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Dreams End With Collapse of Tinker Bell Market

Investors gather outside the New York Stock Exchange in October 1929 -- the last time the markets dragged down the U.S. economy, triggering the Great Depression. Is it possible that recent market failures will lead to a Great Recession?
Investors gather outside the New York Stock Exchange in October 1929 -- the last time the markets dragged down the U.S. economy, triggering the Great Depression. Is it possible that recent market failures will lead to a Great Recession? (Associated Press)

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By Allan Sloan
Tuesday, April 1, 2008

What in the world is going on here? Why is Washington spending billions to bail out Wall Street titans while leaving struggling homeowners to fend for themselves? Why are the Federal Reserve and the Treasury acting as if they're afraid the world may come to an end, while the stock market seems much less concerned? And finally, what does all this mean to those of us who aren't financial professionals?

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Yesterday, Treasury Secretary Hank Paulson officially unveiled his new regulatory proposals; however, those have no bearing on today's problems. So, take a few breaths, pour yourself a beverage of your choice, and I'll tell you what's happening -- and what I think is going to happen. Although I expect our current mess will resolve itself without a catastrophic meltdown, I'll also tell you why I'm more nervous about the world financial system now than I've ever been in my 40 years of covering business and markets. Finally, I'll tell you why I fear that the Wall Street enablers of the biggest financial mess of my lifetime will escape with relatively light damage, leaving the rest of us, and our children and grandchildren, to pay for their misdeeds.

We're suffering the aftereffects of the collapse of a Tinker Bell financial market, one that depended heavily on borrowed money that has now vanished like pixie dust. Like Tink, the famous fairy from Peter Pan, this market could exist only as long as everyone agreed to believe in it. So because it was convenient -- and oh, so profitable! -- players embraced fantasies like U.S. house prices never falling and cheap short-term money always being available. They created, bought, and sold, for huge profits, securities that almost no one understood. And they goosed their returns by borrowing vast amounts of money.

The fantasies began to fade last June when Bear Stearns let two of its hedge funds collapse because of problems with mortgage-backed securities. Debt markets, here and abroad, went sour big-time. That, in turn, became a huge drag on the U.S. economy, bringing on the current economic slowdown.

Whether we're in a recession is academic. What matters is that we're in a dangerous and messy situation that has produced an economic slowdown unlike those we're used to seeing.

How is this slowdown different from other slowdowns? Normally the economy goes bad first, creating financial problems. In this slowdown the markets are dragging down the economy -- a crucial distinction, because markets are harder to fix than the economy.

The last time this happened was in 1929. And it touched off the Great Depression. The precedent is unsettling, to say the least. You can only imagine how unsettling it is to Federal Reserve Chairman Ben Bernanke, a former economics professor who made his academic bones writing about the Great Depression.

Academics now feel that the 1929 slowdown morphed into a Great Depression in large part because the Fed tightened credit rather than loosening it. With that precedent in mind, you can see why Bernanke's Fed is cutting rates rapidly and throwing everything but the kitchen sink at today's problems. (Bernanke will probably throw that in too, if the Fed's plumbers can unbolt it.)

So why hasn't the cure worked? The problem is that vital markets that most people never see -- the constant borrowing and lending and trading among huge institutions -- have been paralyzed by losses, fear and uncertainty. And you can't get rid of losses, fear and uncertainty by cutting rates. Giant institutions are, to use the technical term, scared to death. They've had to come back time after time and report additional losses on their securities holdings after telling the market that they had cleaned everything up. It's whack-a-mole finance -- the problems keep appearing in unexpected places. We've had problems with mortgage-backed securities, collateralized debt obligations, collateralized loan obligations, financial insurers, structured investment vehicles, asset-backed commercial paper, auction rate securities, liquidity puts.

To paraphrase what a top Fednik told me in a moment of candor last fall: You realize that you don't know what's in your own portfolio, so how can you know what's in the portfolio of people who want to borrow from you? Combine that with the fact that big firms are short of capital because of their losses (some of which have to do with accounting rules I won't inflict on you today) and that they're afraid of not being able to borrow enough short-term money to fund their obligations, and you can see why credit has dried up.

The fear -- a justifiable one -- is that if one big financial firm fails, it will lead to cascading failures throughout the world. Big firms are so linked with one another and with other market players that the failure of one large counterparty, as they're called, can drag down counterparties all over the globe. If the counterparties fail, it could drag down the counterparties' counterparties, and so on. Meltdown City. In 1998, the Fed orchestrated a bailout of the Long-Term Capital Management hedge fund because it had $1.25 trillion in transactions with other institutions. These days that's almost small beer.

Add to that the Wall Street ethos: If you take big, even reckless, bets and win, you have a great year and you get a great bonus -- or in the case of hedge funds, 20 percent of the profits. If you lose money the following year, you lose your investors' money rather than your own, and you don't have to give back last year's bonus. Heads, you win; tails, you lose someone else's money.


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