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Shadow Economy 

How prime brokers paved the way for the biggest bank heist in history


This is the third of a multipart series on the state of the economy and how we got here.

 Wall Street is dangerously similar to German New Wave movies. Movies by Werner Herzog, Rainer Werner Fassbinder, Margarethe von Trotta, Volker Schlöndorff, Wim Wenders--you know the genre. Their movies are difficult and dense. Mostly, they are horrid. I hate these movies, but have never forgotten one.

I make the comparison because Wall Street, like German New Wave cinema, has always featured heroes with impossible dreams or people with unique talents in obscure fields. And like German New Wave, the obsessiveness of Wall Street's main characters has also always taken the place of plot. The plan of Wall Street's hot shots has always been that there is no plan. People are on their own. God is absent. Truth is elastic. The important thing is to keep on pushing.

In the lives of these characters, whether from German New Wave or Wall Street, a lot is improvised. For both groups, life is lived in the theater of the ridiculous. In the Wall Street version, that materializes in statements such as "I am ridiculously rich" or "I am ridiculously lucky." It's generally the opposite for characters in German New Wave.

In German New Wave movies, chickens often stand in for people. It's too painful to watch a German New Wave movie without a little existential comic relief every now and then, and the directors know it. There are long shots of chickens on the beach, buried up to their necks in sand, as the tide comes in. Shots of dancing chickens. Hypnotized chickens. Cannibalistic chickens. Dwarves throwing chickens. Chickens talking to themselves. Chickens jumping off of cliffs.

Lately, the chickens have come home to roost on Wall Street. And like German New Wave cinema, the stories coming out of Wall Street this year are touched by the ridiculous, but more fundamentally Wagnerian in scope, influenced by operatic themes. Themes like character, ambition, greed, scandal, disgrace, bankruptcy, ignominy, shame and even justice.

Yes, justice.

Bear Stearns Bust

On Thursday, June 19, the FBI made its first big bust since last summer's subprime mess, the first big bust since the housing and credit crises that followed the subprime mess pushed our country into a recession.

Hooray for the FBI. They busted hundreds of housing developers, mortgage lenders and brokers, lawyers, real estate agents and appraisers across the country, while two hedge fund managers on Wall Street were arrested in a separate but related case. (Incidentally, those two guys were referred to, but not named, in our May 28 article, "Secrets and Lies," about Bear Stearns.)

FBI director Robert Mueller was quick to congratulate himself. "This dragnet operation is an example of our unified commitment to address a significant crime problem," he told reporters. "The FBI will continue to direct its investigative and analytic resources toward the mortgage fraud and corporate securities fraud that threaten our nation's economy."

Nice start, Bob.

The fact that the investigation is ongoing underscores that the problems on Wall Street are not isolated to even a few hundred bad apples.

"These arrests make it clear that the causes of our credit problems are very broad-based and can't be put at the feet of any one player," Mark Zandi of Moody's said at the same press conference. "It makes it clear that everyone was involved to one degree or another--from lender to investment banker to hedge fund manager--all the way from the bottom to the top."

You forgot to mention someone, Mr. Zandi. You too, director Mueller.

Prime brokers. The new masters of the universe.

Among all their colleagues on Wall Street, it is the prime brokers who dream the most impossible dreams and who have the most unique talents in the most obscure fields.

If Werner Herzog were to make a movie about Wall Street today, he would be looking into the face of the prime broker. I'm reading from a possible movie review: "The face of the prime broker has the quality of a dream--at once vivid, but vague; easy to touch, but beyond reach; at once scary like science fiction and ethereally lovely like a fantasy. It is a beautiful face, reflected in the eerie blue of a computer screen, but in the end, it is the last face you will see before the market crashes."

So who are they, these prime brokers? These guys who print the new money in the shadow banking system? These guys who live for all that is unregulated and opaque?

First of all, they are not regular people.

"They are professional madmen," said Warren Buffet in his famous 2005 speech to shareholders at Berkshire Hathaway.

Except for Warren Buffet, nobody spoke up. Since Buffet's speech, billions and billions of dollars, perhaps a trillion, were stashed in offshore accounts, as Wall Street managed its own fortune. (It's a myth that Wall Street manages the fortunes of its clients. It does not. It serves itself the cake. We're lucky if a few crumbs fall off the plate.)

Let's now break this silence, and with it the omerta of prime brokerage.

'Unspoken Terror'

It all started innocently enough, generically enough.

In the beginning, through the 1980s and '90s, prime brokers were the guys at big investment banks like UBS, Morgan Stanley, Merrill Lynch, Goldman Sachs, Bear Stearns, Lehman Brothers, etc., who supported the nascent hedge fund industry with basic services.

A hedge fund start-up--and there were thousands of them back in the '80s and '90s, as many as 8,000 at one time--usually bought a basic package from a prime broker. The core services in the package included global custody (clearing, custody and asset servicing; no problem, all plain vanilla); securities lending (especially for what's called "naked short sales," which is illegal); financing (facilitating the crazy extreme leverage at hedge funds, sometimes as high as 40-to-1); customized technology (providing hedge funds with reporting necessary to value positions and risk; this is where things started to get funky); and operational support (prime brokers became the hedge fund's primary operations contact with all other members of the broker-dealer community, and oh, did this invite abuse).

It is easy to see how young hedge funds became so dependent on prime brokers. Prime brokers served as incubators for hedge fund hatchlings that were proliferating like so many baby chicks at a Tyson chicken farm.

In addition to all the above services, prime brokers also provided what is quaintly called "value-added" services in the hedge fund industry, including capital introduction (introductions to the prime broker's institutional clients and other possible investors, a blatant conflict of interest but nobody in Congress cared); office space leasing and services (read: free or discounted office space, replete with staff and support--a bribe for business? you bet); risk management advisory services (prime brokers advising hedge funds on the very same junk bonds they secretly wanted to dump on them); and something ambiguously called "consulting services" (often focused on how hedge funds could circumvent established regulatory requirements, usually by domiciling operations beyond the jurisdiction of U.S. law).

It got worse after 2000.

Introduce swaps and derivatives into the mix. Yeah, baby. Things suddenly got really interesting. Preserving the integrity of the balance sheet at hedge funds got thrown out the window as swaps and derivatives grew, including the exponential growth of something called "synthetic positions."

"Synthetic" means fake, bogus, fixed, fraudulent. It's that simple. Add to synthetic positions the liquidity of the first years of our decade as Alan Greenspan brought interest rates down to almost nothing, and you get the picture. In one year alone, from 2005 to 2006, the market for credit default swaps, just one product, grew from $12.4 trillion to $26 trillion.

Most markets are a zero-sum game, meaning there are an equal number of winners and losers. For every dollar someone makes, someone else loses a dollar. Prime brokers changed all that. Because prime brokers never lost.

Prime brokers acting as the hedge fund industry's only interface with the world (see "operational support," above) were able to create a shadow banking system where the counterparties to any hedge fund's trades were unknown, even to the hedge fund. Add to that opaqueness a lack of infrastructure where a lot of trades are unconfirmed or delayed, and there are the makings for greatest bank heist in history.

While the Federal Reserve Bank has since 1996 published reports on these obvious problems, it wasn't until September 2005 that the Fed addressed what was termed the "unspoken terror" of settlement issues among prime brokers.

Funny that it took two more years before Congress noticed. All it took to get their attention were last summer's subprime mess, the blow-up at Bear Stearns and a country plunged into a recession.

Shadow Masters

Dreamers and those with unique talents in obscure fields are the folks who built the shadow banking system. They are the prime brokers.

Like actors in a Werner Herzog movie, they inhabit a strange new world, one as big as the traditional banking system or bigger, but where there are no federally insured deposits and where shadow banks neither have nor want--or even need--access to short-term borrowing from the Fed or any other central bank during times of crisis. It's a world where no risk is too great, where collateral isn't necessary, where there are no capital requirements and where counterparties are never identified. Shadow banks are beyond the reach of law, are almost always found offshore and redefine the term "international crime organization." Indeed, because shadow banks always make money, they would even profit from the collapse of the global financial system. They might even cause it to happen.

Prime brokers have been the new masters, no question about it. But their primacy may finally be threatened.

"This bright new financial system--for all its talented participants, for all its rich rewards--has failed the test of the market place," said Paul Volker, former president of the Federal Reserve, during a speech I attended in April. "It adds up to a clarion call for reform."

Two months later, at a press conference where I was also present, Timothy Geithner, president of the Federal Reserve Bank of New York, answered that call.

"The structure of the financial system changed radically during the boom, with dramatic growth outside the traditional banking system," Geithner warned in his speech, adding that unregulated growth in opaque assets made the last crisis difficult to manage and could make a future crisis impossible to manage.

And two weeks before the FBI busted those two guys at Bear Stearns, U.S. Treasury Secretary Henry Paulson said the Federal Reserve should "be allowed to collect information from large complex financial institutions." He said, "Regulators should have a clear path toward figuring out how to intervene in a crisis and how to close a failed brokerage firm."

Sounds like Paulson is expecting more trouble. If this were a New Wave German film instead of the banal horror of real life, someone would figure out that it must be time to pull out the chickens.

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