Paper Fortunes & Financial Innovation

A former Goldman partner has written a new book about the dangers of financial innovation.

http://www.amazon.com/Paper-Fortunes-Modern-Street-Where/dp/0312382170/ref=sr_1_1?ie=UTF8&s=books&qid=1265841279&sr=8-1

....And an interview with Mr. Smith.

http://www.time.com/time/business/article/0,8599,1958294,00.html

"There is now about $140 trillion in market capitalization in the word's financial markets looking for investments. That money can now move around very easily. But even if a relatively small portion of that money goes after something — say, mortgages — it can quickly cause a bubble and a crisis."

Short, concise and directly to the point. There is too much money chasing returns. If central banks kept rates at higher levels this would not be such a daunting problem as money would exhibit less velocity. Higher rates raise risk premiums. People all of a sudden actually turn into risk managers instead of prop traders. What Mr. Smith is stating is that turning illiquid assets into liquid assets had become an art form and that these liquid assets melted up into a giant and dangerous bubble. But many investors believed that only stocks exhibited bubble like behavior. At the end of the day its liquidity that creates bubbles. The currency markets are very liquid because there is something called the carry trade. The housing market which historically wasn't that liquid, became liquid with the invention of the MBS/CMO. They were able to attach a liquid asset to an illiquid asset. This is very dangerous. China was swimming in dollars and it had to be recycled somewhere.

"Proprietary investing certainly played a big role in the financial crisis. Bear Stearns, Merrill Lynch, Lehman Brothers, UBS and Citigroup all had large amounts of mortgage bonds or real estate investments that they had parked on or off their balance sheets — but were responsible for. They were chasing the same higher yields that all their investing clients were. Those investments comprised the greatest part of those firms' write-offs. Those weren't client-driven trades. They decided to take them themselves. The idea that proprietary trades were a trivial part of the losses at the banks is just not realistic."

Anyone who says that Prop Trading wasn't a major cause of the crisis is just living an illusion. But it all goes back to the liquidity question. I was reading about a story of a guy who was working on a whole loan desk, and he was just buying loans left and right, when asked why was he buying like a nut? He just said. There is endless liquidity and it will never end.

"But I can see where breaking up the banks would be a positive for the free markets. We want a system where firms are able to take risks, but we have to protect ourselves from the risks eating us alive, which can happen when the risks are concentrated in just a few banks. Breakups would distribute risk over a greater number of players and would probably be good for the banks as well. Most financial firms are trading at very low multiples these days because of their inherent trading and balance-sheet risks. Most investors just can't understand them. They are too much like black boxes. Once you lessen the risk, the value of the strong underlying banking franchises ought to be more visible and appreciated."

Brilliantly and simply put.

I keep reading and hearing many so called experts who conveniently blame the crisis and subsequent economic pain on the globe savings glut as well as bad regulatory policies, while completely absolving the Fed from blame when it came to their own monetary policy. This is wrong and extremely dangerous. There is some truth to the global savings glut and the lack of regulatory oversight, but it all begins and ends with the FOMC.