SEC Lifted Debt Limit For Brokerages In 2004
Monday October 6, 2008
This is a story of deregulation. It’s also a story of how our government was an enabler in the mess that is the Great 2008 Wall Street Bailout. (I refuse to use the new MSM moniker, “rescue".)
In 2004, the Security and Exchange Commission, led by then-chairman William H. Donaldson, unanimously approved a major change (deregulation) in the “net capital” rule, a change that reduced how much money banks had to hold in reserve to protect against bad investments (losses).
The net effect of the rule change was to allow the investment banks to "leverage" their money more aggressively. What this means in layman's terms: for every dollar of equity, the investment banks could increase their debt. Bear Stearns was soon up to 33 to 1, and a lot of that debt was in mortgage-related securities. The corollary for Main Street (sorta): assume you have $50,000 in Certificates of Deposit (and have no other assets) and use those CDs as collateral for a loan of $1.7 million. If you default on your $1.7 million loan, your lender is S.O.L., as my dear departed mom would say. (Also see The ABCs of CDOs: How We Got Into Today's Financial Mess)
I'm certain you won't be surprised to learn that the deregulation request came from the nation’s five largest investment banks, banks that were complaining about proposed European Union regulation. One of those firms, Goldman Sachs, was run by Henry M. Paulson Jr., who would be Treasury Secretary by 2006. Another was Bear Stearns, which we would bail out before its fire sale in March 2008.
There was only one dissenting voice, a software programmer who "help[ed] write computer programs that financial institutions use to meet their capital requirements." No one on the Commission asked him any questions.
As the NY Times notes, at the time of the rule change the SEC was told by staff that "companies for the first time could be restricted by the commission from excessively risky activity." This was a selling point: exchange a relaxation of the reserve requirement for improved access to balance sheets.
That was 2004. In 2005, President Bush appointed Rep. Christopher Cox (R-CA) as SEC chief. William S. Lerach said the nomination "is like putting the fox in the chicken coop." After his nomination, Cox said: "The free and efficient movement of capital is helping to create the greatest prosperity in human history."
And under Cox's leadership, the SEC did almost nothing to try to figure out just how that capital was moving about (emphasis added):
The SEC assigned seven people to examine the parent companies, which last year controlled financial empires with combined assets of more than $4 trillion. Since March 2007, the office has not had a director. And as of last month, the office had not completed a single inspection since it was reshuffled by Cox more than a year and a half ago...
Cox dismantled a risk management office ... that was assigned to watch for future problems... Last Friday, the SEC formally ended the 2004 program, acknowledging that it had failed to anticipate the problems at Bear Stearns and the four other major investment banks.
The SEC lifted the net capitalization rule in exchange for being able to more closely regulate the investment banks. Had they not done so, the European Union was going to regulate foreign subsidiaries of the investment banks. The investment banks complained about being regulated by both the SEC and Europe; in exchange, they wound up effectively regulated by no one.
Yet they came crying to Congress with their hands out when their own greedy policies brought the global financial industry to its knees.
This is a sad chapter in the history of the Securities and Exchange Commission, which was created during the Great Depression to help restore confidence in the stock market. The first chairman was Joseph P. Kennedy.
This explanation of events certainly give credence to Sen. John McCain's call for SEC Chief Cox to be fired.
And it answers a question I've had for weeks: how could it have been legal for these firms to be so incredibly over-leveraged?
Related: Wall Street: A Failure To Regulate
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