Here’s how the WSJ presciently described it last April:
No one is sure what will happen to this complex brew in the event of a serious market downturn. When markets turn bad, leverage can create a snowball effect. Lenders and derivatives dealers demand that investors provide them with more collateral—the stocks, cash, or other assets they pledge to cover potential losses. Sometimes investors dump stocks and bonds to raise cash. Prices drop more, losses accelerate, and more selling ensues. Some Wall Street analysts have taken to referring to a nightmare version of this scenario as “The Great Unwind”
America has been a nation of debtors for years. Prior to the 1929 stock-market crash, brokers allowed customers to buy stocks with as much as 90 percent borrowed money—called margin debt. When the market began sliding, investors had to dump shares to keep their debt levels below 90 percent, igniting market panic. Nowadays, the SEC limits margin borrowing by most investors to 50 percent of a stock’s purchase price.
But those limits don’t apply to all of the derivatives and other financial instruments that now pack the portfolios of hedge funds and other big investors. Estimates by analysts of leverage at major securities firms, borrowing by hedge funds, and margin loans to individuals added up to $4.9 trillion in 2006, compared with $1.8 trillion in 2002.
Gotta love those 1929 references.
The WSJ goes big on A1 with an exclusive interview with Treasury Secretary Henry Paulson and reports that the Bush administration is calling for more regulation of markets to try to prevent a repeat of the current financial crisis.
We’ll quote at length because it’s a lengthy list of regulations from the free-marketeers:
Mr. Paulson told The Wall Street Journal that the recommendations of the President’s Working Group on Financial Markets, which he leads, include strengthening state and federal oversight of mortgage lenders and brokers. The group will also recommend implementing what he termed “strong nationwide licensing standards” for mortgage brokers, a move that will probably require legislation.
The group also will propose directing credit-rating firms and regulators to differentiate between ratings on complex structured products and conventional bonds. In addition, it wants rating firms to disclose conflicts of interest and details of their reviews and to heighten scrutiny of outfits that originate loans that are enveloped by various securities.
Another recommendation from the panel is to push issuers of mortgage-backed securities to disclose more about “the level and scope of due diligence” and about the underlying assets of the securities. The panel is also seeking disclosure of whether “issuers have shopped for ratings”—that is, have had to go to more than one credit-rating firm before getting the triple-A stamp of approval.
And the panel will urge global bank regulators to revisit the latest version of bank capital requirements, known as Basel II for the Swiss city where they were negotiated, so that banks that take on risks hold sufficient capital. The panel also wants regulators to complete updated standards for how banks manage liquidity.
This doesn’t go far enough—it’s our opinion that the credit-rating model is hopelessly conflicted and needs to be dismantled, for instance—but it’s better than the laissez-faire fundamentalism we might expect to hear (though we understand that’s political poison these days and the Bush administration is in part playing catch-up to congressional Democrats). Still, we’re especially glad to see that Treasury agrees about the need to put a check on the scandalous mortgage-broker industry. We imagine markets will be comforted, too.
The WSJ also says Paulson will call for Fannie Mae and Freddie Mac to raise more capital and cut their dividends.
In an interesting Heard on the Street column, the WSJ reports on C1 that Wall Street is treating one of its own—Bear Stearns—as if it has a contagious disease.
Bear swears it doesn’t have any cash problems, but the Street ain’t so sure:
Traders handling certain long-term transactions, such as credit-default swaps, said they are being extra cautious when Bear is the counterparty. In some cases, traders are seeking higher-ups’ permission before acting