Dr Dread: Cleansing the system

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Investment banks are things of the past, says our resident naysayer. And financial services lawyers are about to become very hot property.

The system is bust. The food chain is coming apart rapidly. Banks' capital ratios are flashing danger signals.

Investment banks only continue to exist courtesy of the blank check of Uncle Ben. Rating agencies dare not act ethically and truthfully for fear of self-destructing. Regulators, the very embodiment of incompetence, are now trying to slam every exit door after the proverbial horse has bolted.

Governments have little or no concept of what has exploded, and will waste their energies in the blame game. Never before in the history of the financial markets have we seen this kind of blatant attempt by the authorities to craft perception that all is well - they have no choice, this is the last hope - to mould perception by blunt intervention, deception and outright lies, and then pray, pray really hard that all will be well.

Lehman, which went with its begging bowl to the Fed last week, now has its share offering oversubscribed - really? And who were the takers? What collateral did the Fed assume for the $29bn financing of the Bear Stearns bailout ? What is the market value of that collateral? The spin is on, and folks are buying - out of a desperate denial of reality, and the hope that all will be well and happy days are here again.

Fund management, research and advisory firm Gavekal use the analogy of 'dynamite fishing' to describe a financial crisis: you throw sticks of dynamite in the water and observe what comes up - first the little fish, then larger ones, and eventually a whale shows up, indicating the end of the crisis.

Six months ago, speculation was that Northern Rock was the whale. Today, most are convinced Bear Stearns is the whale. Possibly. As long as the Fed monetizes the entire balance sheet of worthless junk on the books of investment banks, the perception of Bear being the whale will become a reality.

This is the situation we are faced with now. With this unlimited source of overtime for printing machines comes governmental regulation of investment banks and more importantly, the cancerous side effect called inflation.

Winners and losers

Investment banks as we know them will cease to exist - gone are the days of leverage of 40-1 (a conservative estimate).

Derivatives have and will remain a despised asset class and all the mark-to-geek models will become heavily regulated. Proprietary trading will go through a prolonged period in the outhouse as the fear instinct reigns over the greed instinct. Gone are the days of the 'trader option' with asymmetric risk-return profiles.

Compliance officers, once looked upon as the inferior cousins that must be amused out of political compulsion, will rule. Risk managers - too often hired as a marketing tool for hedge funds and to provide political cover for prop desks - will emerge with a vengeance as the final arbiter of leverage, balance sheets, and quality of trade. Credit analysts will be expected to do independent thinking and assessment rather than relying on backward-looking corrupt rating agencies for guidance on portfolio risk.

The 2%/20% fee structure of hedge funds will be sorely tested. The half-life of the average hedge fund will be halved at a minimum (to around two years) as capital availability diminishes. Administrators of hedge funds, probably the most incompetent and most manipulated creatures in the financial universe, will undergo a sea change through consolidation and intellectual upgrading, which is so sorely needed.

Lawyers with financial backgrounds will be the most sought after asset, given the fratricidal litigation we are about to witness.

Most of these changes have been discussed over the years as an interesting academic exercise. Turbulent and violent forces have now been unleashed - we are only in the third inning of a nine-inning game. These disruptive forces will bring about a cleansing that will be complete, brutal and thorough.

The systemic excesses, ineptitude, incompetence and corruption are sunk so deep into the fibre of capital markets that such a cleansing is not only needed, it is inevitable.

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