Greed, stupidity created financial mess

Any banker, trader or investor asked to invent the perfect market environment for creating wealth beyond the wildest dreams of avarice would come up with conditions akin to those of the past decade. So what went wrong?

The financial community, through greed, stupidity and hubris, has fouled its own sandpit. The era of munificent moneymaking conditions -- gentle regulation, ever-faster information flows, freely available credit, unprecedented access to global investors and oil-enriched buyers of anything yielding north of zero -- is ending with an almighty bang, not a whimper.

Appraisers valued homes at fictitious levels. Lenders granted mortgages to people who couldn't pay. Bankers created Frankenstein instruments they couldn't value. Traders invented prices they couldn't justify. And investors bought securities they didn't understand.

Since its inception, the derivatives market has echoed the fairground hawker's call to "scream if you want to go faster.'' Every time Microsoft Corp. upgraded its Excel spreadsheet software to accommodate more cells, rows and columns, the structured finance guys were able to graft yet more layers of complexity onto their products.

The U.S. bond insurers exemplify the gluttony of recent years. Few financing techniques could be duller than guaranteeing municipal bonds. It turns out the so-called monolines found it as boring as you might expect, and decided to spice up their lives -- and their fee income -- with a little derivatives action on the side, to the tune of about $100 billion in collateralized debt pledges.

As a result, some $2.4 trillion of debt carrying the imprimatur of the seven biggest bond insurers may lose the AAA grade as the rating companies start to downgrade the monolines. One, Ambac Financial Group Inc., was cut by two levels to AA by Fitch Ratings last month, threatening the value of the $556 billion of debt it insures.

Tim Price, investment director at PFP Wealth Management in London, reckons the financial community has "behaved as if untethered by any moral or social accountability," potentially sowing the seeds of its own demise.

"It would be ironic if, just when capitalism seemed to have won the global battle for consumer hearts and minds, its venal banking sector had sown the seeds for its own destruction and replacement by a newly resurgent spirit of socialism and protectionism," Price wrote in a January research report.

Government intervention

Bernard Connolly, chief global strategist at American International Group's Banque AIG unit in London, goes further: "The global capitalist system is now at risk of collapsing; it could not easily withstand a stock-market crash coming after an implosion of the credit bubble," he wrote in a Jan. 21 research note. "We hate the idea of extensive government intervention. But it is going to come."

What's missing from the current market prognosis is a sense of contrition or remorse, any reflection that "Maybe we should have done things differently."

A Martian eavesdropping on locker-room conversations in the financial district would get the impression that stock markets are getting trashed because of a perfect storm of bad luck, the unexpected arrival of black swans, with millions of victims and zero perpetrators.

Moreover, the culprits seem entirely oblivious to the possibility that by the time the smoke clears, governments and regulators might have slapped the financial markets in handcuffs and straitjackets -- especially if millions of U.S. baby boomers see their retirement savings wiped out in a stock-market crash.

Banks may be obliged to hoard more capital for a rainy day, crimping their ability to make loans. The dead hand of regulation may drop onto the shoulders of the hedge funds, forcing them to reveal details of their trading strategies and holdings. Central banks will want to reconsider how they play their lender-of-last-resort role when liquidity evaporates.

New rules are likely to prevent money-market funds from gambling the savings of widows and orphans in the derivatives casino. Rating companies will be barred from collaborating with the alphabet-soup securities chefs to ensure that the latter get their AAA ratings in return for paying humongous fees to the former. And the charade of mark-to-make-believe derivatives pricing will be outlawed by the boards that set accounting standards.

The current financial system prevailing in much of the developed world -- featuring lightly regulated free markets and independent central banks running monetary policy -- hasn't been around for long enough to have achieved immunity from government meddling. Its track record in safeguarding savings and promoting financial stability is patchy at best.

Moreover, while its reputation was stained by the debacles of Enron Corp., WorldCom Inc., Parmalat Finanziaria SpA, the dot-com bust and the inability of its cheerleading equity analysts to advise investors to do anything other than buy stocks, the financial community escaped sanction for the most part. This time, its luck may have run out.