(w)Ron(g) Paul’s Free Market Fairytale

[media-credit name=”Erika Frost” align=”aligncenter” width=”250″][/media-credit]Gather round, all ye children, for I haveth a tale for thee on why Ron Paul is oh so wrong…

Once upon a time (two weeks ago, actually), MF Global filed the eighth-largest bankruptcy in history, with debts leveraged 40 to one against its capital. That means that for every one dollar of capital MF Global owned, it was buying 40 dollars’ worth of debt. To put that into perspective, Lehman Brothers was leveraged 30 to one when it collapsed in 2008 along with the housing market, flushing our economy down the toilet. Yet while we lingered in that economic sewer, with the scent of Lehman Brothers’ crap still fresh in our nostrils, the jackasses at MF Global decided to pursue those exact same risky practices that got us into this mess in the first place.

But wait, it gets even better. Jon Corzine, the then-CEO of MF Global, is a former senator who has spoken out many times for the need for better regulation of Wall Street. In a speech he gave at Princeton in September of last year, just a few months after he joined MF Global, Corzine talked about how it was unacceptable that some of Wall Street’s biggest players leveraged their shareholders’ money at a ratio of 30 to one leading up to the crisis. Yet in the very next year, Corzine decided to go bipolar and take his own company’s leverage ratio to an insane 40 to one rate with a $6.3 billion bet on high-risk debt from countries like Italy, Spain and Portugal.

As the debt crisis in Europe widened and defaulting became a possibility, the value of that debt tanked, meaning huge losses for MF Global. When investors started asking for their money, it became apparent there wasn’t going to be enough to go around since the company had so little capital to fall back on. Bloomberg Businessweek reports that MF Global’s bondholders will likely recover as little as 10 cents for every dollar they had invested in the company! The insanity of the whole situation is that Corzine obviously knew exactly how risky it was to leverage his company to such an extreme rate, but he did it anyway because of the potentially huge rewards.

The collapse of MF Global is the latest proof that the free market is not always “self-regulating” in the way that Ron Paul and others would have you believe. The New York Times reports that prior to 2004, investment banks were forced to maintain leverage ratios no higher than 12 to one by a longstanding Securities and Exchange Commission regulation. However, the big investment banks successfully lobbied the commission to lift that requirement, arguing it would free up billions to invest in the growing mortgage-backed securities market (oops!). MF Global would not have collapsed if those regulations were still in place today. Of course, Ron Paul and co. will still try to mold MF Global’s failure to fit their free market fairytale: that the collapse of MF Global will prove a cautionary tale for other investment banks against leveraging themselves so highly, leading the market to regulate itself through better business practices since all companies want to ensure their own preservation … blah blah blah.

This WOULD make complete sense, except for the fact that we all just witnessed the cautionary tale of Lehman Brothers over-leveraging itself three years earlier! And you can’t argue that Corzine didn’t take note, because he himself was one of the cautionary tale’s own storytellers! It’s like if the third little pig went around bragging to all his neighbors about how safe he was inside his brick house only to sell it the next day and build a new house out of sticks, thinking about all the money he’d be saving. In comes the wolf, huff and puff, pork chop dinner, nom nom nom.

The truth of the matter is that in an unregulated free market, the huge short-term gains that an investment bank can make on risky bets can easily trump long-term concerns for the company’s health. When a company and investors are making millions on risky bets that pay off, anybody who says, “Hold on a second, guys,” is going to be thrown under the bus before they can even finish their sentence. This conflict of interest is always going to create a slew of risky companies that people invest in anyway because of the huge short-term gains they can make. When the house of cards starts to fall, these high-risk investment banks will go bankrupt, but there will always be others more than willing to fill those empty shoes in the future. The result is a much less stable financial system with big booms and even bigger busts — busts that will disproportionately hurt the average Joe.

When the SEC was preparing to make its decision to eliminate leverage requirements in 2004, according to the Times there was one lone dissenter, a risk management expert who sent in a two-page report warning the agency of its grave mistake.

“He never heard back from Washington.”

Daily Nexus columnist Riley Schenck thinks it’s about time Paul and co. close the storybook and take a good hard look at reality — the pictures aren’t so pretty.