IT'S ALL ABOUT CONFIDENCE AND ORDERLY MARKETS

This week’s 'roller coaster ride' in the US and global equity and debt markets has been all about investor confidence, and almost nothing else. There were no concerning economic reports that triggered sell off’s on Monday and Wednesday, nor were there reports of economic optimism that triggered massive buying on Tuesday, Thursday, or Friday. As we close out the week, we do so at about the same level at which we started it: the DOW at, or near, 11,400, the S&P 500 above 1,250, the 10 year Treasury note above 3.5% and oil at close to $100 per barrel. The one striking exception to this was gold, up to nearly $864 an ounce.

Throughout the week, the markets were pummeled by concerns over liquidity for some of the most important players in the domestic and global credit markets, and whether or not those firms would find the resources to continue operations critical to our economy. The concern over these issues was immediately reflected in the equities markets and stock markets around the globe began to see a level of emotional and pricing volatility that may well be unprecedented. These concerns were born of the recognition that if capital market providers (investment and money center banks, etc.) were unable to meet their obligations it would slow the economy yet further, which in turn would make it more difficult for these organizations to do their jobs, and a spiral might ensue that could be devastating. These are issues pivotal enough to warrant federal intervention, and intervene they have. Governments around the world began to make decisions to shore up the capital markets, and in most cases these are the very decisions for which the equity and debt market leaders have sought support over these last many months. Perhaps the most important of them involving the reemergence of the Resolution Trust Corporation (RTC), and dramatic revision of the short sale rules and regulations. Though we can’t begin to address the complexity of all of the various issues at hand, we can discuss the two of these.

Treasury Secretary Paulson, Fed Chairman Bernanke, and SEC Commissioner Cox have jointly recommended various ‘big fixes’ to the current financial turmoil; solutions that are, quite frankly, the embodiment of the phrase, ‘necessity is the mother of invention’. President Bush announced this morning that his administration, along with various house and senate leadership, from both sides of the aisle, are standing behind these recommendations, and will move them through the appropriate legislative bodies with all due haste. The RTC and short sale reform stand at the heart of their recommendations.

The RTC is designed to acquire illiquid assets from capital market providers desperately needing liquid assets, in exchange for cash, and then to take the time to sell those assets to investors in an orderly and timely manner, to realize their full value. Under the premise that the RTC will purchase these assets at ‘reasonable’ prices, and then sell them for fair market values over time, the RTC should be able to return to the US taxpayer the funds the RTC was provided to the acquire the assets. While that’s a pretty substantial presumption, it makes sense. The assets at issue are too big and under too much pressure to be able to remain on the balance sheets of capital market providers without exasperating the current economic slowdown. There are even too many of these assets to stay on the balance sheets of the Federal Reserve and the US Treasury, but the US House and Senate have an even bigger balance sheet, and the assets can reside there until such time that they can be sold off to others, and not damage the economy or critically burden the US taxpayer. Most of these assets are bundles of mortgages, or mortgage-backed securities over which there is considerable concern of default, and foreclosure against devalued properties. The reality is, that while too many of these mortgages will fail, most will not, and the long term value of the bundled mortgage package is far greater than the apparent, or ‘fire sale’ value the SEC’s mark-to-market rules require the holders of these instruments to report and capitalize against.

The RTC was successfully utilized in the wake of the Savings and Loan debacle of the late 1980’s and early 1990’s. It helped restore confidence to the real estate, debt and equities markets, and did so at a reasonable cost to the economy and tax payer. Bringing the RTC back into operation once again, with capable leadership and sound regulatory oversight, can offer our economy and taxpayers the same benefit today.

Short selling in the stock markets isn’t a very intuitive process, and for most of us it’s not only hard to understand, but hard to justify. It is also an important tool in a free market, and worth continuing within appropriate guidelines. In the past, one could sell a stock that they didn’t own as long as they provided adequate capital in their brokerage accounts to assure that they would be able to purchase the stock in the future. The presumption being, that the price of the stock when sold was higher than it would be when purchased, and the result would be a profitable series of transactions. Investors were only allowed to sell stock in this manner, or ‘short’ the stock, in the event that the last transaction for the stock was on an ‘up-tick’, or higher than the transaction before. This assured that a series of ‘short selling’ transactions could not result in an ever declining value for the stock at issue. Essentially, the ‘short seller’ couldn’t create the value decline from which they hoped to profit.

For many decades this strategy actually assisted in the maintenance of an orderly stock market. But over the years, certain ‘short sellers’ found ways around some of the rules, and realized they could manipulate markets in ways that buyers of stock could not. They didn’t have to publically disclose the amassing of major ‘short’ positions, they found ways of ‘shorting’ the stock without ever having to actually purchase it in the future, and ultimately, when the largest of the US stock trading organizations, the New York Stock Exchange (NYSE), began to delineate transactions in penny increments rather than in 1/8’s the ‘up tick’ rule was declared too difficult to administer or regulate, and too inconsequential to make a meaningful difference. WRONG.

The ‘up tick’ rule was eliminated less than a year ago and the ensuing volatility in the markets has been torturous. Market makers, hedge funds, speculators, and ‘volatility traders’ began to focus on individual companies in industries already under economic and market pressure, and began to drive their share values down so far that some of these companies failed, or were forced to consider seeking capitalization elsewhere. The value of companies such as Bear Sterns, Lehman Brothers, Merrill Lynch, Morgan Stanley, Fannie Mae, Freddie Mac, and others have been devastated, and some of these companies have either required federal intervention, been take over by others, or worse.

SEC Chairman Cox has now placed a moratorium on short selling of 799 financial stocks for a limited time; presumably long enough to restore order to the trading of those stocks, and to end the egregious manipulation of these company’s share values and capital base. Included in this action was the restoral of the ‘up tick’ rule. While this is a great first step, the SEC needs to permanently restore the ‘up tick’ rule, to require the same type of reporting of ‘short’ positions as that of investors amassing ‘long’ positions, and to vigorously prosecute those that seek to manipulate markets.

The US House and Senate need to immediately back Bernanke and Paulson’s plan to restore the RTC, and stand with Bush in striving to restore confidence in the financial markets. Additionally, the RTC must be given sufficient funding as to not have to ‘clear’ purchase decisions through politicians seeking favor, but not so much leeway as to allow the RTC to become ‘all powerful’ in the capital markets. Objective criteria needs to be established for the valuation of assets, for both purchase and sale, by those with the appropriate credentials, and having the title of congressman or senator ought not to be considered as a credential in this case.

The US economy has shown remarkable resilience in the face of horrendous pressures for the entirety of Bush’s presidency, and longer. Some would suggest it is the Bush administration that has wrought much of this pressure, and others blame the appetites of high-income earners and investors. While they can in no way be held without responsibility, they also cannot be required to shoulder the blame on their own. In the end, it is the public that bears the brunt of the problems our economy has faced. And yet, our economy has continued to grow. The economy, including each and every household in this country, has endured the actions and outcomes of terrorists, market (oil and financial) manipulators, hurricanes, real estate and dot com bubbles, wars, state and national legislators, and previous administrations since the dawning of this millennia, and yet the economy has continued to grow.