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Hello, Alternative Universe

Junk and chumps, pump and dump, barbarians and brokers, smoke and mirrors and other assets of our risk-positive fiscal mess



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

There is no glory on Wall Street. There is only greed. There are no good guys or bad guys. There are only winners and losers. In fact, there are only guys like Steve Schwarzman and Pete Peterson.

In 1984, Schwarzman and Peterson got crushed like a couple of grapes under the very chubby feet of a guy named Lew Glucksman. (Everything about Lew was chubby, not just his feet.) This happened at a place called Lehman Brothers, at that time a venerable Wall Street partnership. It was a classic power struggle, but no biggie in the whole scheme of things.

Schwarzman and Peterson bounced back quickly. In 1985, they started a new firm with a shared secretary and $400,000. Their new company was called the Blackstone Group, and it is the stuff of legend to say that fortune smiled on them. Schwarzman and Peterson are now two of the richest men in the world. Since 1985, they've done over $400 billion in deals. They are arguably the leading global alternative-asset managers in the world. What's more, they invented an entirely new financial world while they did it.

Problem is, we have to live in it.

Problem Swallowing

Problem is, there are lots of problems on Wall Street. For starters, we've seen the consolidation of power and the concentration of both capital and revenue in fewer and fewer hands. The few institutions left on Wall Street—and there about 10—are now like superstores or warehouses. And the story of how they came to dominate Wall Street is very much like the story of how Costco or Sam's Club came to push mom and pop retailers off the map.

I would know. I started my career at Alex Brown & Sons, the oldest investment bank in the country, established in 1800. A guy named A. B. "Buzzy" Krongard hired me. (Buzzy later turned out to be the No. 3 guy in the CIA.) Alas, in the decade of the 1990s, the proud people at Alex Brown got swallowed up by Bankers Trust, which in turn got swallowed up by Deutsche Bank. I also worked for Colonial Management Associates, which got swallowed up by Columbia Management Group, which got swallowed up by FleetBoston, which got swallowed up by Bank of America.

I worked on the floor of the NYSE for Spear, Leeds & Kellogg, which was swallowed up by Goldman Sachs. I worked for Dean Witter, which got swallowed up by Morgan Stanley. None of the firms I worked for were small companies, what we on Wall Street quaintly call "boutiques." I worked for big companies. Yet they've all been swallowed. All of them.

Now, the 10 or so institutions that dominate Wall Street are monopolies. We've also seen the reinvention of these very same companies on Wall Street. There is now no difference between a commercial bank and an investment bank, no difference between a lender and an adviser. There is now only the monolithic Merrill Lynch or the monolithic Citigroup. Capital is concentrated in these few firms. Naturally, so are revenues. But risk, too, is concentrated. This is a big problem. Because if every deal has got to be bigger and bigger to earn fatter and fatter rewards, then these few institutions must assume greater and greater risk. And risk management is what making money is all about.

Prime Junk Chumps

The Glass-Steagall Act, enacted during the Great Depression to prevent another stock market crash by separating commercial banking from investment banking, was repealed in 1999. In today's lineup of traders, deal makers, underwriters, lenders, advisers, market makers, portfolio managers, brokers and others, it is impossible to point to the chief suspect in the defrauding of America that is now being commonly called the "subprime crisis."

The traditional institutions of commercial banks and investment banks have given way to a new set called hedge funds, private equity funds, and other alternative asset managers. Emphasis on "alternative." Schwarzman and Peterson saw the trend; this was their genius. But there is little to no regulation of alternative-asset managers.

Which brings us to the next problem: There is little to no regulation of the alternative assets that these alternative-asset managers dream up and manage.

A lot of this stuff is debt—debt that is diced, spliced, altered, reheated, topped off with nuts, whipped cream and a cherry and then packaged and repackaged to the American investor. This debt is sold not directly to the little guy, the retail investor—you and me—but to the institutional investor who is presumably acting on our behalf through pension funds, insurance companies, mutual funds, endowments and others.

In the parlance of Wall Street, this debt is "securitized." Call this debt by any name, but don't call it secure. The popular names for this debt are collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs), first widely heard last summer when the subprime market was blowing up. These CMOs and CDOs are spread across the spectrum of risk. Some are senior debt. Some are subordinated debt. Some are OK. The rest are junk. Junk as in subprime junk.

Guess who owns that debt now? You do. Through your pension plans, insurance policies, mutual funds, university and hospital endowments—you do, we do, I do.

And ever since the Federal Reserve Bank bailed out Bear Stearns, you now also own this debt as an American taxpayer. Yeah, chump, you. The losses—er, liabilities—were shifted to you.

There's more. The Fed now lends money—our taxpayer money—to all of Wall Street. The Fed lends not just to its member banks, like before the subprime mess, but it now also lends to all those reckless broker dealers out there, firms like Bear Stearns. The Fed lends your money to them through something that is called the "discount window."

And, man, is that money discounted! The Fed is giving it away. As of this writing, borrowing from the discount window hit something like $36.2 billion a day. A day.

Impossible Things

In Alice in Wonderland, the Queen says, "I believe in as many as six impossible things before breakfast."

Within the last decade, a thousand impossible things are dreamed up before dawn. Not only is there the packaging of new forms of debt, but the minting of new forms of money. Literally, new forms of money: they're called swaps and derivatives.

Swaps and derivatives trade like stocks and bonds, but most of them aren't registered securities like stocks or bonds. But swaps and derivatives aren't exactly Monopoly money, either. What are they? Ridiculously complex and esoteric. For the last decade, risk managers on Wall Street pulled their hair out, lost sleep and finally gave up trying to quantify the risk inherent in them. Yeah, they've given up. When it came to swaps and derivatives, even auditors couldn't find their ass with both hands.

And yet trillions of dollars in swaps and derivatives trade every single day in markets that didn't even exist a decade ago. For the most part, the biggest volume of swaps and derivatives don't even trade in a physical marketplace like the exchanges in New York or Chicago. The transactions are opaque because they are largely undertaken by private parties in electronic markets, most of them offshore.

Swaps and derivatives trade in a virtual market, a shadow market. A market that in the United States alone is estimated to be a $45.5 trillion market.

Here's the perspective: The size of the worldwide bond market is estimated at $45 trillion. The size of the worldwide stock market is estimated at $51 trillion. And the size of the worldwide swaps and derivatives market is estimated at $480 trillion in nominal or "face" value. That's 30 times the size of the entire U.S. economy and 12 times the size of the entire world economy.

Brokers & Barbarians

How is this possible? Advanced technologies make this market possible. Welcome to money's alternative universe. Alternative trading systems. Electronic communications networks. Central banks. Private banks. Brass plate banks. Russian Mafia banks in Cyprus. The Vatican's bank in the Cayman Islands. The Bush and bin Laden families holding hands and tip-toeing through the tulips in financial cyberspace. Digital barrels of oil in virtual supertankers in the Persian Gulf. Digital ounces of gold in virtual vaults in Switzerland. Digital bushels of corn in virtual silos in Iowa. Eurex. Euronext. The World Federation of Exchanges. A transnational community of anonymous traders who have never met and never will.

Merrill Lynch trading swaps and derivatives with Iran. Mullahs on the mainframe. Citigroup trading swaps and derivatives with Venezuela. Chavez on the craps table. UBS trading swaps and derivatives with almost anyone out there in the ethers—Christ, the anti-Christ—it doesn't matter to UBS. What matters is that traders keep liquidity coming out the yin-yang.

We've seen the emergence of a new master race on Wall Street who work hand in hand with the traders. They created this market of swaps and derivatives, and help traders manipulate this market through their own brand of highly sophisticated pump-and-dump schemes and do their damned best to keep this market secret and off the books. These are the prime brokers.

Not in keeping with their other brethren on Wall Street, either short-term traders or long-term bankers, prime brokers are the new barbarians at the gate. They augment the activities of the hedge-fund guys and private-equity guys—and then take the game to a whole other level.

Believe me when I say their interests are not aligned with your interests.

At press time, oil nears a record $117 a barrel. The dollar continues to fall. Our credit woes continue to worsen. The United States is deep in debt and still digging. We're all paying for the nation's debt addiction through both direct and indirect taxes. Our leaders, such as they are, are tracking the storm of inflation and the threat of the most serious recession since the Great Depression. Still think this doesn't have anything to do with you?

Steve Schwarzman and Pete Peterson are betting on it.

Next: Where has that Black Swan been hiding?

John Sakowicz is a Sonoma County investor who was a cofounder of a multibillion-dollar offshore hedge fund, Battle Mountain Research Group. He was assisted in research by Arianna Carisella.

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