Twelve years of Wall Street down the drain
Many of the seeds of today’s crisis were planted a dozen years ago, says this Wall Street analyst, and we’re still reaping that harvest.
Twelve years ago, the financial world was in the process of going crazy.
In retrospect, it seemed like a much simpler time than today. But big trouble was already brewing.
That’s the thesis of a seasoned observer of Wall Street who never looks at the street through rose-coloured glasses.
Mr. Raymond DeVoe Jr. was led down this path of financial nostalgia by an April article by Ms. Elizabeth Wurtzel in the Wall Street Journal entitled “Twelve Years Down the Drain.”
We’ll follow him down that path in the pages of The DeVoe Report while he reminisces about the not-all-that-good-old-days and ponders whether or not this is a bull market, a sucker rally, or both.
First: how the Dow Jones Industrial Average came full circle over a dozen years, courtesy of Ms. Wurtzel.
Decade of reckless abandonment
On August 6, 1997 the Dow Jones reached 8259 after hitting its low for the year, 6391, on April 11. Low and behold, almost exactly 12 years later, on March 11, 2009 the Dow was back down to 6547.
Now it is back above the 8500 level. But in between the gains of a dozen years were wiped out — “down the drain” in Ms. Wurtzel’s words.
Compared to today’s financial, political and international problems, 1997 may seem simpler. “But 1997 was also a year of incredible arrogance, hubris — and stupidity,” says Mr. DeVoe.
It was the beginning of what the author calls “the decade of reckless abandonment” — a world that lost its financial head.
Long Term Capital Management (LCTM), the hedge fund designed by two Nobel Laureates, was leveraged as high as 90:1. Their “Convergence Theory” claimed that only an event occurring once in 700 years could derail it.
Boom! Less than a year later, Russia defaulted on debt and “the theory that spreads between low quality and high quality debt would converge because ‘the world had become a safer place’ was blown out of the water.”
LCTM had to be liquidated by a consortium of Wall Street banks under pressure from Federal Reserve chairman Alan Greenspan. Sound familiar?
The birth of subprime
1997 was also the beginning of the high-tech bubble. We all remember how that turned out, but we may have forgotten that the Fed goosed the craziness by lowering rates and flooding the market with liquidity.
It took longer for the tech bubble to burst than for LCTM to go up in smoke, but both were sailing on a sea of easy money.
That may seem like water under the bridge now, but another bridge was being built to the future, and it was a very insecure structure.
In 1997, the Clinton administration was determined to put some teeth in the act that sought to prevent “red lining” or “zip code discrimination” in mortgages. Red lined areas frequently had a high population of minorities.
After much manipulating and lobbying, mortgage lenders finally gave in and lowered their financial standards, not just for minorities, but all applicants. Thus was born the subprime mortgage.
“This might no have developed into the catastrophe it became,” says Mr. DeVoe, “except for the Fed, Wall Street and the ‘Shadow Banking System’.” The Fed kept churning out easy money. And as homebuyers flooded in to the mortgage market, Wall Street got into the game.
The three-legged stool
“Wall Street was a latecomer to the party, but did as it frequently does — goes wild with excesses,” points out Mr. DeVoe. When it was discovered that these mortgages could be packaged into mortgage backed securities, then re-packaged into collateralized debt obligations … oh boy!
Here’s the worst part. “The demand for these securities seemed insatiable, so supply had to be created to meet the soaring demand.” In came the “Shadow Banking System” — all financial safeguards were scraped away to get more mortgage buyers on to the market.
Wall Street didn’t care whether or not the mortgages would ever be paid. It just wanted more debt to tie up into lucrative packages.
And so the stock market soared from 8400 to over 14,000, standing firmly on the “three-legged stool” that would carry Americans into a golden retirement — Social Security, home equity and all the money contributed to equity (401) k plans. Now two legs of that stool are broken, and the third is looking pretty shaky.
So after coming full circle, where does the stock market stand today?
The profits were phony
Mr. DeVoe is not prepared to spend a lot of time debating whether it is a bull market — “by many broad measurements it would qualify” — or a sucker rally. That’s not the most important question in his mind.
The question is, where do we go from here? The “decade of reckless abandonment” is not likely to recur for a generation or more.
At the beginning of that decade, the financial sector made up 16 per cent of U.S. corporate earnings. By the end of it, that figure had soared to 41 per cent (and remember, there were also manufacturing firms with financial arms like GE and GM, so maybe it was closer to 50 per cent).
The bonuses Wall Street handed out were real, says Mr. DeVoe, “but the profits were phony.” So the financial sector has shrunk back to even less than its former weight in the economy.
Until we know who will make up “the gaping hole in corporate profits,” we cannot really predict whether this three-month bull market will go on or pull up short and reveal itself as a sucker rally.
When the market’s flushed twelve years down the drain, it can’t get it all back in 90 days.
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