Taking the Socialist Road

I just listened to Henry Paulson, US Secretary of the Treasury, announcing what maybe the largest bailout in history of the most irresponsible, greedy and predatory companies on Wall Street. There is the most supernal irony in the fact that within the span of a single week, the Bush administration has accomplished what they have claimed the Democratic Party has been trying to do for decades--the transformation of US free enterprise capitalism into something that looks more like the Union of Soviet Socialist Republics of yesteryear. As Jeffrey Sachs opines, the bailout of AIC amounts to a nationalization of the world's largest insurance company. But if the Dems want to tax and spend, here we have spend and tax.

Perhaps the most insightful explanation of what happened may be found in this piece from The Big Picture: How SEC Regulatory Exemptions Helped Lead to Collapse which quotes an article by Lee A. Pickard, former SEC Director for Trading and Marketing Division

"The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch.

The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.

Making matters worse, according to Mr. Pickard, who helped write the original rule in 1975 as director of the SEC's trading and markets division, is a move by the SEC this month to further erode the restraints on surviving broker-dealers by withdrawing requirements that they maintain a certain level of rating from the ratings agencies.

"They constructed a mechanism that simply didn't work," Mr. Pickard said. "The proof is in the pudding — three of the five broker-dealers have blown up."

The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. It requires that firms value all of their tradable assets at market prices, and then it applies a haircut, or a discount, to account for the assets' market risk. So equities, for example, have a haircut of 15%, while a 30-year Treasury bill, because it is less risky, has a 6% haircut.

The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower.

Having taken the socialist road, now we are in uncharted territory. No one knows what we will find here. Thanks to Bush, we are all socialists now.