102008 The Credit Crisis Metanomics Transcript


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102008 The Credit Crisis Metanomics Transcript

  1. 1. METANOMICS: REAL WORLD AND VIRTUAL WORLD FINANCIAL MARKETS OCTOBER 20, 2008 ROBERT BLOOMFIELD: Good afternoon and welcome to the 52nd edition of Metanomics. Today we’re going to turn our focus on to the credit crisis in the Real World, with banking and markets expert Maureen O’Hara. We’ll also get a quick update on the state of Second Life’s financial sector from Michael Lorrey, better known in Second Life as Intlibber Brautigan. Thanks to our sponsors InterSection Unlimited, Kelly Services, Language Lab, Learning Tree International and, of course, Cornell University’s Johnson Graduate School of Management. I would like to welcome our audience members at our various event partners, including JenzZa Misfit’s historic Muse Isle, New Media Consortium, Orange Island, Colonia Nova Amphitheater, Meta Partners Conference Area and Rockliffe University. Welcome also to those of you watching at our new community partner’s site at Venture Square hosted by Ancapistan Capital Exchange, BNT Holdings and Woodbury University. Today we’re using InterSection Unlimited’s ChatBridge system to transmit local chat to our website and website chat into our event partners. This great technology brings you in touch with people all around Second Life and on the web watching at metanomics.net. So wherever you are, speak up and let everyone know your thoughts. Politely, of course. As always, we start our show with a segment entitled On The Spot, so before we jump into the Real World markets, we’re going to get an update on Second Life’s financial sector, by
  2. 2. putting Intlibber Brautigan On The Spot. Intlibber, known in the Real World as Michael Lorrey, has been one of the most active and storied players in Second Life’s financial markets. Currently he heads up Ancapistan Capital Exchange, known as ACE, and Brautigan & Tuck Holdings, known as BNT. He was also one of the early members of the Second Life Exchange Commission which sought to protect in-world investors by imposing standards on stock exchanges and listed firms. Intlibber, welcome back to Metanomics. MICHAEL LORREY: Thank you for having me again. ROBERT BLOOMFIELD: The last time you were on, actually you were on a couple times back to back in January, when we had two panel discussions about Linden Lab’s newly announced banking policy. According to this policy Second Life residents couldn’t accept deposits in exchange for a promise of repayment with interest, unless they provided proof of Real World regulatory oversight. Dave Altig, of the Federal Reserve Bank of Atlanta, who was on that panel with us, reported later on that, in the immediate wake of that policy, about a hundred small banks closed, and the handful of major players remaining were trying to revise their structures to comply with the policy. So, Intlibber, I’d like to start by asking: Can you tell us how your own companies have responded to the banking policy? And, more generally, what’s happened to the financial sector in Second Life since those days in January? MICHAEL LORREY: Certainly. We had two financial institutions in the BNT family. One was BNT Financial, which had been originally called My Second Bank or M2B. It was a bank that had grown alongside us as a separate company, under different ownership until the
  3. 3. gambling ban started causing the collapse of Ginko and other related banks. So we wound up taking over that bank in order to get it back on sound footing. So we worked through the fall at that until the bank interest ban came along. What we were presented with at that point, with BNT Financial, was converting the depositors to shareholders in what would be a Real Estate Investment Trust. Rather than a forced conversion without any choice with people, we originally wanted to reopen it as what’s called a Contractum Trinius type depository institution, which is a Medieval type contract structure similar to how Muslim countries do their banking today, where there’s religious prohibitions upon interest, similar to the Medieval churches’ ban on interest and the holy Lindens’ ban on interest as well. So because of some legal situations at that point, we were limited to making one choice, and so we had to go with the Real Estate Investment Trust, or REIT, structure. So we took it public on the ACE Exchange, and we gave the depositors a choice of voluntarily converting a hundred percent to stock or seeing what the IPO could get them in some sort of immediate return. We were able to get over 55 percent of depositors to agree to conversion 100 percent to stock, and then we sold about another 100,000 or 200,000 Lindens’ worth of shares at IPO. And so the funds raised at IPO were then distributed amongst all the holdouts, and the remainder of their deposits were converted to shares. Since that time, because of the flexibility that we had in giving people choices, we maintained a lot of loyalty, and people have been able to liquidate their remaining holdings as they needed. And, in the meantime, because it was an REIT, that institution was paying dividends based
  4. 4. upon land sales in ten of BNT’s 52 Sims that we assigned to the Trust. So while BNT managed the Sims and ran its operations off of the tier revenues, any land sales in those Sims those moneys went into a fund for dividends on a monthly or quarterly basis. So we’ve been able to offer about a one to two percent a month yield on the shares in the REIT, which is a pretty good return on investment and translates roughly to slightly under the sort of interest rates that many banks were paying prior to the interest ban. So that’s what happened. So that's--yes, Beyers. ROBERT BLOOMFIELD: If I could just get a sense, Intlibber, of I guess the total scope of your own investment in your Second Life activities in U.S. dollars and also the size of the investment that others have given you to control through all these companies. MICHAEL LORREY: Well, I control 60 percent of the shares in BNT Holdings, which is the parent company of the estate company, as well as BNT Financial and Ancapistan Capital Exchange. And that at current prices, that investment is currently worth somewhere on the order of about 75 to $85,000 U.S. ROBERT BLOOMFIELD: Okay. And you have 60 percent of that? MICHAEL LORREY: No. That’s what the value of my 60 percent is. ROBERT BLOOMFIELD: Okay. Then so you’ve raised somewhere on the order then of 50 to 75,000 from other people for that? MICHAEL LORREY: When we IPO’d, we raised 13-1/2 million Lindens, which is about
  5. 5. $45,000, and we earned quite a bit in addition to that in stock trading last year. We were able to fund the expansion of our estate beyond that. At that time, the company was actually worth quite a bit more because the Sims were worth quite a bit more and the land could be sold for more. Since that time, the real estate market has taken a downturn, much as it has in Real Life. One of the reasons that we opened ACE was to have a financial institution as a financial draw to our business-oriented estates that would be the anchor of our estates. So last October we opened our own exchange, Ancapistan Capital Exchange, and that was opened as a zero interest institution. At that point, because of what we had been seeing with the banks and concerns about maintaining liquidity and that sort of thing, we didn’t want to feel responsible for having to invest our depositors’ funds for them to earn interest to pay them. We wanted to trust our investors, with their funds, to make their own investment decisions. So we made that conscious decision at the very beginning of ACE in last October, that they would be responsible for their own investment and profit earnings, and we would not pay interest on cash deposits. They would be free to earn dividends on their stock investments or day trading profits and that sort of thing. ROBERT BLOOMFIELD: Now we’ve got a graph of ACE’s stock price. I just wanted to walk through this first to make sure I understand the structure and just ask you about performance. It shows basically the stock price was a Linden for a number of weeks, and I gathered that was while you were selling this as an initial public offering at a Linden a share?
  6. 6. MICHAEL LORREY: That’s right. ROBERT BLOOMFIELD: Okay. So there are about seven and a half million shares outstanding, of which you own half. So that means you’ve raised about 14,000 U.S. from other people for the stock exchange, ACE itself. Is that-- MICHAEL LORREY: That’s correct. ROBERT BLOOMFIELD: Am I in the right ballpark? MICHAEL LORREY: Yes. ROBERT BLOOMFIELD: So the stock price has declined since the IPO at a dollar to somewhere around .6 Lindens a share-- MICHAEL LORREY: That’s correct. ROBERT BLOOMFIELD: --which is a fair bit of loss for your investors, though maybe not as bad what we’re going to talk about in a few minutes on the Real Life markets. But I’m wondering if you can just tell us what happened with the ACE stock price. MICHAEL LORREY: There were a few things going. First, we’ve all seen what happened in Real Life. Real Life economics has certainly impacted across Second Life as a whole. While the overall Second Life economy has expanded, it hasn’t expanded as fast as the user base has, so the amount of economic activity per avatar has actually decreased quite a bit. The
  7. 7. avatars who work in Second Life, to earn their money, wind up having to work a lot more hours in order to earn the same or less money. So what we’ve seen is a lot of folks that had invested in the market a year ago or less, some have been liquidating some of their investments in order to keep tier bills paid and that sort of thing. Obviously you had greater supply than demand, and that’s going to push down prices. That, along with the impact upon people’s disposable income in Real Life impacting their ability to bring real dollars into Second Life and as also the oil prices just hitting the disposable income incredibly, along with our normal summertime recession, which typically hits us every summer, this summer was pretty bad compared to previous ones. We’re not too surprised at the general downturn. We’ve been seeing that across all the capital markets, but it’s not surprising that it happened. ROBERT BLOOMFIELD: Our On The Spot segment is almost over, but I do have a couple more questions. Second Life’s financial sector has often been called the Wild West because of the lack of any traditional form of regulation, and it’s also been called a fool’s game for the same reason. The blogs and even the Real World press have been filled with stories of various scandals. So just to put it as simply as possible, why would anyone invest money in Second Life, with strangers, when they have basically no regulations to protect them? MICHAEL LORREY: Well, to answer that question, I’ve actually been exploring what’s commonly known in the Real World as the over-the-counter pink sheets, to look at how things are done there, because the level of capitalization with companies on the pink sheets is still significantly higher than what we see in the Second Life markets. But the more I’ve
  8. 8. learned about those markets, it seems to me that actually the pink sheets are far more chaotic and under-regulated and a lot more fraud and scams go on there than we have ever seen on even the worst financial institution in Second Life. Period. I can say that unreservedly. With ACE in particular, however, I’m very proud to say that we’ve had the lowest rate of business failure of any exchange in Second Life. We’ve been extremely picky about what companies we allow to IPO on our exchange. Those that do, many businesspeople they may know how to run their business but not really know the finance side of things, and so we’ve mentored and worked with quite a number of businesspeople in how to operate a capitalized company versus just a normal mom and pop type craft business. So we’ve been very responsible, I think. And, compared to the pink sheets, I think that we are far more responsible in Second Life than we see in those markets. ROBERT BLOOMFIELD: LukeConnell Vandevere, who has been heading up the world’s stock exchange, has been pretty explicit in interviews I’ve had with him, and on his website where he says, “World Stock Exchange is just a game. It’s a pretend investment.” Do you view investments in ACE as being real or some version of a game or pretend investment? MICHAEL LORREY: Well, you know all of life goes by game theory so if you want to call it a game, I mean life is a game, that we can talk about abstract generalities and trivialize things in that direction, in any scale and on any plane. But the thing is that people do real work in Second Life. They do real work in these companies, and they pay out money that’s converted. Linden dollars may be considered by Linden Lab to just be a license or a
  9. 9. product, but the fact is that people are able to convert that into real U.S. dollars, as real as U.S. dollars are. So calling it a game, I think that’s really a disservice, and it totally denigrates the integrity and honor of the work that people do every day in Second Life, to provide their livings and to create the Metaverse and the content base that’s making up our economy. ROBERT BLOOMFIELD: Okay. We have time for a couple more questions. I am going to ask one and take one of the many that I haven’t had a chance to get to from the backchat. The one I have is: You’ve had an association with Woodbury University, which has also been controversial in its own right, being accused of various griefing activities. I’m wondering just very briefly what’s the nature of your relationship with them? And, in particular, I know you are a profit-oriented businessman. What’s your profit motive? MICHAEL LORREY: Profit motive is earning a profit. Woodbury, when they first came into Second Life as a student project in their media department last year, they got off to a rocky start. Students there were anime fans, and they brought in a crowd of folks that attracted some people that were not the sort of people that people in Second Life really appreciate. They caused some trouble. We formed a relationship with Woodbury as soon as we determined what was going on, and we’ve been working closely with Woodbury for a very long time, not just to get the PN griefers out of their campus, but at the same time to utilize the people on the campus, who had the contacts in that community, to help combat griefing. The work that we did was twofold. Number one, to neutralize and demoralize the groups that are committing the griefing. And, number two is to reduce their manpower.
  10. 10. And so instead of treating griefing as a quote-unquote “war on e-terror,” like some people like the JLU and Prokofy like to portray it as, we approached it as an issue of juvenile crime. Any criminal justice person can tell you, dealing with juvenile crime you need to have diversion programs, you need to have creative outlets, you need to provide economic opportunities. That’s how you reduce juvenile crime in any community of any civilized nation. We implemented those sort of things. We helped provide creative outlets. We gave economic opportunities to the creative people who wanted to have a legitimate existence in Second Life. Some of those people coming into Second Life the first time maybe got caught into a wrong crowd, but they changed their minds about how they wanted to live their Second Lives, and we helped them re-legitimize. And we had a very good relationship with Michael Linden when he was running the G Team on that very strategy, and we were able to work very successfully in helping quite a number of the people who had inadvertently gotten caught up into things, to get out of that, and quite a number of them are very peaceful and constructive members of Woodbury campus. I’m very proud to say that, based upon the numbers that we’ve been keeping, the work that we did in taking this strategy, we’ve reduced the amount of griefing on the grid by about 80 to 90 percent over the past year. And while there are certain people who will denigrate and criticize that, the effects are that those stand. ROBERT BLOOMFIELD: Okay. We’re out of time, but I do want to ask this one question from Jag Nishi, which is--and so just a very brief answer please: Why was your main account banned by Linden Lab? Did that have to do with your financial activities?
  11. 11. MICHAEL LORREY: No, it’s not banned. ROBERT BLOOMFIELD: Well, I guess that’s brief. So if it’s not banned, it probably wasn’t as a result of your financial activities. Thanks so much, Intlibber, for coming on and telling us a little bit about your business, what’s been going on in the markets. And I look forward to having you back on so that we can get more time to get to the many questions that we’ve been seeing in the backchat that I just didn’t have a chance to get to. So hope to see you again on Metanomics. MICHAEL LORREY: Enjoyed. Thank you for having me. ROBERT BLOOMFIELD: Okay. Let’s turn to our main guest of the day now. Maureen O’Hara is a professor of finance and my colleague here at the Johnson Graduate School of Management at Cornell University. Maureen, welcome to Second Life. MAUREEN O’HARA: Well, thank you, Beyers. It’s certainly different and a lot of fun to be here. ROBERT BLOOMFIELD: Just so our audience is clear, Maureen is totally new to Second Life, but is very familiar with issues in banking and financial markets. We’ve written a number of papers together, but that is just a drop in the bucket of Maureen’s vast ocean of work in banking, as well as financial exchanges. I will refer people to your website. I know our producer can paste in some links so people can see your bio, and there will also be a lot of information on metanomics.net so people can learn a little bit more about why I wanted you to explain to us what’s going on in the markets today.
  12. 12. So let’s just jump right in, and I think the place that I’d like to start is just by understanding the nature of the problem that we’re facing right now in particularly the credit markets. And then we’ll move back a bit and try to figure out how we got there, and then we can move forward and try to figure out what’s going to be happening. But where we are now, I guess the phrase is the credit market is frozen, and we’ve got a graphic on that, showing some of the various interest rates. Can you walk us through what this means? MAUREEN O’HARA: Sure, Rob. I think it really is important that we start where we’re at right now, which is we’ve heard a lot about subprime mortgages and other things, and they’re certainly in the background the problem. But the issue today and the reason why the stock market has been so variable and the reason why the Federal Reserve has become so engaged is really picked up by this picture. And I’m hoping everyone’s looking at this. ROBERT BLOOMFIELD: Yeah. They’ve got that on their screen. MAUREEN O’HARA: All righty. So you can see that normally--so we have a graph here that shows the Treasury Rates in sort of the lower line there, and then you have the red rate which is the LIBOR Rate and the light blue rate which is the Commercial Paper Rate. So generally, when markets are working, the Treasury Rate is, shall we say, lower bound on interest rates. So when the Treasury auctions off new securities, that’s sort of the risk-free rate in the U.S. What you can see is that, in general, Commercial Paper Rates are higher, and that makes sense because they’re unsecured commercial debt. So they’re obviously not as safe a prospect as lending money to the Treasury, and naturally you end up getting a
  13. 13. higher yield if you’re willing to lend money to commercial companies via the paper market. And similarly the LIBOR Rate is the rate for overnight borrowing in dollars, which is set in Europe, and that’s why it’s LIBOR’s, the London Inner Bank Offer Rate. And generally, the LIBOR Rate is going to be very close to something called the Fed Funds Rate, which is our inner bank market rate. So you think about the Treasury Rate gives us the low bound; that’s the risk-free rate. Then above that you have the Fed Funds Rate or the inner bank market rate in the U.S. The LIBOR Rate, which is the inner bank market rate for dollars in Europe, tends to be right around the Fed Funds Rate. And then slightly, and as you can see sometimes it’s not even slightly; sometimes it’s just the same as LIBOR, the Commercial Paper Rate. Now all of this diverges when we get to mid-September, and this is really when the credit markets froze. And, by freezing, what it means is that nobody would lend to anybody else. So you ended up having a huge problem, and a lot of it stemmed, if you will, from when Lehman Brothers crashed. So to put all these pieces together, when Lehman Brothers failed, there were a lot of people who were holding commercial paper that had been issued by Lehman Brothers. So commercial paper is short-term borrowing that’s issued by corporations. It’s unsecured, and it’s widely held. It’s held by money market funds. It’s held by other corporations. If, say, a corporate treasurer has $300,000 in cash right now that he or she doesn’t need until their next payday, rather than just let it sit around the bank, they lend that money to another corporation who needs, say, $300,000 for the next five days. That’s the commercial paper market.
  14. 14. Now, in mid-September, when Lehman failed, they had outstanding all of this commercial paper. A lot of that commercial paper was being held in money market funds. So all of a sudden the money market funds found themselves holding an asset that was worthless. That caused a run at two of the big money market funds, the Reserve Fund and Putnam. And consequently, that’s where you begin to see this huge divergence because what happened was when people worried about the run at the money market funds, they took the money out of money market funds, and they put it into treasuries. In fact, they took the money out of everything and put it into treasurers. So you see the treasury yield plummet, and the rates and everything else go up because no one’s willing to lend to anybody but the Treasury in this now new very scary world. ROBERT BLOOMFIELD: And the Treasury is paying them basically a tiny bit more than they’d get if they stuck it under their mattress. MAUREEN O’HARA: Essentially that’s really true, Rob. In fact, at one point, the Treasury Rate actually hit zero at one point during the day, in the midst of all of this bank run. So the fall in the Treasury Rate here is actually the secondary yield on treasuries. The Treasury Auction Rates haven’t fallen quite this dramatically, but they’re close. So once you end up in this flight to quality, you have a huge problem. You have a run at the money market funds. No one will lend commercial paper, so huge companies that depend on commercial paper find that they can’t borrow. And usually what a company that borrows in the commercial paper market does is, they have a backup line of credit at the bank. So when the commercial paper market freezes, that just throws all these borrowers back onto
  15. 15. the banking system. So that’s been the problem. The credit markets are frozen. The Fed has been working to unfreeze them in the U.S. And the Central Banks around the world have been working to unfreeze them in Europe and in Asia and other places. There is some good news. It looks like they’re having some success, but obviously we’re not back yet. ROBERT BLOOMFIELD: And then we have a rather striking graph of the Stock Market for the last eight years or so. What is striking to me on this is not just that the price levels we're at look like where we were at the trough in late 2002, but just how quickly they have dropped. It really has been since that mid-September point that you were just showing on the credit market problem. So what’s going on here it’s basically that everyone knows the big corporations out there are going to have trouble lending and so that’s going to reduce demand as well as the ability of a lot of firms to meet their payroll. I mean is that what’s driving this? MAUREEN O’HARA: You’ve really hit on the problem, Rob. As we look out there and we look at the credit markets, small, medium, even the largest corporations are finding they can’t borrow. Right? GE was allegedly not able to roll its commercial paper. Now GE denies that, but the reality is that, if GE’s having trouble funding their operations, what can any other normal company expect. So part of what you saw was just terror gripping the Stock Market, that companies can’t fund, and what that means is, first, they’re going to have to issue much more expensive types of debt. Instead of being able to borrow in the short-term markets where interest rates are low, they may have to issue long-term bonds, which tend to be expensive. And, at the same time, of course, part of what’s also spooking people is looking around and realizing that a lot of the problems that have been lurking in the
  16. 16. background, in terms of economic productivity and spending, are also now coming home to roost. Individuals who’ve been holding retirement savings in the stock market are 30 percent poorer, and they’re not going to be running out to buying things from businesses either. So you’ve really got sort of a very cyclical, almost circular, world here, where the market is falling because people are afraid that no one’s going to buy, because they’re not rich anymore, because the market fell. And you end up with a really awful scenario. And, at the same time, of course, you have people pulling all their money out of money market funds and other areas, and that’s forced the Fed to come in and offer full deposit insurance on the money market funds. They’re guaranteeing the municipal bond funds. And, in fact, they’re now trying to guarantee inter-bank lending to try and get the banks back into lending. So very, very touchy situation. ROBERT BLOOMFIELD: Before we talk about what people might be able to do about this and what they’re doing about it now, let’s just take a quick look back and see the roots of the problem. I guess we should start with--we have a graphic that was titled by Inside Banking and Commercial Lending. It was titled “Time Runs Like a Fuse," and it shows the rise of subprime mortgages. So these are mortgages that were higher risk than traditional so-called prime mortgages, and these, just to look at some of the numbers here, in the late ’90s, they were somewhere around $100 billion and represented ten percent of all originations of mortgages. In 2005, they were over $650 billion and represented 20 percent of all the mortgages. Actually I see SLCN is showing another scary graph, a different one, but closely related, which is on home prices showing a major peak in, what was that, 2006, I guess; ’05
  17. 17. and ’06 was the peak. And they’ve really been plummeting since then. I mean, was there a fundamental problem with issuing subprime mortgages, or is it more complicated than “don’t lend money to people who can’t pay you back”? MAUREEN O’HARA: Well, at some level, that’s about the bottom line. But I think there’s a couple of things that we need to think about as we set the stage for what went wrong. Part of what this graph is actually underlying is the fact that banks were really struggling to find new areas in which to lend because the bread and butter that they typically had done, things like loans to businesses, increasingly were being done in the market without the banks. So again, the commercial paper we talked about earlier, banks were increasingly losing market share in commercial and industrial loans. So they looked around for where they could earn a return on their assets that made sense. Interestingly enough, real estate had real appeal because the default rates on real estate traditionally have been much, much lower than default rates on other assets. And even subprime mortgages had relatively low default rates. So one feature that explains this big boom is that commercial banks were looking for an area to ramp up in, and subprimes looked like a good area in terms of low defaults and reasonably high yields. Part of what I think was a problem though was that the subprime market had traditionally been a very, very small market, had not really traditionally been packaged up into mortgage bank securities. So the history on which to base projections of default rates and the like were extraordinarily limited, and the credit rating agencies seemed to ignore the fact that they really didn’t have much data. And so they started to classify these assets as being far, far less risky than they really were. And, of course, part of what we also see here is really a failure in regulation.
  18. 18. The subprime problem is not uniformly distributed across the country. In some places, like New York state for example, we had very little of the subprime originations. It depends on state regulations and various other things. A lot of the subprime originations really took place in state-regulated entities, and mortgage brokers, in many cases, weren’t regulated by anybody. So you really had an interesting challenge of putting some of these things together. But just to give you an idea of some of the difficulties, Washington Mutual, which we all saw- -originally, we thought that was being sold to--we Washington Mutual was sold to J.P. Morgan Chase. They had $53 billion in option adjustable rate mortgages and $16 billion in subprime mortgages. So some particular institutions, Washington Mutual being one of them, really went big time into this. ROBERT BLOOMFIELD: And now the other thing that these institutions did, I guess, there are two complicating factors. One is that they created these mortgage-backed securities or collateralized-debt obligations, and they created these incredibly sophisticated securities. And the other is that they started selling a lot of credit-default swaps. So I guess I’d like to just quickly walk through what these are and then ask you a couple questions on your take of how these contributed to the problem. So I’d like to start, if SLCN can bring up that mortgage-backed securities graphic. There, I see it now. So what would happen here is that banks and other agencies would go out and write a lot of mortgages, and then they would package these up, and they’d all become part of one big pool of mortgages. And then, from that pool, they would create a bunch of
  19. 19. different securities so you could get, for example, if you wanted the lowest-risk security, you could say, “Well, I’m going to take first rights for the interest payments and repayments of principal on these mortgages. And, the first loan that defaults, well, that won’t affect me. It’ll have to take a lot of defaults to touch me.” And then you walk down to the lower and lower-rated and higher and higher-risk securities, which are the first ones to take the losses. I’ve been through lots of meetings, talking about how to account for these and why businesses are doing them. And, frankly, I always thought they were fairly persuasive as ways to allow investors to decide how much risk they were willing to take on. I guess that didn’t work out so well. Do you think that these securities just weren’t designed appropriately, or was it just too hard for the credit rating agencies to assess the risk? MAUREEN O’HARA: I think there’s a couple of things going on here, Rob. I mean we’ve had mortgage-backed securities since, I mean, the first Ginny Mae’s are 1975. So the concept of taking mortgages and packaging them up and then splitting up the cash flows is not a new concept. What is a new concept was the development of the CMO, the collateralized mortgage obligation. That’s really a late 1980s. And that was the first structure that’s like the one you have depicted here where you divide the underlying collateral into securities that don’t share equally. The original Ginny Mae’s, you all had your 1/2000th or 1/25000th of the underlying pool. In a CMO, you begin to divide it up into different securities that have different maturities for example. The problem that we got to, moving further along, why these are now not working well are two things. One, the underlying mortgages were often not made correctly so we have
  20. 20. tremendous amounts of defaults that we didn’t used to have. But more importantly, if you take this structure that you have in front of you now and you say okay, the issuer had no trouble selling off the Triple A pieces. Maybe he didn’t have any trouble selling off the Double A’s or even the A’s. But what about those B pieces? What if they couldn’t really sell those? Well, then what they did is, you took those lower-rated traunches and you pooled them into another trust along with the lower-rated traunches from other issues. So now you have a brand new pool of mortgage loans. They’re not actually mortgage loans though. They’re now pieces of mortgage-backed securities. You pool all those, and you issue a new security based on that, and the new security has a structure just like this one, where the top traunch of that is going to become Triple A, and the next traunch down is Double A, on and on and on. ROBERT BLOOMFIELD: I think my head is about to start hurting. MAUREEN O’HARA: Yeah, I think that’s perfectly understandable. What happens then is that you now have bought what you think is a Triple A security, but it’s actually based on Double B collateral. The reason the rating agencies let them get away with this is that I think they dramatically underestimated the default probabilities. And so as these things began to implode, it just ricocheted through the entire industry. ROBERT BLOOMFIELD: As the banks started worrying more about their risk of default, they started writing credit-default swaps, where basically one bank would promise that they would step in and pay if there were a default. And actually we have a graph on the growth of these markets showing $50 trillion of credit-default swaps that are actually based on more
  21. 21. on the order of $15 trillion of mortgages themselves. So I guess, first of all, can you explain how you can have $50 trillion of securities that are basically insuring a much small amount of underlying assets? MAUREEN O’HARA: It’s complicated by a bunch of things. First off, the credit-default swaps originally weren’t designed to insure mortgages. They were designed to insure corporate debt. So we don’t even have the bond market on this table, but that’s where the CDS market, Credit-Default Swap market originally came from. Now the question is why is it so big, and the answer is, it’s because there’s no way to net out a position. So let’s do a real simple example. Suppose six months ago, I was getting worried about Lehman Brothers, and so I wanted to buy insurance against the Lehman Brothers’ securities that I had bought. So I go to you, you’re a big financial institution, and I buy a credit-default swap, and you write that credit-default swap. Now you’ve got exposure to Lehman Brothers. You’ve also got an exposure, if you will, to me, but actually your biggest problem is Lehman Brothers. I have what I hope is insurance against Lehman Brothers, but obviously it’s only as good as you, whether you can make good on it. Now suppose three months pass, I sell my Lehman Brothers debt, and I decide that I don’t need this exposure anymore. Well, now the problem is how do I get out of this contract. It’s not as simple as a typical contract. They’re not traded on an exchange, so I can’t go back to the exchange and just sell it. So what happens is that since I’m long, that is, I own a credit-default swap, I then turn around and I offer to write or sell a credit-default swap. So since I’m both long and short, my net position is zero, but that means I didn’t actually get rid of the initial contract, I simply took a position in another contract. So now we’ve got two
  22. 22. contracts. And that’s the problem in this market. There was no way to net out positions. The estimates are that, if you could have netted out positions, this market is really only about $3 trillion and not the $50 trillion we have here. And, in fact, some estimates put it at $65 trillion. But there’s a piece of what’s going on here, Rob, that I don’t think has come out clearly yet, at least in our discussion, and that’s the following: Let’s go back to that previous page where we were thinking about the structure of these CDO’s or collateralized-debt obligations. And we were taking traunches, and we were then creating yet another CDO that was based on the first CDO. That’s sometimes called a synthetic CDO or a CDO squared. The problem is, you might want to put some assets in there that are Triple A rated. But there aren’t that many Triple A rated assets out there. So what you do is, you lever it up using credit-default swaps. So in a simple world, what you could think of is, you buy the top traunch of a CDO, which yields 25 basis points over treasuries. Then you take that traunch, put it into another CDO. Use the credit-default swaps to lever that other CDO up by say 50 times. So the assets in that other CDO are actually credit-default swaps which they’ve written, which is generating money for that CDO. That’s how the leverage comes in, and that’s why the CDS market became so important because, buried into a lot of these CDO’s are credit-default swaps. So when credit-default swap markets started to have problems or, conversely, when the CDO markets started to have problems, nobody is sure whether they’re facing a counterparty risk or not. So it’s a mess. ROBERT BLOOMFIELD: I guess what I’d like to do now is start talking about solutions, and I’m wondering is there a direct solution to that problem? I know that back in 2000, Congress
  23. 23. passed the Commodity Futures Modernization Act, which barred the Commodity Futures Trading Commission from regulating credit-default swaps, and they’re not traded on markets, and that’s one reason it’s so hard to net them out. And now they’re all sitting out there, and they’re embedded in other securities. Do we just have to sort of wait and let those securities live out their lives, or is there something we can do immediately? MAUREEN O’HARA: Well, you’re right, Rob, that these problems will actually go away a bit over time. Today was a major netting of Lehman Brothers’ credit-default swaps so, hopefully, that will net some of those out. A couple of things are happening. Right? First off, for all practical purposes, a lot of the markets are frozen. There are no new CDO’s being issued. You couldn’t create a synthetic CDO if you wanted to, so there’s no more of these. Now the solution to the credit-default swap market is, it has to move on to an exchange, trading away from OTC trading. If we traded credit-default swaps like we trade futures markets, then when somebody is long and they want to get out, they just take a short, they net it out, and it goes away. A lot of the counterparty problems would completely disappear in an exchange trading structure. And there’s a lot of movement right now. The betting is that the CDS market will actually move to the Chicago Mercantile Exchange where it will be traded like a future. That will be a big step in the right direction. ROBERT BLOOMFIELD: What’s your timeframe on that? Are you talking months? MAUREEN O’HARA: Well, I think the CME came out with a plan, joint with Citadel Capital, which is one of the biggest private equity hedge fund money out there, to launch a CDS
  24. 24. platform within, I believe, two months’ time. Now their problem is, if you launch it, it’s sort of the old “if you build it, will they come.” Will people actually go to this platform to trade? I think the regulators will definitely be pushing the banks to give up this business and move things to a Futures Market. So I think the CDS problem will resolve within the next six to eight months, as these things move to exchange trading. But it is a problem because the banks don’t really have an incentive to want to let go of this business. It’s been extremely lucrative for them. The only thing that makes me think that they will give it up is simply that the regulators have had it with the banks. They’re tired of this nonsense. They’re going to want this moved. So I think that’s the ultimate goal there, with the CDO and the CDO squared, those markets are completely frozen. You can’t do a new issue. They’re not going anywhere. One had hoped that we’d see a bit of thawing in those markets, but certainly not before, I think, middle of 2009. It could be much, much longer. ROBERT BLOOMFIELD: Okay. Two of the U.S. responses to the credit crisis that have been most in the news have been, first, the notion of taking this $750 billion and using that to simply buy the so-called toxic assets that are held by these banks. And then more recently, we have the Treasury Department essentially forcing the banks to accept equity infusions, or cash infusions, in exchange for preferred stock equity interest. Since these are such political issues, I hate to ask it this way. You’re going to hate me for this, but isn’t the first one just giving a gift to people who made the big mistakes? And isn’t the second one socialism?
  25. 25. MAUREEN O’HARA: Well, I think actually those are both good points. The first one, buying up the toxic assets is essentially what we did when we had the savings and loan (S&L) crisis, and the whole idea was, “Let’s take these bad assets off the balance sheet. Let’s let the Treasury hold them and not force banks to just sell them on the market and drive their prices even further down.” So the S&L crisis is our model for that one. Does it help the banks? Does it help bail out people who made bad choices? Absolutely, but part of the problem we’re seeing now is that, when the banking system isn’t functioning, everybody loses. So that’s just the way it is. Buying equity in banks was the British solution, which is very interesting. I mean we have not traditionally done that. Last time we did that was back in the Depression, but the U.S. is not really comfortable in owning banks, and yet now we’ve moved along that British platform as well. I think the idea here is maybe the banks are better able to liquidate these things. By giving them enough money to be able to take losses, they all move these things gradually off their balance sheets. I actually am not sure that’s going to happen so much as by recapitalizing the banks, you now put them in a position where they’re willing to lend. I think that’s what this second solution is about. It’s saying, “Look. You got bad assets. We’ll buy them from you. You’ll work them down. What we’re more worried about right now is that you are not lending to even good companies. And, until you are, this economy is going to stagnate.” Buying equity in banks is a way to recap, to restart them. And it also is going to give the regulators more say in what the banks can do. No more of these ludicrous CEO packages that let them earn $250 billion, that sort of nonsense. They’re going to end up having to behave a bit more, and that’s certainly a big feature here.
  26. 26. ROBERT BLOOMFIELD: We’ve got a bunch of questions coming in, in backchat, and we’ll only be able to get to a few of them. One of them, from Tammy Nowotny, is: Looking back at the proposal to privatize Social Security--I guess that was about four years ago now--do you have a take on what that would have meant if that had gone through now? Well, actually let me just ask. Is that something you’ve thought about? MAUREEN O’HARA: I don’t know that the Social Security privatization debate really enters in here so much. I mean that’s really transferring, again, away from the government to individuals, and there certainly is a lot of concern about that process. I’m not sure how much that matters in this current debate, but maybe I just haven’t thought it through enough, Rob. ROBERT BLOOMFIELD: There’s been a fair bit of talk about the repeal of Glass-Steagall, which allowed different types of financial institutions to merge so you could have--well, you know it a lot better than I do so I guess I’ll let you explain briefly what that repeal was and also whether you think--I’ve heard people say that that created a problem and was part of the solution. MAUREEN O’HARA: It’s an interesting problem, Rob, because the repeal of Glass-Steagall really was part of something called the Gramm-Leach-Bliley Act, which allowed for insurance investment banking and commercial banking to be put back together again, something we had outlawed in the Depression. I actually think that Gramm-Leach-Bliley did something even more important that sometimes gets lost, and that’s that, when the decision was made to put those three industries together--insurance, commercial banking and
  27. 27. investment banking into one entity--there was a question raised, which was, “What’s the best way to regulate these things?” And the decision made in Gramm-Leach-Bliley was to say, “Okay. We’re going to let the piece of the business that’s been regulated, say, the securities piece typically regulated by the SEC, they get to regulate that part. And the insurance part’s going to be regulated by the insurance regulators, and the banking part is going to be regulated by the Fed.” Now there’s an alternative approach which Britain took, which is to say, “Okay, now that we’ve built these monster financial institutions, let’s have one regulator who regulates the whole thing.” And that’s what they did in Britain. They created the Financial Services Authority, which is this super regulator. We, in GLBA, chose the other direction and said, “No, no, no, no, no. We’re not going to have one regulator for these big firms. Instead, if you take Citicorp as an example, the SEC will regulate their broker-dealer function in Smith Barney, and the Fed will regulate the banking part in Citi, and the insurance part, which was Travelers at that point, will be regulated by the 50 different state insurance regulators because we don’t have a national insurance regulator.” What that really means is there’s not any one person watching the whole thing, and, to some extent, I think that’s been a flaw that has been emerged throughout this whole process. Interestingly, putting together commercial banking and investment banking didn’t actually become very attractive. You had a few firms like J.P. Morgan Chase and Citi and Wachovia who did it, but the big powerhouses in the market stayed apart. Right? You had Morgan Stanley and Goldman Sachs and Merrill who didn’t go and combine those two things. Ultimately, we’ve now pushed the wall to become that combined entity. So I think we just
  28. 28. didn’t think through regulation carefully enough. ROBERT BLOOMFIELD: Okay. We’re basically out of time. I’m wondering if you can talk a little bit about what you see happening in the credit markets, in the equity markets, and on Main Street, over the next year or so. We do have a graph here from the Federal Reserve, which is projecting a pretty big decline in inflation and only a modest increase in unemployment, but, boy, that’s ancient news now. Those were way back in September. What do you see coming up? MAUREEN O’HARA: I think there is some good news out there, Rob. The European markets are thawing, and that’s extremely important. We’re seeing the LIBOR Rates coming down. That’s a good indication that there’s less stress out there. The Fed is guaranteeing inter-bank lending and so are all the ECB banks. So right now the Fed is much more involved in funding everything. Right? The Fed’s buying commercial paper. The Fed is guaranteeing money market funds. The Fed is providing lending to broker-dealer firms. So we now have a very, very large central bank, and it does seem to be easing a bit, which means that credit will begin to ease up. And that’s crucial because you’re not going to get housing prices to stop the fall until you get people buying housing. But nobody can buy a house right now because they can’t get a mortgage. I think the Fed’s efforts are going to pay off. I think we’re going to start seeing the economy turn in terms of the credit markets and the like over the next three months. But you can’t get around the fact that we’re going to be entering into a recession, and the next year is probably going to be pretty ugly.
  29. 29. ROBERT BLOOMFIELD: Okay. Well, I guess I listened to the good news part of that and say, from your mouth to God’s ear, one of my mother’s favorite phrases. And then we knock on wood, you know, and hope we can get through the next year or so. So, Maureen O’Hara, thank you so much for coming on to Metanomics and sharing your expertise with us. Maybe we’ll be able to get you back in a little bit, to talk about how things have changed. MAUREEN O’HARA: Excellent. ROBERT BLOOMFIELD: Thanks a lot for coming on to Metanomics. MAUREEN O’HARA: All righty. Bye, Rob. ROBERT BLOOMFIELD: Bye bye. So let me, as usual, close our show with a brief attempt to Connect The Dots. A stock phrase in discussing the credit crisis is to distinguish between Wall Street and Main Street, even though no one’s quite sure what Main Street means, other than that it sounds wholesome. But what I’d like to do right now is talk just briefly, not so much about Main Street, but about two economic drivers that are a key target audience for this show: entrepreneurs and intrapreneurs who are looking at using Virtual Worlds for their businesses. So obviously, problems on Wall Street affect entrepreneurs because it dries up access to capital, but the news isn’t necessarily all bad. Clay Risen of the New Republic recently wrote that unlike a lot of sectors Silicon Valley thrives on an entrepreneurial ethos. Which means that, when people lose their jobs, a lot of them put up their own shingle and, since startup costs in software and web technology--and I would
  30. 30. argue many Virtual World activities--are pretty low. And, that means that there’s a good shot that people who have interesting ideas are going to be able to pull them together because they’ll have the time, and they won’t need a tremendous amount of capital. So Mr. Risen proposes that venture capitalists are probably feeling pretty bullish right now. I’m hoping we will hear from some in the next couple weeks. Now let’s turn to intrapreneurs. Intrapreneurs are a lot like entrepreneurs, but they’re seeking out opportunities for the businesses that employ them. I’m not quite so optimistic about intrapreneurs these days because, when firms are crunched, funding for Virtual Worlds will often be the first to go. But I am glad to report one intrapreneurial success today. The intrapreneur is Sandy Adam, a technical marketing specialist in e-marketing for the chemistry division of Sigma-Aldrich. Sigma-Aldrich has customers in biotech, pharmaceutical development, generally in the life and biochemical sciences, and they have customers globally across educational, government, nonprofit and for-profit sectors. The sciences place so much emphasis on communication and networking, and Sigma-Aldrich, because of their role dealing with all these firms that are actually often providing products for one another, as much as buying them directly from Sigma-Aldrich, it’s natural for them to use Second Life as a way to get in the center and become a nexus for that communication. Yesterday Sandy announced the first of five islands in Second Life, focused on Sigma-Aldrich business units, to be developed in the coming months, and this week there are going to be events in concert with the National Chemistry Week that’s going on. So if you want to hear more about this, stick around at 2:00, one hour after we end here, Sandy will be on Cybergrrl Oh’s Real Biz program right here on SLCN. So congrats to Sandy, and I
  31. 31. hope Sigma-Aldrich finds Second Life to be a worthwhile investment. Before I sign off, just a very quick thank you to all the people who make Metanomics happen, particularly Bjorlyn Loon and JenzZa Misfit. Bjorlyn is the Metanomics producer and director of communications, while JenzZa is the Metanomics estate and live event manager and also our indispensable imagineer. So thanks, Bjorlyn and JenzZa. Thanks to everyone else for coming, along with our guests Maureen O’Hara and Intlibber Brautigan. I hope to see you all back next week when we talk with USC professor Dmitri Williams, who’s been working on a terabyte-size database provided by Sony Online Entertainment, looking at players of online games and player behavior. That’s a series of projects Dmitri will be talking with us about, funded by the National Science Foundation. So that should be an interesting show. See you then. Bye bye. Document: cor1037.doc Transcribed by: http://www.hiredhand.com Second Life Avatar: Transcriptionist Writer