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Make it a Margin Call: The Change to Fix the Risk

Stock-Markets / Credit Crisis 2008 Apr 01, 2008 - 03:41 PM GMT

By: Paul_Petillo


It would probably be best to talk about what we know. Getting those headlines out of the way will, without a doubt, give us some insight into where we are headed. At least in theory.

Bear Stearns avoided bankruptcy when JP Morgan, who seized a unique opportunity to pick apart the firm for its brokerage business and clearinghouse operations at a price” that, despite being revised upwards from $2 to $10, left most folks inside Wall Street speechless.

But that wasn't quite bad enough. The camps of McCain, Obama, and Clinton reminded us that there are no real economic leaders in this election cycle. Instead we heard President Bush suggest that his tax rebate would do the trick. I believe he referred to it as a shot in the arm when in fact he should have called a shot across the bow.

At no time has the president shown a greater disconnect than in the past months. I'm going to miss him when he's gone largely because his flawed economics and shortsightedness will be difficult to replace.

But politics aside, the consumer has scattered for the shadows like so many cockroaches in the light. Confidence numbers fell, spending hit new lows and housing prices continued to fall. Words like recession were morphing into the possibility of a depression as skittish investors looked for the next shoe to drop.

Boston Fed President Eric Rosengren chose his words carefully when he suggested that he was uneasy with the current situation, “Regardless of what you call it, it's a period of growth that's much too slow relative to what we'd like to see.'' Greenspan we all know now has added to the discussion pointing out that no market is perfect and corrections, well, they happen.

Whether you feel it directly or not, which, if you are listening to every news anchor depends solely on the condition of your mortgage. Even if you have some equity in your home, this does not mean a bank to loan you money. But that equity, even if you are unable to use it offers some solace. You can rest assured that today, the recession hasn't touched you. But what about tomorrow?

Now that the recession has been formally announced by economists and politicians alike as officially here, the only questions left to be answered seems to be how long will it last and what will become of the current system. To suggest some answers for the first question: at least through to the end of the year and in all likelihood, we will not, in all likelihood have turned an economic corner until the first quarter of 2010.

The second question is a little harder. Even though we would like to play the blame game, asking who knew what when, we know now that no one knew anything who was supposed to know everything.

The Fed has offered us a glimpse into their economic acumen and we should all be very worried. Some have suggested that the average person manning a trading desk knew more about what was happening over the last six months than most of the oversight committees that should have been doing what we thought they were designed to do.

A spokesman for the SEC offered the following observation, which appeared in a Wall Street Journal article penned by Kara Scannell: “As the SEC is addressing whether there were gaps in its information, it is debating whether it would have been useful to have data about short-term, or "repo," financing from the banks that clear trades and hold collateral for the securities firms under the agency's review.”

The two agencies offered no real reason why they failed to see the Bear Stearns meltdown before it happened. The SEC claims that the investment bank assured them that everything was okay days before it was not. SEC officials we actually scrutinizing the books as the company was falling down around them.

Now the SEC, for all it is, is not able to do much more than regulate markets, keeping order where apparently there seems to be none. The Fed, as we all know can throw money at the problem and as we have seen is often a reaction that seems to be too much too late. Instead of ahead of the action, they are chasing a moving train of events.

This has given Henry Paulson, the Treasury Secretary the opening he has been looking for.

His closed-door effort to deregulate the system that is currently in place has troubled me to such an extent that I even went to the effort of including an essay about the subject as an appendix to Investing for the Utterly Confused (McGraw-Hill 2007). His advocacy for lower regulatory hurdles is well known and his current position should be scrutinized for the same beliefs. With agencies blaming one another and Congress wondering who can take control and offer the country some sound economic leadership, Mr. Paulson has begun to push for consolidation.

With all of their Depression era regulations in place banks are for lack of a better word, handcuffed by the Fed. That sort of stringent regulation has created a safely functioning system that protects depositors from the kind of disasters that have recently occurred with investment banks.

Mr. Paulson would like to add investment banks, which, once they began borrowing from the Fed, would need to disclose information that should have been available to the SEC. Then, firing up the mixmaster, Mr. Paulson would churn the SEC and the Commodities Futures Trade Commission, along with federal bank and thrift regulators into one entity. Practically salivating at the recipe is the influential lobby group Securities Industry and Financial markets Association.

Tempering their joy at the thought of what, at least on the surface, seems to be less regulation, Wall Street is still worried. Even if the current system seems antiquated, less regulation in the form of consolidated offices, many of which have seen funding cuts and lack of staffing because of those financial restrictions, is not the answer. The entities work as long as everyone is playing the same game. Trouble is, everyone bent the rules.

It is time for the simplest and least expensive solution to take hold: the margin call. With Wall Street able to borrow $25 for every dollar it holds in assets, the focus became how much risk is too much risk. By simply lowering that ratio by $10, much of the creative and often opaque risk would evaporate. The result would be less over-the-top profits and considerably less gambling with investor's money but with it, more disclosure and financial and economic stability.

Many have said that Bear Stearns demise was due to a lack of confidence that exposed a lack of liquidity and the inability to value what they held as assets. Critics of tighter margin requirements believe that the profits they could no longer generate from their trading desks would come instead from increased fees for their customers. If the marketplace can set the price, then this will not be an obstacle.

There is no easy solution but adjusting the margin requirements held in reserve will protect all of us at a far lesser cost to taxpayers. Reorganizing the whole financial oversight and regulation of financial markets smacks of the consolidation fiasco that is Homeland Security.

To begin changing the system Mr. Paulson, all you need to do is ask Wall Street what they fear the most.

By Paul Petillo
Managing Editor

Paul Petillo is the Managing Editor of the and the author of several books on personal finance including "Building Wealth in a Paycheck-to-Paycheck World" (McGraw-Hill 2004) and "Investing for the Utterly Confused (McGraw-Hill 2007). He can be reached for comment via:

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