhanded mortgage brokers forcing money on unsuspecting dupes who couldn't possibly afford those new homes, and as one economically challenged commentator succinctly captured the typical coverage recently: "There had to be some laws broken somewhere."

Rather than cast about for someone to blame, however, it seems we'd all be better served by trying to understand what really happened so we'd have a fighting chance of fixing it now, and perhaps of seeing it coming and being able to head it off the next time. To that end, I'm puzzled about three aspects of this mess: Why did the folks actually lending the money think these loans were a good idea? How did default rates--which only recently reached 6%--topple, not only the entire mortgage market, but nearly the entire financial system? Finally, why did the investment banks--with their long, long history of schlepping bad investments to the unwary public and not-so-savvy institutions--get caught holding their own empty bag this time?

While the answers to each of these questions can be as complex as you'd like to make them, the short answer to all of them is you: the independent financial advisor. The subprime melt down is the result of Wall Street's latest attempt to come to grips with the dramatic changes in the financial industry brought about in large part by the independent advisory movement. Unfortunately, it undoubtedly won't be the last of such boondoggles.

The Wall Street Hijacking

To help me get to the bottom of all this, I talked to Tom Sowanick, chief investment officer at the $20 billion independent financial services firm Clearbrook Financial in Princeton, New Jersey, and the former head of Merrill Lynch's Global Wealth Management Strategy group. Much of Sowanick's 29 years in financial services was spent at Merrill, where he gained intimate knowledge of how Wall Street and the investment banks work. Based on that perspective, he offered some penetrating insights into the subprime meltdown and why this time, it truly was different, with the investment banks getting caught with their own pants down.

Sowanick's first observation is that the current crisis isn't so much a mortgage problem as it is a Wall Street crisis. Again, with default rates at 6% and foreclosures much less than that, we're a long way from the magnitude of the Great Depression. So, while there were certainly some bad loans written, that problem isn't bad enough to shake the whole financial system to its foundations.

As that farsighted fund exec pointed out over a year ago, the first part of the problem is that the mortgage business isn't controlled by deposit-taking commercial banks anymore, it's controlled by investment banks. The important difference in the case of subprime loans is the leverage available on Wall Street. "Commercial banks have their own regulators that keep their leverage rates in the single digits," says Sowanick. "Investment banks, under the SEC, use leverage multiples of 30 to 40." Translation: When investment banks bundle mortgages into securities "products," they can borrow a lot more money against them than banks can. Which they then use to make more loans, and so on. That means they can use mortgages to make a lot more money than banks when times are good (say from 2002 to 2005) and lose a lot more money when times aren't so good: say, like now.

That's how Wall Street essentially hijacked the mortgage business out from under the commercial banks. Because they could make more on the mortgages, they could charge less interest. What's more, they could also reduce the risk, or so they thought. One subprime loan might be risky, but if you bundle a bunch of them together, with some risky ones and others not so much, collectively the risk is decreased. At least, that was the theory. And the ratings agencies bought this reasoning, rating many of the mortgage-backed products AAA.

Once the raters were on board, selling these investments to institutions, pension plans, mutual funds, and individual investors was what Wall Street does best. (As I write, the crisis hasn't trickled down to the investor level yet, but unless Washington does an unusually good job of heading this off, it probably will by the time you read this, creating another wave of losses, along with a new round of wailing and gnashing of teeth.)

The Wall Street Meltdown

As for Wall Street's meltdown, Sowanick says there were really three problems. Remember that interest rates had been very low since 2002. With low interest, lots of folks could afford mortgages, which Wall Street was more than happy to provide, and the housing market boomed. At the same time, the Fed, through Alan Greenspan and then Bernanke, was telling everyone that rates would stay low, so investors were happy to buy up low-interest mortgage securities as fast as the investment banks could roll them up, and everyone made money.

Then, in the middle of 2004, says Sowanick, rising prices for oil and other commodities forced the Fed to start raising its discount rate from 1%--by the middle of 2006, it hit 5.25%. While the Fed steadfastly maintained this was only a short-term increase to stabilize prices, some of the buyers of mortgage-backed securities eventually began to get nervous, and sales started to slow. But by that time, Wall Street was fully committed to mortgage securities--and the hefty profits they generated. So, taking the Fed at its word, they continued to buy relatively low interest loans (which enabled mortgage brokers to offer them). Then they made an even more fateful decision: When they couldn't sell them, they'd hold them for their own accounts, until the buy side picked up. All the while, of course, borrowing more money against them to make even more mortgage loans.

Are you starting to see a problem? By 2007, with oil prices still climbing and the Fed holding interest rates relatively high, adjustable rate mortgages began to adjust upward, and defaults began to climb. As I said, the default rates might have been troubling to bankers, but it they weren't disasters in and of themselves. To highly leveraged Wall Street, however, it was a different story. The ratings agencies had no choice but to downgrade those mortgage portfolios, which then lost value as collateral for the loans against them. That led to margin calls, which quickly reached billions of dollars. And no one, not even investment banks, have extra billions lying around. With more leverage out of the question, Wall Street was in serious trouble. In hindsight, it's ironic that this house of cards began to collapse when Merrill Lynch forced a margin call on Bear Stearns that it couldn't meet. Eventually, the margin call roulette wheel came around to Merrill, bringing it down, too. The problem, as you can see, wasn't so much the mortgages themselves, but Wall Street's massive leverage against them. When the value of those mortgage portfolios fell, the brokerages and AIG had nowhere to turn, except the federal government. Had the Fed and Congress stepped in to guarantee those mortgages a year ago, as the fund executive suggested, the markets would have been stabilized and no one would have gone out of business.

You Caused the Crisis

Fascinating as this is, perhaps the most insightful thing that Sowanick told me was the reason that Wall Street turned to mortgage backed investment products in the first place, laying the groundwork for the entire subprime debacle: The traditional brokerage business--selling stocks and bonds--is all but dead, forcing investment banks to package increasingly risky products, which have much higher profit margins.

What is killing Wall Street? Discount brokerages played a role, to be sure. But I believe the real stake to its heart is the threat of independent advice. Independent advisors on platforms that enabled them to recommend virtually any mutual fund in existence buried the ultra-lucrative proprietary product business. Well-allocated portfolios sounded the death knell for selling advice about stocks and bonds. And one-percent asset management fees was the wolfbane for wrap accounts.

With their margins in the retail market shrinking, wirehouses found marketing their brokers as "objective advisors" a hard sell, too. So they've been forced to create complex--and risky--packaged products like mortgage-backed securities. How could they be dumb enough to get caught holding their own over-hyped investments? There's only one plausible explanation: They had no other choice.

As the financial services industry continues the slow, painful transition to marketing through independent advisors (as the insurance industry did 20 years ago), I suspect we haven't seen the last of these high-risk gambles intended to prop up an out-moded sales force.


Bob Clark, former editor of this magazine, surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at rclark7000@aol.com.

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