On Thursday, Sept. 18, 2008, the astonished leadership of the U.S. Congress was told in a private session by the chairman of the Federal Reserve that the American economy was in grave danger of a complete meltdown within a matter of days. “There was literally a pause in that room where the oxygen left,” says Sen. Christopher Dodd (D-Conn.).
As the housing bubble burst and trillions of dollars’ worth of toxic mortgages began to go bad in 2007, fear spread through the massive firms that form the heart of Wall Street. By the spring of 2008, burdened by billions of dollars of bad mortgages, the investment bank Bear Stearns was the subject of rumors that it would soon fail. [ MORE ]
Housing and financial crises often precede, or follow the disintegration of empires. The dissolution of the Habsburg and the British empires, as well as the implosion of the USSR were all marked by the eruption and then unwinding of imbalances in various asset, banking, and financial markets.
The collapse of Communism in Europe and Asia led to the emergence of a new middle class in these territories. Flushed with enhanced earnings and access to bank credits, its members unleashed a wave of unbridled consumption (mainly of imported goods); and with a rising mountain of savings, they scoured the globe for assets to invest their capital in: from football clubs to stocks and bonds.
The savings glut and the lopsided expansion of international trade led to severe asymmetries in capital flows and to the distortion of price signals. These, in turn, encouraged leveraged speculation and arbitrage and attempts to diversify away investment risks. The former resulted in extreme volatility and the latter in opaqueness and the breakdown of trust among market players and agents.
The recent implosion of the global equity markets – from Hong Kong to New York – engendered yet another round of the semipternal debate: should central banks contemplate abrupt adjustments in the prices of assets – such as stocks or real estate – as they do changes in the consumer price indices? Are asset bubbles indeed inflationary and their bursting deflationary?
Central bankers counter that it is hard to tell a bubble until it bursts and that market intervention bring about that which it is intended to prevent. There is insufficient historical data, they reprimand errant scholars who insist otherwise. This is disingenuous. Ponzi and pyramid schemes have been a fixture of Western civilization at least since the middle Renaissance.
Assets tend to accumulate in “asset stocks.” Residences built in the 19th century still serve their purpose today. The quantity of new assets created at any given period is, inevitably, negligible compared to the stock of the same class of assets accumulated over decades and, sometimes, centuries. This is why the prices of assets are not anchored – they are only loosely connected to their production costs or even to their replacement value.
Asset bubbles are not the exclusive domain of stock exchanges and shares. “Real” assets include land and the property built on it, machinery, and other tangibles. “Financial” assets include anything that stores value and can serve as means of exchange – from cash to securities. Even tulip bulbs will do.
In 1634, in what later came to be known as “tulipmania,” tulip bulbs were traded in a special marketplace in Amsterdam, the scene of a rabid speculative frenzy. Some rare black tulip bulbs changed hands for the price of a big mansion house. For four feverish years it seemed like the craze would last forever. But the bubble burst in 1637. In a matter of a few days, the price of tulip bulbs was slashed by 96%!
Uniquely, tulipmania was not an organized scam with an identifiable group of movers and shakers, which controlled and directed it. Nor has anyone made explicit promises to investors regarding guaranteed future profits. The hysteria was evenly distributed and fed on itself. Subsequent investment fiddles were different, though.
Modern dodges entangle a large number of victims. Their size and all-pervasiveness sometimes threaten the national economy and the very fabric of society and incur grave political and social costs.
There are two types of bubbles.
Asset bubbles of the first type are run or fanned by financial intermediaries such as banks or brokerage houses. They consist of “pumping” the price of an asset or an asset class. The assets concerned can be shares, currencies, other securities and financial instruments – or even savings accounts. To promise unearthly yields on one’s savings is to artificially inflate the “price,” or the “value” of one’s savings account.
More than one fifth of the population of 1983 Israel were involved in a banking scandal of Albanian proportions. It was a classic pyramid scheme. All the banks, bar one, promised to gullible investors ever increasing returns on the banks’ own publicly-traded shares.
These explicit and incredible promises were included in prospectuses of the banks’ public offerings and won the implicit acquiescence and collaboration of successive Israeli governments. The banks used deposits, their capital, retained earnings and funds illegally borrowed through shady offshore subsidiaries to try to keep their impossible and unhealthy promises. Everyone knew what was going on and everyone was involved. It lasted 7 years. The prices of some shares increased by 1-2 percent daily.
On October 6, 1983, the entire banking sector of Israel crumbled. Faced with ominously mounting civil unrest, the government was forced to compensate shareholders. It offered them an elaborate share buyback plan over 9 years. The cost of this plan was pegged at $6 billion – almost 15 percent of Israel’s annual GDP. The indirect damage remains unknown.
Avaricious and susceptible investors are lured into investment swindles by the promise of impossibly high profits or interest payments. The organizers use the money entrusted to them by new investors to pay off the old ones and thus establish a credible reputation. Charles Ponzi perpetrated many such schemes in 1919-1925 in Boston and later the Florida real estate market in the USA. Hence a “Ponzi scheme.”
In Macedonia, a savings bank named TAT collapsed in 1997, erasing the economy of an entire major city, Bitola. After much wrangling and recriminations – many politicians seem to have benefited from the scam – the government, faced with elections in September, has recently decided, in defiance of IMF diktats, to offer meager compensation to the afflicted savers. TAT was only one of a few similar cases. Similar scandals took place in Russia and Bulgaria in the 1990’s.
One third of the impoverished population of Albania was cast into destitution by the collapse of a series of nation-wide leveraged investment plans in 1997. Inept political and financial crisis management led Albania to the verge of disintegration and a civil war. Rioters invaded police stations and army barracks and expropriated hundreds of thousands of weapons.
Islam forbids its adherents to charge interest on money lent – as does Judaism. To circumvent this onerous decree, entrepreneurs and religious figures in Egypt and in Pakistan established “Islamic banks.” These institutions pay no interest on deposits, nor do they demand interest from borrowers. Instead, depositors are made partners in the banks’ – largely fictitious – profits. Clients are charged for – no less fictitious – losses. A few Islamic banks were in the habit of offering vertiginously high “profits.” They went the way of other, less pious, pyramid schemes. They melted down and dragged economies and political establishments with them.
By definition, pyramid schemes are doomed to failure. The number of new “investors” – and the new money they make available to the pyramid’s organizers – is limited. When the funds run out and the old investors can no longer be paid, panic ensues. In a classic “run on the bank,” everyone attempts to draw his money simultaneously. Even healthy banks – a distant relative of pyramid schemes – cannot cope with such stampedes. Some of the money is invested long-term, or lent. Few financial institutions keep more than 10 percent of their deposits in liquid on-call reserves.
Studies repeatedly demonstrated that investors in pyramid schemes realize their dubious nature and stand forewarned by the collapse of other contemporaneous scams. But they are swayed by recurrent promises that they could draw their money at will (“liquidity”) and, in the meantime, receive alluring returns on it (“capital gains,” “interest payments,” “profits”).
People know that they are likelier to lose all or part of their money as time passes. But they convince themselves that they can outwit the organizers of the pyramid, that their withdrawals of profits or interest payments prior to the inevitable collapse will more than amply compensate them for the loss of their money. Many believe that they will succeed to accurately time the extraction of their original investment based on – mostly useless and superstitious – “warning signs.”
While the speculative rash lasts, a host of pundits, analysts, and scholars aim to justify it. The “new economy” is exempt from “old rules and archaic modes of thinking.” Productivity has surged and established a steeper, but sustainable, trend line. Information technology is as revolutionary as electricity. No, more than electricity. Stock valuations are reasonable. The Dow is on its way to 33,000. People want to believe these “objective, disinterested analyses” from “experts.”
Investments by households are only one of the engines of this first kind of asset bubbles. A lot of the money that pours into pyramid schemes and stock exchange booms is laundered, the fruits of illicit pursuits. The laundering of tax-evaded money or the proceeds of criminal activities, mainly drugs, is effected through regular banking channels. The money changes ownership a few times to obscure its trail and the identities of the true owners.
Many offshore banks manage shady investment ploys. They maintain two sets of books. The “public” or “cooked” set is made available to the authorities – the tax administration, bank supervision, deposit insurance, law enforcement agencies, and securities and exchange commission. The true record is kept in the second, inaccessible, set of files.
This second set of accounts reflects reality: who deposited how much, when and subject to which conditions – and who borrowed what, when and subject to what terms. These arrangements are so stealthy and convoluted that sometimes even the shareholders of the bank lose track of its activities and misapprehend its real situation. Unscrupulous management and staff sometimes take advantage of the situation. Embezzlement, abuse of authority, mysterious trades, misuse of funds are more widespread than acknowledged.
The thunderous disintegration of the Bank for Credit and Commerce International (BCCI) in London in 1991 revealed that, for the better part of a decade, the executives and employees of this penumbral institution were busy stealing and misappropriating $10 billion. The Bank of England’s supervision department failed to spot the rot on time. Depositors were – partially – compensated by the main shareholder of the bank, an Arab sheikh. The story repeated itself with Nick Leeson and his unauthorized disastrous trades which brought down the venerable and veteran Barings Bank in 1995.
The combination of black money, shoddy financial controls, shady bank accounts and shredded documents renders a true account of the cash flows and damages in such cases all but impossible. There is no telling what were the contributions of drug barons, American off-shore corporations, or European and Japanese tax-evaders – channeled precisely through such institutions – to the stratospheric rise in Wall-Street in the last few years.
But there is another – potentially the most pernicious – type of asset bubble. When financial institutions lend to the unworthy but the politically well-connected, to cronies, and family members of influential politicians – they often end up fostering a bubble. South Korean chaebols, Japanese keiretsu, as well as American conglomerates frequently used these cheap funds to prop up their stock or to invest in real estate, driving prices up in both markets artificially.
Moreover, despite decades of bitter experiences – from Mexico in 1982 to Asia in 1997 and Russia in 1998 – financial institutions still bow to fads and fashions. They act herd-like in conformity with “lending trends.” They shift assets to garner the highest yields in the shortest possible period of time. In this respect, they are not very different from investors in pyramid investment schemes.
Both presidential candidates want to crucify SEC Chairman Cox for failing to control our creative financial institutions. But rumor has it that Congress specifically excluded the devilish derivatives from SEC purview. Let’s fire the right bunch of “poips” for a change!
Scary markets are brought about by many factors, some normal, and some not so normal. It’s often helpful to look backwards before getting too paranoid about the present. The S & L crisis of the early 80s might be an appropriate starting point.
Later that decade, a multi-year rally had its head lopped off by high interest rates, high inflation, and a computer loop. Ten years later, another soaring market was toppled by economic factors. The turn of the century witnessed the bloody demise of the no-value-at-all dot-com illusion.
A profit taking strategy during the rally days was all that was necessary to cash in on “The Crash of ‘87.” In 2000, the route to immunity could be summarized as: “no IPOs, no mutual funds, no dot-coms, no problem.”
The common historical (hysterical) thread is clear. Rally begets correction; correction spawns rally. This time around, ironically, conservative investors had no trouble avoiding the derivatives that eventually sunk the markets. But, the products were so “out there,” and the regulators so out-flanked, that the unwinding has unglued several investment world icons. This correction is different— but not in the ways you might think:
The scope of media coverage, analysis, and sensationalism; masses of inexperienced, non-professional, speculators; and the popularity of investment products are new phenomena. Millions of nameless non-credentialed Internet investment experts and financial bloggers add to the pandemonium.
Similarly, the proliferation of passive investment mediums (index funds); regulatory tolerance of speculations of all forms, shapes, and sizes; and the relaxation of the trading safeguards that have protected investors for decades encourage a reckless, gambling approach toward what was once investing. We’ve seen what conscienceless commodity speculators have accomplished in world markets.
We have experienced a major movement away from plain vanilla stocks and bonds, and have popularized the thrill ride of speculative activities. 401(k) fund selections include short-long funds, currency trading strategies, and commodity futures. IRA investors seek out the most exotic forms of speculation, convinced that, with a Blackberry and a lunch break, they can master the complexities of high finance.
Regulators have allowed funds of hedge funds into small investor portfolios; brokerage firms short shares that don’t exist multiple times; the once sacred up-tick rule has been abandoned when shorting itself should be a banned substance; and CDOs make it difficult to determine just who owes money to whom.
Enough? There’s more, but you get the idea. Today’s problems are much more visible than yesterday’s. Today’s worries involve bigger numbers. Tomorrow’s solutions will undoubtedly bring creative MBAs to discover new financial WMDs. The investment gods are angry. We need to bring back that old time rock and roll, and an investment world content with individual stocks and bonds.
In less complicated times, the difference was in the fixing. Speculators suffered, but safer investment styles were less vulnerable. Let’s elect a Congress that will regulate the speculations and allow us to get back to the basic, fundamental, adventure of building and protecting our nest eggs. Think back, just a few cycles ago— familiar?
The Market was breezing along during the summer of ‘87, enjoying one of the broadest rallies ever experienced on Wall Street. From the very start, equity prices seemed incapable of going down. The mystical DJIA 2000 barrier was shattered early in the year and upward the market soared.
On through 2100 it rumbled, then 2200, and 2300— even the comic strip, dartboard approach proved successful, and many subscribed to it. The securities markets were simple, with fewer labyrinthine products, and only the dark cloud of rapidly rising interest rates in an otherwise clear sky. 2400 on the DJIA by July and on it went. No end in sight.
The institutions introduced hundreds of new mutual funds, pumped up their marketing efforts, and pushed the rally skyward— 2500, 2600, 2700, just incredible. None of the salivating mutual fund unit holders saw it coming; Wall Street didn’t care. The Dow topped out at 2722 that August— about the same number of points involved in a swinging September 2008. Only the names and the products have changed—
The parallels to today’s markets are interesting. Value stocks and bonds were moving lower while IPOs and other speculations were bubbling higher. As prices weakened, analysts began to mumble. The economy certainly didn’t look like a doom and gloom scenario— just those pesky interest rates. And then it hit the fan.
Technology bombed the market when programmed-trading sell signals ran fast and furious down the cables, resetting themselves lower, and lower, and lower— but the stock being sold actually existed! Wall Street panicked! Inflation fears, higher interest rates, tension in Europe, foreign oil, war in The Middle East, and so on. All of the usual suspects were touted by the media as the culprits that caused “The Crash of ‘87.”
It just doesn’t take a whole lot of Wall Street manipulation (or arrogance) to turn speculative greed into investment fear. The wizards had done it again, sucking the franklins from unsuspecting individual investor portfolios, just as they would two cycles later when their dot-coms sealed the fate of another generation of speculators.
Yes, the similarities are striking— one meltdown to the next. But this time is slightly different. This time the Masters of the Universe were helped by Congress and the SEC to pick our collective pockets, and a few of them have actually, and appropriately, drowned in their own garbage. I’ll shed no tears for the fallen giants, but let’s all cry out loudly about the problem— a problem that both Barack and John were a part of.
It’s Congress that gets to chastise and create regulations for the bad guys. This year, and in those that follow, let’s fire the DC fat cats that caused the problem, and find some regulators with the guts to label speculations as thoroughly as they do medications.
