When the investment banking firm of Bear Sterns recently imploded from $29 billion in shareholder value to essentially nothing in a matter of days, I was prompted to crack the books I had to study to become a licensed broker dealer many years ago.
In my own experience of meeting the expectations of securities regulators who conduct audits and review our quarterly reports, I found it unbelievable to think that Bear Sterns managed to hide what was obviously a highly-leveraged, precarious perch in the investment community.
While few people actually understand money in a fundamental sense, even fewer people fully understand the workings of the brokerage community and the degree to which they are free to use customer money as collateral for loans. The allowable margin for a brokerage firm is 15-to-1. This means that a firm conducting a general securities business can borrow as much as fifteen times the amount of money they have in customer securities. Does that come as a surprise? Whose idea was that?
By comparison, retail investors are carefully limited to borrowing not more than about 50 percent of what we have invested in stocks. When we do borrow to invest, it's called a margin account, and a "margin call" is what we get when the stock drops enough so that our loan is now more than 50 percent of the total value of the stock we own.
Margin requirements were adopted back in the 1930's in response to what was seen back then as "uncontrolled speculation." In those days, the term "bucket shops" applied to brokerage firms that just deposited customer money in a bucket (out in the back somewhere.) It was never actually invested in stocks, but they kept track of share prices and gave customers who then sold an amount of money from the bucket that represented their new share values. The system worked as long as there were as many losers as winners so as not to run out of money.
With leverage of 15-to-1, is the brokerage community much beyond a giant bucket shop today?
It's interesting to learn that Hank Paulson, our Treasury secretary and former head of Goldman Sachs, is calling now for more government regulation in the financial markets. It's about time.
I'm getting tired of hearing about these financial institutions, like Long-Term Capital a few years ago, that "threaten to collapse our entire financial system." Thank goodness, in the case of Bear Stearns, we taxpayers had the Federal Reserve at our disposal and ready with a bailout. To his credit, Paulson insisted that the failure of Bear Stearns, their loss of $29 billion and 14,000 jobs, was a reasonable price to pay for the hubris that threatened the free world as we know it.
The Bear Stearns event should send a shot across the bow of the rest of the investment banking community and create a healthier environment for those of us just struggling to save for retirement. We don't deserve these threats to our security.
Unfortunately, our watchdog, the SEC, is still locked a partisan dispute resulting in what is still a missing tie-breaking director, and this demoralizing paralysis has persisted for almost two years. Meanwhile, the $3 trillion dollars of our 401(K) money is what props up all of these ingrates.
Patience will be rewarded.