By J. Morton Davis - 10/14/08 04:34 PM EDT
Devastating financial collapse has produced a clamor for new regulation to prevent such a cataclysm from recurring. I will recommend some new rules in this piece that could help achieve this critical objective. But before we impose new regulations and/or bureaucracies that may be unnecessary, overly restrictive, very costly and ineffective, we should decide whether existing tools are adequate — and if not, why not.
The truth is that more alert and aggressive leaders would have seen the dangers of the last two financial and stock market debauches — the technology bubble of the late ’90s and the more recent housing bubble — and could have taken action that either avoided them entirely or cut them off early and thus minimized their impact.
During the technology bubble, Federal Reserve Chairman Alan Greenspan understood the market’s “irrational exuberance” in which investors, just as in the tulip craze of the 17th century, paid ever higher, unjustified prices for shares of unproven companies, while borrowing deliriously in margin accounts to buy still more. Their accounts flourished until, inevitably, reality punctured the bubble and caused a painful crash and economic recession.
Since Greenspan, whom I know and respect personally, had warned about irrational exuberance, I wrote to him urging that he indicate his displeasure by raising margin requirements on common stocks and thereby put a damper on the speculation binge. His answer to me was that he did not believe in micro-managing, only in macro-managing. But I strongly suspect that the real reason Greenspan did not act was that his peers had complained so loudly after his initial comment about irrational exuberance triggered a sell-off. Wall Street did not want anyone cramping its ability to earn undreamed of underwriting and brokerage-commission profits.
Greenspan had the tools and rules to avoid this debacle. But powerful Wall Street interests and their Washington lobbyists, pursuing selfish objectives and inordinate greed, carried the day and prevented effective action.
Greenspan was similarly aware of the relentless rise of housing prices. And surely, likewise, he had the tools to puncture that bubble. Yet he did not do so. Preston Martin, a former Fed chairman, once wisely said “the role of the Fed was to take away the punch bowl when the party got too wild.” That was happening on Greenspan’s watch, but instead of trying to discourage or stop it he suggested it was a positive evolution helping many people realize the American dream.
He failed to stop mortgages being issued to NINJOs (No Income No Job), No Docs (no documents) and no-down-payment applicants. He did not act as major rating agencies gave triple-A ratings to these mortgages that were being packaged and sold as safe securities. Not only did he not take away the punch bowl as the party became wild, he kept interest rates at historic lows to allow more unqualified people, incapable of meeting their payments, to become homeowners.
Greenspan insisted that adjustable mortgage financing gave so many a shot at “the American Dream,” but he must have known that unrealistic, enticing, initiation financing would prove short-lived. Once interest rates rose from historically low levels, defaults and foreclosures would be inevitable. Greenspan meant well, but “the road to hell is paved with good intentions.”
So, with the mortgage debacle as with technology bubble, failure lay not in a lack of tools but in the fact that they were not used. Not only did the Fed chairman not remove the punch bowl, he added booze to it and cheered on the drinkers. Again he may have been influenced by those earning Wall Street fortunes, as well as by homebuilders, banks and brokers gathering mortgages to sell to institutions securitizing them for investors eager for triple-A rated securities that yielded more than other triple-A securities.
These high returns should have caused skepticism among buyers. Why would one group of triple-A securities offer a higher yield than other identically rated securities? It was too good to be true, yet irresistible. But when something seems too good to be true it generally is. The Fed knew it or should have known it, or at least should have looked carefully at it and done something about it. This is equally true of so many in Congress who overlooked and even encouraged irrational investment in mislabeled triple-A mortgages from Fannie Mae and Freddie Mac (notwithstanding their already-discovered fraudulent accounting disclosures).
So just introducing more rules is no remedy. The Sarbanes Oxley Act was well meaning but too hastily introduced in reaction to scandalous behavior at Enron and WorldCom. It has proven enormously costly and burdensome and did nothing to help avoid the latest disaster.
We need leaders at our regulatory bureaucracies who will use the tools available to them rather than respond to powerful interests or lobbyists urging them to forgo decisive action.
Finally, I would strongly recommend a number of actions.
First, limit leverage for commercial and savings banks and investment banks, and even hedge funds. Bear Stearns, Lehman Brothers and others went broke and jeopardized the entire world’s financial system because of their enormous leverage — the amount of actual capital they had in relation to the assets they were able to carry.
Long-Term Capital Management, leveraged excessively to carry its portfolio of treasury bonds, became insolvent and jeopardized the financial stability of the United States. A financial crisis was avoided only by Fed action to mobilize a bailout group of major investment bank investors including Merrill Lynch and Goldman Sachs. It is excessive leverage that causes major economic disruptions and upheavals.
When investors bet the right way, leverage generates fantastic returns on their capital. If a $1,000 investment increases by 50 percent it has earned $500. But if an investor invests $1,000, but it represents just 3 percent of the total securities he buys (with the rest paid for with borrowed money) he would earn 33 1⁄3 times that $500, or $16,667. So leverage is very seductive, as it was for Bear Stearns and Lehman. When things are moving in the right direction it leads to fabulous returns (as it does for so many hedge funds and accounts for their far greater returns than traditional mutual funds). But when things go just a little wrong and one has only 3 percent invested capital, then a small drop of, say, 5 percent leads to insolvency and, in the case of world financial institutions, creates dire consequences for the entire economy.
In 1929 it was leverage, with individuals putting up only 5 percent to buy a stock, which led to forced selling when the market started to fall. This caused more forced selling, known as margin calls, to replenish the capital that was wiped out by a 5 percent decline. And so it snowballed to the great crash of October that year.
It was the crash that led the Fed to set the amount of margin required to buy a stock (and then only appropriate stocks selling for more than $5 per share). So there is a healthy precedent for limiting leverage.
Excessive leverage causes disasters and should be made illegal. It is terribly unfair that because someone greedy took an enormous risk with huge leverage, all of society is subjected to the sort of systemic meltdown we are now suffering.
The other main activity that contributed to the 1929 crash was short selling of stock in overwhelming volumes, which caused declines and triggered forced selling by people who bought the shares on margin. In many cases groups had joined together to “short” a given stock to force just such an outcome so they could enjoy a big profit by buying back the stock they had sold at a much lower price.
Incredibly, sizable hedge funds are required to report their long positions immediately and regularly but somehow have convinced the regulators that they should not report their short positions. For heaven’s sake, why not? Why do less constructive positions deserve more special treatment than those held as real investments?
Subsequently, in an effort to limit short selling, the “uptick” rule was implemented. This says a security sold short must be sold at a price no less than the price of the immediately preceding sale. While not perfect, it did prove somewhat effective. About a year ago the SEC unwisely decided to suspend that uptick rule at the urging of Wall Street firms that were earning substantial profits from short sellers. The firms also earned easy income from lending securities for a fee to those who shorted stocks.
Only those who actually own shares in a company should be allowed to sell them. We should protect investors who use hard-earned savings to buy a piece of America (financing the growth of companies), and not accommodate the shorts or the greedy Wall Street bankers who benefit from these “shorters” while arguing that it helps create liquidity. Real liquidity comes from real buyers and real sellers who meet at the exchanges to execute constructive transactions.
Instead of a lot of new rules and regulations, we need active, intelligent and timely implementation of rules and tools that already exist. This, and my two suggestions, if acted on, would be very constructive.
Davis, a shareholder in The Hill’s parent company, is an economist, an MBA graduate (with distinction) from Harvard Business School and author of From Hard Knocks to Hot Stocks (William Morrow and Co.) and Making America Work Again (Crown). He can be reached at email@example.com.