The Forgotten Way The Federal Reserve Managed Financial Leverage
The Forgotten Way The Federal Reserve Managed Financial Leverage.
Today, Financial Leverage is simply the way we do business. Most of us don’t give it a second thought: when we go to the store, we pull out the “plastic” and pay for our goods and items. Little do we realize that we have just made a loan with our credit card company. The dollars we’re using to pay are part of a revolving loan with our VISA, Master Card, or other credit provider.
A majority of all purchases are made this way. And, if you’ve noticed, many businesses encourage you to “pay by credit.”Wall Street hopes you heat up your cards as you spend, spend, spend during this Holiday Season. Your borrowing on those little plastic cards directly translates into more retail sales.
This time of the year is the most critical sales period, the time when most retailers will make most of their income. Black Friday, that massive sales day after Thanksgiving, was initially projected to be when shops and stores broke into solid profitability. Sales were pure profit From here until the end of the year. So grab your favorite credit card, get out there, and help those retail stores and shops.
But Americans haven’t always looked at Credit Card spending this way. There was a time, and indeed an entire generation, that looked at credit cards like Dracula sees garlic or the Cross: absolute anathema, which should be shunned at all costs. I know I lived through at least part of those times.
In 1972, when I began my career as a Stock Broker, credit was considered a danger, a financial obstacle, a short stop on the way to financial ruin. It was just 33 years since the end of the Great Depression. Most of these senior executives and economic leaders had lived through that Depression. They had seen the far side of the mountain, the time when credit had turned to dust for many.
It was the World War I generation; most were in their 60s and 70s, and like today’s Baby Boomers, many had progressed to heads of agencies and corporations. I worked for E.F. Hutton & Company, where the Regional Partner, Gordon Crary, was part of this generation. My graduate Professor, Charlie McGolrick, likewise, for the heads of the Securities and Exchange Commission, Bradford Cook, and the New York Stock Exchange, Robert Haack. All had seen that dark and gloomy time in American history when, for a decade, Americans were unsure where their next meal might come from or how they would meet their financial obligations.
Everyone I ever met from that generation blamed their financial woes on leverage. My grandparents, who were also members of the World War I generation, went even further, seeing not just an economic “sin” but a spiritual one as well. Like most families of that time, they knew of at least one relative whom the 1929 Stock Market Crash ruined. My Grandmother’s uncle filed that spot for us. At one time, a wealthy man lived the remainder of his life under the generosity of his extended family, relatives who would never dream of taking a loan from the bank. He was another example of Shakespeare’s admonishment: “Neither a borrower nor lender be.” (Hamlet Act 1, Scene 3).
It fits in perfectly with the policies at EF Hutton. They, too, felt that excessive credit was a danger that both the firm and the individual stock broker should avoid. As a cub broker, I was often admonished to evaluate a client to determine whether we should permit them to trade “on Margin.” Should the brokerage firm lend part of the money to invest?
Hutton remembered that during that ’29 crash, the margin accounts cost Brokerage Houses dearly. When stocks purchased on margin decline, the client must bring in additional funds, but if they cannot, the Brokerage House bears the loss. In the 1929 crash, this was the principal way many brokerage firms failed — too many margin calls.
Because of their strict margin lending rules, I had precious few margin accounts. And those that I did have first went through extensive review by my manager and me.
These tight lending standards were perfectly consistent with the entire industry. Remember that industry executives and regulators of that day had lived through the Depression. They each had a gut-level aversion to financial leverage. Ask them what caused the Crash, and you’ll get the same answer: financial leverage. Brokerage firms extended too much credit, which could not be repaid when stocks declined.
1929, you see, was just the culmination of a cycle of ever-expanding credit. Today, we know that time as the Roaring ’20s, the time of bootleg gin, speakeasies, and flappers. It was a time when the nation went on a binge of “party hearty.” During the ’20s, rules were meant to be broken. The nation learned that Prohibition wasn’t serious. It might have been the law, but it was acknowledged more in its violation than anything else.
The same was doubly true in the investment world. Wave a copy of your latest monthly stock statement before a banker, and they’d gladly lend you money. Go to a couple of different bankers, and you’d likely get a couple of other loans, all on the same collateral (stocks). On top of the free-flowing money, there were also “bucket shops,” where you were never sure if the bucket shop executed the order. The “bucket shop” said it was (gave you a statement), but in the end, you had to take their word for it.
The brokerage business was as fast and loose as the average “floating crap game (see movie: Guys and Dolls).” The lack of regulation and the easy loans created an explosive combination that was bound to blow up eventually. And blow up it did in 1929.
After the Crash, most Americans were in shock. How could such a relatively small, esoteric business cause the failure of the entire financial system? Back then, few were involved in the investment business. Outside of Manhattan, few people had ever heard of, much less followed the stock market. My Grandmother’s uncle was one of those very few. None of the modern investment products like mutual funds, money market funds, index funds, or annuities existed back then. Investing was mainly a stock and bond proposition.
To even the most casual observer, it quickly became that this business required massive reform. And for one moment in time, our legislators rose to the occasion. In a series of laws, namely the Securities Laws of 1933 and 1934, Congress reformed what it meant to be a securities investment. Gone were the bucket shop back-of-the-envelop “certificates.” Under the ’33 Act, there were procedures that ensured that there was a genuine business behind that stock certificate. And that the officers and professionals who reported the financial results were providing truthful and honest Annual and Quarterly Reports.
Moreover, any violation, especially fraud, was met with federal criminal indictments. In 1934 came the reform of the exchanges; bucket shops were gone, and now the Exchanges themselves had to qualify, as well as all the brokers/dealers who were members. By the 1940s, the reformers were ready to go after the notorious “pool” operators. Those fat cat operators banned together and drove the price of stocks higher or lower to mislead the public that they could make millions by manipulating stock prices.
The crooks on Wall Street had to head for the hills. Congress and the newly created Securities and Exchange Commission were cleaning up Wall Street for the first time in a generation.
It’s been 90 years since those reforms made the US Securities Markets the fairest and most productive in the world. Unfortunately, many 1930s reforms sit idled, forgotten, and unused. The great irony is that we live in a time that resembles the Roaring 20s of the twentieth century. Many trader friends tell me that they believe markets are currently being manipulated. Indeed, some of the High Frequency Traders (HFT) activities raise questions. In the options markets, there are often questions about massive purchases or sales that look to be an effort to influence the underlying securities or other assets.
We will deal with those topics in a future article. But for now, let’s examine how we’ve abandoned our chief tool in fighting excess financial leverage.
Let’s return to 1972, my first year as a broker. It was an extraordinary year. The Dow Jones Industrial Average closed above 1,000 for the first time. It was a monumental event, as the magic 1,000 mark had become a significant hurdle. Once before, in 1966, the Dow had touched 1,000 but could not close above that level. Markets fell into a new bear phase over the next several months. So, it meant a lot when markets again touched 1,000, and this time was able to remain above 1,000.
So, put yourselves in the seat of the market regulators, and remember back then, it’s likely that you were part of the World War I generation, the generation that lived through the Depression. If markets are reaching new all-time highs, there’s a strong likelihood that investors are becoming over-leveraged.
As part of those significant reforms of the 1930s, the Federal Reserve was the Regulator that oversaw the amount of leverage brokers could provide. Under Regulation T, the Fed could raise or lower the percentage of lending for investments. When the market hit that new high (1,000 on the Dow), the Fed increased the initial margin requirement from 50% to 65%.
Throughout the 1940s, 50s, and 60s, the ability to set the margin lending rate (Reg T) had been one of the Fed’s most effective methods to rein in excess speculation. And once again, Reg T worked like a charm, lowering speculation just enough so that markets did not overheat. By raising the initial margin, the Fed prevented those “run-away” (parabolic) markets that often presage a significant crash. In other words, it is a market that would look exactly like 1929. The fact that we did not have one of those skyrocketing,
speculative spikes in 1972 tells me that the Fed was right. They prevented that excessive speculation, just as Reg T was designed.
SIDEBAR
The Fed received tremendous, entirely unwarranted criticism for raising the initial margin rate. Critics claimed that because the Fed boosted rates, a bear market ensued. It argues that margin interest rates are the principal driver of stock performance.
However, to set the record straight, let’s look at some of the other factors that intervened in causing the bear market. In 1973, middle east countries cut off America’s oil, causing prices at the gas pump to skyrocket. It was the OPEC oil embargo. In the early 70s, the US was still fighting the Vietnam War, which increased the financial burden and slowed the domestic economy. During the mid-70s, President Nixon was forced to resign in disgrace, throwing the country into political turmoil. Also, inflation began to expand, throwing the nation into a period of “Stagflation” (a deadly combination of low productivity and high inflation).
At least, it seems probable that these macro-factors had a far more lasting effect on the stock market than did initial margin rates.
Reg T The Past 50 Years
Regrettably, the Fed utilized its Reg T authority only once more. In 1974, they lowered the initial margin lending rate to 50% and never moved it again. To this day, Reg T has sat on the shelf gathering dust. Just think of how many times a slight lifting of Reg T might have cooled an overheating market. With an actively managed Reg T, the Fed might have dampened some of the euphoria leading up to the 2008 Great Financial Crisis.
As for those issues raised by my trading buddies, the modern virtual pools and high-frequency trading raise their Reg T rate. It might not stop their behavior (indeed, we may need a new set of reforms to do that), but it might curtail some of the excesses.
Isn’t it odd that in a time when the Federal Reserve has pledged to fight inflation wherever they find it, there is one asset class, stocks, that remains outside the Federal Reserve’s oversight? We need to remind Chairman Jerome Powell that Reg T still works.
Today’s Reality
Wall Street has become one of Washington’s most influential and powerful forces today. Its K Street lobby is second to none, able to wield vast sums of money for a candidate it supports.
Presidents, including the current occupant of the White House, often use Wall Street as a proxy for the economy. For instance, they point to a new high in the Dow as an indicator that the country is in good shape. It may be questionable economics, but it is excellent politics as the President is giving a tip of the hat to one of his most important constituents.
To paraphrase Charles Wilson, the former head of General Motors: “What’s good for Wall Street is good for America.” For many of our nation’s leaders, Wall Street has become America — a special place not to be trifled with. Keep the street happy, and politicians can enjoy all the unique benefits of the campaign, including lobby support, money, and votes.
So it’s no accident that the Federal Reserve has put aside the most effective instrument in controlling Wall Street’s Financial Leverage. Today, significant investing sectors utilize leverage at a level not seen for a century. These high-leverage groups include Hedge Funds, Specialty Exchange Trade Funds, Mortgage REITs, and private equity funds. Most of these investment strategies involve leveraging their portfolios to ten times or more. One dollar “invests” in $10 or more of assets.
It is a level of financial leverage last seen in this country during the 1920s when there was little or no regulation. Today, we have the world’s most extensive financial regulation, yet we are repeating a time before the Securities And Exchange Commission, before the massive slate of securities regulation.
While the Federal Reserve can still use Reg T to control leverage in the Equities Markets, many current high-leverage strategies have evolved in the half-century since Reg T has been sidelined. Derivatives of all types, including stock and other options, began after Reg T went quiet. If we were serious about controlling Financial Leverage, a first step would be to apply an enhanced Initial Margin where it was designed, significantly raising the margin on stocks. Then, seek to expand Reg T to manage new “exotic” investments, such as derivatives.
Our current failure to control leverage within the financial arena leads to an incredible imbalance in the overall economy. Instead of raising margin rates on Wall Street, the Fed seeks to curb excesses (inflation) by raising interest rates for everyone. It depresses the general economy. Real Estate drops, car sales decline, and consumer spending is lower — all the while Wall Street levers up, reaching new high after new high.
It’s time to bring Regulation T back and apply it, as intended, as a chief method to control financial leverage.
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