Mortgages are not to blame for crisis

August 15, 2007|By Peter Morici

The recent market meltdown had much less to do with bad subprime loans than advertised. It was caused more fundamentally by excesses at hedge and private equity funds.

Those contraptions, invented by the sinfully wealthy barons of Wall Street, lied to themselves and their investors about the efficacy of their schemes. Now they are quiet as bad home loans take the rap for a global meltdown that the U.S. housing market is not large enough to cause.

Essentially, hedge funds are pairing contracts to buy future stocks believed to be undervalued with contracts to sell stocks believed to be overvalued. Derivatives may have fancy drapings, but they mainly boil down to complicated contracts to buy and sell securities.

Hedge funds estimate future stock prices with computer models, which establish pairings of stocks whose prices should move in opposite directions. That can work for one or a few investors whose individual purchases do not influence stock prices.

But when many hedge funds are involved and large numbers of shares are wagered, hedge-fund betting begins to determine stock prices. Hedge fund managers become involved in a game of trying to outsmart one another. By betting with borrowed money, these funds endanger commercial banks whose officials are stupid enough to believe their schemes.

This is akin to a Las Vegas bookie taking only bets on the Washington Redskins and none on their opponents, while financing the book on money borrowed from a New York bank. It's an Ivy League-level Ponzi scheme.

In this environment of complex financial derivatives operations, private-equity firms like Cerberus Capital Management have been pushing paper that is not backed by sound business plans.

The European Central Bank was correct to shore up banks' balance sheets by providing more liquidity last week. But its high-profile tender offer did more to scare markets than calm them. Banks are calling in notes from hedge funds and denying private equity funds new loans for questionable investments.

It's a modern-day run on the bank - but in this scenario, the banks become the depositors and the hedge and equity funds are the banks.

Unfortunately, the European Central Bank acted as if it were Franklin D. Roosevelt and is out of its depth. Mr. Roosevelt did more than provide liquidity during the banking crisis that hit three weeks after he became president; he closed the banks so that depositors could not withdraw their savings and stopped banks from foreclosing on farm and home loans until sanity resumed.

The European Central Bank and the Federal Reserve Board need to get between the banks and the hedge and private equity funds, much as New York Federal Reserve Bank President William J. McDonough did in the Long-Term Capital Management crisis in the late 1990s - or they need to simply provide liquidity and take a lower profile.

In the end, the European Central Bank and Fed need to reassure markets through steady, calm action and not behave as European bank officials did - like a frightened child.

Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission. His e-mail is: pmorici@rhsmith.umd.edu.

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