Another One Bites The Dust!

How appropriate! The Queens hit really hits the nail on the head. Over the past 2 weeks, we saw the demise of the "investment banking" business model.

Bear Stearns was acquired by JP Morgan, Lehman Brothers filed for bankruptcy protection under Chapter 11, Merrill Lynch was driven into the arms of Bank of America in a "shot gun" marriage, and Goldman Sachs and Morgan Stanley sought the protection of the Fed by applying for and being granted status as a "commercial bank".

Let's get something straight. These were never banks in the common useage of the word. They were merely securities dealers who grew too big and decided that that they needed a more exalted name. Banks usually take deposits from consumers and make loans. The so-called "investment banks" took no deposits, instead borrowing from banks and big investors through various vehicles such as bonds and "repo" agreements.

What does the change in status mean?

First of a;ll they will now come under the supervision of the banking regulators and will be able to access the Fed's discount window. Most important of all, as a bank they will be able to designate certain securities as "long term" holdings and therefore can value them at cost (less impairment) and not mark-to-market (and take the hit in their income statements).

What's the downside?

As securities dealers, they were not covered by the FDIC, nor were they regulated or supervised by the banking regulators. They will now be required to file financial returns to the banking regulators and maintain commercial bank reserves. Lehman Brothers was infamously geared at 35 times capital ie their borrowing are 35 times their paid up capital. Lehman owed US$613 billion as of 31 May 2008.

Commercial banks are required to maintain capital reserves of at least 8%. In China the China Banking Regulatory Commission (CBRC) requires commercial banks to have 16.5% reserves. HK securities dealers are required to have $40 of capital for every $100 they lend to clients for margin purchases.

"Investment banking" will never be the same again. The Glass Steagal Act forced banks to spin off their securities dealing arms in 1933, and regulation fell to the SEC which must shoulder a good part of the blame for not properly supervising the "investment banks" and their toxic products. Admittedly, it is difficult for supervisors earning US$80,000 a year to debate complex products with "investment bankers" earning tens of millions of dollars in bonuses.

The current agruments about "naked short selling" is a case in point. In HK, only certain stocks with sufficient market capitalisation are eligible for short selling. And, you can only "short sell" if you have already borrowed the stock before hand. If settlement is not effected on T+2 ie 2 days after the trade day, the seller is subject to "buy-in" at the then market and will be penalised. Borrowers will also be required to post and maintain a margin with the lender (usually around 105% of the market price).

In the US, sellers do not need to have borrowed the stock before the sale and therefore they do not need to post any margin unless the price goes up, and then only for any price difference. Thus, the number of shares that are sold short may be many times the number of shares available.

In HK, we learnt our lesson during the Asian Financial Crisis and have tightened the rules to ensure settlement on T+2 so that it is not possible to maintain open "naked short" positions for more than 2 days. Also, "short selling" must be disclosed.

I can remember Christopher Cox saying that the US is the "gold standard" in regulations and supervision when he took office as SEC chairman. I wonder if anyone still believes him. The performance of the Bernanke, Paulson ands Cox before the House says a lot. Bernanke was studious as a professor (which he was), Paulson was selling the package like the "investment banker" that he still is. Cox was totally out of his depth. I would not be surprised if he is replaced soon by someone who actually knows how the market works.