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No More Secret Banking

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Alarmed at lenders’ loosened customer standards, Andrew Redleaf saw a red flag waving in the mortgage market as early as 2002. By 2006, the contrarian hedge fund manager was predicting the credit market panic of 2007-2008, driven by the dangerous use of structured products in which billions were invested but whose actual value was unknown.

Redleaf, prescient enough to have also forecast the crash of 1987, is founder and CEO of Whitebox Advisors, in Minneapolis, managing about $3 billion in assets invested in its family of hedge funds.

In his insightful, witty — and suspenseful — new book, Panic: The Betrayal of Capitalism by Wall Street and Washington (Richard Vigilante Books, March 2010), co-authored by Whitebox communications director Richard Vigilante, Redleaf faults modern investment theory, or the efficient market, as the heart of the worst financial crisis since the Great Depression.

Indeed, Redleaf, 52, a champion of free-market capitalism as a backdrop for creativity, takes modern finance to task in his crackling 18 chapters.

Transparency, he writes, would have prevented the meltdown. The banking collapse occurred because “no one — not the regulators, investors, bank CEOs — could tell whether Bear [Stearns], Lehman, Goldman Sachs or Citi was broke or not”…and “the government’s Fannie and Freddie con probably made [the crash] inevitable.”

It was, says Redleaf, a crisis of information brought by “secrecy” of the so-called too-big-to-fail banks, “opacity” of mortgage-backed securities, “blind faith” in the efficiency of modern securities markets — where systems and processes replace human judgment — and regulators’ blocking investors’ access to critical information.

Redleaf, writer of a dynamic, popular blog and trenchant monthly client letter, is a native Minnesotan who earned both a BA and MBA in mathematics in three years at Yale. He started out in 1978 at brokers Gruntal & Co., then traded options in Chicago. After co-founding Deephaven Market Neutral Fund, a hedge fund firm, he launched Whitebox in 2000.

Research chatted with Redleaf by phone this past April. Here are excerpts from that conversation with the bearded money manager, who contends: “The notion that risk equates with reward is…a mass delusion…that has lulled financial advisors into complacency about the risk to which they expose their clients.”

In Panic, you write that “the top executives of banks joined with fly-by-night mortgage brokers and agencies of the government in an unspoken conspiracy of fraud.” What chance of a fiasco like that happening again?

It won’t happen in the exact same way in the exact same markets and securities, but yes, it can happen again — though not for a while. To a very large degree, the [Obama Administration's] financial reform legislation will be irrelevant as soon as it’s passed because it will be focused on yesterday’s problem. The problem isn’t today or tomorrow or the day after tomorrow. It’s next week — or three, four, five years down the road.

So in a different time and a different place, it’s apt to happen again: helping people get loans who shouldn’t get them, helping people not pay loans when they can’t or don’t want to.

You blogged that Senator Christopher J. Dodd’s (D.-Conn.) financial overhaul bill “deserves to die.” What are your thoughts about it right now?

It’s awful. It’s especially wrong in the details and indicative of a huge amount of confusion. Let’s start with consumer protection. I’m sure that there were a number of hard-working people that were lured by deceptive practices and were genuine victims. But that’s just a footnote to the financial crisis. Nobody has demonstrated that there was a wholesale group of victims.

The point is, we already have laws against fraud and deceptive business practices. It’s not at all clear that the bill addresses a significant problem that isn’t covered by existing law.

What was the fundamental cause that triggered the crisis?

A lack of information and disrespect for information. If I were king, the reforms would center around disclosure — for financial companies for sure, but for all public companies. The government would require institutions to publicly publish their investment positions in detail. Really, any prospectus for any securities offering is a joke. You can summarize them all: If you buy this security, you should expect to lose all your money.

What’s amazing is that even now there are articles about how banks are artificially, meaningfully, strengthening their balance sheets at quarter end…so that they have more leverage than their public filings indicate. If people had access to everything at Lehman Brothers, the worst of the excesses wouldn’t have happened because [the firm] would have been shown [to be near the edge].

But is it realistic that financial institutions would publish all their investment positions?

It’s not going to happen.

What kind of information wasn’t available at the time of the crisis?

If, say, Lehman Brothers wanted to ask, “What percentage of people that we have an interest in clearly can’t afford their homes?” that would have been an unanswerable question because that information disappeared in the process of securitization. You could get the average FICO score or the home’s value. But you couldn’t get an applicant’s loan or employment history — stuff that would have been in a loan file — because when it’s securitized, you have to standardize it and base it [only] on publicly available information.

You blogged that as the crisis was building, “the regulators knew exactly what the banks were doing and were wildly enthusiastic about it.” That’s shocking to people who are still asking, “Where were the regulators?”

The regulators thought securitization was great because even though it meant losing information — such as what percentage of people clearly can’t afford their houses — you had price information, and they were going to be market prices.

You wrote that in the mortgage-backed securities market, “the dumb money ruled. [It was] an expert’s market in which most of the experts were clueless, conflicted or both.” That’s pretty scary!

And now [former Federal Reserve chair] Alan Greenspan is back on the Sunday talk shows trying to rehabilitate his reputation. But I don’t think the story that very few people saw [the looming crisis] is true. Of the 50 hedge funds that matter [out of several hundred]… 10 to 20 got it right.

What practical suggestions do you have for trying to prevent a similar breakdown from occurring?

In all sorts of ways we ought to be moving to clearer, brighter lines. We have to abandon what I call “strategic ambiguity.” Things ought to be guaranteed or not — as opposed to, for example, Fannie Mae and Freddie Mac were always said to be “implicitly guaranteed;” but then after the receivership [was put in place], the term became “effectively guaranteed.” It should either be guaranteed or not guaranteed. It shouldn’t be ambiguous depending on the politics at the time.

What other ideas do you have for financial reform?

We desperately need more clarity. The super-regulator — the systemic-risk regulator we’re supposed to have — is vested with lots of discretion, but not a whole lot of black-letter guidance. We need more black-letter law, more explicit rules. We need to stop making it up as we go along [by using] regulatory discretion. For example, we’ll orchestrate the [sale] of Bear Stearns, but we won’t do it for AIG. But then we’ll do it on punitive terms, but we’ll re-negotiate the punitive terms because we don’t think it’s working.

Any more solutions?

We should encourage the opening of well capitalized banks by people who haven’t ruined banks. If you want to put up a dollar of your own money, you should be able to gather two or three dollars of insured deposits. Lots of hedge fund and private equity types would open banks and put up real capital, and we should let them do it and be minimally leveraged. They’d have real skin in the game.

You don’t believe in the efficient market hypothesis, no way, no how. Why?

Because it [states] that judgment doesn’t matter, that statistical science replaces judgment, that you can separate markets from mind. [But] capitalism comes from the word, “caput,” which means “head” — you know, “think.” Why don’t we have good accounting? Institutional investors don’t demand it. Why? They don’t believe it matters. Basically people believe that the markets are getting it right and that if they had better information, it wouldn’t make any difference. It’s a thread that runs through to the present.

You said that it was “the government’s moral failure that turned the credit crunch into the most dangerous, worst damaging economic crisis since the Great Depression and even now threatens to extend the damage out for years to come.” Please talk about that possibility.

It’s because of the absence of black-letter rules. It’s treating one party differently from another. It’s saying Fannie and Freddie are financially strong and having them sell securities on the basis of that pronouncement and then seizing them for the public benefit [a few] months later. It’s not disclosing…I don’t think there is anyone in the world who can say whether Bear Stearns was the victim of a classic bank run or if it was insolvent. We don’t know the answer to that question because the government acts as if they don’t want us to know.

You started betting against the junk mortgage market back in 2006. But you write that you “really didn’t see the September [2008] crash coming” and that you bought Fannie and Freddie preferred stock after the government said those agencies were in good shape. But then, when it seized “the twins,” as you call them, “preferred shareholders saw their dividends canceled. The government had lured investors into a trap.” So did you think at the time, “I should have known better?”

I’m sure I thought all the time that there was a substantial chance that they were seriously underwater, that they had negative activity. But I didn’t see the need for receivership. I thought they would be allowed to continue to operate. They had the chance to make a lot of money going forward and earn their way out of it. But I didn’t quite see the extent to which the Administration was making it up as they went.

How did your hedge funds perform during the crisis?

We did horribly in the fall of ’08 and the spring of ’09 — the direct aftermath. If you put ’08 and ’09 together, we did fine! But we recovered over the rest of ’09.

Well, what lesson can financial advisors learn from this debacle?

Don’t buy things on faith — even securities traded on regulated markets. You should buy things when you have a compelling reason to believe they’re a good deal. The key to financial security is thrift, frugality and savings. People should save more and lead thrifty, frugal lives.


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