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Portfolio > Alternative Investments > Hedge Funds

Three Years in, Crisis Lingers

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Two years ago we witnessed the near failure of capitalism, after more than a year of financial shocks, including the correct call by some in the investment business—FPA Funds’ CEO Bob Rodriguez (on sabbatical in 2010) and then-CIO of TCW Jeffrey Gundlach, now DoubleLine Capital CIO among them—that there was something seriously amiss in the credit markets.

Many reports date the financial crisis to September 2008, but back in mid-2007, Gundlach said at the 2007 Morningstar Investors Conference that mortgage debt in the U.S. was an "unmitigated disaster."

In June 2007, more than a year before the worst part of the crisis, Rodriguez noted at the same conference–and I wrote in an article in Investment Advisor:

It's "hard to get a sense of how bad it is," Rodriguez argues, adding that it's not only hedge funds that own CMOs [collateralized mortgage obligations] and CDOs [collateralized debt obligations], but banks and other financial services companies that may have thought they bought investment grade tranches of CMOs–even AAA-rated securities–and are finding that what they have instead is not trading at the same prices as other AAA securities. "I don't buy the ratings from the ratings agencies," Rodriguez cautioned, adding that he's "not sure how widespread the unknowable risk" is. See "Coming Home to Roost."

In July 2007, two leveraged Bear Stearns mortgage-backed securities hedge funds exploded, filing for bankruptcy. Bear Stearns repaid lenders $1.6 billion, and Merrill Lynch, one of the lenders, seized assets of the funds. But shareholders were left hanging with only a note from the company that essentially said, too bad for you. Shareholder value was near zero.

S&P was revamping its ratings methodology for subprime mortgages, and had in July 2007 put on potential downgrade watch "612 U.S. Subprime RMBS Classes." AndBrookstreet Securities, a broker-dealer that had put customers into subprime CDOs–on margin, Reuters said at the time–had just failed. See "Subprime."

As the months ticked by we saw then-Treasury Secretary Henry Paulson, and then- New York Fed Chief Tim Geithner, who is, of course, the current Treasury Secretary–and Fed Chief Ben Bernanke reassure investors that the situation would not be contagious, and later, work to control the damage when problems spread.

The Dow Jones Industrial Average continued to chug along until its all-time high in October of 2007.

Banks and broker-dealers started to report massive losses. Top bank and brokerage execs were ousted. The Sunday afternoon releases of bad news started, and continued, occasionally, until at one point those of us covering the crisis were on alert for the news that started to come almost every Sunday. Still, until the swoon of Bear Stearns into the arms of JPMorgan in February 2008, even though credit markets had seized, many financial services CEOs and Secretary Paulson were still shouting about containment of the crisis.

As we remember September 2008, the nationalization of Fannie and Freddie, and of AIG, the bailout of nearly every major Wall Street broker or bank, and the failure of Lehman, it's important to also recognize that the crisis started grinding on more than a full year earlier. No wonder investors–and advisors–are fatigued.

Is it any surprise, then, that more than three years into the crisis, investors remain unimpressed with and distrustful of Wall Street, reportedly removing their money from equity funds every week since last Spring? For those who still question why it is important for the SEC to mandate a fiduciary duty for brokers who provide advice to investors, why individuals need "Investor Protection," just think about what has happened over the past three-plus years. If one questions why it is necessary to have a "Bureau of Consumer Financial Protection"–with a very strong leader like Elizabeth Warren, again, a review of the last 38-plus months is in order.

For those who rail at the Dodd-Frank version of the Volker rule or the new Basil III requirements for higher capital levels at banks, saying these rules will cost jobs and that banks will not lend; again, a careful review of the past three years would be helpful. If you really look at what has happened to the global economy and how far we still have to go in recovery, how could Dodd-Frank or Basil III have called for anything less?

Comments? Please send them to [email protected]. Kate McBride, AIF(R), is editor in chief of Wealth Manager and a member of The Committee for the Fiduciary Standard.


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