Taking Stock / Where Are the Fat-cat Investment Bankers Today? Hoisted by Their Own Petard

Where to begin? How can you sum up a week like this one?

Should we start with Lehman Brothers, a bank founded in 1850 that until a year ago had traded at a market value of $50 billion, and which nobody would touch with a barge pole this week?

Or should we recap the story of AIG, American International Group, the biggest insurance company in the world, which a year ago had been worth almost $200 billion? This week it begged for a lifeline from the Fed or anyone else willing to lend it money.

Perhaps we should begin with a theoretical discussion on the eclipse that darkened the sun of American capitalism. Or maybe we should use a financial metaphor and say that the terror attack by sophisticated financial instruments will cause America more harm than the strike that flattened the Twin Towers. You could start the story of the shocking events on Wall Street almost anywhere. But we chose to start somewhere completely different: the edition of BusinessWeek published on February 19, 2007.

The magazine came to mind when it turned out that not a single financial institution in the world would come to Lehman's rescue and that the piles of money that had seemed so cheap and accessible in the international markets had suddenly turned rare and expensive.

The cover on that edition of BusinessWeek was special. It consisted of two sentences: "It's a Low, Low, Low, Low-Rate World" and "Why money may stay cheap longer than you think." The cover referred to an article with an opinion piece in the middle about why the real estate market wouldn't fall off the rails.

Here are some thoughts from that analysis, followed in each case by what actually happened.

b Is this the great real estate crash that everybody was afraid of? The magazine inquired. Home prices stayed more or less where they'd been a year ago, while sales had fallen to their level of 2003. The sharpest drop was in sales of new houses under construction, the author wrote. Contractors were dumping inventory before building anything more. The inventory of unsold homes would be finished by mid-year, the piece predicted.

(Like all Americans, the BusinessWeek editor believed that the real estate market couldn't suffer a real crash. Since then, home prices in America have fallen by 20% to 30%, the worst slump in the sector in American history. Hundreds of thousands of Americans are being thrown out of their homes because they can't make their mortgage payments.)

b The credit and thanks for the real estate market's strength, BusinessWeek wrote, were due in part to low interest rates. The rate on a 30-year mortgage was a very low 6.2%. Add to that the increase in average income and what you got was that buyers throughout most of America could afford a home.

(Surprise! Interest rates on mortgages continued to drop in the last year and a half, to 5.8%, a 30-year low. But the moment the real estate market started to implode, it became hard to sell those homes, and borrowers had trouble repaying their loans.)

b Globalization and financial innovation were two of the main reasons behind the low interest rates, BusinessWeek wrote. Investors knew more about the loans they were buying - by which the magazine was referring to various mortgage-backed financial instruments - which means they could pay more for them.

(This is scary. Less than two years ago, America's analysts, bankers and economists thought that the newfangled financial instruments meant investors had more information about the mortgages market. In practice, it turns out that investors knew less and less. Not only simple investors, but the most polished of investment bankers as well.)

b Mortgage-backed loans became far more attractive assets. Therefore, more dollars were chasing the mortgage market, BusinessWeek wrote - hence the low interest rates. A year ago (it wrote a year ago), investors in mortgage-backed securities would get a two-page brief about the mortgages portfolio they were buying. They were getting details on each loan.

(Okay, that's hilarious. Less than 17 months later it turned out that investors had no clue what lay in those black boxes the bankers put together with the help of the credit rating agencies. Now we know those black boxes were weapons of mass financial destruction when triggered by the collapse of home prices.)

b CDS, which enabled investors to gamble for or against a borrower's bankruptcy risk, improved transparency and forced out the bad borrowers, BusinessWeek wrote.

(Come September 2008, this miraculous security that increases transparency turned out to be a time bomb in corporate balance sheets. AIG lost $10 billion from issuing CDS.)

BusinessWeek wasn't alone in these opinions. They represented the sentiment on Wall Street of the time. Relying on much the same concepts, BusinessWeek's sister company, Standard & Poor's, gave blue-chip ratings to securities that turned into junk.

The crisis on Wall Street now isn't like any other crisis in the last 100 years, because at its heart are institutions and people who had been thought to be the ultimate in sophistication, innovation and excellence.

Who bought, sold, gambled, cooked and ate these securities, which exploded last week? People who were supposed to be the cream of the cream. The difference this time is that the people who cooked up this mess aren't going to just serve it to widows and orphans. This time they got caught up in the excitement and gorged themselves.

Thousands upon thousands of bankers and financial engineers have lost and will lose their jobs. Wall Street is going to be a lot less rich and a lot smaller. Sure, many of the bankers got off the train in time: They took home bonuses in the millions and more, while investors in their shares went broke. But most of them stayed on the careening train and were still there with the investors when it fell into the void.

There's an old joke on Wall Street about tourists who admired the bankers' yachts in the harbor, then asked where their customers' yachts were. Thing is, after funding the bankers' lifestyle the customers didn't have any. But this time around, plenty of the bankers lost their yachts too.