A quarterly magazine of urban affairs, published by the Manhattan Institute, edited by Brian C. Anderson.
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A Safe Haven for Investors
American regulations protect account holders from around the world; will policymakers thwart them?
29 April 2008
After the Federal Reserve stepped in last month to prevent Bear Stearnss collapse, observers pointed to Bears crack-up as the latest evidence of massive regulatory breakdown. But before we pronounce our decades-old financial regulatory system a failure, we should consider Australia, where brokerage account holders recently suffered at the expense of creditors, something that wouldnt have happened here even if Bear Stearns had failed. The contrast underlines how America still ably, if imperfectly, protects the worlds investors and savers. But such protection could be in peril as policymakers try to avoid inevitable financial and economic pain.
Over the past month, account holders at two Australian stock brokerage firms were shocked to discover that their investments had disappeared. Investors in a third firm also have cause to worry. What happened? In setting up their accounts, the investors deposited stock so that they could borrow against it. Under Australian regulation, the firms were, in turn, allowed to take these customers stock holdings and use them as collateral to borrow money from major banks, including Merrill Lynch and a brand-name Australian bank, ANZ. The brokerage firms then used that money to make more loans of cash and stock to other borrowers, who in turn made their own bets in the stock markets. As new debt on the part of the brokerage firms and their customers fueled an expansion in trading, and as that expansion in turn fueled new debt, the firms structure grew ever more precarious. As long as the markets were rising, everyone was making enough money to keep current on the debt. (Sound familiar?) But when Australias equity markets began plummeting last year, many borrowers found themselves unable to repay their loans.
Eventually, the brokerage firms themselves couldnt pay back their debts. Under the Australian rules for this kind of account, that failure allowed the lending banksincluding Merrillto seize all of the firms clients accounts, quickly selling off some of their stock to recoup their losses. Even brokerage clients who borrowed comparatively little money against their stock holdings, and those who kept up with their payments, face huge losses. The implosion has shaken confidence in Australias stock market, notes the Wall Street Journal. More Australian brokerage firms are expected to go through the same upheaval over the next few months. Companies that dont employ these firms risky practices have been quick to tell their customers so, lest they face massive withdrawals.
As for the regulatory glitch that allowed the big creditors to seize customers accounts, its wildly at odds with every other . . . broking arrangement in the land, the Sydney Morning Herald noted. Your house, your car, and your mobile phone belong to you, even if you borrowed money for the purchase. If the mortgage broker, the car dealer and the mobile phone retailer all go belly-up, it wont make a lick of difference to you so long as you keep up the repayments. Chimed in the Australian: The biggest financial losers have been investors who thought they owned the shares. . . . Investors deserve to know that their retirement savings are being properly managed and regulated.
Contrast the Australian debacle with America, where, thanks to our long-standing regulations, such an event couldnt happen at a brokerage firm, at least not legally. As Bear Stearns edged toward the precipice six weeks ago, its account holdersinvestors placing their own stocks and bonds in accounts with the firm, sometimes even in order to borrow against themenjoyed protection. Thats because the Securities and Exchange Commission forbids firms from using account holders assets as collateral for other firm or client borrowingthat is, the firms cant use your stocks and bonds to speculate or to help other account holders speculate. Even if your brokerage firm goes under, you are not an unsecured creditor of the firm, but a depositor whose assets are segregated. Theres an added protection, as well, at virtually all reputable firms, should they collapse: if customers securities do go missing, a congressionally chartered private company, SIPC, protects account holders at participating securities firms for up to $500,000.
Had Bear Stearns failed, its creditors, not its account holders, would have stood to lose their shirts. In fact, the SEC ably protected Bear Stearns account holders and left creditors, who were supposed to be sophisticated assessors of risk, on their ownat least until the Fed came to the rescue. Australias regulatory system, at least in these particular cases, worked in the opposite direction: it protected sophisticated creditors like Merrill, which had lent money to the three brokerage firms, at the expense of account holders.
Strict American protections for savers, too, have made our current financial-industry crisis less severe than it might have been. Bank depositors know that the government protects their accounts for up to $100,000 per depositor per bank, in case of bank failure. This knowledge is why, even as the media have carried the direst news about household names like Countrywide and Citibank, we havent seen people panic and withdraw their money from banks.
This silent success of our regulatory system doesnt negate real problems. We still face upheaval in the unregulated financial world that has evolved over the past two decades alongside our long-regulated system. This universe, of course, includes the world of opaque structured-investment vehicles, collateralized debt obligations, and other complex instruments, about which weve heard so much of late. The severe crunch were having in this unregulated sphere is already affecting the economy beyond the banking world. In recent years, banks increasingly relied on this unregulated system to raise money for loans to customers. Now that these sources of financing have dried up, many small borrowersfrom credit-card holders to homeownersare finding their own access to credit curtailed or even cut off.
But American investors have an option that investors in many other countries dont. If they want to avoid taking big risks with their money, or if they dont want to worry that someone is going to make offlegallywith their stock, they can enjoy the security of a well-regulated investment and savings regime in their own domestic economy. Investors in some parts of the world, however, know that leaving their wealth in their own country means exposing it to the risk of sudden inflation, capital controls, or expropriation during a crisis. Thats why wealthy Chinese and Latin American investors buy expensive real estate in New York, and why Middle Eastern and Russian investors have accounts in London and elsewhere.
Todays biggest long-term risk to American financial stability is that our own government will imperil our status as a safe haven for the worlds savers and investors. Consider what the Federal Reserve is doing to the dollar. The Fed has pushed interest rates down precipitously, risking sustained runaway inflation. It hopes that easier money will keep home prices from falling even further and prevent banks from having to write off even more hundreds of billions in bad debt, in turn staving off a recession. But the Feds actions are partly why the price of goods that are bought and sold mostly in dollars, from oil to wheat, has skyrocketed around the world. This erosion of the de facto global currency has precipitated stockpiling and rampant speculation, encouraging nations in less developed parts of the world to hoard rice and even prompting suggestions that American consumers stockpile staples like cereal so that they can stay ahead of higher future prices. The inflation also hurts nations that tie their currencies to the dollar, including many governments in the Middle East. These nations are now effectively importing our inflation because they follow our monetary policy.
If the world loses faith in the dollar because American policymakers want to avoid short-term pain, it could turn elsewhere for a more reliable global currency. Such a scenario isnt imminent, but neither is it inconceivable. This switch would cause far more long-term damage to the American economy than even the most painfully protracted recession could. America would start to see its own account holders money leave in drovesnot for a better-regulated area of our own system, but for a safer haven overseas.
Nicole Gelinas is a contributing editor to City Journal and a Chartered Financial Analyst.