"Those who fail to learn from history...

...are doomed to repeat it". Winston Churchill's advice is very timely because it seems like 60 years is about as long as we can go before having to RE-learn the important lessons from The Depression.

The repeal of the The Banking Act of 1933 (AKA The Glass-Steagall Act) in 1999 was the beginning of the failure that ultimately led us to where we are now. One of the big lessons that the Crash and Depression taught us was that banks who took deposits and made loans should be separated from investment houses so that problems on Wall St. wouldn't wipe out the whole financial system. When we unlearned the lesson in '99 the banks and Wall St. had a heyday of buying each other up in a rush to create 'financial super markets'. The idea was that once you came in to deposit your paycheck, they could sell you a few stocks, bonds, mutual funds and even some insurance.

Eventually we ended up with a couple of these huge financial institutions and the smaller regional players followed suite, merging and buying each other up to get big enough to stay competitive with the giants. Those from the Northwest may remember when Washington Mutual was a regional savings bank in the Puget Sound area and ran ads saying that they were your friendly local bank and would never do the bad things that the huge evil banks do.

Unfortunately the net result of combining low risk depository institutions with high risk investment houses is that the banks now had Wall St. risk and could be endangered by the very threats that we learned to keep them separated from. Worse yet, a handful were allowed to get "too big to fail" which meant taxpayers, open your wallets when the inevitable happened on the investment side.

The second lesson we unlearned was allowing the SEC to fail to enforce the rules against naked shorting. As far back as the Securities Exchange Act of 1934 speculators who wanted to make a bet that the value of a particular stock would fall had to borrow and have it in their possession within three days the stock that they were shorting. 'Shorting' a stock is the opposite of buying a stock hoping it will go up, the stock is sold first and bought back later theoretically at a lower price. For example ABCo is shorted at $100 and bought back later at $50. The profit is the difference less the cost of borrowing. Having to borrow the stock first meant that there was a limited supply of a stock and therefore speculators only had so much fire power in driving down the price to create their profits. When there is no limit on the amount of shorting that can be done to a stock, speculators can crush a stock or even a whole market sector. The SEC had the rules in place, but failed to enforce them. When this is combined with the next lesson un-learned the effects can and were devastating.

Unlearned lesson #3, the SEC repeals the uptick rule in July '07. Instituted in 1938 to prevent 'bear raids' by then SEC Commissioner Joseph Kennedy Sr. (Yes, the Kennedy dad was the first SEC commish partly because he knew all there was to know about stock manipulation). The 'uptick rule' was another rule limiting the ability of speculators to perform a bear raid (drive down a stock) by requiring the price had to move up at least a fraction before successive short positions are initiated. Since the repeal in '07 the S&P 500 has fallen more than 50%, certainly not only because of bear raids but the ability to pile on a falling stock clearly shows up in the volatility in the markets which has risen to all time highs in the last year.

I hate to use the word synergy in the negative but the combination of these three unlearned lessons built a huge bonfire under the banking system. Add the accelerant of the mortgage mess created by congress forcing Fannie and Freddie to back loans to sub-prime borrowers all that was needed was a match. The spark came from the crash of the securitized debt markets and woof! Up went the flames, down went the banks and trillions of our childrens' earnings were turned into tax dollars.

The problem is that banks, the heart of our financial system were allowed to stuff themselves full Wall St. speculations, when those 'investments' value declined the banks' balance sheets were damaged and that damage was compounded when speculators began their bear raiding, which further damaged the balance sheets causing them major shortfalls in the capital they are required to have. Even worse, because they are considered market savvy 'investment banks' they were allowed to leverage their assets three or four times more than back when a bank was a conservative institution for the preservation of depositors' money. Leverage is all good on the way up but it's a killer on the way down. So now as the downward cycle began their balance sheets were being eroded four times faster and there were no limits on the raiders.

With their assets (stock value + loan portfolio) disappearing unchecked it's no wonder that 'banks' don't have any money to lend, even the bailout money must go towards propping up the balance sheet. As Harry Truman said: "The only thing new in the world is the history you don't know"

Giovanni Isaksen
Ashworth Partners Ltd.
www.ashworthpartners.com

Ask me about the Dealizer income property analysis tool.