Editorial comment

	Vol. 229 No.11
PERRY A. FISCHER, EDITOR

We knew better

I don’t remember where I heard it. It’s been 20 years or so. I think it was on some TV stock market show, where some psychologist was explaining the horrors of being an addicted gambler, how it was more ruinous than drug addiction. He then went on to explain that 25% of all addicted gamblers got their start on Wall Street. He then said that 20% of addicted gamblers try to cure themselves through suicide.

Many of us benefited from the extraordinary leveraged profit of the past several years in myriad ways; I know I did: dot-com stocks, real estate, commodities-and let’s be honest, we’ve all benefited from the run-up in oil prices. It was as if making a lot of money by “investing” a little money was a god-given right, something that all the smart people did. That’s the way the world works. Many folks heard a tiny voice telling them that it was nothing more than gambling luck, and that they knew better, but they quashed that thought. Most folks contented themselves with euphemisms, telling themselves they were “investing.” I was no different.

How did we get here? I only have 1,000 words, so I’ll have to oversimplify.

In real estate, when you do the math, it turned out that I could buy a $200,000 piece of property, put next to nothing down, then sell it in two or three years and make 400% profit. So that’s what I did, and the property value went up an astonishing 9% a year, and even a $10,000 investment, which was mostly in closing costs, had netted me over $40,000 in less than 3 years. So I repeated the process.

Each time, I felt stoked-because I felt that I knew what I was doing. Yet somewhere deep inside, I heard a little voice that said, “Actually, you did next to nothing: You added no value, you did no work, you did not even sweat. You just got lucky. This will end. You know better.” But it was easy to quash that little voice; I was making money, and it was the best kind-easy money.

The vast amount of money created by the dot-com bubble rolled into the real estate bubble, which then rolled into the commodities bubble. Since 2000, a previously small part of the market, called swaps, started to soar after legislation was passed to make it more legal. It enabled the last two bubbles to endure far too long. Most important, it is a completely private market.

Here’s how it works. Suppose I take out fire insurance on my house. Now suppose 20 other people take out fire insurance on my house, none of whom I know and none of whom have ever seen my house. Let’s make it even more absurd. Suppose that a derivative financial paper is created that just trades on the value of the fire insurance on my house.

Now suppose my insurance company sees a lot of lightening storms coming through my city, or an arsonist on the loose; the company might get nervous. So it goes out and gets insurance on its insurance-a hedge-just in case the house does burn down. If my house does burn, there are now dozens of people who have a stake in it, and they form an interconnected web, the extent of which no one knows. Some are banks in China, some are local banks, some are “investors.” Yet, everything works, until one day my house actually does burn down, at which point all these people start asking for payment, and if just one insurer cannot pay, it creates a break in the web that multiplies.

Now imagine that my house is worth $1 billion. Then imagine that there are 60,000 houses with similar insurance contracts. Substitute the word “bond” for “house” and that’s how the swaps market could be valued at $60 trillion-all based on bets that nobody thought they’d ever have to pay on. But then an investment bank failed, and it all came unraveled.

It was just like gambling in Las Vegas, except without the regulation.

Trading of these swaps has simply ground to a halt. The US government is buying some of them, but without trading, there’s no basis for a price. So, the government is going to rely on the few hundred or so swap-a-dee-doo technicians in the world that might be qualified to make a judgment as to value. Problem is, these are the same traders that stand to lose billions in the swaps market collapse. So the government is requiring that they make a promise that they will have a pure heart and not assign values to swaps that would benefit them personally. I know it sounds insane, but that’s where we’re at.

Meanwhile, the FBI is investigating whether some of these private deals were done illegally. It’s true that billions were made, but I doubt the FBI has enough savvy to understand the subtleties of the swaps world. I know I don’t.

I’ve been watching an oddball indicator that I invented this year. Simply go to the Google News website and search for the exact phrase “Great Depression.” In January, it returned less than 1,000 hits; in early July, when I wrote the column “The end is nigh-capitulation and feckless wimps” (August World Oil), it was at 5,000 hits; by October, it was at 50,000 hits. I think that when this ad hoc indicator gets to some maximum-and this requires hindsight-this financial crisis will begin to end.

We could fix this mess for the future. We could increase the margin on commodities from the current 5−10% to 50%, but we won’t, even though doing exactly that went a long way toward fixing the excessive leverage problem that characterized the 1929 collapse. We could reinstate the Glass-Steagall Act (repealed in 1999), which kept banks, brokers and insurance companies from being the same thing. We could repeal virtually everything in the ruinous 2000 Commodities Modernization Act. But I doubt that securities dealers, banks and insurance firms would allow any of these things to happen. They simply have too many politicians in their pocket.

We probably will get a new regulated market, the swaps market, which will have swaps rated by Moody’s and S&P, trades logged and both swap parties known, and swaps with a commodities leg will be known and subject to limits. But it’s also likely that the financial engineers, the so-called “masters of the universe,” will always be one step ahead of the regulators, creating the next multi-trillion-dollar scam. And each time, some little voice will tell us nothing good can come from creating massive personal wealth while doing next to nothing. But we’ll do it anyway. That’s why the 20% attempt to “cure” themselves rather drastically.