March 13, 2009


A Simple Guide to the Banking Crisis (Michael Mandel, March 12, Business Week: Economics Unbound)

Proposition 2: Foreign investors preferred to put their money into investments that were perceived as having low risk.

Here’s the story. Suppose you are investing in a different part of the world. You are likely a bit skittish about putting your money so far from home, so you are likely to choose relatively safe investments.

In the same way, foreign investors in the U.S. flocked to investments which offered decent returns and high (perceived) safety. This demand for safety showed up in the Fed statistics. Between 1998 and 2007, foreign investors poured roughly $10 trillion into acquiring financial assets in this country. Out of that total, only about $3 trillion went into supposedly-risky equities, mutual funds, and direct investment in U.S. businesses. The rest went into perceived less-risky investments, such as Treasuries and mortgage-backed securities (after all, housing never goes down!).

But there’s more. Wall Street catered to this foreign demand for safety. Many hedge funds, for example, promised “positive absolute returns”, meaning that they would do well even in down markets (see here). That’s one important reason why hedge funds boomed in this decade—they promised safety to foreign money, which were willing to pay big fees to get it. Many hedge funds were pitched directly to foreign investors. When John Paulson testified before Congress in November, he said that 80% of his $36 billion in assets came from foreign investors.

And when there wasn’t enough “safe assets” to sell to willing foreigners, the intrepid investment bankers created more. Consider, for example, credit default swaps, which pay off if a bond defaults—in effect, insurance on debt. Wall Street saw this as a ‘two-fer.’ They would sell corporate bonds to foreign investors, and at the same time collect fees on credit default swaps on the bonds in order to reassure those apparently too-nervous investors from another part of the world.

But the joke in the end was on Wall Street. The foreign investors bought the bonds, but they also bought the protection—which much to everyone’s surprise was needed. And the U.S. banks and investment banks were left with piles of ‘toxic assets’—the obligation to pay off all sorts of bonds and derivatives.

As much as the Right would like to blame Washington and Main Street, the fault lies on Wall Street.

Posted by Orrin Judd at March 13, 2009 7:03 AM
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