Since whatever I would say about the latest trillion dollar bailout by the United States government would be unprintable, I am going to devote this column to describing what should have be done instead. This financial meltdown is happening due to a lack of liquidity. The brokerage firms were buying long term assets with short term financing, a recipe for eventual disaster. In an ironic twist, Wall Street, the banker for the entire world, was unable to secure its own financing. Lehman Brothers was rolling over $100 billion each month to finance the real estate on their books.
All of the financial firms currently have billions of dollars of illiquid, toxic mortgage securities on their books, which can not be sold. Secretary of the Treasury Paulson proposed last week that the Federal Government buy these securities in an entity similar in structure to the Resolution Trust Corporation (RTC), which was created by Congress to bail out the savings and loans in the eighties. The RTC ended up costing the American taxpayer $150 billion dollars.
This newest rescue will be much bigger, the biggest bailout in the world. The amount of money requested by Bernanke and Paulson is 40% more than the Pentagon’s entire budget for a year. It is $2,000 per every American citizen. The last two weeks have seen the largest government interference in the markets since the Great Depression. This hardly seems warranted when the Dow Industrials is at the lofty level of 11,000.
What bothers me most is that the firms being saved by this bailout will not pay with a reduction in shareholder’s equity. This bailout should have been structured similarly to the AIG rescue that gave the government 80% of the equity of the company. A substantial reduction in the trader’s equity would have taught them not to gamble. Instead the US has socialized risk.
It is as if we have switched from playing rugby to crochet at half time. The government, instead of the marketplace, is now the referee deciding who the winners and losers are. Winning no longer means managing your company well, but being the most astute beggar of the US government.
After a week that saw the bankruptcy of the fourth largest brokerage firm, the fire sale of the number one securities firm, and the nationalization of the nation’s biggest insurance company, the Dow Industrials ended up for the week. There is something wrong with that. In order for the markets to work properly in the future, they must feel pain and moral hazard.
I am not sure why the brokerage firms should be bailed out while Main Street was blithely ignored. I would rather have seen this money go to keep people in their homes or to buy foreclosed homes to reduce the glut overhanging the real estate market. The collapse of the real estate market is still the central cause of this market downfall, but yet this bailout does not address that. This plan does nothing to thaw bank credit. Without the free flow of bank credit, the economy will continue to stagnate.
If they were going to do a bailout, I do not understand why they waited until after Lehman Brothers with $600 billion in assets and 25,000 employees declared bankruptcy, Merrill Lynch sold itself to Bank of America, and AIG with $1 trillion in assets was nationalized. Bear Stearns was rescued 6 months ago. They should have had ample time to review the situation before now. .
No one has answered the question of at who determines what price level these securities will be purchased at. Can the brokerage firms survive after the resulting write downs?
If I were Secretary of the Treasury, the first thing that I would do is close the markets while we are negotiating this bailout. The market needs time to absorb this information. Although the Treasury only had a half formed idea, Paulson had to appear before the cameras early in the day on Friday to reassure the markets. The recent volatility in the market has made it just a casino albeit with worse odds than Vegas.
I would remove the head of the Securities and Exchange Commission (SEC), Christopher Cox. Fed Chairman Bernanke and Paulson have been running the show. During this financial crisis, he has been largely absent. In order to restore faith in the markets, you need to bring in someone strong, preferably a market player, to helm the SEC.
It was a mistake last week for the SEC to suspend short selling in certain financial stocks. Blaming the short sellers for this market crisis is as nonsensical as blaming matches for a fire. The stocks of financial firms deserve to be lower due to their own mismanagement.
The markets need short selling. Sometimes, short selling is a legitimate hedge strategy. Short sellers have been the most prescient market players in recent years. They are the ones that were the first to warn on Enron and this crisis. Markets needs both buy and sell information.
While short selling was suspended in 799 financial stocks, what happens to the trading in the stocks that were not protected? It does not seem appropriate to discriminate. To stem the down movement of stocks, I would reinstitute the uptick short selling rule that the SEC foolishly eliminated right before the crisis started.
Not just the SEC, all regulators have been AWOL. The alphabet soup of regulators needs to be overhauled and combined into one regulator. Credit swaps are at the heart of this crisis, but yet this multi-trillion dollar market is not regulated at all. The insurance company AIG was nationalized by the Federal Government although the Federal Government does not even regulate insurance. The Federal Reserve is lending the brokerage firms money while they are regulated by the SEC.
Four years ago, the SEC pushed through a rule that allowed brokerage firms to increase their leverage from 12 to 1 to 27 to 1. From 2004-2007, Lehman Brothers added $300 billion in securities while only increasing shareholder’s equity by $6 billion. The amount of leverage brokerage firms are permitted should be drastically cut. The structure of salaries on Wall Street must be overhauled. Right now, traders are incentivized to take risk. They keep the winnings and walk away from the losses. Salaries on Wall Street must reflect the good years and the bad years over at least a five year horizon.
One of the reasons that this crisis has been so severe is that America is fighting it with one hand behind its back. In the last several decades, financial assets have moved away from being controlled by individuals to funds, but the legislation has not keep up with the times. The Glass-Steagall Act forbids funds from having majority ownership of financial firms. Private equity funds, which have $2 trillion dollars in assets, were not allowed to step in and bail out the Wall Street firms. I have to think that one of them would have considered buying Lehman Brothers at a price of $3.50 a share if they could have. The Glass Steagall Act must be amended so they can ride to the rescue in the future.
Whether I like it or not, this bailout will most likely pass Congress. The bigger question is, can capitalism survive its latest entanglement with socialism?
Laura Goldman worked on Wall Street for over twenty years for such firms as Merrill Lynch and UBS Warburg. She now runs her own investment advisory, LSG capital, from Tel Aviv. She is an independent commentator, and her views do not necessarily represent those of "Globes".
This article should not be taken as advice to buy, sell or continue to hold any securities without consulting a qualified investment professional, and anyone acting on the advice of this column does so at his or her own risk.
Published by Globes [online], Israel business news - www.globes.co.il - on September 22, 2008
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