April 1 and the Absurdity of the Financial System

Happy April Fool's Day!

Brian Richards
Brian Richards
Apr 1, 2010 at 12:00AM
Other

Effective March 31, 2010, the Federal Reserve ceased its $1.25 trillion program of buying mortgage-backed securities, something it had begun doing soon after the financial crisis hit in late 2008.

While that much is fact, everything else about our announcement yesterday was fiction. Happy April Fool's Day!

HAFD
Sorry to disappoint the (incredibly high volume of) Fools who believed that we were indeed opening Long-Term Mortgage Management (our homage to failed hedge fund Long-Term Capital Management) to pick up where the Fed left off. We are not, in fact, buying mortgage-backed securities, and so you cannot join in the fun with us. And that napkin-signed commitment from Uncle Sam? It's … a forgery.

We hope you enjoyed this year's joke, and we hope some of its wackiness highlights important lessons for investors. Let's focus on three in particular:

1. Don't buy what you can't afford.
In its program, the Federal Reserve bought $1.25 trillion in mortgage-backed securities. Long-Term Mortgage Management wanted to operate on the same scale, so we planned on getting clever:

Here's how we got to $1 trillion. First, we're raising $1 billion from investors in LTMM. … Next, we borrowed $10 billion by leveraging this collateral 10-to-1. Learning a thing or two from Lehman Brothers, we then "un-factualized" this debt with repo 105 loans, which made us appear debt-free with that $10 billion still in the bank. From there it was just rinse and repeat, leveraging our $10 billion into $100 billion, and then $100 billion into $500 billion. The other $500 billion was borrowed from the Federal Reserve. Basic financial engineering.

It's no wonder late in the day we faux-announced that a single glitch on an options bet in Asia bankrupted the entire operation. Leverage is a dangerous game. It's just as dangerous for Joe Investor dabbling on margin as it is for investment operations dealing with billions of dollars. Margin could lead to financial ruin, which is why almost all retail investors should stay away from it.

2. Don't buy what you can't understand.
We flat-out acknowledged that this venture was uncharted territory for the Fool. The LTMM site said, simply: "The way Long-Term Mortgage Management works is not fully understood."

Nonetheless: "Together, we can raise a fortune, buy buckets of cheap mortgages, and split the inevitable profits. … Admittedly, this is pretty new to us. But we're already hiring quants like Thornton Anders (center, blue, with goggles)."

Michael Lewis recently argued that the financial crisis was less about corruption than about stupidity -- and, as he pointed out, Wall Street is supposed to be the Smart Money. The pros just didn't sufficiently understand the risk.

This is a strikingly clear message: Don't buy what you can't understand, the corollary of which is: beware that which sounds too good to be true. If it is and you don't understand it well enough to know why, you'll be holding the bag. Our hijinks were in full effect in the Q&A:

Q: Is this too good to be true?
A: This is a once-in-a-lifetime opportunity.

What bankrupted Long-Term Mortgage Management was an eight-sigma event (odds: 1 in 819 trillion) that started with what a trader thought to be a routine butterfly spread options strategy on sugar futures. But this was no routine butterfly spread options contract. Good thing the feds promised to back us fully …

3. Don't buy the status quo.
As we were constructing this year's joke, we cooked up a ton of ways to parody "too big to fail" -- and realized that it's almost too absurd to parody. But we did it anyway: "At the extreme, if we blow the whole damn thing, they'll bail us all out." That's basically the same get-out-of-jail free card given to AIG and Citigroup in the fall of 2008.

You'd think that bailing out billion-dollar firms would be politically risky, but little has been done to prevent such a systemic risk. The financial reform proposal moving through Congress doesn't go far enough toward fixing the problem. The proposed legislation relies on so-called resolution authority, which allows regulators to seize and wind down a failing firm. This sounds great in theory, but it's basically what we did with AIG, Fannie Mae, and Freddie Mac -- disasters that cost taxpayers hundreds of billions of dollars.

As former IMF chief economist Simon Johnson wrote in his blog:

Unfortunately, on the major issue -- too big to fail financial institutions that caused the 2008-09 crisis and that will likely trigger the next meltdown -- [Senator Dodd's financial reform bill has] nothing meaningful in the proposed legislation. The lobbyists did their job a long time ago. 

This is unacceptable. Today's megabanks aren't just too big to fail -- they're also too big to regulate and way too big to clean up in the middle of a crisis. While resolution authority is necessary, we also need to limit the size of our banks to levels far below where they stand today and (as the Senate legislation thankfully specifies) forbid FDIC-insured commercial banks from engaging in risky activities like proprietary trading.

Last November, my colleagues Morgan Housel and Ilan Moscovitz wrote a fantastic plea for ending "too big to fail." They closed by promising to email their article to all 535 members of Congress, as well as to the major banks and their trade associations.

They sent approximately 300 separate emails (some congressional leaders don't make public their address) -- and did not receive a single reply.

This, too, is unacceptable. So at the risk of exemplifying the popular definition of insanity, we're going to try it again -- we'll be sending this article to as many of the 535 members of Congress as email allows.

But this time, we need your support. If you agree with our stance that "too big to fail" needs to end and that any meaningful financial reform needs to make our banks smaller and safer, then click the "Recommend" button at the top of this article and then post a simple "Too big to fail needs to end" comment below. (And if you disagree, please challenge our views by posting a comment.)

Whether you bought the joke or saw it coming, we hope you enjoyed it and had a safe, happy, and Foolish April 1.

Brian Richards would like to give a big thanks to all the Fools who made this year's joke happen. Brian does not own shares of any companies mentioned. The Motley Fool has a disclosure policy.