FFIRS.indd viFFIRS.indd vi 2/2/11 7:27:02 AM2/2/11 7:27:02 AM FINANCIAL ORIGAMI FFIRS.indd iFFIRS.indd i 2/2/11 7:27:01 AM2/2/11 7:27:01 AM Since 1996, Bloomberg Press has published books for fi nancial professionals, as well as books of general interest in investing, economics, current affairs, and policy affecting investors and business people. Titles are written by well- known practitioners, BLOOMBERG NEWS ® reporters and columnists, and other leading authorities and journalists. Bloomberg Press books have been translated into more than 20 languages. For a list of available titles, please visit our Web site at www.wiley.com/ go/bloombergpress. FFIRS.indd iiFFIRS.indd ii 2/2/11 7:27:01 AM2/2/11 7:27:01 AM How the Wall Street Model Broke Brendan Moynihan FINANCIAL ORIGAMI FFIRS.indd iiiFFIRS.indd iii 2/2/11 7:27:01 AM2/2/11 7:27:01 AM Copyright © 2011 by Brendan Moynihan. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifi cally disclaim any implied warranties of merchantability or fi tness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profi t or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data Moynihan, Brendan, author. Financial Origami : How the Wall Street Model Broke / Brendan Moynihan. p. cm Includes index. ISBN 978-1-118-00181-3; ISBN 978-1-118-03030-1 (ebk); ISBN 978-1-118-03031-8 (ebk); ISBN 978-1-118-03032-5 (ebk) 1. Financial engineering. 2. Financial risk. 3. Securities industry —United States. 4. Global Financial Crisis, 2008 –2009. I. Title. HG176.7.M69 2011 332.601— dc22 2010049551 Printed in the United States of America 10 9 8 7 6 5 4 3 2 1 FFIRS.indd ivFFIRS.indd iv 2/2/11 7:27:02 AM2/2/11 7:27:02 AM To Kristiana, John, and Matthew FFIRS.indd vFFIRS.indd v 2/2/11 7:27:02 AM2/2/11 7:27:02 AM FFIRS.indd viFFIRS.indd vi 2/2/11 7:27:02 AM2/2/11 7:27:02 AM vii Author’s Note xi Introduction xiii Chapter 1 Fold Sides to Center 1 Commercial Banks 5 Savings and Loans 9 Securities Firms 10 Transferring Risk 12 End of an Era 14 Chapter 2 Result, Turn Over 17 The Three Derivatives 22 Options 23 Futures 24 Swaps 25 Chapter 3 Fold Sides to Center, Again 29 Changing the Rules 33 A New Environment 36 Contents TOC.indd viiTOC.indd vii 2/1/11 7:00:10 AM2/1/11 7:00:10 AM viii Investing in Mortgages 39 Banker Incentives 42 Chapter 4 Fold Tip to Point 45 Other People’s Money: Equity 50 Agents Transferring Risk Become Principals Taking It 53 Chapter 5 Fold Point Back 59 Rules, Refold, Rave, Ruin 64 A New Environment 66 A New Risk 68 Chapter 6 Fold in Half 75 Mortgage Origami 78 Subprime Origami 81 The Rating Game 82 Banker Incentives 86 Manufactured Product 89 Chapter 7 Pull Neck Upright 91 Low Volatility, Low Risk 96 The CDS Market Develops 98 More Insurance Than Needed 101 Opaque Markets 103 Other People’s Money: Debt 106 Chapter 8 Pull Head to Suitable Angle 109 Vindicating Greenspan 115 How, Not Will, You Pay? 117 Broken Markets 119 Chapter 9 Complete 125 What’s Wrong with Wall Street? 130 Government-Sponsored Enterprises 131 Government-Sanctioned Credit-Rating Agencies 137 Banks 139 What’s Right with Wall Street? 141 CONTENTS TOC.indd viiiTOC.indd viii 2/1/11 7:00:10 AM2/1/11 7:00:10 AM [...]... especially since the federal government six months earlier had arranged for the ailing investment bank Bear Stearns & Co to be purchased by a commercial bank, JPMorgan Chase? How could the largest money fund in the world break the buck? How could the Wall Street business model break? If Wall Street is broken, can’t we just go back to a time when it was fixed? Flash back to the days just before the Reserve... incentives in place at the time The month before Greenspan’s testimony on the subprime crisis of 2007–2008, Lehman Brothers Holdings Inc filed the largest bankruptcy in U.S history, six times the size of the previous record-holder, Worldcom Inc., and ten times bigger than then second biggest, Enron Corp Lehman’s bankruptcy ended an era on Wall Street, one that stretched back more than the two or five or ten... years most have occupied themselves with when examining the financial crisis of 2007–2009 Identifying the right time frame is critical to understanding what happened on Wall Street and how we arrived at the financial crisis Arbitrary designations will not do Wall Street has odd notions about time Measuring “year-to-date returns” is an arbitrary convention, and so is lumping together decades as though 10... the only major currency in the world on the gold standard, just as the California Gold Rush dumped increased supply onto the market Lehman Brothers formed in the same year, as a cotton merchant in Montgomery, Alabama Its collapse 158 years later would trigger the biggest financial and economic crisis in the United States since at least the original Great Depression, the one in 1873 It would not be the. .. Although the products look and sound complex, there is nothing new under Wall Street s sun Grasping the origami involved in folding the same old pieces of paper will make understanding Wall Street and what happened in 2007–2009 easier than you think, and it will offer some insights on how to fix some of its problems xiii FLAST.indd xiii 2/1/11 6:59:45 AM INTRODUCTION Wall Street firms performed Financial. .. Tracing a deposit through these types of institutions helps reveal the flaws and conflicts of interest that developed over the past several decades, eventually breaking the Wall Street business model Commercial Banks In 1971 median household income in the United States was about $10,000, which gave the typical family about $400 in savings at the end of the year.3 Depositing the $400 into a savings account... borrowers together and shifting the risk of holding cash to others who did not have enough for their purposes As required by law, before lending any of the deposits, the bank set aside 10 percent into a special account just in case the depositors wanted to make a withdrawal or write a check If the bank had lent out all the funds, depositors would not have access to even a portion of their money The set-aside... As if I had the money back in a safe The, the money’s not here Well, your money’s in Joe’s house that’s right next to yours And in the Kennedy house, and Mrs Macklin’s house, and, and a hundred others Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can Now what are you going to do? Foreclose on them? I got two hundred and forty-two dollars... from their accounts The FDIC protected deposits at banks, and Congress wanted some protection for investors’ money at securities firms This is not a guarantee on the securities themselves, only the content of the accounts at the firms But it is an insurance fund, not a federal government agency End of an Era Harry Brown, the co-creator of the world’s first money-market mutual fund, which opened to the. .. than just the products it has offered over the years For decades through the 1960s, the firms had for the most part carried out distinct functions within the securities industry Some specialized in advising and underwriting, others in sales, and still others in trading Gradually, though, at punctuated points in time when the overall regulatory environment was changing, they began to refold the separate . Cataloging-in-Publication Data Moynihan, Brendan, author. Financial Origami : How the Wall Street Model Broke / Brendan Moynihan. p. cm Includes index. ISBN 97 8-1 -1 1 8-0 018 1-3 ; ISBN 97 8-1 -1 1 8-0 303 0-1 . 97 8-1 -1 1 8-0 303 0-1 (ebk); ISBN 97 8-1 -1 1 8-0 303 1-8 (ebk); ISBN 97 8-1 -1 1 8-0 303 2-5 (ebk) 1. Financial engineering. 2. Financial risk. 3. Securities industry —United States. 4. Global Financial Crisis, 2008. years and broke Wall Street over the past three. It examines the evolution of Wall Street, shows the logical sequence of events that brought us to this point, and presents some ideas for how to