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PhillyArena Community => NBA Discussion => Topic started by: Skandery on October 20, 2008, 03:31:07 PM
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. . . of our whole economic mess said in layman's terms. Although I'm not usually a fan of Ben Stein, I found this article informative, straight-forward, and pretty darn truthful. Bolds are mine.
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Why I'm Still Buying
By: Ben Stein
Posted on Friday, October 17, 2008, 12:00AM
This is my most serious column yet. So let's get to it.
I get a fair amount of mail about the economy. Lately, much of it asks the same questions:
* What the heck happened to our economy so suddenly and powerfully that it caused the immense uproar and fear and stock market crashes we have had lately?
* Why didn't I, Ben Stein, famous so-called braino, get what was happening and why did I remain optimistic so long?
* What is the future going to bring?
First of all, obviously, I don't know what the future will bring. If I knew the future, I would be the richest man on the planet very soon and I assure you I am very far from that.
But I now see what has happened and I can explain that, and it might give a tiny bit of insight into what will happen in the future.
Start around 1995. Groups involved with civil rights issues and activities for poor people began to complain that poor people and especially non-white poor people got mortgages much less often than white well to do people. Many economists, including me, explained that it was not at all surprising that poorer, less credit worthy people were often turned down for credit. That's how credit is supposed to work: you lend to people who will pay you back.
But the advocates for poor and black people had immense political clout. Under President Bill Clinton, they passed legislation that called on banks to be required to lend to non credit worthy borrowers. The laws, including the Community Reinvestment Act, the CRA, required two large government sponsored enterprises, Fannie Mae and Freddie Mac, to buy those lower quality mortgages from the banks, guarantee them, and sell them to the public. These were bundled into immense pools of subprime mortgages as they were called, and sold all over the world.
Soon, the private sector got into the act in a vast way. They also went to banks and bought their subprime loans, packaged them, and sold them as Collateralized Mortgage Obligations all over the world.
Supposedly, the subprime collateralized mortgage obligations (CMOs) were sliced up in such a way that buyers could have a very high likelihood that they would be repaid even if many of the mortgages in the portfolio defaulted. This assumption was based on a misunderstanding of poor quality credit that had been popularized during the era of the junk bond investment powerhouse, Drexel Burnham Lambert.
As it happened, these low quality mortgage bonds were recognized as highly likely to have real problems very soon after they started to be issued by private banks in the billions. The people who recognized the high likelihood of defaults were able to profit from that likelihood:
First, they could sell the mortgage securities short, a straightforward wager that has long been available.
Second, they could buy credit default swaps (CDS) from financial entities. These were essentially a side bet that anyone could make about a certain mortgage bond (or any other kind of security). It paid off fantastically if the bond went into default or was close to default. The people who sold these CDS were banks and insurers, especially Merrill Lynch and A.I.G., that believed the mortgage bonds would not default and therefore charged very little to the other side, the counterparty, to make the bet.
Things went along well for everyone on the long side for several years as the housing market boomed. Even if borrowers could not repay their mortgages, they could refinance the mortgages for more money than was owed on the original mortgage, pay off the first mortgage and live happily in their new home. The mortgage in question in the bond would - again-- be paid off and the bond would continue happily in its owners hands.
Then, the housing market started to stabilize and soon fall, as housing prices do. They move in cycles, although around a rising mean, as we economists say.
Now, when the subprime mortgage holder could not pay off his mortgage, he could not refinance. Instead, he had to default. When a lot of these mortgages defaulted, the bonds into which they had been lumped declined in value.
So far, I, your humble servant, followed the deal just fine. It was extremely similar to the collapse of the Drexel Burnham Lambert junk bond empire. This had caused barely a ripple in the national economy when it fell apart in the early 1990's. I assumed that the same would happen with junk mortgages. There would be some failed banks and insurers, but the Federal Reserve, the Federal Deposit Insurance Corporation, and the Treasury could make all of those losses good. The total amount of subprime mortgage bonds was large but not compared with bank capital or the regenerative powers of the Fed.
So, I assumed, and wrote, things would be fine.
Where I missed the boat was not realizing how large were the CDS based on the junk mortgage bonds. They were not only large, but absolutely staggeringly large. Where the junk mortgage bonds were in the hundreds of billions, the CDS were in the tens of TRILLIONS. If the sellers of the CDS had to pay off in large part, the liability greatly exceeded the total bank capital in the United States and maybe in the world. That is, the derivatives based upon the junk mortgage bonds could be - and were - not in any way limited to the size of the mortgage bonds themselves, and this I did not know until a few months ago.
It is this liability that swamped the banks, investment banks, and insurers. It is the CDS liability that broke AIG and Lehman.
When I realized the extent of this problem, I wrongly thought the federal government would step in and in some way rescue everyone who had sold CDS. They did, except they 'forgot' to rescue Lehman. Lehman was so large that when it failed, it was like a torpedo striking an ocean liner below the water line. A gaping hole was left in the whole world finance system.
Bankers panicked. If Lehman could fail, then anyone could fail. In that case, the banks that were still solvent figured they had better hoard their assets and stop making loans. This led to the ongoing credit freeze. This led to a rapidly gathering economic downturn and a drastic fall in prices of all kinds of securities, real estate and commodities. It also led to a severe credit squeeze on hedge funds, which saw credit dry up and their asset prices fall suddenly, and were forced to sell stocks and other assets on a dramatic scale, leading to still greater falls in securities prices, and the worldwide panic that it still unfolding.
In turn, this led to huge infusions of liquidity into the banks of the world, the semi-nationalization of the banks of the United States and of many other nations to shore them up, thaw credit, and bolster world markets and economies. These were drastic steps for drastic times, all generated by derivatives. Warren Buffett had warned us against them, and he was dead right, as always.
Now, these acts should help. But it might not do the job all by itself. Major lender solvency issues remain. If housing prices keep falling, more mortgage bonds will default and the liability attached to the credit default swaps based upon them will still be in the trillions or even tens of trillions.
I might well be too alarmist here, but I think the only rational possibility is for the federal government or the New York State government (because most of the CDS were entered into in New York) to simply annul the credit default swaps as void as being against public policy. After all, there was no insurable interest in most cases, which tends to void insurance contracts, which is what a CDS is.
Once that happens, the banks can breathe freely again, take risks, and the economy can revive. Or, perhaps the housing market will stabilize, mortgage based bonds will rally, and the CDS will be out of the money and will not be a threat to the lenders. But something has got to happen to defuse these deadly derivatives.
In any event, we now know a lot we did not know before. Credit default swaps are way too dangerous. Derivatives generally are dangerous. There is much that Ben Stein does not know. I hope this explains some of how we got to this precarious place, I apologize for not seeing it sooner. But I am still optimistic that the government will save us from the CDS, and we will go on to renewed prosperity. In other words, I am still buying.
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Its also very important to remember that the Gramm-Leach-Bliley Act of 1999 that acted to repeal the Glass-Steagale Act of 1933 passed after the Great Depression was what made it possible for banks like AIG and Lehman (by LAW--Bank Holding Companies) to act as insurers also (able to issue CDS's) also. You would think after the GREAT FREAKIN' DEPRESSION, when law-makers drew a line in the sand and said, DO NOT DEREGULATE PAST THIS POINT, that common sense and cursory knowledge of history would keep the Gramm-Leach-Bliley Act from ever getting out of the draft room!! NO no, not our leaders! ::)
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Pretty good read
Why don't you like Ben Stein though?
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His schtick gets old. :-\
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Very good article by Ben and pretty damn accurate. I also like his solution, to declare these credit default swaps null and void. What matters here is keeping credit available and reasonable so that people who can buy homes will be able to sell them to those who want or need to sell them.
The real problem is that no one did anything to stop this from happening, even after people like Warren Buffet and Jim Sinclair started warning people about them. Jim told the CEO of Bear Stearns that what his company was doing would destroy it, and he didn't listen. He was making too much money selling the very things that would bankrupt his firm.
There's no way to know where we're going from here, but consider that the economy was already slowing and that housing was a big part of it. With housing down, so is construction, and we know the auto companies are in trouble, along with the banks and the insurance firms. There are lots of losses from this speculative fallout- and let's face it, that's what all this was, speculators chasing yield and buying these mortgages and the CDS's for insurance. People and countries around the world bought these things, and the US should not be insuring them against loss. Everything is a risk in this life and if you make a mistake you pay. It is simple as that.
But the world's economy was still slowing, as the US found itself at the end of the credit rope, not because no one was willing to lend, but because the US appetite for borrowing had already started to slow. The world is going to have to find another way to grow rather than selling to the US for cheap, and the US is going to have to find another way to survive without relying on foreign investors who don't know where to put their profits.
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Its also very important to remember that the Gramm-Leach-Bliley Act of 1999 that acted to repeal the Glass-Steagale Act of 1933 passed after the Great Depression was what made it possible for banks like AIG and Lehman (by LAW--Bank Holding Companies) to act as insurers also (able to issue CDS's) also. You would think after the GREAT FREAKIN' DEPRESSION, when law-makers drew a line in the sand and said, DO NOT DEREGULATE PAST THIS POINT, that common sense and cursory knowledge of history would keep the Gramm-Leach-Bliley Act from ever getting out of the draft room!! NO no, not our leaders! ::)
Skandery, you are wrong about this. First AIG was/is not a bank, it was/is an insurance company. Lehman was an Investment Bank, and not a Commercial Bank. A swap is not insurance. Though it functions like insurance, it is a completely different instrument. It is not a regulated insurance product. It is a swap, meaning one party swaps some or all of its risk onto another party through an instrument called a swap. The Gramm-Leach-Bliley Act of 1999 did not allow banks or investment banks to sell insurance when previously they could not. Insurance is regulated by the states.
If Glass-Steagale were still in place then our present situation would have crashed in March with Bear Stearns, and the crash would have been far worse than the situation we are in today. This is because Bear could not have been purchased by Citi, because Glass-Steagle would have outlawed that. So Bear would have gone bankrupt, at which point Lehman would have defaulted, and those two together would have taken AIG down, which would have caused Fannie and Freddie to collapse, which would have lead to a collapse of Merrill, Goldman, and Morgan Stanley. Glass-Steagale would have made it impossible for Bear, Merrill, Goldman, and Morgan Stanley to merge with commercial banks and or become bank holding companies. So as bad as things are today, it would have been far worse with Glass-Steagale.
To assume that a regulation written and designed in the 1930's, given the changes in products, markets, and technology, is the best and most appropriate regulation today, is either naive and utter fantasy at best, and an absolute abdication of legislative responsibility at worst.
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First AIG was/is not a bank, it was/is an insurance company.
For being ONLY an insurance company, they sure seemed to be highly leveraged into the same financial derivatives that brought the Investment Banks (and NOT other insurance firms: All-State, State Farm, American Family, etc.) down?
Lehman was an Investment Bank, and not a Commercial Bank.
For being JUST an investment bank, they sure went down fast when they had to, for lack of a better term, "cover" the trillions of dollars of swaps that starting rolling in.
For being two completely different companies that provide completely different services why does Ben Stein write and most economist agree that the SAME thing broke them.
Stein: It is the CDS liability that broke AIG and Lehman.
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I know I'm not the one getting the MBA, I'm just a simpleton. But like I once said to Joe, these things sure do look like ducks, and they sure do quack like ducks.
To assume that a regulation written and designed in the 1930's, given the changes in products, markets, and technology, is the best and most appropriate regulation today, is either naive and utter fantasy at best, and an absolute abdication of legislative responsibility at worst.
I've had a Business Analyst specializing in investment securities and product development AND a fund analyst for Standard + Poor's tell me face to face that getting rid of the specific rule (one sentence) in Glass-Steagall that dilineated a certain financial entity COULD NOT be a Bank Holding Company and an Insurance (or Insurance-like) Agency propagated this mess far worst than it would have. No doubt that manufacturing demand the way Clinton/Fannie/Freddie kindled the fire. Repealing that specific rule in Glass-Steagall through gasoline on the fire.
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I know I'm not the one getting the MBA, I'm just a simpleton.
Skandery,
I recognize that you and I disagree on a great many thing politically. That's fine, to each his own. To make a veiled inference though that I am looking down my nose at you because I am choosing to extend my education is pure and simple bullsh!%. It is below your dignity and I do not appreciate it.
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I know I'm not the one getting the MBA, I'm just a simpleton.
Skandery,
I recognize that you and I disagree on a great many thing politically. That's fine, to each his own. To make a veiled inference though that I am looking down my nose at you because I am choosing to extend my education is pure and simple bullsh!%. It is below your dignity and I do not appreciate it.
Look, if it'll help smooth things over, you're both simpletons.
;)
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I recognize that you and I disagree on a great many thing politically. That's fine, to each his own. To make a veiled inference though that I am looking down my nose at you because I am choosing to extend my education is pure and simple bullsh!%. It is below your dignity and I do not appreciate it.
Kevin, it was actually a poor attempt at referencing the fact that I am aware I'm out of my league in the particular subject. In reading it over, I should have worded it better not to sound condescending. Really it was a submission, "In providing my rebuttal, I realize you are much more knowledgeable about the nuance and detail of the matter based on experience and education." And its really out of respect for you that I felt I needed the disclaimer. I apologize for how it came out.
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Hey, if it helps . . . I HAVE my MBA, and I don't understand half of what ziggy is saying most of the time.
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Hey, if it helps . . . I HAVE my MBA, and I don't understand half of what ziggy is saying most of the time.
FYI, ziggy means "Warren Buffet" in my language ("El perro que se llama Warren El Buffet" actually). Coincidence? I think NOT!
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I recognize that you and I disagree on a great many thing politically. That's fine, to each his own. To make a veiled inference though that I am looking down my nose at you because I am choosing to extend my education is pure and simple bullsh!%. It is below your dignity and I do not appreciate it.
Kevin, it was actually a poor attempt at referencing the fact that I am aware I'm out of my league in the particular subject. In reading it over, I should have worded it better not to sound condescending. Really it was a submission, "In providing my rebuttal, I realize you are much more knowledgeable about the nuance and detail of the matter based on experience and education." And its really out of respect for you that I felt I needed the disclaimer. I apologize for how it came out.
Skandypants, I think ziggy needs a hug....just remember to disarm the C4 you have strapped to your chest before you do it......
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Skandypants, I think ziggy needs a hug....just remember to disarm the C4 you have strapped to your chest before you do it......
Will do. Does the primal scream of "jihad to the infidel" come before or after the hug??
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Skandypants, I think ziggy needs a hug....just remember to disarm the C4 you have strapped to your chest before you do it......
Will do. Does the primal scream of "jihad to the infidel" come before or after the hug??
You towel-headed-dipshizzle! Have you not been paying attention to the "sensativities" of the posters around here?
The scream is now "agree to disagree to the ardent supporter of the opposing view point"!
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Kevin, it was actually a poor attempt at referencing the fact that I am aware I'm out of my league in the particular subject. In reading it over, I should have worded it better not to sound condescending. Really it was a submission, "In providing my rebuttal, I realize you are much more knowledgeable about the nuance and detail of the matter based on experience and education." And its really out of respect for you that I felt I needed the disclaimer. I apologize for how it came out.
Hug accepted!!
I will give my take on how Credit Default Swaps (CDS), an instrument that was designed to reduce risk, and spread risk, failed to do what they were intended to do. I will also give my take on why I don't believe regulation is "necessarily" a pre-requisite to avoiding these kinds of circumstances. This is only my take on the issue.
The reason CDS's have turned so bad for AIG and other is that they did not recognize the difference between the systemic risk associated with a swap, as opposed to the risk associated with "insurance". AIG sells insurance and I believe they, and many others, viewed CDS as insurance, but it does not function like insurance. With insurance, a company sells a policy, takes premiums, and makes payment if the specifics of the contract eventuate. Same with a swap. The difference between the two though is how risk is transmitted through the process.
With life insurance for instance, the death of one policy holder has no impact on the death of any other policy holder. Person A dying has no impact on the probability of person B dying. Same with fire insurance, health insurance, auto insurance etc. They are all wholly independent events. As a result, an insurer that takes in premiums, invests the proceeds, earn a return, and make payouts on perhaps 5% of all policies (health insurance being the one major exception). 1000 people have life insurance and yearly maybe 50 of those 1,000 will die and their beneficiaries will get benefits. There is very little variation in payouts yearly, but there are always claim payouts yearly by the insurance company.
With a CDS, the payout stream is completely different. The only time a payout happens is when someone defaults. You do not have a regular occurrence of payouts. So instead of year after year of paying out between 4 and 6% of all policies, you can go 10 or 15 years without making a single payout. Once you do have a default, then it becomes a cascade of further defaults. This is for a number of reasons. As opposed to insurance, the default of one increases measurably the probability of default by another. In other words the death of one increases the probability of the death of another. If the first death causes another death, then the second death increases at a greater rate the probability of further deaths, because the death of each has an impact on all firms, even those with no direct relationship. This leads to a cascade of defaults. So you can go from 10-15 years without a payout, to a cascade of defaults which take 100% of your capital in very short order.
So take for example Lehman. They sold thousands of Mortgage Backed Securities. They bought CDS's on their default, which increased the value of those securities, because the perceived risk was now less, because you had insurance against the default of Lehman. So literally thousands of CDS's were bought and sold, so that when Lehman defaulted, there were thousands that had to be paid on. This is roughly analogous to a person buying 500 life insurance policies on themselves. None by themselves is much of a hit, but 500 simultaneously is a big hit. So thousands of CDS had to be covered, and as soon as they had to be covered, then that immediately put at risk firms making those payouts, If that action caused any of them to fail, then the process cascaded upon itself.
That was AIG's mistake. They viewed a CDS in the same light as typical insurance which it is not.
Regulation would not have necessarily eliminated this probability, and Glass-Steagale did not outlaw insurance companies from buying unregulated CDS or any other type of financial derivative. Glass-Steagale did not outlaw what securities Commercial Banks, Investment Banks, Merchant Banks, Brokerages, or Insurance Companies could buy. It limited what they could originate and sell.
I am not anti-regulation. I believe that regulation has a place. Rules are necessary, and you have to create an environment where the playing field is the same for everyone. The problem with regulation is that it is assumed that it will protect you when often it won't. Regulation won't eliminate bad judgment. Regulation will often not be able to adapt to changing times. Glass-Steagale was written in the 1930's, and the entire financial marketplace has changed radically. As a result it often times is outdated, and not applicable to present circumstances. Regulation can often times make things worse. Regulation like risk models are designed to address normal functioning markets, but when you have a dysfunctional market, like we have been in recently, then regulations can exacerbate problems, or not address specific problems. Mark-to-market is the most obvious example in my mind. If Glass-Steagale had still been in place then our present market situation would have been worse by an exponential degree.
What is much more important is transparency, and a clear and functioning market. The lack of regulation of CDS didn't cause this problem. How would regulation have kept the rapid growth in credit default swaps from happening? It wouldn't have, because the fault was in bad judgment, not something suddenly now allowable, which previously not allowable under Glass-Steagale.
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I understand. Basically the judgement call to buy Credit Default Swaps could have been made with or without the regulations in place under Glass-Steagall. That's new information for me.
Eloquent explanation for how systemic risk is wildly different when you're talking CDS as opposed to regular insurance. Basically a self-propagating, self-accelerating process once the market destabilizes, and very plausible in retrospect. Large scale failures were happening before most knew what was happening.
My question becomes: economically, is their a tangible benefit to the public for the creation and market trade of some of these higher order financial instruments?
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Skander, ziggy did a great job of explaining CDS. There are a couple more points I would like to add.
The value assigned to the CDS's were several times the value of the underlying mortgages. In simple terms they basically sold the same $1 of mortgage payments several times over. This also contributed to the cascading effect once the first mortgage "dies".
The other piece of information that shows it was judgement (or lack thereof) is that Goldman Sach started unwinding their positions in these derivatives more than a year ago. Other banks/financial institutions chose to not get deeply involved in buying these products. Outside of AIG name another major insurance player (I think there is one in Europe - Fortis, I believe) that was sunk by this crisis?
As far as your question of whether these derivatives provided tangible benefit...that depends. If you rode the market upwards and were lucky/smart enough to take some of the profits off the table then you benefited. The other tangible benefit was the huge amount of easy credit that floated around the globe. People in the US...as well as most developed nations...have run up massive amounts of debt. The world's entire economy is built on there being an ever growing supply of credit. Consumption, fueled by easy debt, has been the engine driving the world's economy. When people stop spending...whether their choice or not...then companies stop making profits. Then those companies cut costs (layoff workers) which adds to the economic pressure because there are fewer "consumers". This is part of why I am strongly against any bailouts and/or stimulus checks from our government. It is just a way of collectively borrowing as opposed to individual borrowing...but it does encourage consumption. The best thing our government could do is reduce govt debt. This would then free up capital to be used by companies and individuals. Part of the lack of credit is because the "lenders" are all buying US Govt debt. If you had an extra million lying around would you lend it (buy commercial paper) to some company that could be hitting a downturn in their cycle? Or would you lend it to Uncle Sam (buy treasuries)?
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I understand. Basically the judgement call to buy Credit Default Swaps could have been made with or without the regulations in place under Glass-Steagall. That's new information for me.
Eloquent explanation for how systemic risk is wildly different when you're talking CDS as opposed to regular insurance. Basically a self-propagating, self-accelerating process once the market destabilizes, and very plausible in retrospect. Large scale failures were happening before most knew what was happening.
My question becomes: economically, is their a tangible benefit to the public for the creation and market trade of some of these higher order financial instruments?
Skander I haven't ignored you. Been very, very busy of late. I saw this thought I would post. Once again I am not against sensible regulation, but all regulation will have unintended consequences. How severe those unintended consequences are in difficult times can have significant reverberations.
Basically this article is pointing to the fact that with the Investment banks now Commercial bank holding companies, the hedge fund sector has lost its major funding source, which is causing massive de-leverage in the hedge fund industry, which is what is driving the markets around the world into the tank. Just to put into perspective as bad as the US markets are, they have outperformed Europe the last 12 months by 15% +/-, and Asia and the emerging markets by 25%-40%+/-. Now is the unwinding of the hedge fund sector a bad thing? It could be argued both ways, and I happen to think that the hedge fund sector and the shadow banking system are directly in the middle if the mess we have today, so I believe this correction is a needed thing. At the same time people around the globe are losing trillions, because a regulatory requirement is sucking funding out of markets. That could be considered a good thing, and I am not proposing that it is bad, but it is an unintended consequence.
Emerging Markets Capital Flight Exacerbated By Goldman and Morgan Stanley Becoming Banks
I somehow managed to fail to connect the dots on this one. When Morgan Stanley and Goldman, the far and away two biggest prime brokers (as in lenders to hedge funds) became banks, tougher regulatory requirements forced them to curtail hedge fund lending significantly.
To give you an idea of the concentration in this business, Morgan, Goldman, and number three (until late 2007) prime broker Bear Stearns had among them 70% market shares, with some sources saying as high as 75%. So with all three now regulated as banks, the reduction in credit availability, even absent adverse market conditions, margin calls, and redemptions, is considerable.
From Roger Peston at the BBC (hat tip reader Doc Holiday):
As for this most recent phase of the withdrawal of credit, which has caused financial crises for a series of emerging economies in eastern Europe, Asia and South America (see "Now there are runs on countries") and also global falls in share prices, it was in a way wholly foreseeable.
It was caused, to a large extent, by an exceptional and unprecedented shrinkage in the prime brokerage industry, which in turn led to a serious reduction in the volume of credit extended to hedge funds, which in turn forced hedge funds to sell assets, especially those perceived as higher risk.
This contraction in loans provide through prime brokers was the inevitable consequence of the collapse of Lehman, but also - far more importantly - of the recent conversion into banks of Morgan Stanley and Goldman Sachs.
Morgan Stanley and Goldman are - by far - the biggest prime brokers, with Morgan Stanley the number one.
But as banks, they're prevented by regulators from lending as much relative to their capital resources as they had been as securities firms.
So the US authorities should have known - and presumably did know - that by allowing Morgan Stanley and Goldman to become banks they were in effect forcing a serious contraction in the hedge-fund industry, which in turn would lead to sales of all manner of assets held by hedge funds and precipitate turmoil throughout the financial economy.
Which, as if you needed telling, only goes to show that regulatory intervention carried out with the best of intentions can have consequences that - in the short term at least - can be very painful.