Legislation for the Creation and Protection of Real Wealth

September 6th, 2009


Sent to 535 members of Congress


Legislation for the Creation and Protection of Real Wealth by Jonathan Bannon Maher


In 1612 as Galileo looked at the night sky through a telescope, he observed that the moons of Jupiter moved in such a way that only the sun could be the center of the universe. He was later forced, under threat of torture, to retract his claims, but is now considered by many to be the father of modern science. It appears the descendants of Galileo's torturers are now working as lobbyists.

If the objective of capital markets legislation is to create and protect real wealth, then it must require that free markets also be fair markets. Markets that are free but not fair transfer or destroy rather than create wealth. And when it is obvious that the market is free but not fair, traditional investors will be disinclined to invest their savings, reducing the total amount of money available to companies as well as professional investors, ultimately limiting the country's economic growth.

I previously wrote software used to trade billions of dollars, currently am working on a healthcare related technology startup, and have a few thoughts on creating and protecting real wealth that I ask you to consider as you finalize and vote on legislation governing the capital markets.

(1) Reinstate the uptick rule to allow time for a company to react to a drop its stock price as well as protect against the systemic risk of automated trading. The uptick rule requires that a stock's last price move was up before allowing someone to bet that it will go down. The SEC removed this rule in 2007 stating that it was no longer necessary because the markets move so quickly.

Automated trading systems are designed to instantaneously react to market information and events by buying and selling investments, and reportedly make up around 70% of stock trades. A major unforeseen event could trigger cascading sell orders, where one system sells off causing another to sell off and so on, dropping the entire market off a cliff in a matter of seconds. Such a scenario would not allow for the possibility of government intervention, and shutting off trading for a period of time would not stop automated trading systems from resuming their sell off when trading reopens. The effect would be magnified as traditional investors pull out their money.

Note: This occurred on May 6th, 2010. I appear to literally have been the only person at all to have predicted or explained it. I pointed this out to nearly every journalist who wrote on the topic, when days after no one knew what had happened, and got only 1 response effectively confirming this to be true.

For example, on September 8th, 2008, a 6 year old news article about United Airlines bankruptcy appeared on the front page of Google News. Enough shares were sold to cause United Airlines stock market value to decline by 1 billion dollars in 12 minutes, and 75 percent that day. With some automated systems deciding what is news worthy and others trading on that information, the uptick rule becomes critical as the only safeguard that operates in lock-step with automated systems and would slow the sell off process to allow for the possibility of intervention, should an event occur that impacts the entire market.

I would actually take the uptick rule one step further and suggest something I will call the uptick+ rule. The uptick+ rule would require that the last uptick before a short sale be caused by more than a single share, because automated trading systems could, in milliseconds, detect a block in their sell off, and buy a single share to unblock it. For example, sell 100, buy 1, and repeat.

(2) Require all financial products with a significant market capitalization to be traded on an exchange. Unregulated markets allow for traders to damage and destroy for profit without accountability as regulators do not have oversight of trading records. Once trading had been moved to an exchange, adapt and run the software on trading records has been used on stocks for years to identify potential fraud and manipulation. Don't limit the requirement for exchange based trading to specific financial products as new products will simply be developed.

(3) Require a pre-borrow on short sales of stock. A short sale is an agreement that allows an investor to profit from a decline in a stock's price. A pre-borrow means that stock that is held by someone betting the price will increase, is held against someone betting the price will decrease. This prevents price dilution caused by an increase in the total number of outstanding shares. This goes one step past banning naked short selling, which allows shares to be located for borrowing rather than borrowed.

For example, say there are 10 shares of a company and the company is trading at 10 dollars. If 1 share is sold short without a pre-borrow, the order then divides 11 shares by 10 dollars, making each share worth 9 dollars and 20 cents. A substantial unexplained drop in price can be magnified when other investors become uncomfortable and sell. This can be done in conjunction with a campaign where misinformation is distributed to strategically selected recipients who are made to believe they are receiving legally privileged information as a favor, so that the misinformation isn't verified but still acted upon. Recipients can include creditors, partners, analysts, rating agencies and the media. This is most easily done to small to medium size public companies that are inherently hard to value, such as those creating real wealth for the country by developing new technologies or medicines, but can sometimes be done to larger institutions as well.

In the days before the stock of investment bank Bear Stearns was acquired in March 2008 by J.P. Morgan for about 2 percent of its value the previous year, SEC data shows that tens of millions of artificial shares had been created. As these shares were created, rumors began circulating about a cash shortage at Bear Stearns. In response, the President of Bear Stearns went on television and told people he couldn't figure out where the rumors were coming from and that the bank had 17 billion dollars in cash. The price dilution caused by the artificial shares coupled with a misinformation campaign caused investors to sell the stock and clients to withdraw their money. This led the government to provide a 30 billion dollar loss protection guarantee to J.P. Morgan during its acquisition of Bear Stearns, in order to prevent a bankruptcy which may have critically damaged interdependent financial institutions globally.

The SEC reported that near the end of June 2008 about 2 billion of these artificial shares were in existence, collectively driving down the wealth of the entire country.

If it's possible for financial institutions to create software to automatically trade the market in milliseconds, then it's possible to create software to keep track of outstanding shares of stock.

(4) Ban Naked Credit Default Swaps (NCDS). CDS is insurance on a loan and NCDS is insurance on someone else's loan. CDS creates a financial incentive to arrange home loans with limited regard for a borrower's ability to repay, as a lender collects fees when loans are arranged, and when the homeowner starts to have trouble with monthly payments, to push them into bankruptcy, as the lender can then collect the full amount of the loan through the CDS. NCDS on corporate loans create a financial incentive to push a company into bankruptcy, because the investor does not have an investment in the company and profits most from a default. NCDS are also available on United States Treasuries. These problems can be minimized by requiring a significant non-transferrable interest in the loan, and only allowing CDS on the percent of the loan held.

If naked short selling is banned but naked credit default swaps are not, those who have profited from naked short selling have the option of moving over to the NCDS market to continue their activities with something like fractional NCDS, sold with share size buy-in requirements. Banning naked trading in one market but not another is like putting homeless people on a bus and sending them somewhere else -- it makes some people feel better until they realize it doesn't solve the underlying problem.

(5) Impose leverage limits that would allow investors to hold on to investments in the event of an economic collapse. Leverage is using borrowed money to make investments. When the value of an investment purchased with borrowed money declines, the borrower is required to either provide collateral or to sell the investment. When a substantial number of investors are unable to provide collateral and forced to sell, this creates a cascading effect, where sales cause prices to decline, forcing others to sell, causing prices to decline, and so on.

For example, over the past few years, mortgage loans were purchased by investors with up to about 30 times leverage, meaning that for every 30 dollars held in mortgage loans an investor only had to provide 1 dollar. Investors in these home loans included many pensions and endowments. When homeowners began making late payments, the value of these investments declined, requiring investors to either provide cash or sell the investments. This led to a cascading sell off. Many of these home loans were insured by AIG, who was then required to provide collateral on behalf of investors, but couldn't because of the cascading sell off, which ultimately prompted the government to step in on behalf of AIG and provide 180 billion dollars. This situation was driven by a cascading sell off caused by excessive leverage on home loans that should never have been made but were because lenders collected broker fees and sold the loans to investors who insured them with credit default swaps.

(6) Aggressively prosecute those who seek to profit by working to damage or destroy, and in particular, those who do so at the expense of companies that create real wealth for the country by developing new technologies or medicines. Easy targets often seem to be prosecuted at the expense of those who pose a systemic risk. These prosecutions actually do more harm than good because it gives investors a false sense of security while emboldening those who pose a systemic risk.

Bernard Madoff, former Chairman of the NASDAQ, according to his confession statement written after he turned himself in, ran a multi-billion dollar fraud out of his Chase checking account. According to a former Madoff secretary, regulators had asked about job openings during reviews and later sent over resumes.

Effectively detecting and investigating fraud, and effective policy making, may require a fundamental shift in staffing at enforcement agencies, where people are not hired who may ultimately be looking to get a job at one of the companies they regulate. Additionally, neutralizing those who pose a systemic threat may require heavyweights who can be effective market guardians when outnumbered by the best lawyers money can buy. For example, the public still doesn't have any information about who created artificial shares of Bear Stearns and spread misinformation, but has complete information on two employees who may have misled investors about the value of mortgages in a single Bear Stearns fund. This is an example of emboldening those who pose a systemic risk while prosecuting those who don't.

All regulatory changes would have to be done in coordination with foreign counterparts so that traders don't simply move their trading outside of the jurisdiction of the country.

Finally, because real wealth creation is no longer driven by putting people on an assembly line, also needed, in descending order of importance, are a public education system that prepares people with the tools and desire to innovate and engage in lifelong independent learning, a healthcare system that maximizes the lifelong productivity of all workers and supports young capital strained innovative businesses, and a patent system free from lawsuits designed for financial gain at the expense of innovation.

When Adam Smith published what has since become the free market handbook, An Inquiry into the Nature and Causes of the Wealth of Nations, advocating against government intervention in business affairs, mass transit meant putting two people on a horse. The world has become substantially more complex and those who claim the sun is not the center of the galaxy, no matter how persuasive the argument, may not be a good source of guidance. Now is the time to put in place comprehensive legislation.

Thank you for reading.