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Author: GoNuke One star, 50 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 10551  
Subject: SEC Regulation Date: 10/5/2008 12:48 AM
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The SEC was created in the wake of the great stock market crash of 1929 and the subsequent recession. For many years the US led the world with respect to regulation of securities markets. US regulations were stricter, rendered the markets more transparent, and made it safer for people to invest. Indeed I remember being taught at business school in the late 1970's that the strict regulations imposed by the SEC drew capital from around the world to the US. The thesis was that it was dangerous to invest in most other stock markets unless you were an insider or a majority shareholder on the grounds that less regulated markets afforded little protection to minority investors. At the time I was in graduate school insider trading wasn't illegal in Germany. Canada, which had relatively stringent regulation by world standards was still less regulated than the US. One large Canadian oil firm: Dome petroleum, went bust in the 1980's after it sought listing on a US stock market and had to comply with SEC reporting rules. It turned out the company had managed to secure huge quantities of debt from a variety of Canadian Banks yet none of these banks were aware of how much Dome owed the others until they read about it in an SEC filing.

Over the last 25 years the US attitude towards regulation has turned sour. Regulation is vilified. Some people are suggesting regulation is a form of socialism. The fact is that without these regulations nobody could carry out the kind of analyses that investors are accustomed to. Stock screens rely on data that SEC regulations force corporations to provide. The US financial system has out-performed every other national system providing more capital for more businesses -including start-ups, and financed more people's retirements. Regulation has made this possible by making the markets trustworthy. Money flows to the US and throughout the US because of trust. Investors are confident that their money will not be stolen. It might be lost, a company's management might make bad decisions, but management will find it very difficult to steal your investment.

The pain that is being felt now: the credit crisis, the inflated house prices and toxic mortgage backed securities, and the falling value of the stock markets are a consequence of inadequate regulation. For example in 2004 the SEC, at the request of the then major investment banks, eliminated a regulation that limited how much money the brokerage arms of the big investment banks could borrow.

The following is taken from the liked New York Times article below:

http://www.nytimes.com/2008/10/03/business/03sec.html?

"In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency [SEC] also decided to rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.

Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measurement of how much the firm was borrowing compared to its total assets — rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly.

The 2004 decision for the first time gave the S.E.C. a window on the banks’ increasingly risky investments in mortgage-related securities.

But the agency never took true advantage of that part of the bargain. The supervisory program under Mr. Cox, who arrived at the agency a year later, was a low priority."

I urge you to read this article and the rest of the Times articles in the "Reckoning" series which describes how the credit crisis evolved.

Clearly mortgage lending also requires more regulation. Because house buyers weren't required to make down payments they ended up bidding at an auction using other people's money (supplied by banks). There was no long arm of the marketplace to ensure houses did not become over valued. This is what led to the great Tokyo real estate bubble. Often the lenders took no risk because they quickly sold the loans on to over leveraged banks which turned these opaque assets into tradable securities. "Liar loans" were transformed into AAA rated securities.

As an investor it frightens me to think that such activity is possible in the US market. Like the banks that are afraid to lend money to each other, I too am afraid to invest more money in the US. I want to see more regulation and the restoration of confidence. When I lose my next fortune I want it to be a consequence of my own mistakes not the SEC's.

The great depression happened, at least in part, because banks gambled depositors cash and lost some of it. Depositors found out about these losses and made "runs" on banks. This bankrupted a lot of banks and cost depositors their savings.

This time round very wealthy depositors and hedge funds made runs on investment banks. These runs destroyed a lot of wealth but neither I nor Congress understood what was happening. Paulson understood. He was one of the fellows at the meeting with the SEC in 2004 urging that his bank and others like them be free to regulate themselves.

Bank failure, massive destruction of wealth, credit markets frozen by fear: we have all lost money and the engine that we rely upon to make more money (the economy) is stalling. It could all have been avoided with proper regulation.
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