The End of An(other) Era
Posted on: September 23, 2008 - Email Article - Printable Version
Speaking from a most cynical viewpoint, I can’t help but see the events of the 
past several weeks as a nation that privatizes its gains while socializing its losses. No taxpayers were clamoring for a share of the profits when AIG’s business was flush with cash the past five years. The basis for a capitalistic market presupposes winners and losers; reward does not come without risk. While I am sure I am not enlightening anyone to ideas that haven’t previously been exposed, the bottom line is that economic theory must collide with practicality. Undoubtedly, there are numerous free-market proponents revolting at the unprecedented actions of the Federal Reserve. The difficultlies for the government, however, lie in the secondary consequences for Main Street a collapse in Wall Street creates.
I am by no means going to attempt to pass judgment on the recent actions of the Federal Reserve and Treasury. Indeed, the success or failure of these actions will be indefinite for several years. However, what is tangible at present is the change in the landscape of Wall Street (if we can call still call it that?). Regulation has often been seen as the enemy of capitalism. However, it is clear the conservative policies of the past decades have unraveled into the unwelcoming arms of the U.S. taxpayer. Uncle Sam will now be at the helm to ensure another systemic failure does not put his wallet at risk again.
Last Men Standing?
The last card was pulled from the deck when the Fed announced Sunday they have agreed to convert the two remaining independent broker dealers to traditional bank holding companies. Under this model, Morgan Stanley [MS: 17.62, 0.00 (0.00%)] and Goldman Sachs [GS: 88.78, 0.00 (0.00%)] will be subject to stricter regulation and new capital requirements.
The realization on the part of the investment banks goes back to a point I discussed in a previous post. All of the broker dealers were leveraged ~30x at the start of the year, while the commercial banks remained around 11x. Leverage allows for outsize returns from a limited capital base. The downside to leverage became abundantly clear with the disappearance of three independent investment banks. Sunday sent the last two men standing falling with the rest.
A Brotherhood Unraveled
I can’t help but think the biggest loser in the events taken place over the past several weeks is Lehman Brothers [LEH: 0.00, N/A (N/A)]. The Federal Reserve refused to bail out Lehman on the grounds of ‘not putting taxpayer dollars at risk.’ In March, the government issued $29 billion of our dollars to prevent the collapse of Bear Sterns. Last week the Fed issued $85 billion of our dollars to rescue insurance company AIG (a state regulated entity). In perhaps its most drastic use of taxpayer dollars, the Treasury Department will now authorize the use of $700 billion of our money to purchase illiquid assets from financial institutions operating under the same business model as Lehman.
AIG
Perhaps the most interesting story to emerge from the turmoil of the past weeks is the AIG [AIG: 1.66, 0.00 (0.00%)] intervention. The government now owns 79.9% of insurance giant AIG after issuing a 24 month, $85 billion loan to the company. Invoking section 13(3) of the Federal Reserve Act, the government stepped out of its realm of regulation to bail out this state regulated entity. 
Fannie & Freddie were not capitalistic enterprises in the first place, and so I support them not being treated as such. Likewise, the investment banks have operated under the regulatory rules of the Fed for the past several decades. However, the precedence set from such intrusion in the private sector is worrisome.
A speaker with several years of experience in the financial services industry summed up the AIG mess the best way I have heard. Traditionally, insurance was intended to cover uncorrelated risks: Your house is no more likely to burn down because my house burns down. However, AIG’s dealings in the derivatives market meant that they no longer insured uncorrelated assets.
Perhaps that is the most important lesson to take away from this financial mess; diversification means nothing when correlation moves to one.
-Adam Brown
Disclosure: The mutual fund this author is associated with is long GS
The Following Stocks Were Mentioned In This Article: AIG, FNM, FRE, GS, LEH, MS
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Adam,
Great write up. What kind of effect do you think the recent changes will have on hedge funds? Most likely new regulations will be implemented regarding how much leverage these banks can employ, in order to be more proactive and not have another breakdown in our financial system. We have already seen many hedge funds forced to close up, what do you see happening in the next year or so? Thanks.