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The Federal Reserve Board, for I think quite undestandable administrative reasons, carries the same margin requirements on both long purchases and short sales. No allowance is made under the Board's margin requirements for the hedged investor, even though he is far less vulnerable than other borrowers in a market decline. That is why it is necessary for me to carry my accounts in foreign banks.

In Switzerland, where bank lending is based on prudence and experience rather than legislation, I have been able to borrow on a much smaller margin that would be permissible in this country. Such narrower margins are financially prudent to the lender because, in a falling market, profits accruing from the short positions can substantially offset losses from long positions.

In Appendix C I discuss in greater detail exactly how my account is handled. Benefits Of This Account

One of the most important benefits of my account is that it serves to stabilize, rather than destabilize the U.S. market. The account therefore fosters a principal purpose of the margin regulations, despite the fact that U.S. margin requirements technically are not complied with.

While on the one hand, I am inflating the prices of stocks in the American market by buying them on credit, which is permitted by our margin regulations, on the other hand I am deflating such prices by selling stock short to a largely offsetting degree. If the market declines, the margin that is released on my short position is more than adequate to provide the margin required on my long position. So my borrowing does not serve to inflate stock values when the market is rising, nor am I required to liquidate securities and thereby depress share prices when stocks are declining.

A second benefit from my account is that it helps our balance of payments and the capital shortage. I borrow funds, either Euro-dollars or Swiss francs, which are deployed in this country. If I am able to increase my net worth over the years, the funds that I borrow abroad will increase and can contribute over the long term to a continuing favorable influence on our balance of payments and provide additional funds for worthwhile new financings.

Third because I have more funds at my disposal under my existing arrangements than I otherwise would have, I buy and sell more shares than would otherwise be the case, thereby increasing the liquidity of our stock markets.

Fourth, since I am applying considerable expertise and analytical ability to both the purchases and sales I make, I hope that I am contributing towards making the market more efficient. An efficient market is one where stocks sell where they really ought to sell in terms of their fundamentals.

Of course, I generate more commissions than would otherwise be the case and thereby help the brokerage community—which, these days, needs such help very desperately.

Because this arrangement has permitted me to increase my net worth more than, I think, would have been possible within the letter, but not the spirit of U.S. margin requirements, my taxes to the U.S. government and the governments of New York State and New York City have been higher than would be the case otherwise.

A final advantage is, I think, an intangible yet important one: the relationship that I have developed with a number of foreign bankers, whether I am currently doing business with them or not. It is simply one more bridge, one more communication, between an American investor and foreign investors. I believe that their exposure to me helps them in understanding this country and our securities markets. Short Selling Is Frequently Misunderstood

There is a certain opprobrium that many Americans feel towards short selling. Isn't it morally wrong to profit from adversity? The answer to that, as far as I am concerned and as far as many hedge fund operators are concerned, is that we go short certain stocks merely to enable us to go long other stocks prudently. It is a means of minimizing general market risks in an overall investment program.

As a further elaboration on this subject, I have presented in Appendix D an article from the New York Times by Robert Metz, who quotes Mr. Arthur Okun's advocacy of banning short sales in bear markets and my rebuttal to Mr. Okun, which Mr. Metz printed in a subsequent issue of his column. The Special Privilege Of New York Stock Exchange Member Firms

Very few people are aware that, unlike every other American, the broker who is a clearing member of the New York Stock Exchange does not have to put up any margin on short sales in his firm account. I do not criticize this exemption, because it permits members of the New York Stock Exchange to participate in many arbitrage transactions that would otherwise not be practical for them. What I wish to emphasize is that, within the confines of the U.S., a certain special group of people is permitted to do almost exactly what I do. I do not believe there is any cogent reason why this privilege should be denied to private investors. On the last page of Appendix C you can see the exact workings of this special privilege. Any Change In The Margin Law Should Provide Special Provisions For Hedged

Portfolios Because hedging provides the economic advantages listed above, I respectfully submit that, if the margin regulations are changed, special provisions should be made for hedged portfolios. I would suggest two possibilities. First those portfolios where the net long position is never allowed to exceed the net worth of the funds involved might be exempted from margin requirements altogether.

Under existing margin requirements of 65%, an American investing with an American stock broker can maintain a net long position of 150% of his net worth. Thus the hedged investor, operating under the exemption above suggested, would have a less inflationary and therefore destabilizing effect on the stock market than an investor who merely takes advantage of margin laws prevailing within this country.

A second suggestion would be to permit hedged portfolios to take advantage of the provisions now restricted to members of the New York Stock Exchange in their firm account. In this manner hedged funds would be free to borrow as much on the long side as would be permitted by prevailing margin regulations, but could sell short without putting up any additional margin. Since the short sales would merely reduce the overall exposure of the long position, this proposal also would permit hedged funds to be a more stabilizing influence than they are now.

ATTACHMENT A

Estimate of Swiss Bank Loans Collateralized By U.S. Marginable Securities

The Swiss National Bank reports that the 72 banks which comprise the bulk of the Swiss banking system carried $3.1 billion of loans secured by other than mortgages as of November 30, 1969. No industrywide figures are available as to what percentage of these loans are secured by U.S. marginable securities. It is possible, however, to make an "educated guess”.

The Union Bank of Switzerland, which is the country's largest, accounting for 18% of the banking system's assets, reports that its loans collateralized by marketable assets, such as securities, commodities, metals, etc. (as distinguished from inventories and receivables, for example) amounted to 47% of its total loans secured by other than mortgages. If this percentage is representative of the entire Swiss banking system, then roughly $1.5 billion of loans are collateralized by marketable assets. Of course, a substantial percentage of the collateral behind these loans represents foreign securities, commodities, and unlisted U.S. securities, most of which are not subject to our margin requirements. Based on a number of conversations I have had with Swiss bankers over the years, I am inclined to believe that no more than 75% of this collateral represents marginable U.S. securities. If that is true, then it might be said that only about $1.1 billion of credit has been extended for the purchasing and carrying of listed U.S. common stocks and convertible bonds.

ATTACHMENT B

Restricted Accounts Under U.S. Margin Regulations

Margin regulations prescribe the minimum percentage of the initial purchase price which must be put up when a security is purchased. Currently a buyer of a marginable U.S. common stock must put up 65¢ of every dollar invested, and can borrow the other 35€. However, if the price of the stock he has purchased declines, he is not required to put up additional margin under the law. Whatever additional margin he has to put up when the security declines is up to the lender and the lender's own financial judgment and has no bearing on the margin law.

The Federal Reserve Board margin requirement is referred to as the "initial" margin and generally whatever minimum margin the lender may require is regarded as a “maintenance” margin. An account is regarded as "restricted” when, as a result of, for example, a fall in the price of a security, the market value of the securities represents less than the initial margin. For example the price of

the security might fall to the point where the margin in the account, that is the market value of the security minus the value of the loan, declines to 45% of the market value of the security.

Under these circumstances Regulation T prohibits the broker from increasing the loan. The complexities start to arise when securities in the restricted account are sold. Under the margin regulations if some securities in a restricted account are sold a certain percentage of the cash proceeds can be returned to the borrower with the percentage determined by a complex formula.

Another mechanical problem arises under the following circumstances. Let us say Stock A is bought on 65% margin and then rises 20%. At such time the buyer would be entitled to withdraw funds from the account to again bring his loan up to 35% of the market value of the stock. Let us say, however, that he does not ask for funds and that the stock subsequently declines below his original purchase price, so that the account becomes restricted. Under these circumstances he is still entitled to withdraw from the account the amount of money he could have withdrawn when the stock was up 20% so long as the maintenance margin conforms with the broker's own internal policy. However, it obviously takes an elaborate computer memory or a large “back office" staff to determine what would be available to the customer under such circumstances.

ATTACHMENT C

Details of Swiss Hedged Account

I have arranged to borrow about 65% on listed securities held long from foreign banks. I have also arranged to handle my short account on about 35% margin. Because a short account must ultimately be carried by a member of the New York Stock Exchange, subject to margin regulations, the Swiss banks lend me the difference between their 35% margin and the U.S. required 65%.

It will be noted that the Swiss banks with which I deal generally require less margin from me than the 50% generally required from their other customers. This is because of my hedged position.

So far as the mechanics are concerned, my wife or I carries a brokerage account with a Swiss Bank. The bank, in turn, has accounts with American brokers. In the typical case I will place the order with an American broker for the account of the Swiss bank. I will then cable the Swiss bank, which in turn confirms my order by cable to the broker. Then the Swiss bank will make appropriate debits and credits to my or my wife's account in Switzerland. The important point to understand is that it is not my account with the American broker but rather the Swiss bank's account with the American broker where the security transaction in this country takes place.

To give a specific example, let us say I wish to buy 100 shares of stock X in my Swiss bank account. I will go to an American broker Y and ask him to buy 100 shares of stock X for the acount of the Swiss bank. At the same time, I will cable the Swiss bank asking them to buy 100 shares of stock X for my account through American broker Y. American broker Y purchases stock X for the Swiss bank and is subsequently covered by the cabled confirmation that he receives within 24 hours. Stock X is then delivered to an American bank, acting as custodian for the Swiss bank, against payment. For long positions all transactions between the Swiss bank and the American broker on my behalf are in cash accounts. There are no margin accounts involved.

In order to provide the funds for the payment of stock X, typically the Swiss bank will lend me about 65% of the market value of stock X and I will deposit 35% of the market value of stock X in an American bank account of Swiss bank.

As mentioned above, on the short side of the Swiss bank must carry a short account with a broker in the U.S. Here again let me emphasize that the account is carried in the name of the Swiss bank. Typically, the American broker will accept orders from me followed by cabled confirmation of the Swiss bank. Here, however, since short sales are involved, there are no deliveries and receipts of securities from the U.S. custodian. Rather the security positions represent stocks borrowed by the U.S. broker.

To give an example, if I wish to short 100 shares of stock X, I will request the American broker to do so and cable the Swiss bank. The Swiss bank in turn cables the broker. The broker, after executing the short, wires the Swiss bank requesting that margin be provided for the short sale, currently 65% of the market value of that short sale. The Swiss bank instructs one of the American banks with which it carries U.S. funds to transfer such funds to the American broker. Since the Swiss bank is providing me 35% margin, the Swiss bank may request that I deposit 30% of the market value of the stock sold short with one of its American depository banks.

The attached table compares my investment position, with a 50% net long position, as it would be in Switzerland (in Column b), as it would be if I were subject to U.S. margin requirements (Column a), and (in Column c) as it would be if I were subject to U.S. margin requirements, but enjoyed the preference on short selling of New York Stock Exchange member firms.

COMPARATIVE FINANCIAL STATEMENTS—50 PERCENT NET LONG POSITION WITH MAXIMUM GROSS POSITIONS

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1 A New York Stock Exchange firm clearing for its own account is not required to put up margin on a short position.

ATTACHMENT D

[From the New York Times, May 27, 1970] MARKETPLACE: SHORT SELLING: BAN IS URGED

(By Robert Metz) Arthur Okun does not like short selling-particularly in a bear market. He thinks short selling tends to drive prices down even further.

The vice president of Hoppin Bros. & Co. asks this question to illustrate his point:

"Does it make sense to allow a trader to borrow stock and sell it in the hopes of making the price go down? If a man feels the price of a stock is too high, he doesn't have to buy it. Why should he be allowed to use the property of another individual in an attempt to make it worth less?

Mr. Okun did not say it, but many investors are unaware that, if they leave shares in a "street name,” the brokerage house so named can lend the stock to a short seller.

Mr. Okun—who emphasizes that he is speaking for himself and “the good of the industry” and not for his firm—wants the Securities and Exchange Commission to ban short selling. He would make a “limited” exception in the case of specialist firms that sell short in connection with their attempts to make markets orderly.

He believes that, without short sellers, prices would be able to rebound much more readily if the “killers” were not in there short-circuiting the rallies.

Not everybody would agree that short selling leads to early squelching of rallies. The New York Stock Exchange commented that it banned short selling during the British monetary crisis of 1931 and that the results were “not good.”

The Big Board ruled then that short positions already outstanding would have to be covered. This led to some "unnatural rises."

Mr. Okun said that a ban on short sales, as he contemplates it, would be designed to prevent short sellers from shorting in the future and would not effect their short positions already outstanding.

He said he was particularly concerned about potential mischief in the hedge funds, which are permitted to sell short.

"Suppose a hedge fund concentrated on selling a few stocks short and did this consistently," he said. “The little guy, already burdened with losses, sees his stock going down further on heavy selling that may be simply the work of a determined hedge fund.

If the general investors dump their shares, the hedge fund accomplishes its goal. It buys shares at a lower price and covers its position for a profit.

"Suppose a hedge fund worked with a group with a profit in a stock getting them to dump. They could start a run together that would drive the price down dramatically.

“Then the two groups could switch roles, with the hedge fund selling shares it held outright and on which the fund had a profit to serve the other group interested in establishing a short position."

Mr. Okun, who is an institutional consultant for Hoppin Bros. as well as a vice president, is of the opinion that this kind of thing can happen.

He believes that, should this kind of thing go on, it would be similar to the pooling operations of the nineteen-twenties. He thinks that, under S.E.C. rules, the hedge funds are so little removed in operation from pools that perhaps they should be declared illegal.

Once the market is in good shape again, Mr. Okun believes that the question of shor selling should be reviewed. However, he thinks that the exchanges ought to use their computers to label short sales day by day or, if possible, trade by trade. That way the investor would know when his stock was being shorted.

At present, short sales can take place only on an “uptick”-after a trade at a price higher than the previous one. Aside from that, however, the investor has no clue as to whether the sale is short or long.

(From the New York Times, June 1, 1970)

MARKETPLACE: TO THE DEFENSE OF SHORT SELLING

(By Robert Metz)

Ban the short sale?

That's what one Wall Streeter suggested here a couple of days ago. In his view, it would prevent the "killers" from stopping rallies cold.

The hedge fund operators, who often sell short as part of their over-all effort to make profits for shareholders, don't like the ideas of banning shorts at all. Here's what Robert W. Wilson has to say about it:

"I run a very small domestic hedge fund called Wilson Associates and a more substantial amount of money domiciled in Switzerland, which I operate on an even more highly hedged basis than the domestic fund.

"Obviously, it would be very contrary to my interests for short selling to be banned. [But] I hope that I present persuasive arguments that the banning of short selling would not be helpful for the stock market.

"Much—if not most-short selling, particularly by hedge funds, is done as a market hedge against stocks owned long. To illustrate, let us say a hedge funds owns $100 worth of stock X but becomes bearish on the market and would like to have only $50 in common stock.

"He has two alternatives. He can sell $50 worth of stock X or he can go short $50 worth of stock Y. In either case the over-all effect on the market is the same." He went on to say that suggesting that shorting can kill a rally applies only to those investors who are shorting stocks on balance. If the investor with $100 of stock X shorted $150 of stock Y, he would be short on balance and would have a more depressing effect on the stock market than if he were not permitted to short at all.

“However, even in this case the short sale enables the buyer to obtain the stock at a lower price than otherwise,” Mr. Wilson asserted. “If it were not for the investor shorting stock Y, the buyer would probably have to pay more for stock Y.

“If the stock subsequently declines, the buyer will have lost less money than if our hypothetical investor had not shorted it to him.

“Similarly, if the buyer holds on to his shares long enough, he may be able to sell at a higher price than otherwise to our hypothetical investor when he covers his stock.

“Therefore, short selling helps those buyers who are long-term oriented and are not simply short-term traders. I do not see why short-term traders, whether little guys or big guys, need any special protection.”

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