In 1988 the Wall Street Journal ran a full-page recruitment advertisement for a New York bulge-bracket bank: a bald egghead with a single strand of hair was looking quizzically at the reader, under the caption ‘We’re looking for Eggheads with Attitude’. This spelt trouble down the road, for sure. Twenty years on and the eggheads have just about blown up Wall Street and the rest of the world’s money streets, and the blast has now reached Main Street.
How did this happen? The eggheads eagerly designed new products around ever-more sophisticated mathematical models that were driven by computer power and labelled with three-letter abbreviations — ABSs, CDOs, CDSs, CFDs, ERSs, IRSs and so on. The generic name for these inventions was ‘derivatives’, since they were derived from an actual transaction such as, for example to insure a debt (credit default swaps — CDSs) or an exchange rate (exchange rate swaps — ERSs) or an interest rate change (interest rate swaps — IRSs) or a share price (contracts for difference — CFDs) or whatever.
Then the attitude kicked in as the eggheads sold these new-fangled financial instruments to other eggheads in other banks and institutions. At first it was slow work to build these new electronically driven markets as it all depended on the target counter-party also feeling the need to recruit his own eggheads with attitude, but by 2001 the CDS market, for example, was worth $900 billion, enough to feed a large number of eggheads.
The directors and shareholders came to love these eggheads as they were developing new revenue streams for the banks and all in the name of greater financial security, or so they thought. All they were creating, however, was a financial world that had nothing to do with the real economy.
As the complexity of these new instruments expanded exponentially, the directors, auditors and regulators were left trailing and not really knowing what was going on in these unregulated and non-transparent markets — but what the hell, the bank was making so much money that nobody bothered to think of the consequences if something went wrong. By 2008 the CDS market was worth an unimaginable $55 trillion — 55 times bigger in just seven years! — spawning whole armies of eggheads now feeding at the numerous derivatives troughs.
Then came Bear Stearns’ demise and, especially, Lehman’s bankruptcy. Lehman was brought down by toxic mortgage waste packaged up as collateralised debt obligations (CDOs), but it had a gross exposure to the credit default swap (CDS) market of $729 billion. This counter-party had gone bust, but no matter, these things were insured, weren’t they? They were indeed, down the road at American International Group (AIG — ‘Anything Insurable is Good’). The AIG Financial Products unit that built that position for AIG was based in London’s Curzon Street and most trades were executed by Banque AIG in France and Lehman’s London office, so it was beyond the reach of the US insurance regulators and the UK bank regulators.
AIG’s problem was simple to understand: its CDS portfolio of $500 billion, despite bringing in $250 million a year, left it grossly exposed, and when the chips were down and the market had had its way with CDSs, the losses were astronomical. The AIG position on Monday 15 September dwarfed the problems at Lehman.
Lehman had been trading on Wall Street for 158 years; AIG had been started by an American missionary in Shanghai in 1919, collecting weekly pennies for life-assurance policies. The much smaller Lehman was the biggest bankruptcy in history and now the much bigger AIG was threatened with the same fate — entirely because of CDS exposure.
It is reckoned that the whole CDS market has contracts roughly three to four times greater than the underlying debts issued, which would mean that up to $400 billion of CDSs may have been written on Lehman’s own bonds alone. So Uncle Sam had no option but to bail out AIG with an initial $85 billion and take 79.9 per cent of AIG’s equity.
This crisis is not over yet, even though the US government has been forced to set up an $850 billion ‘troubled-asset relief programme’ to purchase toxic mortgages or CDOs from banks, but no one has yet said how the related CDSs will be dealt with. The US has been down this road before, with the Savings & Loans crisis of the 1980s, which saw the creation of the Resolution Trust Corporation.
This agency took over 747 S&Ls holding $400 billion of assets; when the S&L assets had been sold and the crisis had abated by 1995, the total cost to the taxpayer was $125 billion, or a ‘respectable’ 32-per-cent loss. That is beginning to look cheap this time round, because in those days the species called egghead with attitude had not emerged from its Darwinian womb.