New York – Let’s have a game of monopoly. Who will win? So that the strongest child does not simply run off with the money we need to establish certain rules to make the game worth playing. It is no different for the financial markets; they need rules to work effectively. These rules are crafted carefully-for the most part-to maintain control, while incenting the participants to compete and thus make the markets more efficient. Imagine if the average Monopoly player was not limited to the money in hand, because each player could borrow up to 30 times his/her cash in hand. Clearly this is nonsensical for property owners who should not owe more (debt) than their property (equity) is worth.
On a farm, you don’t let the fox guard the henhouse and in small business you don’t let the person that writes the checks do the bank recs. It’s not a matter of trust, it is a matter of process. This is because we all know that fear and greed are strong motivating factors that can push ethical people to do unethical things. So it is really absurd that the 2004 changes to the Securities Exchange Act of 1934 allowed a relaxation of capital requirements on the bulge bracket firms and that the Cox SEC stopped inspecting these firms over a year ago.
The genesis of the situation that certainly contributed to the current global financial crisis began April 28, 2004 when the Donaldson SEC decided to allow the bulge bracket firms to measure their Basle capital requirements against the investment bank holding company’s capital, rather than against the brokerage business. This was an exemption that released billions of dollars of capital reserves that could now be “productively employed” in pursuit of greater profits. The SEC’s decision was a compromise, in which the bulge bracket firms were able to leverage up significantly in exchange for the SEC having the ability to look at the books of the entire investment banking operation. The rule, that would become know as the net capital rule was covered under Item 3 of the April meeting agenda.
At the time, the net capital rule seemed to make sense because it allowed the SEC greater access to the books of these institutions. The SEC set up a 7 person supervisory group to examine the parent companies. Only muted warnings as to the increased debt being laded on balance sheets were heard from the supervisory group and these went largely unheeded. And since the group was reshuffled by Chairman Cox, there has not been one examination of any of the firms in over a year.
Fierce competition from other IBs and hedge funds, low interest rates and flaccid stock markets pushed these firms to compete in ever more complex securities utilizing ever greater leverage to goose profits on wafer-thin margins. The price tag-Priceless.
Still there were those that did see this coming. Or more correctly saw it coming and said something about it. A short list includes: Sean Egan of Egan Jones, Nouriel Roubini of RGE Monitor, Michael Mayo of Deutsche Bank, Bill Poole of The St. Louis Fed, Richard Baker of Managed Funds Association (if you recall Baker was all over Fannie and Freddie when in Congress), David Einhorn of Greenlight Capital and Bill Ackman on Pershing Square.