Thursday, September 18, 2008

Regulation? What Regulation?

Ben Stein, a conservative Republican, thunk about this just after Bear, Stearns disappeared. So happens (not a coincidence) that Einhorn's observations, and Stein's, are precisely on track with those of Lee Pickard, quoted at the link.

...Einhorn points out that the fellows who run big investment banks have a strong incentive to maximize their assets and leverage themselves into deep trouble because their pay is a function of how much debt they can pile on. If they can use relatively low-interest debt to generate slightly higher returns, the firm earns more revenue and executive pay increases

Under an interesting set of rules promulgated by the Securities and Exchange Commission in 2004, called “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,” the amount of capital that had to underlie assets was reduced substantially. (Mr. Einhorn rightly says that this set of rules should have been called the “Bear Stearns Future Insolvency Act of 2004.”)

Through the act, the S.E.C. — acting as one of Wall Street’s chief regulators, mind you — also allowed such things as “hybrid capital instruments” (much riskier than cash or Treasuries), subordinated debt (ditto) and even deferred return of taxes, to be counted as capital. The S.E.C. even allowed the banks to hold securities “for which there is no ready market” as capital.

Einhorn has even more troubling observations. He says the S.E.C. also allowed broker-dealers to set their own valuations on assets and liabilities that were hard to value. And broker-dealers could assign their own creditworthiness ratings to counterparties in complex derivatives transactions when those counterparties were otherwise unrated

Uh-huh. None of which would bother me (or you) if we hadn't been shanghai-ed into a position where WE may actually pay part of Bear Stearns' or AIG's losses (if there are any.)

And here Ben asks the pertinent question:

The S.E.C. told me that all of its actions were helpful to investors and that no one could have prevented the Bear Stearns collapse because it was caused by liquidity issues, not capital issues. My respectful response is that if Bear were thoroughly well capitalized, why would liquidity issues come up at all?

Under the "old rules," capital had to be 1/8th. The "new rules" allowed 1/30th. BIG difference.

...One truth, that deregulation is sometimes a good thing, has been followed down so long and winding a road that it has led to an immense lie: that deregulation carried to an extreme will not lead to calamity.

IOW, common sense should prevail. But that's not always the case, eh?

To think that people of this mind-set are in charge of the finances of the nation that is the cornerstone of world freedom is terrifying. Mr. Einhorn may well have done us a service of great value.

HT: Dreher

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