Professor Elam

San Antonio student JerryHerrera makes the case for reading the  August 13, 2007 issue of Business Week, cover stories, Bonfire of the Builders.  This is of course by the way a play on words mimicing the title of what famous book about Wall Street?  Anyone know?  Hint it was fiction based on fact.  Anyway, get your hands on a copy of this issue and read  Builders.

I hope that all students are soaking in the actual financial meltdown of the markets that we are experiencing.  This is not what the economists on tv are saying, how can they be in such denial?  Because they have all bought into the idea that one invests for the long term. Well, if you go bankrupt tomorrow the long term lasts exactly 24 hours….just ask the folks at American Home Mortgage or New Century Mortgage, or holders of TRMP, not bankrupt yet, just down 75%.

Regrettably there is not course on financial history of markets.  I try to make up for that with this blog.  so here goes.

This of course is not the first financial crisis the US has undergone, nor will it be the last.  Capitalism is maarked by these upheavals. AFter the Crash  of 1929, one of the recommendations of a Blue Ribbon committee gathered to investigate the cause and prevention of another crash, made this suggesiton.

Do not allow stock trades to be made by telephone!  the thinking was that folks got too invovled in short term knee jerk panic reactions. If they actually had to physicallly stroll into the broker office it would require more effort and probably not as many would show up and therefore selling would not be as severe.  Well gee, what would that committee think of on line brokerage accounts where all one has to do is tap a key to trade?  That acceleration of trading has taken us to new heights DOW 14,000 and now is taking us back down even faster.

Another more profound suggestion that was made law was the Glass Stegall Act. This forbid commercial banks from participating in the stock brokerage or investment banking business. It turned out that many comercial banks had made 10% equity loans against stock.  Back then one could borrow 90% of the value of the stock.  So it only took a 10% decline to wipe out all the equity and then we were both broke.  This is essentially what the new hedge funds have done but more on that in the next post.

Notably your great political hero Phil Gramm removed Glass Stegall in 1998 as he left office so greedy were the commercial banks to play the stock game,  The end of course came a scant two years later with the dot.com crash, anyone heard from Phil lately. Oh Phil was of course an economist who taught at A & M…..

Now some definitions to help you understand all this.

Commercial bank – designed to handle checking and savings accounts, makes personal and commercial loans to indificuals and business,example, Regions, Guaranty, Sterling are all independent banks,
CITI, Wells Fargo, J P Morgan Chase are multi national money center banks who have spread into other quarters, to say the least thanks to our departing Senator Phil

Investmet bank An invesment bank underwites new issues of stocks and bonds, ie, it takes companies public and raises money for them.   They act as an intermediary between the investing public  (otherwise known as pigeons, lambs led to the slaughter, easy  marks, etc.) They will organize and underwriting syndicate (notice the similarity to the mob term syndicate?) to sell the securities to the pigeons, er public.  This also consists of determining the perfect price at which to offer the stock.  And so the money is raised from the public or buyers and passed on to the issuer less of course a generous underwriting fee and  selling commissions.  This also involves registering the securities and getting approval from the SEC.  The three largest investment banks are Merril Lynch, Goldman Sachs, and Morgan Stanley.  Smaller examples include folks like  A G Edwards. Edward Jones or Stifel Nicolaus, all of St. Louis.  Lehman Brothers and Bear Stearns are in this group, at least as long as they manage to stay in businesjs. 

Merchant Banks Not content with merely underwriitng these guys want to make even more money. This idea originated long ago in Europe with folks like  the Rothschilds.   The idea here is that the firm will act as both a commercial and investment bank, originating financing adn loaning the money on an interim basis. This is what Bear Stearns has been doing in its hedge funds. BS loans the money to builders having raised it in the hedge fund. It then collects interest with the idea of rolling all the loans into a saleable package to sell to the public as in income investment.  Ivan Boesky in his heyday, see
Den  of Theives. claimed to be a Merchant  Banker in this fine old tradition. He was of course a complete fraud trading on insider information.

Now  the trick of course is rather like the old joke about handling the hot horseshoe out of the fire, you don’t want to hold it long.  Ever more greedy, hedge funds borrowed as much as ten times their loans to brokers to make the loan.  That enabled them to make ever larger loans, remember we are working on a percentage commission here.  This is fine as long as you can re package theses things and sell the to an often unsuspecting public.  The name of one of the funds says it all- High Grade Structured Credit Strategies Fund.  Well it was structured all right…..But once fear sets in and one cannot sell this to someone else, a vicious downward sprial ensues. The homeowners first and then the builders cannot make the higher payments required by the variable rate loans. Then the value of the loan or collateral goes down.  And if one is leveraged ten to one, remember our bankers in the 1929 crash, we only have to exeperience a 10% decrese in value to have a 10 x 10% = 100% loss of value.

This has also happened to the hedge fund Cerebrus that bought Chrysler though they are not guilty of this kind of pyramiding.  Cerebrus intended on selling shares or bonds to the public to finance the purchase, now no one wants to lend them the money, at least not at these interest rates. Why not? 

Because there are three emotions that govern markets, Hope Fear Greed. Guess which one just reared its ugly head?

Okay, class dismissed for now, more later.