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The Back-to-the-Future Recession, Part 1

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Financial innovation's dangerous round trip.

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Editor's Note: This article, which is part 1 of a 2-part series, builds on themes discussed in Stability Trend Only a Fair-Weather Friend. Part 2 can be found here.

Financial Innovation: The Round Trip

Financial innovation is one of the drivers of the velocity of money. We started in approximately 1991, creating the first securitizations and CDOs. It was done at Merrill Lynch, if I remember correctly. But they started getting copied, and then we went into warp speed, creating all kinds of new CDOs and SIVs that invested in loans, securitized mortgage debt - most of which was rated AAA: banks loans, credit card debt, etc. Without thinking about it, we created a shadow banking system that funded a huge chunk of our total credit markets. It was outside the bailiwick of the normal regulatory authorities.

Then in 2007, we began to destroy the shadow banking system. Why? Because they mismatched their liabilities and assets. They were borrowing short-term and lending long-term - and doing it highly leveraged. They were buying up long-term assets at 4-6%, some (or most) of them rated AAA. Then they were selling commercial paper at 1% or 2% - so you get a 2-3% profit spread.

A 2-3% spread doesn't really make you anything. You're not really excited about that, so since we're dealing with AAA investments that everyone believes to be absolutely safe, let's leverage it up 6, 7, 8 times. Now you're talking a 20% return. Now you're talking about making real money. And I should note that we were also talking real commissions and monster bonuses.

I think one other sidenote needs to be made here: In hindsight, we can look back and wonder what the investment banks were thinking. They must have known they were pushing bad paper into the system.

But their behavior tells us they didn't know. If they really believed they were, there wouldn't have been so much of the toxic debt left on their books. Bear Stearns launched very large funds to buy this debt at obscene leverages and sold it to their best customers. At least some people in management thought there was real value in these securities - which just goes to show how lax or ignored the risk managers were in all parts of the financial industry.

Then it all began to implode, because people started paying attention to some of the assets on the balance sheets of the various SIVs and CDOs and suspected they might not be worth what they'd originally thought. You have subprime mortgages in your Special-Investment Vehicle? Hey, I'm not going to buy your commercial paper. Suddenly, the commercial-paper market simply imploded. This was the start of the banking crisis.

So we started taking the innovation of securitizations off the table. The innovation that had driven the velocity to new highs was now slowly being pulled off. So, velocity slows down, and it's continuing to slow down with each passing month.
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No positions in stocks mentioned.

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