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An Open Letter to Senator McCain & Sentator Obama

Larry Cavalena, Registered Principal
Raymond James Financial Services, Inc
Member FINRA/SIPC

October 16, 2008

Dear Senator McCain and Senator Obama:

In a few days, one of you will become the next president of this nation.  In doing so, one of you will inherit the largest financial mess since President Roosevelt took office in 1933.

There are many similarities between the conditions that lead up to the Depression Era and the financial conditions of today.  During the “Roaring 20’s” stock market boom, banks placed depositor’s money into the stock market on a highly leveraged basis.  Banks lost depositor’s money along with their own capital in the market crash resulting in widespread bank failures.

During Roosevelt’s first term, legislation was passed to regulate banking and investment companies along with the people who worked in the industry.  Some of those regulations were the Securities Act of 1933 and 1934 along with the Glass-Stegall Act.

The Glass-Stegall Act created the Federal Deposit Insurance Corporation (FDIC), separated investment banking from commercial banking and strictly regulated the business of commercial banking.

The majority of the Glass-Stegall Act was repealed in 1999, being replaced by the Gramm-Leach-Bliley Act.  The senate voted to pass this legislation by a 90 to 8 majority.  Today, less than 10 years later, our banks are in trouble again. Back then it was stock investments.  This time it is bad real estate loans.  The words may be a little different, but the song remains the same.

In 1938, the Securities and Exchange adopted the “Uptick Rule” formally known as Rule 10a-1.  The rule basically stated that before a seller could execute the short sale of a given stock that stock must have traded on an uptick. The rule was intended to prevent large short sellers from conducting “Bear Raids”, devaluing perfectly solid stocks.  This short sale rule was repealed in July of 2007. Since then, we have had a substantial increase in market volatility.

The Securities Acts of 1933 and 1934 also provided investor protection against the practice of naked short selling. Short selling is very simple.  A seller borrows stock from the current owner in order to sell the stock at the current price hoping to repurchase the stock at a lower price in the future.  Naked shorting of un-borrowed or stock that cannot be delivered to the buyer at settlement results in a failed trade and is contrary to short sale rules.

The practice of naked short selling provides large traders and hedge funds, like the trading pools of the 1920’s, a means to manipulate share prices. Most brokerage firms do not permit naked short selling.  However, some firms do permit this practice and this is where the SEC has failed miserably in its enforcement.

The Securities and Exchange Act of 1934 provided for regulation T, a Federal Reserve regulation that governs the amount of credit or margin that can be extended to securities investors.  For most investors the margin is 50%:  for every dollar you have in assets, you may borrow 50 cents.  This level of margin requirement has remained unchanged since 1974.  Basically, individual investors cannot put other people’s money at risk.

Hedge funds are different; they are permitted to assume obscene amounts of risk.  When Long Term Capital collapsed in 1998, the fund had borrowed $125 billion on a base of $4 billion in investor capital.  This is a leverage ratio of 30 to 1.  In addition, the fund had off-balance sheet positions of approximately $1 trillion.

Long Term Capital’s collapse in 1998 almost toppled the world financial system and forced massive intervention by the Federal Reserve.  Ten years later, our regulators have learned nothing.  We now have more hedge funds than ever, many employing leverage of 30 to 1 or more.

These hedge fund managers could not take that risk with their own money.  Yet they are permitted to pay themselves obscene salaries and bonuses to take that risk with other people’s money.  When they loose that borrowed money, we get an “Oops, sorry about that” and a need for tax payer help.

When the mutual fund industry began to take shape in the late 1930’s, the Investment Company Act of 1940 was created; this act regulates mutual fund activity to this day.
Yet 10 years after one hedge fund almost toppled the world financial system, hedge funds still operate in secrecy and without specific regulation. This is absurd

The repeal of the up-tick rule, the failure to stop naked short selling, and the lack of hedge fund regulation fall under the oversight of the Securities and Exchange Commission.  The commission’s chairman, Christopher Cox should be replaced along with his supervisory staff.

Deregulation and lack of oversight have done immense damage to our economic system our citizens, and future economic security.  It is time to fix this problem.

Respectfully,

Larry Cavalena is a Registered Principal with Raymond James Financial Services, and has over 30 years experience in the financial services industry.

The statements and opinions here do not reflect the opinions of Raymond James Financial Services, its management or employees.  The information contained in this report does not purport to be a complete description of the developments referred to in this material.  This information have been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.

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