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sings &Perspectives Mu ORANGE COUNTY BUSINESS JOURNAL Volume 1, Number 9 een in ss A October 27, 2008 Fallout From “The Deal” Culture By JP Gough1 “H ow the world turns… The heroes of only a few years ago are today’s rogues or idiots. And conversely, the slow- moving and dimwitted of a few years ago are today’s Forget the facts that one-third of all American home- owners own their homes with no mortgage and that the US has the highest level of homeownership in the world. sages of deep wisdom. Everyone’s position has been All drama. No substance. altered by current events – with shock to some. Don’t confuse us with the facts. Out of a total of $1.25 Looking for “Easy Street” and Drama trillion sub-prime mortgages, about $250 billion (21%) are estimated to be delinquent. It used to be that the American stock market was a beacon of reasonable safety and security for the explicit purpose of long- But delinquent does not mean 100% loss. Some are being re- term savings and investment. But things began to change in financed under easier terms, although current lower interest the 1970’s across the entire spectrum of American society as rates will save many of them (while sticking the rest of us with we began our collective search for the “easy street.” the “hidden cost” of inflation). Regardless, the underlying homes are worth something, even if prices are lower. The ‘easy street’ became embodied in the MBA, who was trained in purely numeric approaches to decision making. This Losses of 10% on a foreclosed mortgage are normal. If we approach fortified the “deal culture” where fortunes are to be assume a new, historical high of 40% loss on all delinquent made through manipulation, timing and exit strategies rather loans (not just the ones actually foreclosed), that would equal than on making anything of true value. “Exit Strategy” became $100 billion in losses (tops). the normal focus for every investment decision. Who even thinks long-term anymore? So if the US government is spending $700 billion on a $100 billion possible loss, what are they doing with the other $600 billion? Everyone has evolved into a financial gamesman, playing asset bubbles where ever they may occur, from stocks to collectibles Additionally, the world’s biggest banks already wrote off $640 to homes to their own businesses. Our collective goal seems billion. If this is all about sub-prime mortgages, the write-offs to be focused on not working, just like the gold of Eldorado for would exceed expected losses by over six times. the Spanish conquistadores (most of who died young, poor and hopeless). Combined – the write-offs and the bailout at $1.34 trillion – exceed the amount of every sub-prime mortgage ever granted. Compounding the search for “easy street,” society has focused …This crisis is about more than just sub-prime mortgages. on trumpeting the “mighty of the moment.” The “drama” of everything has become paramount – with substance being Easy money puffed up asset bubbles across the world, mostly ignored. Recent events of the financial crisis support this view. in real estate, but also across the spectrum of financial securi- ties as well. [See my article “The Origins of the Sub-Prime No one really asked for justification of the $700 billion bailout – not Bust” in the OCBJ in September 24, 2007; http://www.ocbusi- in public anyway. The claims of impending Armageddon were nessbank.com/pdf/OCBJ_SubPrime.pdf] enough to bully everyone into line. Everyone rolled over on the simplistic contention that this crisis is all about mortgages and A culture of speculation on asset prices (believing that to be the saving the homes of common, victimized citizens. source of wealth), along with easy money and well-intended, but very unwise changes in accounting here and abroad, have To prove this contention – do you know anyone who has read come together to create this perfect storm. the 1-inch thick mortgage agreement he/she has signed in 17 different places? Or for that matter, who reads – and is able to When Drama Intrudes On Reality understand – the public proxy statements of publicly traded companies? The explanations for this crisis have morphed over the last few weeks, from “mortgages” to “liquidity.” What really happened What the nation needs today, is transparency and regula- is that everyone stopped trusting each other. tion of the “shadow-banking system” of hedge funds and other investment funds which are not regulated and which That lack of trust was caused by unreliable accounting standards do not report publicly. This should have been done in 1998, – worldwide – where accountants make “estimates” that when the collapse of a hedge fund, Long Term Capital, caused become stated values on balance sheets (as if we can depend a worldwide financial panic. on those numbers; the finance world knows better). As those estimates changed (“Fair Market Value” accounting), over night the Our history has shown that at the bottom of every national crisis, net-worth of some firms and banks was wiped out (“bankrupt”). there is a problem of concentration of power, especially when it is below the surface of public awareness. This change in value was initially only on paper. But accounting or regulation forced the Wall Street firms and global trading In the 19th century, Americans learned the hard way that banks to “monetize valuation differences” of assets because “Money is Power” when the economy of the United States people and accountants today confuse “value” and “price” came under the control of a small number of people called the thinking they mean the same thing. “Robber Barons.” It was this experience with their unbridled power in a “jungle market” that led to the Sherman Anti-Trust Just because your house has declined in value, would you sell Act of 1890. it? Of course not. But investment firms and banks do not have that option of holding. Whether the “price” reflects “value” is Even in those free-wheeling, libertarian days, Congress under- not taken into consideration by accounting. stood that our society could not be prosperous, stable and free if a few individuals could wreak havoc in the national economy A mere “suspicion” of bankruptcy became a self-fulfilling as if in a playroom. The nation came to realize that some eco- expectation for several large Wall Street firms and mortgage nomic and financial concentrations are so large, that the free lenders. In the end, rumors caused their normal daily sources market fails to function. of funding to disappear – creating a “liquidity crisis.” Without normal daily liquidity, these firms could no longer function. Today, a number of hedge funds are so large that they move markets. Abuse is to be expected when the exercise of power So, a “solvency crisis” caused the “liquidity crisis” – ‘I can’t lend is hidden from public scrutiny. Recent examples of abuse to you because I do not have faith that you will be around to include manipulation of petroleum prices and the relentless pay me back.’ attacks on the stocks of whole industries through “short selling.” That is why the initial actions of The Fed and other worldwide As soon as the US government began investigating the manip- central banks failed to unfreeze the markets. Pumping money ulation of the petroleum “futures market” to inflate the “spot mar- into markets, but leaving lenders exposed to loss in bankruptcy, ket,” speculators disappeared overnight (some funds rumored does not change the unwillingness to lend. Which is why Ireland to be fronting for foreign governments that export oil). Since then became the first to issue a blanket guarantee on all its banks. petroleum prices have been falling in both “spot” and “futures” markets. So to ensure that our biggest banks did not become subject to a “liquidity crisis” through rumors, the US government When the SEC first limited short-selling on the stocks of the pre-empted the possibility of such crises by forcing our largest nation’s largest banks and Wall Street firms in July 2008, the banks to take on the US government as an investor and stocks of those “protected” companies experienced an imme- partner. With the US government as shareholder, no one in the diate jolt upward in price – once the constant downward pres- world should doubt our determination to keep our banking sure from the mega-short-sellers was removed. But that left system healthy and functioning. the other 8000 banks in America to defend themselves against intensified attacks from the powerful short-sellers. Forces At Work Below the Surface The Systemic Damage of Short-Selling The grand-standing and vague calls for “More Transparency” and “More Regulation” of our banking system is horribly misguided Many countries do not permit short-selling because of well- because not every “financial” is a “bank.” Furthermore, when we established codes of fairness; they have declared short-selling strive for more transparency in banking and the corporate world, contrary to the public interest. [There are other ways to gamble we make financial reporting an avalanche of thick reports that no on the anticipated decline of a stock, through options and futures.] one reads or can understand. The reason why muscular hedge funds like short-selling is that Having decimated the prices of bank stocks in the last 2 years, the weight and momentum of their positions can force the price the short-sellers have ensured that most American banks are down in the direction of their goal. They do not wait for declines now largely unable to raise more capital to help their commu- in the price of a stock – they make them happen. nities in this time of crisis. Only by increasing capital can banks lend more money into their communities. The hedge funds Short-sellers play on small-investor psychology, whereby 15- weakened our national banking system, making it susceptible 20% of every company’s shareholders are prone to panic sell- to foreign control. ing because they assume that the market has perfect information that they do not. This is a predatory tactic used by This is one of the big reasons that the US government bought the big and sophisticated against those who cannot defend stock in our nation’s largest banks. Until the government did themselves. that, the only available (but smart!) investors for the large banks were foreigners – resulting in almost a wholesale transfer of our There are only two ways to “short-sell”: nation’s big banks to foreign governments (until last week). (1) “Naked” short-selling increases the number of shares out- Time For Serious Changes standing beyond what the company has authorized. This is like counterfeiting money. The most pressing need is to protect the average American’s investment in the stock market from the predatory practices of Someone trades a share of stock they do not possess, which big hedge funds. Long ago, we heavily restricted our banks increases the entire supply of “shares” in the marketplace. This in order to protect the public from that concentration of power. is what counterfeiters do when they print fake money – they Now we need to address the threat from the shadow-banking increase the money supply so as to effectively cause a deval- system. uation of the currency and an undermining of faith in the issuer as well as the general economy. Today, many investment and hedge funds are individually bigger than the majority of the nation’s banks; 90% of all banks (2) “Covered” short-selling is when a speculator borrows are under $1 billion in size! Unlike investment and hedge funds, shares from custodians or fiduciaries (aka your stock broker) all banks are heavily regulated to protect the public welfare. that are holding the stock for you “in trust.” Taking those imperatives into consideration, Congress should: The goal of the short-seller is to destroy as much of the share value as possible so that when the short-seller buys • Outlaw short-selling. back the stock, the stock is cheaper. He then returns the same • Require registration and reporting by all investment and number of shares he borrowed (plus a fee) to the broker, who hedge funds with bank regulators – not the SEC. doesn’t care what the price of the stock is, as long as the bro- ker can account for the proper number of shares. Investment and hedge funds have been operating as a shadow-banking system. So when these funds and their Why would anyone lend their own asset to another person money market funds started failing, only the bank regulators whose sole intent is to destroy it? Would you lend someone (FDIC, The Fed) could bail them out to keep a full-blown your brand new, uninsured Porsche if you knew he would push national panic from happening. it off of a tall cliff into the ocean? [Ask your personal broker how to prohibit the use of your stock portfolio for lending to With these badly needed changes, we can begin a serious short-sellers.] process of repairing the current damage and working toward preventing our never-ending lurch from crisis to mega-crisis. In the last few years, hedge funds have found that they can Let’s learn from history and push back the jungle. shoot fish in a barrel. They use programmed formulas to select and hit as many small companies and small banks in one day 1 as possible. While each trade is small, the profit margins are JP Gough is Chairman/CEO of Orange County Business Bank. frequently large – and computer power today is cheap. So His experience includes Wall Street, global finance and development finance, international banking and community banking. He also has each fund can fleece millions of small investors in one day – an MBA and has done post-graduate work in futures, options and legally. derivatives. Long ago, we heavily restricted our banks in order to protect the public from that concentration of power. Now we need to address the threat from the shadow-banking system…of investment and hedge funds. CONTACT US Orange County Business Bank is committed to providing high quality personal service to our clients. The members of our team are available to answer your questions and to be of assistance. 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