September 18, 2008
I believe that a ban or other restrictions on legal short selling is not in the best interests of orderly operation of capital markets and is essentially a red herring. The act of selling securities short can provide liquidity to markets, and income to those parties who desire to loan their securities. What needs to be done in this area specifically is enforcement of regulations regarding location of securities prior to their short sale. Short selling is merely a symptom, much like a declining stock price, and not the disease.
Legal short selling activities did not create the financial crisis through which the United States is suffering. Legal short selling did not send brokerage firms Bear Stearns, Lehman Brothers, Merrill Lynch and Morgan Stanley, Agencies Fannie Mae and Freddie Mac, and insurance companies MBIA, AMBAC, FGIC and AIG into liquidity crisis. Legal short selling likewise did not cause the mortgage crisis which is forcing homeowners into foreclosure. These are all terrible failures that were caused by management teams that either ignored the risks they were undertaking or were incapable of assessing those risks. These terrible failures could have been prevented by better supervision by government agencies and departments entrusted with the health of the financial system of the United States. What was witnessed over the past 12 months was a reactionary regulatory regime cleaning up financial crisis after the fact. This is a sub-optimal and preventable outcome.
I would suggest the following:
(1) Preserve Capital: Immediately suspend all dividend payments, all bonus compensation and freeze pay increases at all levels for all entities on any government watch list for capital inadequacy. Enforce regulatory mandates to cut costs and restore capital adequacy at new higher levels commensurate with the newly identified risk profiles of these entities assets. Likewise force the reduction of exposure to risky assets by these entities. If need be, make this effective immediately for all financial institutions operating in the markets of any domestically issued debt security. Regulators should focus on capital retention. These are regulatory omissions for companies going out of business on the tax payer’s dollar.
(2) Impose Capital Requirements: Broker-dealers and all issuers of federally guaranteed securities and all insurers of securities which are assets of regulated entities (whether by Credit Default Swap of explicit insurance policy) should be subject to federally mandated tangible equity risk weighted capital requirements similar to those of commercial banks which would apply to the maximum possible exposures to these securities, contracts and insurance policies. De Facto Leverage at these entities is multiples of that of the banking system, and was not effectively restrained.
(3) Create An Industry Funded Regulatory Relief Fund: Investment banks, default guarantee writers, credit enhancement insurance companies and others exposed to the capital markets should be required to make deposits into industry recovery funds similar to those required by the Federal Reserve Bank. Citizens and government officials assumed that there was no systemic risk from failure of one of these parties. Traders, bankers and their executives have been paid tremendous compensation while making toxic investments that effectively destroyed their shareholders’ and lenders’ capital not to mention tax dollars. The tax dollars of the citizens of the United States are being put at risk to liquidate the toxic trading positions of highly compensated dealers’ trading desks. The best way to minimize tax payer exposure would be to require industry capital to collateralize future rescue packages similar to FDIC depositor insurance.
(4) Increase the Size of the FDIC’s Emergency Funds: The FDIC is undercapitalized. It should be the responsibility for the industry to provide additional capital for future industry crisis. This higher fund level should also apply to the funds supplies by entities in (3), above.
(5) Anticipatory Regulation of Systemic Risk: Regulators should tightly monitor and limit exposure to financial instruments which have the capability to jeopardize the financial system of the United States. This is a failure of the current regulatory regime to execute their mandate, explicit and implied, to protect the financial system. There have been numerous warning signs of outsized risks in derivates and by federal agencies that issue mortgage backed securities, many of which luminaries such as Alan Greenspan and Warren Buffet have identified in public forums.
(6) Manage Risk Weighted Capital: Entities listed above need to have their asset quality scrutinized more effectively especially for any entity which has the ability to draw on tax payer funding or guarantees.
(7) Improve Financial Disclosure Requirements: With more information on the securities and contracts which these companies have entered, investors could have possibly raised red flags years ago and prevented risk levels from rising to inordinate levels. Sunlight is the best antiseptic.
Attention should be focused on these areas first.