Paul Kedrosky: Fire the SEC’s Chris Cox? Sure, Then Fire John McCain
Oh, now John McCain is suddenly swinging with both fists on capital markets? He just said he thinks SEc Chair Chris Cox should be fired because he allowed naked short-selling and that is driving the current crisis? Un-be-frickin-believable.
First, it is the height of irresponsibility for a politician to grandstand so clumsily when the market is as fragile as it is right now. It shows a remarkable lack of financial sophistication and market smarts on the part of John McCain, and I didn’t have much confidence in either from him in the first place (and that does not make this an Obama endorsement, because he has done diddly to convince me he gets this either).
Second, this has nothing to do with naked short-selling. Repeat after me: The trouble is not with short-sellers. The trouble is not with short-sellers. The trouble is with an over-levered financial system built on a house of cards comprised of under-collateralized toxic paper that was applauded all the way up by “housing is the American dream” nutters who couldn’t see that vast expansions in thinly-traded credit are a path to economic ruin. Focusing on the short-sellers will lead to completely wrong and counter-productive non-solutions to the current crisis.
Unbelievable. Truly.
Five myths about the Wall Street crisis
During the troubles on Wall Street over the past few days, many pundits have parroted tired slogans as the accepted wisdom. They seem to have forgotten that their blithe explanations have been found wanting in the past and are likely to be inadequate in the present…
Myth one: recent developments prove that Wall Street is nothing but a giant casino.
… In fact, as I argued in my book Cowardly Capitalism (Wiley 2001), the contemporary financial markets are characterised by risk aversion rather than a hunger for big bets. This is much more than saying the markets are simply fearful. Rather, I argue that the character of the financial markets has changed fundamentally.
The main reason for their existence used to be to move capital from one party to another. For instance, someone might put their savings into a bank account and the money would then be lent to a company for investment. Today, in contrast, a key purpose of many financial instruments is to transfer risk from one party to another. For instance, the derivatives markets essentially provide a way for institutions to pass on risks between each other. So, one party might want to protect itself against a falling dollar and another might want to bet on the American currency rising.
This ‘cowardly’ nature of the financial markets explains why the financial crisis has spread in the way that it has. Repackaging or ‘securitising’ mortgages initially provided a way for lenders to sell on the risk to other parties such as investment banks. In the short term, this had what was seen as the desirable effect of diversifying risk. But the risk was simply transferred rather than disappearing. Once problems emerged it could spread more easily from one institution to another. This explains what is sometimes misleadingly referred to as a ‘contagion’ effect or virus in the market.
Myth two: the markets were driven by greed.
It would be more accurate to say that the developments are driven by fear rather than greed… a general climate of anxiety in contemporary society that affects the financial markets as everyone else. Markets tend to react in a disproportionate way to the threats that they face.
Myth three: it is all about confidence.
It is true that confidence plays more of a role in the financial markets than in the economy as a whole. But it is a mistake to exaggerate the importance of confidence in the resolution of the crisis. The strength of the underlying real economy is a key factor to consider when trying to determine the likely outcome.
Myth four: it all started with irresponsible American subprime mortgage lending
The crisis is routinely blamed on irresponsible lenders and reckless borrowers whose debts have now gone bad. According to this caricature, a combination of greedy bankers and feckless ‘trailer trash’ are responsible for the crisis. In reality, the American housing bubble was simply a response to the low interest rates maintained by the Federal Reserve earlier this decade (4). This loose monetary policy was in turn a way of keeping an otherwise sluggish economy going by promoting a consumer boom fulled by cheap borrowing. The fundamental problem was therefore a weak economy rather than subprime borrowers or lenders.
Myth five: The recent actions of the American authorities, particularly last week’s nationalisation of the Fannie Mae and Freddie Mac mortgage guarantee agencies, represent an end to the free market on Wall Street
… In fact, despite its reputation as the ultimate free market, Wall Street has long been subject to extensive state intervention.
Several conservative commentators have bemoaned the fact that the American authorities have taken a strongly interventionist stance on dealing with the financial crisis… However, state intervention on Wall Street has long been pervasive. The American authorities intervene in the economy in numerous different ways and tightly regulate the financial markets. For example, in recent months the Fed has bailed out Bear Stearns (another investment bank), pumped in up to $200billion (£112 billion) to nationalise Fannie and Freddie and strong-armed top financial institutions to provide funds to stabilise the market in the wake of Lehman’s collapse. It has injected large sums into the financial markets when they have become troubled and not hesitated to move interest rates either. Indeed, as argued above, the roots of the current crisis can partly be attributed to the earlier actions of the Fed.
Never Sell America Short By Larry Kudlow
Well, it’s time for some perspective. The world is not coming to an end. The stock market has tumbled, but it’s still over 10,000. In late 2002 it was 7,500 and in mid-1982 it was 750. Are things really that bad?
With home prices falling, foreclosures and defaults are at the root cause of the run against all manner of mortgage-related bonds held by the banks. But as investment guru Don Luskin points out, foreclosures today are less than 3 percent. During the 1930s they were 50 percent. Or how about the unemployment rate? Today it’s 6.1 percent. Back in 1982 it was near 11 percent and for most of the 1930s it was over 20 percent.
…
Many banks have taken huge losses on mortgage-backed securities and their derivatives because the SEC insists on mark-to-market. But Karabell asks: Why knock down these bond values, sometimes by as much as 100 percent, when the underlying home values embedded in the mortgages have only dropped 10 to 20 percent? And in the long run, the housing market will recover, as it always does.
Bad accounting rules like this are sinking the financial system. And why hasn’t the SEC restored the up-tick rule to stem cascading share-price declines triggered by manic short-sellers? Short-sellers are an important part of the stock market, and they add liquidity at crucial junctures. But until July 2007, they could only short a stock after the share price rose, not while it was continuing to decline. The SEC also should restore the net-capital rule, which limits banks to a 12-to-1 leverage ratio governing their debt. Over-borrowing by Wall Street is what got many firms into deep trouble.
A gathering consensus also seems to be forming around a new version of the Resolution Trust Corporation, which effectively disposed of bad savings-and-loan assets in the early 1990s. A new RTC could purchase underwater assets that proliferate through the financial system and are clogging the credit and loan arteries of our banks.
Revive Uptick Rule
Regulation: The announcement Thursday that short selling of financial stocks has been banned in Britain is intriguing. We may not want to go that far in our market, but we should at least reinstate the old uptick rule.
Whether the ultimate failure of Bear Sterns, Lehman Bros. and others was hastened by runaway short selling of their shares may never be known. Still, the 30% daily plunges in the prices of apparently healthy financial institutions that we’ve seen in the past few days do make you wonder.
We had similar concerns when we learned of heavy short selling of airline stocks coming out of Europe before 9/11. If terrorists wanted to try to cripple our capitalist system, massive short selling of our equities would no doubt be on their to-do list.
Our equity and credit markets are justifiably suffering from a crisis of confidence that touches all securities. The uptick rule was designed to function best in this environment. The Securities and Exchange Commission, one of our most responsible regulating agencies, is weighing re-enactment. It should move promptly.
More regulation will harm, not help, recovery
Take the US mortgage market at the heart of the present crisis. One of the largest sources of the problem is the role of Fannie Mae and Freddie Mac, the giant US mortgage companies, government-sponsored enterprises that hold or guarantee almost half of America’s $11 trillion mortgage market. They facilitated much of the explosion of the mortgage-backed securities market in the US and they did so because investors always believed that these oddly public-private hybrids carried an implicit government guarantee. (They were right.)
Critics gave warning repeatedly that if they were not scaled back they would threaten the stability of the whole financial system. (They were right again.)
The idea that these two collapsing behemoths somehow represent a failure of the market is about as plausible as saying that the collapsing boxer falling to his knees somehow represents a failure of the canvas.
Nor is it the case, as capitalism’s critics maintain, that the regulatory structure has been dismantled. On the contrary, the US system of financial regulation has been built up over the years into a staggering skyscraper of rules and institutions that induce a sort of governing paralysis.
The regulatory framework is not too small. It is a mess, multiplicated in many areas among different state and federal agencies, and completely lacking in others. It is developed on a base that was created in the 1930s to deal with a wholly different financial environment. Most of those still extant rules that deal, for example with commercial banks, are redundant, while others that should be in place to deal, for example, with investment banks, are not there.
Or take the UK model – please, take the UK model. Tripartite regulation between the Treasury, the Bank of England and the Financial Services Authority was a work of genius – until someone rediscovered the old truth that when you have three people in charge of something no one is really in charge. Again this is not lack of regulation. It is the wrong sort of regulation, misdirected, incoherent and in some respects, excessive.
Or consider another example in which tight regulation is actually hampering economic recovery. Under international financial rules, banks are required to maintain a core capital base as a proportion of their total balance sheet. But in a financial catastrophe, as capital dwindles and assets become riskier, those rules require banks to cut their lending and investments, driving deeper into the vicious circle
The need is not for more regulation but for more relevant regulation, a more intelligent and targeted role for government that acknowledges the essential wisdom of markets but acts to protect the weakest from their excesses.
That might certainly mean a more active role for supervisors in examining bank balance sheets. But it is more likely to require not aggressive government intervention, but simply the insistence on better provision of information to avoid the chaos created in the past year because investors didn’t have a clue about the quality of many of the assets that they held. And in some respects it might even require less public involvement in, or restraint of, the economy: for example, the dismantling of the US mortgage giants and perhaps less onerous restrictions on bank lending when the economy is contracting.
We certainly don’t need a system based on the wholly implausible proposition that, in the end, government knows better than people. We should resist at all costs the historically challenged claim that politicians, or the officials they appoint, can possibly know better than free, liquid, well-informed markets in which, every day, hundreds of millions of people put their own money on the line to choose their own future.
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