If you were to ask the average undergraduate at the University of Pittsburgh what the reasons behind the economic crisis of 2008 were, you would most likely receive a lot of uneducated answers. In fact, if you ask an average person between the ages of 21-25, odds are they probably do not know exactly why the financial world almost collapsed. Why is this? The answer is simple: time. Time has passed, and even if you were 18 when the crisis hit, you probably still couldn’t use your high school intellect alone to fully comprehend the complexity of the issue that was at hand. I’ll try to sum it up in a nutshell; in the 1980’s, Lewie Ranieri was a bond trader at Solomon brothers, the infamous (frat-like) investment bank powerhouse. He saw people taking out mortgage loans, and came up with the idea to bundle these loans together and sell them as bonds. These were called mortgage-backed securities. This market was booming, but the prepayment risk associated with these bonds caused lenders to be hesitant. The street decided that they could chop up these bonds as tranches and sell them in pieces. These were called CMO’s or CDO’s (Collateralized mortgage obligations or debt obligations). Again, the market boomed. The housing market was going up, and it did not seem like it was ever going to go down. Eventually, there weren’t enough reliable mortgage loans to go around. Now, S&Ls were writing mortgages to people with faulty credit and no down payments in order to create more of these extremely lucrative CMOs. These were called subprime mortgages. The banks were giving people the loans, so the people actually believed that they could afford it (which they couldn’t). Deregulation on Wall Street passed under Bush and Greenspan’s (Chairman of the Fed) administration led to many investment banks such as Lehman brothers and Meryl Lynch (among others) to over leverage themselves in these risky subprime CMOs. Once the fixed teaser rate on the mortgages ran out, homeowners started defaulting on their loans all at once. The housing market collapsed, leaving a ton of well-off homeowners underwater. This left banks like Lehman Brothers and Meryl Lynch with billions of dollars of toxic assets. Bank of America took over Meryl, JP Morgan (with the help of the US Treasury) took over Bear Stearns, and Lehman Brothers was left to sink. Lehman went bankrupt. AIG, who insures everything from planes to life insurance, insured almost every mortgage backed security through credit default swaps, so they were also on the brink of bankruptcy (they were bailed out by the US Government of 100+billion dollars). The American people lost all trust in the financial process. Credit started to freeze.
I mentioned age in the beginning of the article for good reason. The reason being is that a good amount of Wall Street traders are around the age of 25. They didn’t LIVE (work in the industry) through the crisis, so I believe they are more likely to repeat it (and they are). It is truly amazing to me that corruption is still alive and in full force on Wall Street. As illustrated beautifully in Michael Lewis’ Flash Boys, high frequency traders (HFT) are using technological advantages to pick off trades before the information makes it to the other stock exchanges. When you press buy on your Ameritrade account, a high frequency trader somewhere in New Jersey might see your order, quickly buy shares on the other 40 stock exchanges, and then sell it to you for a half a cent more. They obtain information milliseconds before everyone else, allowing their fancy algorithms to preform non-stop arbitrage trades. Some HFT firms have gone years without a day of losses. How can they do this? Isn’t this illegal?
NO. Unbelievable, right? Deregulation was a major catalyst in the crisis of 2008, yet it seems like a whole new form of “turning a blind eye” is taking place in the same market! As the market gets more technologically dependent, and the number of exchanges and dark pools increase, more and more of this “legal crime” will exist. These people are literally LEGALLY MANIPULATING THE MARKET! Bradley Hope wrote in the WSJ that orders were being filled at prices that were “sub-optimal” in some dark pools. Researchers said “costs associated with weak infrastructure and slow processing were at times as much as 50 times higher than cases in which fast traders are able to find small opportunities to buy or sell stocks at better prices than other investors relying on slower data feeds.” Do you think the NYSE and WSJ.com closed for a day due to nothing earlier this year? The answer is again, no. HFT firms are stealing from innocent investors and making their wealth off of other people’s hard earned money, while also creating “glitches” in the market that cause these exchanges to experience “technical difficulties”. Eventually, the market will get so technologically dependent that a “glitch” that in the past would be minor, could result in a major crash that effects the whole market worldwide. If more regulation isn’t put in place, a repeat of 2008 seems all but inevitable.
So how do we stop these guys? The answer to that question is far simpler than you may think. High frequency traders use a tactic called co-location. This is a strategy that allows high frequency traders to see stock prices milliseconds, sometimes even just one millisecond, faster than other investors and high frequency traders. This, again, allows them to pick off trades and make a ton of money. They do this by literally placing their computers near (or sometimes inside) of different stock exchanges. For example, the NYSE might charge a HFT firm x amount of dollars for the right to put their computer 5 feet from the door in the basement of the building where their servers are. They might even charge them more to have it a foot closer to the door! And this is all legal! The way to stop the corruption in high frequency trading is to impose regulation that makes co-locating computer systems inside stock exchanges ILLEGAL. This will help, but won’t completely solve the issue at hand.
Another issue that is helping these traders exploit the system is the lack of transparency in dark pools. There have been instances, like I stated before, that trades have been routed into certain dark pools rather than finding a stock from a cheaper exchange. This definitely calls for conflict of interest for institutional traders, but this opaqueness leaves their misguided orders in an incredibly vulnerable state. Because it is “dark,” high frequency traders are able to signal huge orders by placing mini (hidden) buy and sell orders. They then find the big orders, run over to the other exchanges and do the opposite of the order. This allows them to do a simple arbitrage trade. The lack of transparency allows the trader to be virtually invisible. A simple solution to this is making a regulation that forces these dark pools to be as transparent as the public exchanges. This will, at the very least, make things a little more difficult for high frequency traders to manipulate the market inside dark pools.
Although I feel like these are pretty standard regulations that should be in place, I unfortunately do not have the power to set them. And like I said before, disaster looms if nothing gets done. Just like 2008, disaster struck because Wall Street was making too much money. They simply got greedy. Now, a similar situation is taking place. A stock market crash could lead to worldwide consequences. Once stocks go, GDP may be affected. Sooner or later, the unemployment & labor force numbers may take a dip. Consumers again may lose faith in the financial system and credit may freeze. Money would be incredible scarce and raising capital for businesses would be near impossible. Our national debt could rise to incredible heights, causing America to be in a Greece like situation. The government may then be forced to miss an interest payment on a treasury, which would lead the United States of America into a true default. All countries that hold US debt would be affected. Yields on all government bonds would soar. The whole world would be a third world country.
Although these things could happen, I don’t think that it would go to those lengths. I think that the Federal Reserve and treasury secretary would handle things before the United States goes into a true default. I illustrated the extremes above because it is POSSIBLE that these horrible things could happen. HFT is a dangerous practice that could potentially lead to a worldwide disaster. Regulation was ignored before the recession in 08, so lets not ignore it now.
Michael Lewis “Flash Boys”
Andrew Sorkin “Too Big to Fail”
Bradley Hope “Slow dark pools cost investors” (Wall Street Journal)