Have the Hedge Fund Boys Killed Wall Street?

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Dean Baker
International Business Times, August 21, 2007

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The shock waves from the subprime chaos continue to be felt around the world, but it’s not too early to ask about the long-term impact of the crisis on the U.S. financial industry. The picture is not pretty. Just as dangerous food products and toys have damaged China’s reputation as an exporter of safe products, the passing along of hundreds of billions of dollars of bad debt to international investors will have a major impact on Wall Street’s status as an international financial center.

The comparison with China is not favorable. Most analysts are reasonably confident that the Chinese government will move aggressively to improve its regulatory standards so that people in the United States and elsewhere can feel comfortable buying products from China. The Chinese government knows that the country is heavily dependent on sustaining its exports and it will take the steps necessary to ensure that these products meet international safety standards.

By contrast, it is far less likely that the regulatory structure of the U.S. financial industry will be altered sufficiently to restore investors’ confidence in the quality of the financial instruments in which it deals. This should be apparent from an examination of all the regulatory failures that led to the current crisis.

Most immediately there was a failure in allowing for the issuance of millions of deceptive adjustable rate mortgages, disproportionately to moderate income borrowers. A sound regulatory structure would have required clear standardized mortgage packages whose terms are easily understood by non-professionals. The exotic mortgages developed by the financial industry did not fit the bill, as would have been apparent to any serious regulator.

The second big failing was from the credit rating agencies. Somehow, hundreds of billions of debt instruments, that were backed by in part or in whole by near worthless subprime mortgages, got top grade investment ratings. It is hard to imagine what the credit rating agencies were thinking about when they rated this debt as investment grade. Clearly they were not thinking about the quality of the underlying assets.

Of course the failure of the rating agencies to properly police the secondary market encouraged more abuses in the issuance of mortgages. If any mortgage can be passed along into mortgage pools, regardless of how unlikely it is that the mortgage will actually be paid, then fraud and abuse is inevitable.

It became routine for appraisers to issue inflated appraisals to ensure that mortgages got approved. And loan officers would often coach homebuyers to put down income and asset information on application forms, even when they knew it wasn’t true. Garbage mortgages would get bundled with better quality mortgages and other assets in CDOs and other exotic instruments. The intermediaries were able to do such a good job that many investors apparently had no idea what they were buying. These are practices that allowed for a housing boom to grow into an $8 trillion housing bubble.

The hedge fund boys played a role at the buy end of the story. In these days of the global economy, that meant passing along bad debt to every corner of the globe. That is why we’re hearing about funds going belly up in France, Germany, and Australia. Of course, much of this debt also stayed at home. We’ll read about it soon in stories on under-funded private and public pension funds.

However, the bad debt held by foreign investors is likely to have more lasting consequences. These investors wrongly believed that the United States had well-regulated and transparent capital markets. This is not true as foreign investors are now learning. After losing hundreds of billions of dollars on complicated debt instruments, how likely is it that foreign investors will rush back into U.S. markets? Does anyone believe that the Bush administration, or even a subsequent Democratic administration, will have the political will to crack down on the financial industry?

This meltdown comes at an especially bad time for Wall Street. It has already been losing market share for the simple reason that it is not price competitive with other leading financial centers. While top level financial managers are well-compensated everywhere, only on Wall Street do they routinely get paid tens or hundreds of millions of dollars a year. Investors may have been willing to pay a premium to do business on Wall Street if they thought they were getting better returns with high quality financial products. Now that they know better, why pay more?

There is plenty of blame to go around for the abuses that allowed the housing bubble and its corresponding mountain of bad debt to grow out of control. However, there is certainly justice in the fact that Wall Street may be one of the main victims of the impending crash.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.