Friday, March 30, 2012

From the Files: "Round Up The Usual Suspects"

Editor's Note: We've been asked to re-post the following column, published during the dark days of 2008 when the financial world as we knew it was coming to an end and then-Treasury Secretary Hank Paulson was pushing a bailout for his former friends and colleagues on Wall Street.  The reader making the request erroneously states that this post had been taken down, which it had not; and why he/she wanted to read it again, we can't say, but it's always worth looking back at a crisis, so here goes...


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.

2 comments:

Anonymous said...

Mr. Matthews,

Thank you for (re)posting this. I actually have it on my bookmark list......and when I went to access it several wks back, I got the '404 Not Found' message. Its a classic, and will speak to the events of September '08 for decades hence (with biting wit)

Jeff Matthews said...

Well thank you. I'm sorry you got an error notice (Google does make mistakes, sometimes) but in this case it was worth revisiting.

Best,
Jeff