Sunday, September 21, 2008

“Bail Out the Drunks, O’Malley, and Round Up the Usual Suspects”


A party begins in somebody’s back yard. It is quiet at first, nothing out of the ordinary.

But as the night wears on, the music gets louder, the voices get more boisterous, and things begin to get a little out of hand. The neighbors can’t sleep, and one calls the police, but nobody comes.

The party gets louder, more out-of-control. A second neighbor calls the police. Again, nothing happens.

The party kicks into high gear. Drunks wander into backyards and urinate on the neighbors’ houses. A window is smashed. A fence is torn down. Neighbors call the police with lists of specific offenses, but are told the party-goers are all consenting adults, and the police have no reason to believe illegal drugs are being consumed.

In short, the policeman says, the partyers can handle themselves.

Suddenly, above the music and drunken singing comes a hysterical scream. A neighbor investigates and finds a fight has broken out, and somebody has been killed. The party-goers are in a stupor. They can’t agree on what to do.

911 is called and police cars come screeching to the scene of the crime. They discharge dozens of serious-looking cops who surround the premises, shine their flashlights in the faces of drunk and retching party-goers, count the empty liquor bottles strewn across the yard and throw towels over dazed, naked couples.

After carefully sizing up the situation, the officers make their move: they tell the drunks, “We’ll pay for the damages.”

And they arrest the neighbors.


So it is, we think, that the U.S. Government—which certainly shares responsibility with Wall Street for bringing the subprime mortgage mess down on the heads of the American people—acted on Friday when after years and months of ignoring the subprime mortgage crisis, or at least hoping it would go away, eagerly embraced a quarter-trillion dollar bailout fund for the very Wall Street firms that had promoted, securitized and distributed those subprime mortgages that brought the world to the brink of a financial precipice nobody could fathom…and banned short selling, to boot.

“Bail out the drunks, O’Malley, and round up the usual suspects” seems to be the word from Washington.


How else to describe it?

How else to describe a government whose Treasurer proposes a quarter-trillion dollar bailout for his friends and former competitors on Wall Street, and whose securities arm bans short sales in 799 stocks—many of which lie at the heart of the drunken orgy otherwise known as the subprime party—instead of taking action against the Wall Street firms that caused the mess in the first place?

One commentator this weekend, we think, got it right, when he wrote, in part:

Then again, maybe the S.E.C. is trying to cover up its own culpability in this crisis. Four years ago, the agency pushed through a rule that allowed the big investment banks to take on a great deal more debt. As a result, debt ratios rose from about 12 to 1 to more like 30 to 1. Guess what Lehman’s debt ratio was when it went bust? Yep: 30 to 1.

Joe Nocera, “Hoping a Hail Mary Pass Connects”
New York Times, September 20, 2008

Joe Nocera was not, as we say here, making that up.

On August 20, 2004, the SEC enacted a rule called “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities.”

The effect of this rule, as Nocera pointed out, was that it allowed five firms to increase their use of leverage dramatically.

Those five firms were Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley.

If the Federal Reserve is supposed to “take away the punch bowl” when the economic party is getting out of hand, with this rule change the SEC brought in a distillery and said “Here, boys, have fun.”

And did they ever have fun!

Lehman Brothers ramped up its debt-to-equity ratio from 21.4 in 2003 to 30.5 in 2007. Merrill Lynch jacked up its debt-to-equity from 16 to 31 in the same period; Morgan Stanley from 21 to 32.

Now, you can read the actual rule change here:
http://www.sec.gov/rules/final/34-49830.htm.

But we’ll save you some time.

After declaring that “The principal purposes of Exchange Act Rule 15c3-1 (the “net capital rule”) are to protect customers and other market participants from broker-dealer failures [emphasis added]” the SEC states:


“We are amending the definition of tentative net capital to include securities for which there is no ready market [emphasis added]…”

What goes around, as they say, comes around, for as we write this, the U.S. Treasury is proposing a near-trillion dollar fund to buy securities for which there is no ready market.

You would think somebody at the table of Government bureaucrats and sober Congressional “leaders” trying to cobble together a rescue package might think to invite in the short-sellers who tried to warn Wall Street that these companies were headed for trouble.

But no.

Instead, short sellers—many of whom got the subprime collapse absolutely right, without ever resorting to the kind of abusive tactics short sellers as a class are now being accused of wielding in this fear-crazed environment—are being banished not merely from the discussion of what to do now, but from their profession by government directive.

Oddly enough, nobody seems to have considered using a simpler and far less costly way to fight the negative forces that began to feed upon themselves in recent weeks: simply reinstate the uptick rule.

That rule, which very effectively limited so-called bear raids in stocks by requiring that stocks be sold short only on an uptick, was removed by the SEC in 2007...after lobbying by Lehman Brothers and some of the same Wall Street firms now seeking shelter from the storm.

All in all Friday was, we think, a black day for free markets: those who got it right are being punished; those who got it wrong are being rescued.

And the homeowners enticed to buy at the top of the market using financial instruments they understood even less than the Wall Street firms that pushed those instruments, are not being helped at all.




Jeff Matthews
I Am Not Making This Up


© 2008 NotMakingThisUp, LLC

The content contained in this blog represents the opinions of Mr. Matthews.
Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice. It should never be relied on in making an investment decision, ever. Nor are these comments meant to be a solicitation of business in any way: such inquiries will not be responded to. This content is intended solely for the entertainment of the reader, and the author.

20 comments:

Zeegler said...

well said...but you're assuming that Congress will put aside their partisan hostilities leading up to the election in order to pass Paulson's plan

Anonymous said...

Such baloney.

You are talking your book (or more accurately, your profession) and little more.

First, these were not bailouts. Who got bailed out? The managers of the rescued or closed firms got fired. The shareholders saw their fortunes evaporate.

Second, it is possible (per Warren Buffet) that the cost of the Federal actions will be far less than the advertised amount. It should be noted that the Feds drove very hard bargains for each of their recent backstops.

Third, it looks highly likely that bear raids were taking place, one bank at a time. I'm sure you are aware of the put-buying, CDS-buying, short-selling, rumor mongering gambit that was not only possible but was likely in use. The suspension of short selling was the only tool available quickly, and with a certainty of outcome.

Tell me you that if you were Treasury Secretary, you would have stood by and done nothing, except more bailouts this weekend.

Phil Rubin said...

Nocera is among the best and your illustration is spot on and appropos in describing the unfortunate absurdity of the SEC and the get rich quick shmucks on the street (and elsewhere) who got us into this mess.

Bob McCrae said...

This isn't a Friday night movie, something you can pan and walk away. You're in the field yourself. So what do you propose?

Zeegler said...

anonymous or Bob O'Brian (the "CEO", not the reporter)?

Anonymous said...

I sure enjoy your blog, and I agree tthere is plenty of blame to go around ~~including the rulemakers and regulators. But is there any doubt that we were at the brink of the cliff on Thursday ? In 1929 the banks were failing and the government failed to provide any help. Today, what is Paulson supposed to do ?

Anonymous said...

I agree with all of your points. However, as it relates to the uptick rule...there is probably a technical reason that it cannot be returned quickly. These systems are large and complex. The code used to implement the uptick rule was probably removed and/or modified significantly. To bring it back would require a code rollback and significant testing. If I am not mistaken, the uptick rule was phased out slowly. System testing was probably the reason. So, the tech guys/gals are probably not in a position to flip the switch on the uptick rule.

Bob said...

Jeff, I believe it takes a vote or nod from the Senate for the SEC to have made this leverage change. My point here is that many knew about this change yet no one considered it that risky? 2.5% (40:1) - 3.3% (30:1) money to leverage isn't risky?

They knew it was, so why did they do it? That's really the question!

Maybe I just don't want to believe that ourleaders and appointees are that slow!

Kid Dynamite said...

the sickest thing is how Paulson, Barney Frank, Cox et all tried their hardest to TALK away this problem for the last eighteen months, then resorted to this sick bailout and short sale ban because "the alternative would have been worse."

no, gents, the alternative would have been to address the problem sooner - to PRAISE Einhorn instead of Villifying him

nice piece Jeff, and i agree with your point about the uptick rule - and no - the uptick rule could be easily (technologically) re-instated with the control taking place on the exchange level.

Anonymous said...

Jeff, good analysis as usual thanks for your comments. I have a question though; if the purpose is to improve the D/E ratios of these firms; wouldn't it be a lot better to buy equity rather than debt? (i know there are plenty of reasons not to have the government owning all of the financial firms but we're already past that with AIG and obviously we're treating these as special times.

Anonymous said...

And yet we read the following in today's paper:

PHILADELPHIA — Senators John McCain and Barack Obama warned Sunday that there should be more oversight built into the government's $700 billion plan to stabilize the financial markets but said the potentially enormous expenditure would not force them to scale back their ambitious governing agendas.

God help us....

Anonymous said...

good post but in the story i see the cops showed up and stayed and partied.

Anonymous said...

"First, these were not bailouts. Who got bailed out? The managers of the rescued or closed firms got fired. The shareholders saw their fortunes evaporate."

Uh, hello? The CEO's and senior management made their money, to the tune of 100's of millions during the run-up and artificial acceleration of profits by over-leveraging.

Now that their companies are going belly up, they'll cash in their golden parachutes for a final $M bonus before walking away, leaving the shareholders and taxpayers to clean up the mess and foot the bill.

Anonymous said...

Excellect. Just excellent

MightBWrong said...

Once this was at Goldman’s door (GS stock dipped below a $100), Hank Paulson jumped to the rescue…odd (quick Robin to the bat-pole with $800B). Welcome to the United Socialist States of America (USSA, I am working on a flag design). We chastise Putin and Chavez for nationalizing oil companies, but we have no issue with nationalizing Wall Street risk. I wish I had taken out some silly-stupid home loan I couldn’t afford; and then I’d be up for free government money to pay for my stupidity. Now, see that was stupid on my part, but taking silly stupid risk is not what I am in to (which is why Lehman turned me down for a job). But capitalism and free-markets are great on the way up and communism and socialism are great on the way down. I do resent the fact that I’d like to buy into assets for pennies on the dollar from where they were and now I won’t get a chance too (or short them on the way down, thanks Chris Cox for taking time from your Birthday parties to do the stupidest thing you could possibly do.). Asset inflation is good when you own the asset, but not when you are waiting for a pull back so that you can get in on the deal. It would appear that Paulson has gotten in the elevator business with the average American Tax Payer, he gets to ride the elevator, and we get the shaft. I know, I know that the abyss, and panic in the streets, etc. is bad, but bad for whom? This is going to ‘clean’ the balance sheets of banks – but that won’t fix the credit crisis. The days of silly-stupid loans are over for the foreseeable future (50-60 years before we forget); we are back to the 20% down (or more) and the one thing that the average over debt laden American doesn’t have is cash (that’s why they are in debt). Banks aren’t going to lend any more money just because they aren’t on the brink of insolvency. They are going to put that cash into US Treasuries, which is good because we are going to have to sell 1 trillion dollars more in bonds to pay for all of this. So, the only way to get people back out there buying assets is to lower prices, and that comes with asset depreciation; that’s not going to happen with the Fed and Treasury hitting the bid button every time there’s a pullback. For the 2000’s the new quote should be, “A trillion here and a trillion there and you start to talk about real money.” But then again, I might be wrong.

Hayseed said...

nocera as usual has arrived at a conclusion that is in concert with his subjective views and beliefs. ask yourself this: if i tell my son that he can change the ramp for his bike from 2 ft high to 20 ft high, would he do it? or the state of ct changes the speed limit from 65 to 150, would you then go 150, or 175 mph? just because limits are changed doesnt mean the actors will again head to the limits of whatever activity, because it is not in their own self interest. nocera's article presupposes that GS or MS would pueposely put themselves out of business as a result of the SEC changing a capital requirement. that makes no sense whatsoever. certainly, there are bad actors in every situation, and LEH was probably the worst, putting its capital at risk in the worst way.

THE problem can be tracked back to Fannie and Freddie and congressional hacks like Barney Frank and Chris Dodd which enabled it, and FORCED the financial institutions into making/securitizing/buying these crazy loans. the investments banks, given the 70 yr history of FNM and FRE (all ginned up naturally by that daddy-of-all-socialists FDR), KNEW that the loans would be made good - after all, they are essentially guranteed by the US govt.

this was not a lack of regulation problem, this was AN OVER-REGULATION BY GOVERNMENT PROBLEM. in 2005, congressional leaders attepmted to reign in FNM and FRE, and naturally Dodd and Frank stood in the way. why? why? well of course it comes down to money. FNM and FRE were some of the largest contributors on Capitol Hill: Dodd, Frank and OBAMA were the three largest. FNM and FRE became the Dem's honey pot, as it brought votes from the lower income via the housing for all initiative, and again the extreme contributions to their campaigns.

So to sum: a Dem president created the vehicle, a Dem congress reenergized the vehicle to pump up their votes and their coffers, a government ignorant of the risk allowed wall street to believe all of these loans were good, a classic example of Popper's "induction" issue arrived and thrived, and we are left with the people who caused this problem, assigning blame to everyone except themselves. Nocera's points are once again, nearly all wrong.

Anonymous said...

Jeff,
You can't hold the wall street firms accountable for their actions. Their CEOs were obviously under the mind control of Patrick Byrne's Dark Sith Lord (let's call him DSL). While clearly organizing the shorts against Overstock he simultaneously ran all sense of conservatism out of the banks. How many more instances of DSL's influence must we suffer before we listen to Byrne!?

and hayseed... if you paid your son $40mm dollars to raise his ramp to 20 ft he just might do it.

Hayseed said...

you totally miss the point. my son would not take $40mm or $400mm to raise the ramp and take the possible/probable risk that he could lose his life, just as the banks would not have gone to 30+x equity if they reasonably thought that they would lose the firm. they certainly thought that a backstop existed, were heavily encouraged by fannie/freddie/congress to participate in these securities. it is also highly illogical to take a risk that has a reasonable chance of destroying a firm. but i will admit that what in the end got all of them was the inherent belief based on continuous experience, that mortgages were teflon. another pure induction example.

Aaron said...

Jeff: I love this post. Two thoughts came to mind, though:

A) Isn't it possible that by the government buying the distressed assets off the banks' books, that the Treasury and the Fed are, in effect, trying to "make a market" for the distressed assets? I don't think either Paulson or Bernanke wants the government to keep distressed securities on its books, so I keep wondering who the likely buyers will be for them (hello private equity)?

B) I agree that the ban on short-selling is very unfair, especially on non-financial companies being shorted which had nothing to do with the subprime mortgage mess, but my question then is, what is the alternative to dis-allowing market participants to "vote with their feet" on a sector of the market that constitutes a large segment of US stock indexes?

Just wondering, and I could be wrong in my opinions.

Willprospector said...

CORPORATE COMMUNISM
"What is happening with Wall Street being bailed out by the BUSH REPUBLICAN Administration is "CORPORATE COMMUNISM". This is a term I made up to describe the DICTATORSHIP of BIG MONEY in the U.S.A. This is a REVERSION TO FEUDALISM.

These Wall Street executives need to be put in prison. They cannot be rewarded for behaving irresponsibly. They have done to us what Islamic terrorists could not do. The Republican Administration let them do this. If you have any question about this all you have to do is read "Worse Than Watergate" by none other than former Richard Nixon Counsel John Dean! They have done to us what Islamic terrorists could not do. The American people now have to PAY for THESE CORPORATE SCUMBAG-COMMUNISTS. This is PROOF that there is NO SUCH THING AS A FUNCTIONING FREE-MARKET ECONOMY.It is also PROOF that there is not too much government like republicans claim because if they were correct and followed their own advice they would not have NATIONALIZED AIG,Fannie Mae and Freddie Mac. Also had there been enough or sufficient regulation then this would not have been allowed to occur."