VIEWPOINTS : Greasing the Skids for the Next Crash : Six Months After Black Monday, a Look Backward
Fittingly, the rise that has been carrying the stock market to new post-crash highs early this month began with a story that the Group of Seven finance ministers were going to peg the dollar at 125 to 130 yen--for the foundation of the great market bubble that burst six months ago was the Louvre accord, at which the finance ministers agreed to peg the dollar at about 150 yen.
Foreign belief that this rate would hold provoked a great flow of funds to the U.S. stock markets, and ratcheting mechanisms associated with computer-guided trading between financial futures in Chicago and stocks in New York kept driving the prices of the most popular stocks ever higher.
Meanwhile, however, significant numbers of American investors decided that, Louvre or no Louvre, the dollar was going to fall. They “diversified” their investment portfolios into other currencies so dramatically that the outflow of private capital from this country in the second and third quarters of 1987 was equal to all the much-advertised, feared or welcomed private Japanese and European investment here.
As a result, the German and Japanese central banks had to carry the entire burden of financing America’s $160-billion trade deficit. Suspicious markets pushed up deutsche mark and yen interest rates, which pushed ours up, too. By August, stocks were selling for dividend yields of less than one-quarter the interest on 30-year U.S. Treasury bonds. This was not just a record, but double the maximum spread between them at any previous time. If we weren’t in a New Era--and it’s never very likely that one is in a New Era--of course the thing was going to smash.
Now, despite Thursday’s 101-point drop, the market is back over 2000. The federal budget deficit will be higher this year than last, and almost everyone expects it to be higher next year than this. Though the trade deficit improved--1988 will be only the second worst year in our history--we still have to borrow $140 billion a year from foreigners. Nevertheless, the Group of Seven says it will stand firm. Last week’s trade figures gave pause with their demonstration that Washington still lacks any kind of grip on the real world, but basically it’s still ‘here we go again.’
It could be just as bad next time. Most of the reasons why the bubble burst so noisily have been hashed over by the President’s Commission on Market Mechanisms (the Brady Commission) and the Securities and Exchange Commission’s division of market regulation. But one factor has not been explored officially, let alone remedied. And it is, perhaps, the most important.
Baldly, it is the SEC’s abdication of its role as protector of the public in the securities markets. Instead, under the leadership of its former chairman, John Shad, the SEC became a promoter of the interests of the big broker/dealer firms, the big brokerage houses.
Investors thought, for example, that the government had curbed the abuse of credit in the stock market because the Federal Reserve System, through its regulations T and U, required purchasers to put up at least 50% of the price when they bought. But the Brady Report and the SEC study found, without commenting, that “professionals” in the market were borrowing 75%-80% of the price of their holdings.
This happened because firms that were “market makers,” as defined by SEC Rule 3B-8, were permitted an exemption. Market makers were required to put up only a “good faith margin”--that is, they could borrow whatever a bank would lend. And anybody who stood ready to buy or sell a stock--a hedge-fund operator or a “risk arbitrageur” speculating on takeover situations, for example--could call himself a “market maker.” So could big-time brokers trading their own positions, provided they were members of more than one exchange.
Until 1983, the SEC required everyone claiming exemptions from the Federal Reserve regulations to file documents with the commission. Then Shad’s SEC withdrew the requirement. The result is that today nobody polices the use of credit by market professionals--which means, in practice, the hedge funds and takeover artists.
Meanwhile, the SEC has, in effect, jettisoned the rule against going short--selling borrowed stock--into a declining market. In the 1920s, “pools” had driven prices down by selling stock they didn’t own and then buying it at lower prices after the public panicked. To prevent the recurrence of such tactics, the New York Stock Exchange imposed on itself in 1931, and the SEC under Chairman William O. Douglas strengthened in 1938, a rule forbidding anyone to sell stock he or she didn’t already own if the price was already going down.
In December, 1986, however, the SEC sent to Merrill Lynch a “no action” letter that can be variously interpreted but was unquestionably regarded by broker/dealers who sold short into the collapse as permission to ignore the short-sales rules if they conflicted with the firm’s computer-based program trading strategy. People who work on the stock exchange floor saw huge sell orders from the big brokers trading for their own account, none of them marked “short,” as the rules seemed to require. But the SEC had changed the rules.
‘Proprietary Trading’
When the SEC was established in 1934, one of the duties given it by the Congress was an examination of whether the law should permit firms to be both brokers representing customers and dealers trading for their own account. There were official reports in 1936 and 1945 and a Twentieth Century Fund study in 1975, all of them indicating that there remained grounds for concern.
But, as late as 1975, nobody could have imagined brokers making more money from their “proprietary trading” than they made from commissions. This happened, starting in 1982, essentially because Shad’s SEC actually encouraged trading by the brokers. In an era when all the banking regulators were compelling banks to increase their ratio of capital to assets, the SEC cut in half the previous capital requirement for brokerage houses to encourage them to trade. And as a budget-cutting measure, the agency junked its proposed computerized Market Oversight Surveillance System.
On television’s “Adam Smith’s Money World” early this year, Ken Heebner, who runs investments for a Loomis, Sayles mutual fund, complained bitterly about his post-crash discovery of “how aggressively the brokerage community, to whom we are paying commissions, trades against us.”
None of that has changed. The SEC still refuses to police the market-maker exemptions, to enforce its own short sales rules against broker dealers, to strengthen capital requirements that might diminish proprietary trading or to forbid manipulative trading by brokers between the stock and options markets, both of which it regulates.
A market where agents take both fees as agents and profits as principals is an inherently unstable market. Insiders are spooked by it in ways that analysts, journalists and politicians who live a little further away find difficult to understand.
And customers quite legitimately distrust it.
But that’s the stock market we have today. The SEC was established to prevent the operation of such markets. Instead, it has created one.
