Main Street investors saving for their children’s education or for retirement are suffering greatly in the current financial crisis. What is deeply disturbing, however, in addition to the magnitude of the crisis, is that they are suffering not because of bad investments they made but because of bad investments made by Wall Street. This crisis is different, and it requires a new regulatory response.
Walk down the main street of any town in America, and you will not find anyone who bought a collateralized debt obligation or any other of the “toxic securities.” Not only did Wall Street cook up these instruments, but it ate its own cooking.
And it ate to excess, which, in financial terms, means it borrowed to the hilt. If you or I want to buy a security on credit, margin requirements dictate that we put up at least 50 percent of its value in cash, but no such limits apply when investment banks buy for their own accounts.
Indicative of the extent of the borrowing, Bear Stearns had a “leverage ratio” of 35 to 1, which means the firm borrowed $35 dollars for every dollar of its own money. As those mind-boggling Wall Street bonuses showed, that can be extremely profitable when investments are appreciating, but it can prove disastrous when they drop in value. For example, suppose your net worth is a dollar and you combine that dollar with $35 in borrowed money to buy an asset worth $36. If the value of that asset declines by only $2, to $34, you are bankrupt.
And what did Bear Stearns and other investment houses acquire with their borrowed money? To a large extent, they purchased securities backed by mortgages issued to people who could not really afford the property they were buying. Ironically, Wall Street used excessive debt to buy securities backed by excessive debt.
To ordinary Mainers looking with shock at their 401(k) statements, the fact of their loss is far more important than its cause. But to policy makers, understanding the cause of the problem is critical if we are to prevent its recurrence.
When I served as commissioner of Maine’s financial regulatory department and later as the chair of a Senate subcommittee that held hearings on Wall Street misdeeds, the problems were fraud and other abusive sales practices. In some cases, such as those involving Enron, WorldCom, and Tyco, the fraud was perpetrated not by securities firms but by the companies issuing the stock.
In other instances, such as the penny stock scams, unscrupulous brokers made misrepresentations to push up the price of worthless stocks so they could dump their shares at a higher price. Even the Internet bubble, which was largely the result of an overvalued market, was helped along by glowing ratings from brokerage firms conflicted by their desire to earn investment banking fees from the very companies whose stocks they were recommending to the public.
In responding to these problems, we utilized the traditional tools of sales practice regulation – aggressive enforcement against the Enron, WorldCom and Tyco wrongdoers, statutory restrictions on the sale of penny stocks, and new rules requiring the separation of the investment banking and retail brokerage functions to avoid a repeat of the Internet bubble abuses. But those tools would not have prevented a crisis like the one we now have, as the underlying problem does not involve the wrongful sale of securities to ordinary investors, but rather excesses in what investment banks do with their own money.
The need to regulate how such firms invest their own capital was not previously recognized. Indeed, the prevailing attitude was that if firms failed because of bad investments, possibly bringing some of their creditors down with them, that was how the market was supposed to work. In true Darwinian fashion, eliminating firms with less investment acumen would only serve to strengthen American capitalism.
We now know the fallacy of that reasoning, and it has been a very painful lesson. When the large investment houses shoot themselves, the bullets do not come to rest in their corporate bodies, but rather pass through and strike the rest of us. Because of the ripple effects, we pay for their recklessness.
The message for the future is that traditional sales practice regulation will not suffice. Safety and soundness oversight is urgently needed to deal with a problem far more dangerous even than fraudulent sales practices. More specifically, there must be restrictions on the indebtedness these firms may incur and on their ability to pursue unduly risky investment strategies.
If it sounds vaguely un-American to limit how Wall Street firms invest their own money, consider two points. First, ordinary investors already live under such restrictions, as evidenced by the margin requirements mentioned above. Second, it is ultimately a matter of equity. It is hardly fair to allow those who engage in financial excesses to earn enormous bonuses during good time while taxpayers and individual investors pay the price when things turn bad.
It is imperative that Congress reform the outmoded regulatory system to reflect the hard-learned lessons of this crisis. And it is imperative that we do it now.