How SEC Regulatory Exemptions Helped Lead to Collapse
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The losses incurred by Bear Stearns and other large broker-dealers were not caused by "rumors" or a "crisis of confidence," but rather by inadequate net capital and the lack of constraints on the incurring of debt.--Lee Pickard, former director, SEC trading and markets division.
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Is Financial Innovation just another word for excessive and reckless leverage?
Apparently so.
As we learn this morning via Julie Satow of the NY Sun, special exemptions from the SEC are in large part responsible for the huge build up in financial sector leverage over the past 4 years -- as well as the massive current unwind
Satow interviews the above quoted former SEC director, and he spits out the blunt truth: The current excess leverage now unwinding was the result of a purposeful SEC exemption given to five firms.
You read that right -- the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.
Instead, the 2004 exemption -- given only to 5 firms -- allowed them to lever up 30 and even 40 to 1.
Who were the five that received this special exemption? You won't be surprised to learn that they were Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley.
As Mr. Pickard points out that "The proof is in the pudding — three of the five broker-dealers have blown up."
So while the SEC runs around reinstating short selling rules, and clueless pension fund managers mindlessly point to the wrong issue, we learn that it was the SEC who was in large part responsible for the reckless leverage that led to the current crisis.
You couldn't make this stuff up if you tried.
Here's an excerpt from The Sun:
"The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch.
The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.
Making matters worse, according to Mr. Pickard, who helped write the original rule in 1975 as director of the SEC's trading and markets division, is a move by the SEC this month to further erode the restraints on surviving broker-dealers by withdrawing requirements that they maintain a certain level of rating from the ratings agencies.
"They constructed a mechanism that simply didn't work," Mr. Pickard said. "The proof is in the pudding — three of the five broker-dealers have blown up."
The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. It requires that firms value all of their tradable assets at market prices, and then it applies a haircut, or a discount, to account for the assets' market risk. So equities, for example, have a haircut of 15%, while a 30-year Treasury bill, because it is less risky, has a 6% haircut.
The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower.
Chalk up another win for excess deregulation . . .
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Source:
SEC's Old Capital Approach Was Tried - and True
Lee A. Pickard
SECTION: VIEWPOINTS; Pg. 10 Vol. 173 No. 153
American Banker, August 8, 2008 Friday
http://www.americanbanker.com/article.html?id=20080807ZAXGNH3Y&queryid=2110207978&
Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers
They constructed a mechanism that simply didn't work'
JULIE SATOW,
NY Sun, September 18, 2008
http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130/
American Banker excerpt after the jump.
Lee A. Pickard, former director, SEC trading and markets division, on Leverage and Net Capital exemptions :
A brutal combination of bad financial decisions and serious misjudgments about the inherent value and liquidity of securitized instruments, coupled with the use of excessive leverage, contributed to the demise of Bear Stearns and seriously weakened the capital structure of other major broker-dealers.
The Securities and Exchange Commission oversees the financial condition of all broker-dealers, and it used from 1975 to 2004 a "net capital rule" as its primary tool to ensure that broker-dealers had adequate capital bases and sufficient liquidity.
The rule, which I participated in formulating, required that every broker-dealer compute its net capital daily by doing two things. First, it had to value all liquid assets at market prices and then subject that value to a "haircut" of a specified percentage, depending on the assets' expected market risk. (A 30-year Treasury bond was carried for net capital purposes at 94% of its market value because changes in interest rates would affect its market value; riskier securities were subject to bigger haircuts.) Second, the broker-dealer was limited in the amount of debt it could incur, to about 12 times its net capital, though for various reasons broker-dealers operated at significantly lower ratios.
The SEC's basic net capital rule, one of the prominent successes in federal financial regulatory oversight, had an excellent track record in preserving the securities markets' financial integrity and protecting customer assets. There have been very few liquidations of broker-dealers and virtually no customer or interdealer losses due to broker-dealer insolvency during the past 33 years.
Under an alternative approach adopted by the SEC in 2004, broker-dealers with, in practice, at least $5 billion of capital (such as Bear Stearns) were permitted to avoid the haircuts on securities positions and the limitations on indebtedness contained in the basic net capital rule. Instead, the alternative net capital program relies heavily on a risk management control system, mathematical models to price positions, value-at-risk models, and close SEC oversight.
As the SEC itself has noted, this alternative program requires significant judgment, as contrasted with the numerical tests and capital charges (the haircuts) imposed on broker-dealers under the basic net capital rule. The alternative approach also requires substantial SEC resources for complex oversight, which apparently are not always available.
The SEC has maintained that the Bear Stearns collapse was precipitated by rumors and an unprecedented crisis of confidence, driven by lack of liquidity for the large securities positions it held. If, however, Bear Stearns and other large broker-dealers had been subject to the typical haircuts on their securities positions, an aggregate indebtedness restriction, and other provisions for determining required net capital under the traditional standards, they would not have been able to incur their high debt leverage without substantially increasing their capital base.
The losses incurred by Bear Stearns and other large broker-dealers were not caused by "rumors" or a "crisis of confidence," but rather by inadequate net capital and the lack of constraints on the incurring of debt.
The SEC should reexamine its net capital rule and consider whether the traditional standards should be reapplied to all broker-dealers. Moreover, broker-dealer losses should give the SEC pause regarding its recent proposal effectively to abandon the objective debt ratings of nationally recognized statistical rating organizations in favor of "subjective" tests of broker-dealers in determining adequate levels of regulatory net capital.
As the Bear Stearns collapse showed, no broker-dealer is "too big to fail" — unless the federal government comes to the rescue.
Thursday, September 18, 2008 | 06:00 AM | Permalink
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Comments
That's pretty ironic considering the time and effort they put into wiping out small daytraders with the 25K rule "for their own good" (yeah right)
Posted by: txchick57 | Sep 18, 2008 6:22:36 AM
It seems to me that we have been living in this benign environment for so long that we have concluded all of the finincial principles learned in the past no longer apply.
That's just plain stupid!! Who (name Names) is making these bonehead decisions?
Posted by: BG | Sep 18, 2008 6:42:13 AM
Barry, great summary. Man, I love your blog.
Obama should be all over this. This is a very easily understood example of deregulation gone astray under W/McCain. Something that just about anyone could understand ... in a nutshell ...
There were limits on how much the B/D's could borrow, the SEC removed these limits, the B/D's borrowed too much, and now they are dead.
It's like a college kid who gets himself into financial trouble because he was approved for too many credit cards.
Posted by: RG | Sep 18, 2008 7:04:54 AM
Uh. Wow.
I have to say I didn't expect to get to a story like this, an easy-to-understand nutshell that looks very damaging... from a media dynamics perspective this could completely become the narrative, which as someone said could give Team Obama a lot of mileage.
Posted by: John from Concord | Sep 18, 2008 7:23:39 AM
>>Who (name Names) is making these bonehead decisions?
And why? And at whose urging?
Posted by: lutton | Sep 18, 2008 7:27:19 AM
Hey Barry love the blog. You have to strike another firm from your list Morgan Stanley
http://www.reportonbusiness.com/servlet/story/RTGAM.20080918.wfinancewrap0918/BNStory/Business/home
Posted by: Matthew K | Sep 18, 2008 7:30:13 AM
A question,
When central banks "pump money into the financial system", where do they pump it to? Do they buy stock with it? Loan it to banks? Buy Treasuries from whomever want to sell them? Or what?
Thanks
Posted by: KJ Foehr | Sep 18, 2008 7:34:08 AM
Deregulation? Hmmmm...according to Pickard the regulations have been there since '75 but were just 'administratively finessed' (to use a euphemism any bureaucrat would love). No, I don't think you can say it was that....more like terminal hubris (greed?) from the people at SEC who thought they could let things slide, make a few bucks and get out before any real damage was done. Well, I think we see how that little maneuver turned out, eh?
One more thing: for those of you who think this is the perfect weapon to use in the political wars, think again. The current stress in our creaking financial system is already tremendous; it requires hard, decisive, and smart choices. Not the childish "gotcha" nonsense that passes for politics today (on both sides of the aisle I might add).
Posted by: Unscripted Thoughts | Sep 18, 2008 7:35:48 AM
One other question,
Is the central bank action today a big deal for equity prices, beyond the open today? A small deal? Or it doesn't make any difference to stock prices?
Thanks
Posted by: KJ Foehr | Sep 18, 2008 7:41:11 AM
What happened to Washington Mutual and Wachovia? was the leverage increased for banks too?
Posted by: quovadis | Sep 18, 2008 7:51:52 AM
don't blame W he tried . . . From the 2003 NY Times
http://tinyurl.com/6lp5qu
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BR: Its really a shame he didn't have a Cooperative Congress back in 2003. Oh, wait a second . . .
Posted by: jd | Sep 18, 2008 7:51:53 AM
Notice Barney Frank's comment at the end of the NYT article. Interesting.
Posted by: Don | Sep 18, 2008 8:04:10 AM
Let's name names.
Ultimately chairman of SEC William H. Donaldson was responsible.
Heck of a job Donaldson
Posted by: Brownie | Sep 18, 2008 8:04:54 AM
I agree this is a really excellent blog thread.
While its been a perfect storm of ineptitude, this oversight or lack thereof on the part of the SEC is really significant.
As has been previously posted, I'd like to know who the proponents of the ballooning debt ratio were.
Posted by: Clint Golden | Sep 18, 2008 8:08:49 AM
kj:
I don't make my living in the markets unlike some of these wonderfully talented people who blog here. But my take on this is it could make a difference for a few days or even weeks. However, don't miss the forest because of what is happening to a few trees...
The underlying problem is that the world still is undergoing the cure for too much easy credit for too long. Watch the economic numbers each week as they are released, like today for new unemployment claims...what I see is that the biggest ecomomy in the world is still in the indigestion phase, with increasing unemployment, fewer houses being built, fewer houses being sold for anywhere close to what the owners want (which is bound to make them feel poorer), more planned layoffs, severe disruptions in large industries like US autos, and unlike past recessions, our fed funds rate has already been lowered for some time, and it hasn't helped that much.
My advice is be patient. Things will get better and there will be another time to own stocks..but many in the financial media are "rah-rah" boys and girls and their jobs depend on getting that dollar in...
Brer Rabbit had the right idea sometimes when he tangled with Brer Fox...sometimes that Brer Rabbit... "he just lay low..."
Bruce in Tennessee
Posted by: Bruce | Sep 18, 2008 8:11:35 AM
>>Who (name Names) is making these bonehead decisions?
Well, at least we can't pin this one (completely) on poor old Hank Paulson -- as this occurred in 2004 it was on that clueless idiot John Snow's watch.
The SEC chairman at that time was William H. Donaldson (the Donaldson in Donaldson, Lufkin and Jenrette). He was a Skull & Crossbones Yale alumnus (1952, well before Dubya's time), so if you believe in that "good old boy" network, there's something to gnaw on.
Of course, Hank was probably lobbying for this over at GS, which would be a clear case of Be Careful What You Wish For -- you just might get it. But I dunno, maybe this hasn't been all pain and sorrow for GS, as 60% of their competitors have imploded. It remains to be seen if they can survive the unwinding of all this -- but then Hank is now perfectly positioned to make the call on whether GS is "too big to fail" when that time comes.
Posted by: constantnormal | Sep 18, 2008 8:22:22 AM
This all makes sense along the lines of the, "The short-traders did it!" meme.
All along this line of reasoning smelt like the play, "Iraq has WMD's!"
Or in other words, "Look over here folks, nothing to see there, trust us, we know what we're doing. Go have a beer and watch some reality show where people's dreams are crushed, we'll take care of everything..."
Posted by: ReductiMat | Sep 18, 2008 8:30:21 AM
Ah the SEC......another agency run by an incompetent. I have hesitated always blaming the current administration for our problems but the evidence gets more and more over=whelming. Hooooocoudanode
Posted by: grumpyoldvet | Sep 18, 2008 8:36:01 AM
This is a stinker. I'd like to know more about it and no doubt the campaigns are going to be all over it and the congress will be asking questions. It's probably accurate. I've long thought it wasn't lack of regs that were the problem but the will to implement them. I know from talking to a couple of lawyers that worked in govt that the word from on high from the the moment Bush and co took over was back off business. What happens in these circumstances is that a few challenge it and get sidelined or kicked out, some leave, but most just keep their heads down and go with the flow. There's been mountains of evidence of this from just about every govt department so why should anyone doubt that the Republican aversion to regulation has not been a pivotal factor in what's happened. We gave bankers lots of cheap money, the very clever boys who work there and some are exceptionally clever believe me, invented all kinds of new toys which they didn't fully understand, and govt looked the other way. Doctrinaire conservatism today (which is very different from the pragmatic prudent sort I grew up with) is an irony free zone in my experience but it's hard to escape the supreme irony of the greatest bailout of financial markets since the depression being executed by a dedicated, free market, anti regulatory administration that caused the mess in the first place. The law of unintended consequences strikes again.
Posted by: John(2) | Sep 18, 2008 8:37:43 AM
Chalk up another win for excess deregulation . . .
and chalk up another economy implosion to the Republican Party - it ALWAYS blows up and sinks under a Republican administration - two recession under ronnie raygun, one under george senior and now another recession approaching Depression under george junior.
when will the amerikan sheeple learn that a republican administration is really awful / bad for them ???
Posted by: Who Knew | Sep 18, 2008 8:44:25 AM
I don't know if I would term this deregulation, as that is a loaded term. I have no problem with deregulation, as long as rules are thus made simple, easy to read, and easily enforceable. The problem was that the laws on the books were enforced selectively.
This smacks to me of regulators no longer regulating, but becoming ACTIVE MARKET PARTICIPANTS.
Posted by: Danny | Sep 18, 2008 8:45:19 AM
Amazing. Was this all hidden away all this time? Or was it in plain sight like all the NINJA morgatges and real estate fraud and nobody really cared.
The front page of the WSJ is so hysterical (for them) today I can't help but wonder if this is a temporary bottom of some sort.
Posted by: NiNM | Sep 18, 2008 8:45:23 AM
My google of "Freddie Fannie debt oversight 2003" brought me to this .pdf file:
Subordinated Debt Insurance by Fannie Mae and Freddie Mac by Valerie L. Smith Office of Federal Housing Enterprise Oversight, dated June 2007
I'm not a financial wizard like many at this site but in my reading it they knew exactly what was going on.
Here's the link...
http://www.ofheo.gov/media/WorkingPapers/workingpaper073.pdf
Posted by: Clint Golden | Sep 18, 2008 8:46:33 AM
Another example of covert deregulation which is in line with the underlying principles of the Conservative business first and foremost thinking. I am sure some lobbyists have their finger prints all over this.
Posted by: Fred S. | Sep 18, 2008 8:51:57 AM
Re: Barney Frank and FHFA
"Many Democrats oppose strict limits on the GSEs' portfolios, saying they help lower the cost of borrowing for average families, and the debate over limits on Fannie and Freddie's portfolios held up GSE reform legislation last year.
Instead of imposing predetermined limits on Fannie and Freddie's loan portfolios, compromise language worked out by the Treasury Department and Rep. Barney Frank, D-Mass., would have instead given the FHFA the authority to determine limits based on the assets the GSEs kept on hand to cover potential losses. Regulators would have been permitted to limit Fannie or Freddie's portfolios if they determined the companies posed a potential systemic risk to the banking and finance system."
http://www.inman.com/news/2007/05/1/house-amends-gse-reform-bill-allow-larger-loan-portfolios
Seems like his position on this was pretty reasonable to me.
Furthermore, the Bush Administration didn't just try, it actually got the FHFA (just in time to put Fannie and Freddie into conservatorship).
Posted by: OhNoNotAgain | Sep 18, 2008 8:57:27 AM
