In case you missed it, whatever semblance the United States had of being a free market economy has died. Last night Hank Paulson, Secretary of the Treasury, announced a ban on all short selling of US Financial Stocks. The talking heads are heralding this, along with the other measures, as the panacea for the woes in the financial markets, but what this really signals is the beginning of the end of the United States as the financial capital of the world. Should you worry? Yes.
Before I present my argument, let me state this clearly, I have never naked shorted a stock in my life. I have done other things naked, but that is not the subject of this post.
Ayn Rand warned us this would happen. In the classic, Atlas Shrugged, she wrote about governmental powers manipulating markets in order to advance political concerns. Like the book, we do not seem to have the political will to take the correct, but painful, road to recovery. By propping up the financial system with the band-aids of trading restrictions and an explosion of the government's already untenable balance sheet, the necessary adjustments to the financial system are prevented from occurring.
Let's break it down: the investment banks and some insurance companies have invested in long-term risky assets, levered 30 to 1, and funded their purchases in the overnight markets. This is akin to me buying the home I plan to live in for 30 years with only 3% down and funding my purchase with a series of one-day loans rather than taking out a long-term mortgage. Even worse, because I am convinced that real estate prices will continue to go up, I don't bother to get an appraisal or a home inspection. So, when the price of my home goes down and the banks, as financial logic would correctly dictate, will no longer lend, I lose my house and my 3% equity stake. I may think that my home will go back up in value, but at the end of the day, this is irrelevant because my leverage does not enable me to weather the financial storm. Similarly, as the homeowner loses his equity, so should the investment banks. Out of greed, they took on too much risk and funded it too short term. That's their mistake, not the U.S. taxpayer's, and they should not be protected by changing the rules of trading.
The free markets are meant to function as a corrective mechanism for companies, and for governments for that matter too. When a company is doing well, its stock is meant to rise, when it does poorly, the opposite should happen. The change in short selling rules has circumvented that feedback mechanism. Financial companies are now insulated against market discipline. The consequences could be disastrous because the global markets will ultimately provide the discipline that the US authorities lack the courage to administer. The result will be nothing short of the destruction of the US dollar as a reserve currency.
People have thought, and rightly so, that the US was a safe haven to pour money into in difficult times. But, if the rules can be changed so quickly, then who's to say that the authorities do not change them again when they can't fund their ever increasing budget deficit? I shutter to think about capital controls, but this thought now crosses my mind. The US government, long the preserver of capitalism, has just thrown the free markets out the window without a rope. All bets are off and all things are possible.
Are financial institutions sounder today than they were yesterday? Nothing has changed in the amount of unpriceable, illiquid assets that are being held. Nothing has changed in size of the bad commercial real estate loans. Nothing has reduced the counterparty exposure of off-balance sheet, unregulated swaps. What the Fed, Treasury, and SEC should have done was to let the chips fall as they may by allowing healthy financial institutions survive and the weak ones go bankrupt or be forced to merge. They should have let free markets function while protecting the innocent by raising the FDIC limit of deposit insurance from $100,000 to something significantly higher. I commend their protection of money market funds but, at the same time, they must allow the owners of the irresponsible financial institutions, the equity holders, to suffer the consequences of their imprudent practices.
Our strength as a country, has always been to address problems head on, take the medicine no matter how distasteful, and emerge stronger than ever. Sadly, times have changed. Our government has shown that it will change the rules of the markets whenever it seems expedient. Simply put, it will curtail the free markets when it doesn't like what the free markets are saying. In the long run, this will lead to a disaster of unprecedented proportions. It would not be surprising to hear people walking the streets of New York asking "Who is John Galt?"