Commentary: Subprime might just be tip of 'shadow banking' collapse

We don't pretend to know what the future might hold for investment banks or for the whole rickety, over-leveraged "shadow banking system" that these institutions both created and profited from, but we surmise that the shocks and adjustments to that system have only begun.

It's tempting to look at the Federal Reserve's bailout of Bear Stearns last weekend as a decisive, powerful move that will avert a full-blown financial crisis. Like the collapse of Long-Term Capital Management 10 years ago or the failure of Drexel Burnham Lambert a decade before, perhaps this was an isolated case, not a harbinger of systemic weakness.

Let's hope so. But it's hard to be sanguine when it's clear that the Fed's actions do not, and cannot, address the root causes of dysfunctional financial markets.

During the last decade, the "shadow banking system," as Pimco's Bill Gross has dubbed it, has acted as a worldwide central bank. The system, a loose confederacy of investment bankers, commercial bankers, monoline insurance companies, hedge funds, private equity investors, investment managers and old-fashioned speculators came together and, in effect, printed money.

They created new investment vehicles, derivatives such as collateralized debt obligations and other "structured investment vehicles." These investments were simply ways of magnifying the value of the underlying assets, which were typically bundled debt. Magically, a bagful of bundled mortgages then could be heavily leveraged, spinning off debt on top of debt.

The effect was to create a vast money machine, providing the players with outsized paychecks, lavishly compensating them for their participation in an enormous shell game.

As the dust settles, skeptics like Jim Rogers and Gross, who railed about market excesses long before the sleepy regulators at the Federal Reserve took notice, look even more prescient.

Here's an excerpt from Gross's latest monthly letter to Pimco's shareholders:

"Yet those that claim that mortgage loans (are the problem) are missing the larger point. This parlor game is best defined by leverage and not the assets that have been dealt out to more than willing players .... That subprimes have garnered the headlines is only because they were the asset class that failed first. ... levered structures holding commercial loans and auto and credit card receivables are waiting to be exposed ..."

And Rogers, who co-founded the Quantum Fund with George Soros a few years back, takes a coldly cynical view of J.P. Morgan Chase's takeover of Bear Stearns for a fraction of its asset value.

"You know the reason they did it this way was because, if Bear Stearns had to declare bankruptcy, you'd realize that Bear Stearns paid out billions of dollars in bonuses in January -- six weeks ago. If he let them go into bankruptcy, they all would have had to send back their bonuses. ... the Federal Reserve is paying for it. The Federal Reserve is using taxpayer money to buy a bunch of Bear Stearns traders' Maseratis."

The game is over. The music has stopped. On Wall Street, the era of lavish bonuses and high living has almost certainly come to a close. We'd advise the Bear Stearns traders to whom Rogers refers to get out while the getting's good -- and don't spend your last bonus check on a Maserati.

In this particular game of musical chairs, it's doubtful that Bear Stearns will be the only loser.

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