No More Secret Banking

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.