How did some of the smartest minds on Wall Street and at banks, insurance companies, pension funds and hedge funds around the world get into the current financial-market mess?
And how is it that you and I will wind up paying the bill, ultimately?
To answer those questions, let's start with a quick rundown of recent bad news in the continuing meltdown in the credit market for assets based on mortgages and buyout loans.
- Thursday's massive 387-point sell-off in the Dow Jones Industrial Average followed a meltdown in Europe after the French bank BNP Paribas said it was suspending trading in three hedge funds -- with an estimated $2.8 billion in assets as of July 31 -- because it couldn't value them due to huge losses in the subprime mortgage market.
- Two mortgage insurers, Mortgage Guaranty and , have said that a $1 billion investment in a subprime mortgage company could be worthless.
- After seeing $14 billion to $20 billion in assets evaporate as two of its leveraged hedge funds went bust, announced that a third, unleveraged, hedge fund had run up big losses. It froze investor accounts.
- Braddock Financial closed a $300-million hedge fund after subprime losses.
- German bank KfW said it would bail out a German lender with subprime losses.
- Australia's said investors in one of its mutual funds would lose up to 25% of their money thanks to losses in the subprime sector.
- And shares of lost 97% of their value after the lender said it could no longer raise capital for new loans and filed for Chapter 11 bankruptcy protection.
- Some 46 financing deals representing over $60 billion have been pulled from the market since June 22, according to an analysis by investment management firm Baring Asset Management.
How did all this happen? As any good con man will tell you, the success of a con depends on the mark wanting to believe. The victim, in essence, talks himself into getting fleeced.
In this case, the global investment community wanted to believe that Wall Street and other centers of financial engineering could manufacture investment-grade, long-term debt to meet the huge demand of insurance companies, pension funds and central governments for predictable, long-lived and safe interest-paying investments. Because the need for this paper was so great, these marks were willing to suspend belief. They knew in their heads that you can't manufacture investment-grade debt. But in their hearts they wanted to believe. They needed to believe. They had to believe.
Because, you see, it's the only way out for an aging world that's running a huge shortage of the real stuff. So investors were all too willing to buy fake investment-grade paper -- at prices commanded by the real investment-grade stuff -- until finally the con was revealed as assets were marked to market at 50% or less of their assumed value.
The rush to junk qualityMaybe the easiest place to start to understand this global con is with the U.S. corporate bond market. For the past 25 years, there's been a headlong rush to junk quality in a market that once provided investors with an amazing combination of safety and higher-than-Treasury-bond yields.
In 1992, 72% of all the companies issuing bonds rated by Standard & Poor's earned an investment grade. A bond rating is based on an assessment by one of the rating companies -- Standard & Poor's, Fitch's Investment Services, or-- of how likely a company (or country, state, city or sewage authority) is to meet its obligation to pay regular interest on its bonds, and how likely it is to be around in good financial health and able to redeem its bonds for full face value when they mature.