Former SEC Chairman Levitt on the Dangers of The Paulson Doctrine

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Former SEC chairman Arthur Levitt makes the case for why the SEC “is the guardian of America’s capital markets” in a Wall Street Journal op-ed piece (“You Can’t Control Animal Spirits”).

Levitt first makes the point that animal spirits and moral hazard have “caused even more disruption” in the market. Politicians and government officials (the animal spirits) try to instill confidence in the market. But they end up making matters worse in their desire to inflict “moral hazard.” Or what I would more appropriately term selective moral hazard since it was the actions and decisions of the company’s management that engaged in excessive risk taking, not the shareholders. I completely agree with Levitt that the Treasury and the Fed inflicting moral hazard on Bear Stearns shareholders “only encouraged short selling in other financial institutions such as Lehman Brothers (LEH), Fannie Mae (FNM) and Freddie Mac (FRE), because both the short sellers in the market and any potential long-term buyers knew that shareholders wouldn’t be protected.”

Another key point Levitt makes relates to Treasury Secretary Paulson’s “Blueprint” that proposes to give the Federal Reserve more power over monitoring the capital markets. This is a clear conflict of interest. “Banking regulators give investor protection lip service – the Fed protects investors only if it coincides with their primary interest of protecting the bank. The SEC’s duty is to investors, protecting investor’s cash and securities, and working to prevent securities fraud.” The Fed and Treasury’s only concern was for Bear’s counterparty, JPMorgan (JPM), to be protected to prevent a run on the entire banking system. Shareholders are irrelevant to the Fed. And the short sellers fully understand this.

The most important accomplishment Levitt achieved during his tenure as SEC chairman (1993-2001), was Regulation Fair Disclosure. Thanks to Reg FD, major company announcements and SEC filings must be simultaneously released to the public and institutional investors.

Regarding short selling, I agree with Levitt’s idea that large short positions should be required to file with the SEC in the same manner as disclosing large long positions. Levitt views the SEC’s Emergency Order banning naked short selling in 19 financial stocks through August 12, 2008, as a “quick fix.” What’s surprising is that Levitt is concerned that the ban has “created hidden problems in the back offices of investment and commercial banks.” Translation: Wall Street’s administrative systems were never set up for legitimate short selling, i.e. actually obtaining the shares in advance of shorting the stock. Everything has been based on a sort of implicit understanding that the shares can be obtained by settlement date.

Levitt loses me when he states that “a regulator can never, and should never attempt to, control the animal spirits of the market. They can’t – no one can.” Like Greenspan, Levitt played his role in enabling the NASDAQ to bubble and crash in a tech wreck. He approved the exemptions of some Enron partnerships, allowing the defunct company to play a shell game.

“A regulator cannot predict a crisis.” Levitt has joined Greenspan and other former officials in this regard. What they’re really trying to say is that we don’t want to stop the party until the last guest has departed and there’s nothing left but one big mess to clean up. And we’ll leave the mess for someone else to clean up while we sit from the sidelines complaining about the sad state of affairs and why it could not have been prevented.

Related Post: “What the SEC Really Did on Short Selling”

Disclosure: Long JPM

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