My argument for the regulatory roots of the transformation of Wall Street firms from private partnerships to publicly-held companies has provoked an unexpected reaction.
I was confident that linking the transformation to the capital rules imposed on broker-dealers by the Securities and Exchange Commission following the passage of the Securities Investor Protection Act would be controversial. The mythology that the financial crisis was a crisis of capitalism rather than a crisis rooted in regulation has some really fanatical followers. Whenever I cross them, I know they’re going to start kindling the fires in which they like to burn the unorthodox.
But I was surprised that Barry Ritholtz, the famed blogger and investment adviser, took issue with my assertion that SIPA was a bailout. Here’s what Barry wrote:
The 1970 SIPA was not a bailout — it was the enabling legislation that allowed the set up of an FDIC-like insurer, now known as SIPC. Rather than watch 1,000 firms go under, US created a program for Brokers like Banks have enjoyed. (How much taxpayer dollars were spent on this?)
My first response was to wonder if Barry had gotten distracted partway through leaving that comment and forgotten what his point was. “Enabling legislation” that sets up a program creating special insurance and bankruptcy rules for brokers, implemented to avoid having “1,000 firms go under” sure sounds like a bailout to me.
The most comprehensive account of SIPA as a bailout I’ve read comes from UC Davis School of Law professor Thomas Joo’s article “Who Watches The Watchers? The Securities Investor Protection Act, Investor Confidence, And The Subsidization Of Failure.” You can download the entire paper right here.
Professor Cheryl Block defines a “bailout” as “a form of government assistance or intervention specifically designed or intended to assist enterprises facing financial distress and to prevent enterprise failure.” SIPA clearly fits this definition in that Congress acted in 1970 to assist brokerage firms that faced financial distress due to the back office crisis and to prevent their failures. Federal “insurance” programs like SIPC or FDIC deposit insurance may have customers as their direct beneficiaries, but the member enterprise receives assistance in that it is relieved of its obligation to the investor or depositor.
SIPA did not authorize the government to rescue failing firms. Similar to the Dodd-Frank “resolution authority,” under SIPA a failing firm is supposed to be liquidated. Nonetheless, Joo argues, SIPA operates as a “prospective bailout” that provides extraordinary assistance to broker-dealers by increasing investor confidence in the safety of doing business with them.
Here’s Joo again:
Consumer confidence is a key principle behind both the FDIC and SIPC. As Block states, “the presence of federal insurance instills consumer confidence and provides direct and immediate benefits to the industries whose customers are willing to leave higher deposits or invest more funds than they would if uninsured.” This is the explicit Congressional reasoning behind the SIPA scheme. The failure of any firm, and the mere potential for losses due to firm failure can erode public confidence in broker-dealer firms generally. The SIPA scheme was enacted to promote investor confidence in each broker-dealer firm and in the broker-dealer industry as a whole on the theory that this would help to prevent individual and firm-wide failure. Thus, in Professor Block’s analysis, it was a prospective bailout of each member firm and of the industry generally.
The sponsors of the SIPA were every explicit about their intentions in enacting the law: creating public confidence in the soundness of financial institutions.
SIPA did more than just enable the securities sector to organize an insurance scheme. It explicitly gave broker-dealers access to a special kind of bankruptcy intended to avoid having investors mount a “run on the bank” by guaranteeing that in the case of a liquidation, their interests would come before other creditors. Instead of maximizing the size of the estate of a failed firm, as the bankruptcy code requires, SIPA instructs courts to maximize the return to investors. Fairness to creditors—for centuries, a central concern of bankruptcy courts—is not even a consideration under SIPA.
Both Barry and the blogger at Economics of Contempt insist that the insurance fund created by SIPA cannot be a ‘bailout’ because it is nominally funded by its members. But this overlooks several facts.
- The insurance fund, known as SIPC, enjoys a $1 billion line of credit from the Treasury Department.
- SIPC is not subject to any federal taxes.
- SIPC does not have any rational way of deciding what fees to charge its members, and it is likely that it is underpricing the insurance it provides. It is able to do that because, like Fannie Mae, it enjoys the implicit backing of the United States government.
Well, that’s a long way to go for what I thought was a pretty non-controversial point in an otherwise controversial article about the regulatory source of Wall Street’s transformation. I’m surprised I had to go that far to explain a bailout to the author of “Bailout Nation.”
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