Viewpoints : Unleveraging the Market : The SEC could improve stability by requiring high-risk speculators to play with their own money.
Almost 19 months ago, the stock market narrowly missed a horrendous fall that had been set up by the failure of the Securities and Exchange Commission and the Federal Reserve Board to limit borrowing by speculators who held risky positions.
In late March, 1988, the Campeau Corp. deal to buy Federated Department Stores was on the floor at the New York Stock Exchange. Stock with a value of $6 billion if the deal went through was held in large part by gamblers who had borrowed at least $3 billion to carry it. And this was, as everyone now recognizes, a bad deal that should not have gone through.
“If the sources of financing for the Federated deal had backed away, which they had not only every right but every reason to do,” I wrote soon after the deal had closed, “Federated stock would have dropped 30 points in a day. The banks would have pulled the plug on the traders, calling in loans that were no longer adequately secured, and the traders would have had to sell everything else they owned. They couldn’t have sold any quantity of Federated itself because there wouldn’t have been any buyers.”
Something very much like this happened at 3 p.m. Eastern time on Oct. 13, when the announcement hit the tape that the sources of financing for the United Airlines buyout (another bad deal at the price) had been unable to complete the package. The “arbs” hit the panic button, selling first in the Chicago futures pits as the quickest way to protect themselves, and then wherever they could sell. Computers triggered to trade on certain information kicked in and rushed all the wise money to the exits, which again turned out to be crowded. The one-hour drop was about as bad as anything on 1987’s Black Monday, but fortunately there was only one hour of trading time.
Fortunately, too, the futures contracts hit the limits that were imposed reluctantly after the 1987 crash. The fact that the futures couldn’t be traded eliminated the guaranteed profits index arbitrage gave to the insiders in 1987 and somewhat retarded the speed of the fall at the stock exchange.
One of the oldest of market truths is that people panic not because something they own has lost value--one can live with that--but because they owe money that they won’t be able to repay if the price of what they hold keeps going down. That’s why the Federal Reserve forbids the ordinary reader of this newspaper to borrow more than 50% of the market value of the stocks that he buys.
But the rules offer an exemption for “market makers” who qualify under Rule 3b-8 of the Securities and Exchange Commission. Market makers--stock exchange specialists and over- the-counter dealers--at least theoretically accept an obligation to smooth market movements. To assist them in this work, they are permitted to borrow on what the rules call “good-faith margin”--whatever the banks are willing to lend.
In 1983, the SEC dropped its previous requirement that those asserting a status as “market makers” file with the commission an affidavit that they qualified under Rule 3b-8. Stock market speculator Ivan Boesky and his imitators then maneuvered around under the rules of the regional exchanges to claim that they were market makers--after all, they were buying and selling all the time. And the banks, always hungry for business and often not very bright, accepted “takeover arbitragers” as legitimate market makers and lent them up to 90% of the purchase price of what they were buying.
The panic that almost closed the stock markets at midday on Oct. 20, 1987, resulted from the withdrawal of credit to these key “professionals.” Nevertheless, the SEC failed to reinstate its rule requiring applicants for exemptions from the Fed regulation to swear that they are performing a service as market makers.
The commission has refused to restrict borrowing because they think the money that “professionals” borrow enhances the liquidity of the market. The Division of Market Regulation and its director, Richard Ketcham, have taken the position that the market must be liquid enough to permit rapid trading of very large positions by pension funds and other institutions. At a Federal Reserve conference in June, Ketcham said that everybody had to face the fact that we now have a “dealerized” market, in which the brokerage houses themselves--not their customers--are going to be the buyers when the institutions want to sell and the sellers when they want to buy.
But this is the sort of market that the Securities and Exchange Act of 1934 was written to prohibit. “The bill,” said Sen. Duncan Fletcher when introducing it, “seeks to protect the American people by requiring brokers on these exchanges to be wholly disinterested in performing their services for their clients and for the American people trading on the exchange.”
To increase the volume of trading, which is presumed to increase the “efficiency” of a dealerized market, the SEC has winked not only at excess borrowing but at activities by brokerage houses and traders that would have been considered clearly illegal by every SEC before this one.
Markets always “need” more liquidity, however much there is. The stronger the belief that the market is liquid, the greater the number of people who think that they are smart enough to get out ahead of the pack. The fact is that all these guys are about as smart as all those other guys, and none of them is as smart as he thinks he is. And the banks, unfortunately, are willing to fund them one and all up to the legal limit--until they get in trouble.
We have a new chairman of the SEC now, Richard Breeden, a lawyer rather than a market man. He comes as a deregulator, but this introduction to how badly his predecessors have done their job should make him stop and think.
The SEC could, with the stroke of a pen, restore the requirement that people claiming exemption from the margin rules must swear under the penalties for perjury that they are entitled to it. The SEC could also restore the capital requirement for brokerage firms to the level that existed before John Shad of E. F. Hutton became chairman and reduced it by one-third to help his old friends do more trading.
What to do about computerized trading is a harder problem than advocates on either side of that debate will tell you, but if people want to play these often manipulative and dangerous games, the government should make certain that they do it with their own money.
