One Year Later: Give or Take

One might pick March of 2007, when one rating agency admitted on a conference call that it didn't use the ability of borrowers to repay mortgage loans as criteria for rating residential mortgage-backed securities--and that their risk-models didn't include a scenario in which house prices could fall--more than a percent or two, anyway--and we all know now what foolishness that was.

Maybe it was June 2007 when two highly-leveraged Bear Stearns hedge funds failed--they were loaded with mortgage-backed holdings that had dramatically decreased in market value. Bear Stearns guaranteed more than $1 billion to pay back the Wall Street firms that had provided the leverage--the creditors--which were, of course, higher up in the capital structure than shareholders. But the funds' losses were so dramatic that there was virtually no money left in the funds, and Bear Stearns left shareholders to swing in the wind--see ya--no Bear guarantees for shareholders. Investors lost more than $1 billion in those two funds.

Now, of course, there is very little sympathy for investors who are qualified to invest in hedge funds. They are not widows and orphans, generally. However by their very nature, hedge funds are supposed to be, wait for it...hedged! Apparently, or allegedly, these were not so much hedged in a way that was meaningful or positive for investors as used as a levered betting machine. And, although they were hedge funds--these were not money market funds-- the fact that Bear did not so much as apologize to investors for the egregious losses in funds that were supposed to be hedged--said volumes. (See related stories "Coming Home to Roost," and "Litigation A-Go-Go," from Investment Advisor.)

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Back in that summer of 2007, there was a turning point in which some people started to recognize the huge amounts of leverage in mortgage, car and consumer loan, and other collateralized securities, and regulators and others started to realize how complex many new structured or derivative securities were. Some started to realize that unwinding some of these securities in which mortgage or other loans had been shredded and basically scattered among so many owners that nobody could tell who "owned" which mortgage--because it was in so many pieces in hands of so many different investors. That made it impossible to tell servicers of those mortgages--since they were effectively orphaned in terms of ownership--what to do if homeowners defaulted, so there was a gap in ownership responsibility and response to the crisis in its nascent stage.

At that point, credit default swaps and leveraged off-balance sheet bank holdings started to come to light. Remember the Fed's attempt in September 2007 to get banks and brokers to ante up capital for a special account to buy each other out of the toxic paper in SIVs? That failed, in part because they all knew what they held and didn't want/need to add the risk of acquiring any part of their peer group's bad holdings--on top of their own. Also, many of those firms were starting to take enormous write-downs on their own holdings and maybe could not afford to risk any more capital than they had already.

Even back then in the summer of 2007, there were worries about money market funds breaking the buck, a sad foreshadowing of a year later when that actually happened for the first time since the mid-1990s. In the meantime, though, equities continued to hit new highs as Fed Chief Ben Bernanke and then-Treasury Secretary Hank Paulson, along with many Wall Street CEOs claimed that there was no need to worry--that the troubles becoming apparent in the mortgage markets would not spread to the general economy.

So I count the beginning of the crisis as June 2007 or maybe earlier, and the reason this is important to wealth managers is that maybe your clients do, consciously or unconsciously, as well. There is a sense of fatigue as the slow-motion battle to climb out of the recession continues. Even as Bernanke declared last week that the recession is technically over, growth is not necessarily near. One has to ask: how can an economy that is smaller--and not growing again yet in ways that would support job re-creation--escape from staying recessed or depressed until that more jobs can be created?

Yes, there have been huge government programs that have probably helped to slow the economic decline but are they enough to give the private sector the confidence to add jobs instead of contract? The deleveraging that is taking place should be healthy in the long run, too. But still it is jobs that will power your clients to have the confidence to buy homes and cars, to invest, to re-create the jobs that eventually stimulate growth again.

Comments? Please send them to kmcbride@wealthmanagerweb.com. Kate McBride is editor in chief of Wealth Manager and a member of The Committee for the Fiduciary Standard.

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