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How SEC Regulatory Exemptions Helped Lead to Collapse

Thursday, September 18, 2008 | 06:00 AM

in Bailouts | Credit | Legal | Markets | Taxes and Policy

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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.

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 . . .

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.

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Barry Ritholtz sez, 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 Lee Pickard, former director, SEC trading and markets di... [Read More]

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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

~~~

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

This is an exact analogy to changing mortgage standards away from long-term proven ratios and to allowing house prices to run away form traditional price to income ratios. The tried and true ratios are there exactly because they worked.

Winston Churchill once wrote: "Custom is a better tool than logic." Things like this are proof.

Posted by: wally | Sep 18, 2008 9:00:11 AM

The SEC was run by very competent people who argued against the radical "reforms" that the free marketeers were cramming down their throats. Those who did not bend to the mighty political will found their cases stymied, shut down or simply ignored. They left and found other jobs. Notice how the Commission itself has been dominated by de-regulators these last 30 years and finally the fox Cox got control.
Isn't a hamstrung SEC what everyone wanted so that markets could be "free?"

Posted by: dd | Sep 18, 2008 9:01:07 AM

That's some fine advice from Bruce in TN. I'll add that, in my unprofessional opinion, today's capital infusion, a wall of balsa wood--imho, will only make the Hedgies' cash out for margin calls just a tad less bitter.

Under NO circumstances should a small investor buy into this.

Posted by: Will Divide | Sep 18, 2008 9:02:50 AM

Barry -

Incidentally, the statement "all financial innovation is leverage dressed up as something else" - i'm sure I don't have the quote quite right - was originally uttered by John Kenneth Galbraith, an economist whose work my do us some good these days.

Posted by: Justin Dangel | Sep 18, 2008 9:06:01 AM

I'm an inveterate SEC hater, but we need to stop blaming the SEC for not stopping what was from the beginning a very flawed, destructive business model. What kind of pinheads at the brokerage firms thought these were good ideas? Why would you ever want to have such a low net capital ratio anyway - what kind of smart business practice is that? A better idea would be not to need an SEC at all because we make smart, rather than greedy, business choices. That'll be the day!

Posted by: metoo | Sep 18, 2008 9:11:07 AM

Lee Pickard must have forgotten that in order to comply with Basel II, Investment Bank Holding Companies needed the SEC to promulgate alternate net capital rules. These rules went through the nornmal rulemaking/public comment process, and when approved, actually gave the SEC the ability to regulate the holding companies, as well as the broker/dealer subsidiaries.

I would agree that they did a crap job of this, as they had no prior experience dealing with regulating large holding companies. Then again, the Fed and the OTS have not saved commercial banks from themselves, have they?

The real demise of the investment banks has come from their funding models, which are still flawed. No permanent access to the Fed window means that anyone left with just the commercial paper market is likely to be toast.

Posted by: J | Sep 18, 2008 9:17:56 AM

just pointing out the obvious :

the SEC _allowed_ the extra leverage, but they didn't _force_ them to take it. The 5 made that decision all by themselves, nobody forced them to do it.

Sure it was insane for the SEC to do that, but, ULTIMATELY, it was NOT the SEC that was in large part responsible for the reckless leverage, it was the "five".

Just cuz Ma left the lid to the cookie jar open, it is your fault that you gorged on cookies and then puked them up all over the place, perhaps causing a hemorrage and died from it. Ma was an idiot, but it was your fault.

Posted by: Marcello | Sep 18, 2008 9:18:22 AM

The current administration came to washington intent on destroying the federal government. Their largesse, giving federal funds, and contracts to friends and businesses associates regardless of ability to perform the task, and entirely free of consequences for failure, is already legendary in the funding of the Iraq War. However, the idea that they were all gung ho to give 500 Million dollars to a couple of con artists with no track record (indeed a company that didn't exist 1 year prior) -- Custer Battles -- should have told us all something. If they are willing to do that for these relative nobodys, then what must they be doing for people who really matter? 'Course we knew how well they were treating the Oil business and Halliburton (started a whole new war for them). Now we know what they were doing for Wall St. Over and above lax enforcement, and using the FED to pump up the economy (a two fer: you help your friends in business and create a positive political effect) it hadn't been *obvious* how they were benefiting specific individual players.

Now we know.

Posted by: VoiceFromTheWilderness | Sep 18, 2008 9:23:22 AM

So there's our proof that the regulators weren't doing their jobs.

But I'm sure that some idealogue will "rebut" this with some non-sequitur in attempts to change the subjects. Works every time with about 50% of the country.

Posted by: Jeff M. | Sep 18, 2008 9:32:02 AM

God bless you, Comrade Barry.

Posted by: comrade NSA | Sep 18, 2008 9:32:50 AM

Look at J's comment above everybody. The (non-partisan, non-US) Basel standards are heavily implicated in this overleveraging, as everyone involved in any way in banking knows.

Posted by: jult52 | Sep 18, 2008 9:33:49 AM

Now, we all know that this mess was caused by evil liberals in gov't. forcing those kind, compassionate, altruistic financial types to lend money to dead beat poor people.

Posted by: AlladinsLamp | Sep 18, 2008 9:41:26 AM

Don't blame W?
That's just crazy... In 2003, the Republicans had a solid majority in both houses of Congress... If they couldn't reform the rules then, it was simply greed and avarice that prevented it....
I'll lay this whole thing at his feet(along with a long laundry list of other disasters and blunders. He is certainly the most incompetent CEO imaginable... petulant, clueless, politicized, and pedantic...
Can't wait for the MSM to latch onto this story...

Posted by: musicmatters | Sep 18, 2008 9:50:03 AM

Looks like "investment banking" is another oxymoron that has been demonstrated, along with other goodies like "military intelligence".

Fact is that the financial instruments that were created and marketed by the oxymorons were so complex that they were either too hard to understand by clients, ratings agencies, and accounting auditors. Also, the latter two may have been complicit in the financial manipulations under the shield of complexity.

Basel II which allowed the SEC to use complex mathematical formulas to value assets and compute reserve requirements wasn't going to work either.

Posted by: Jason | Sep 18, 2008 9:54:42 AM

from nearby thread:

"...The crooks found their way into the government they despised and winked at their chronies while the nation was raped.
This isn't about regulations; this is about criminal behavior. Maybe you like the wild west, king of the shitpile, soprano free-for-all of the dog-eat-dog world. Maybe you don't like police forces but anyone who thinks they don't need police must not need to sleep. We, the middle class are fed up with the lying, overeducated, elitist pigs who think they're so-o-o-o special when they are really nothing but cheap crooks spinning fantasies about how we "all can get rich" while they rob us blind. Sell it to someone else, pal."--AGG

It's about crooks--and, Yes, the 'regulators' knew--there are hundreds of .pdfs, like the one above, that speak to real-time knowledge of a developing/worsening situation.

There's only been one Representative telling the People about this--you probably know him as the Kook w/ all that crazytalk..

People, wake up, http://www.targetmarketingmag.com/
Bernay's work didn't die with him, it, too, has reached levels unheard of..

BR, nice post..

Posted by: Mark E Hoffer | Sep 18, 2008 9:55:44 AM

W tried? yeah right

Posted by: Bob A | Sep 18, 2008 10:03:14 AM

"What's sad is not that you can't possibly make this stuff up. It's that you don't need to." --- John Stewart

Posted by: Uncle Jeffy | Sep 18, 2008 10:14:42 AM

Government Bailouts for the Rich, Naked Capitalism for Everyone Else

Today, we have the worst of both worlds. Government bailouts for the rich -- naked capitalism for everybody else. This whole mess could have been avoided if the generation that followed the New Deal had the common sense and decency to understand that you cannot turn over capitalism to the capitalists. Greedy individuals will always figure out clever new ways to make their own piles of money at the expense of their fellow citizens and at the expense of their nation's well being. Whether it's the Savings and Loan scandal of the 1980s or the Dot.Com bubble of the 1990s or the Enron collapse or the mortgage meltdown -- it's always the same old story. They pass on the wreckage to the taxpayer as they always do. It's time to put to rest once and for all the Big Lie that deregulation and privatization of government institutions will bring the nation anything other than calamity after calamity.

Posted by: Jump wall streeters !! | Sep 18, 2008 10:15:36 AM

Sure, in hindsight we know it was a mistake to allow investment banks to take such risks. But while it was happening -- admit it -- everyone loved it because so much money was being created from thin air, traveling around the world, and inflating our investments. Joe Everyman could refinance his mortgage at rates lower than inflation and use the money saved to buy more houses or play the stock market. People flipped houses like crazy.

A new era had begun. Investment bankers became the largest political contributors and they became Sec. of Treasury. Quasi-government entities were not left out and had politicians in their power to prove it.

Posted by: Jason | Sep 18, 2008 10:19:14 AM

Leverage is great until it isn't. After LTCM, who coulda blamed IB's for 30-40 times leverage? They were the Masters of the Universe, and besides, knew Greenspan had their back.

While in hindsight this SEC exemption for IB's seems to explain everything, it doesn't. As someone said earlier, the IB's did it to themselves.

What's really sorta humorous is that the IB's are toast and the world hasn't ended. The real economy, while weak and weakening, is still not crashing like an over-leveraged hedge fund. People are still eating, shopping, driving, etc. The Masters of the Universe haven't much mastery over anything, it seems.

I'm w/ Bruce in Tennessee that you should lay low like B'rer Rabbit (love that one, Bruce), but have always figured most "investing", even by the little guys, was just speculating by another name.

Get safe and stay safe, and remember, you can always lend money to the people that print it 'cause you will definitely be paid back (something that explains the 3 month T-bill rates). It may not be worth much when you get it back, but it's likely to be worth more than zero, which is probably what you'd get w/ an IB investment these days.

Posted by: Donkei | Sep 18, 2008 10:21:21 AM

"Why would you ever want to have such a low net capital ratio anyway - what kind of smart business practice is that?"

Maybe to increase profits short term, get a fat bonus at the end of the year and some stock options. If it all goes to hell, the FED is right there to bail you out. I'ld do it!

Posted by: Bonus | Sep 18, 2008 11:03:34 AM

While we are at it lets broaden the blame game and not just focus on some regulator who was asleep at the wheel. Ultimately you have to ask yourself why were they asleep at the wheel? Why was there not more concern about the stability of financial markets when these markets were eventually so big and interconnected that they could bring down the global financial system? Authorities outside the US have over the years repeatedly warned about the very calamitous events we experience today. Germany during its EU presidency warned about the danger of HFs to the financial system. The call for more regulation was flatly negated by Paulson and co.

The complacent attitude that has permeated Wall Street in the last decade or two is a direct consequence of a Federal Reserve that was not only asleep at the wheel but outright collaborating with speculators on Wall Street. By doing so they have violated the trust that the American people put into them. Instead of guaranteeing macroeconomic stability they were guaranteeing the stability of Wall Street. They did so in good faith that they were doing the right thing. Authorities in Washington were hailing them as the financial/economic prodigies they never really were.

Lets not fool ourselves by thinking that the current problems could have been avoided by mere proper regulation nor can they be solved by it. The root cause is far deeper and rests with the Federal Reserve by not setting the appropriate interest rate to guarantee macroeconomic stability. Authorities have to accept the fact that there is no trade-off between the price of money and the potential output of the economy. Investors outside the US increasingly loose faith in the competence of US financial markets. To restore this faith will take extraordinary action.

Posted by: Alfred | Sep 18, 2008 11:03:47 AM

Funny/Sad that the knee-jerk reaction is to blame whatever ideology they don't like. To be expected for sure, but as analysis goes it's not analysis at all.

Blame the SEC regulation or lack thereof, but the SEC (and the rest of the world) was following the European Union's lead. At the time the complaint was that US firms were losing competitiveness to European firms - and W was blamed for that, too.

A rising tide lifts all boats, and a falling tide lowers all boats. Either way, the principal on your debts is not a boat.

~~~

BR: Thank you for that empty aphorism excusing the Nonfeasance and Malfeasance of the past 15 years.

Here's a suggestion, one that is less dimwitted than yours: BLAME THE IDEOLOGY RESPONSIBLE.

Its time to stop wringing your hands, and start naming names and blaming the idiots who are responsible.

Posted by: Invisible Finger | Sep 18, 2008 11:11:30 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."

It comes with each Republican administration.

The financial industry is like a sea squirt. When they reach the safety and comfort of a submissive Republican administration, they take root and eat their own brains.

Posted by: Jon H | Sep 18, 2008 11:22:03 AM

This isn't about regulations or deregulation. It's about money and greed.

Through all this, I haven't seen any indication that what they did was illegal. I would like to find out. At the very least, it looks like someone made decisions that caused problems. Probably those decisions were prompted by greed. They got something out of it.

Find out who made those decisions and why. Follow the money (or other benefits) and maybe something can be done legally or if not, we can change the rules they must work under.

Posted by: Ron P | Sep 18, 2008 11:30:30 AM

It kind of makes sense as to why the SEC hasn't been heard from much since the wheels started coming off. They're all walking away, hands in pockets, whistling and looking over their shoulder.

I feel ill. The net effect will be a return to 1900 style banking. Small community banks, Christmas clubs, passbook savings accounts, and little capital in the 'investment world'. Who can trust this system anymore? Sam Snead had the right idea. Bury your money in coffee cans in your backyard, or keep a safe in your house.

Posted by: Mark W | Sep 18, 2008 11:32:30 AM

"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)."

Right. The usual plea from Republicans who screwed up. Whose fault was 9/11? "Now is not the time for finger pointing!" Did the Bush administration intentionally distort intelligence to support their call for war? "No finger pointing!"

Republicans are always talking about responsibility - except when it comes to themselves taking responsibility.

Posted by: Jon H | Sep 18, 2008 11:34:03 AM

"This isn't about regulations or deregulation. It's about money and greed."

Bullshit. Regulations are needed because humans are greedy and money makes us stupid.

The fools on Wall Street are, at heart, no better than the bluehaired old ladies on the bus to Mohegan Sun.

The Republicans trot out their myths of the emotionless financial Vulcan ubermenches of Wall Street, with icewater in their veins, and they use that to claim that deregulation is justified.

Posted by: Jon H | Sep 18, 2008 11:38:47 AM

«it was the SEC who was in large part responsible for the reckless leverage that led to the current crisis.» But that was well known -- the SEC have been relaxing regulatory standards and accounting standards whenever their sponsors wanted. And part of the argument for the 2004 relaxation was that the banks had gotten leave (by the quasi-abolition of reserve requirements) to have any leverage the wanted, so the broker-dealers wanted "parity". All these guys wanted was a chance to turn their banks and brokers into momentum-following long "hedge" funds, to collect immense bonuses and capital gains thanks to paper profits due to insufficient risk provisions enabled by very generous risk ratings by those splendid friends of Wall Street, the rating agencies, whose management became fabulously wealthy too.

Posted by: Blissex | Sep 18, 2008 11:45:40 AM

Posted by: Jon H | Sep 18, 2008 11:38:47 AM

Jon, if these guys weren't playing with Monopoly Money, their beanstalks wouldn't grown near as tall...

Mark W,

remember, Slammin' was talking about Money, not currency..

Posted by: Mark E Hoffer | Sep 18, 2008 11:49:09 AM

I'm surprised nobody else has mentioned this, but I'm reminded of the following passage in former Treasury Secretary O'Neill's book about working with the Bush Administration:

p. 305 -

[Karen] Hughes...stopped the proceedings. "But there is uncertainty in this economy," she said. "Real uncertainty that this won't solve."...

Bush stopped in midstride and looked hard at Hughes. He was silent for a moment. "The economic uncertainty is because of SEC overreach," he said pointedly. ...O'Neill couldn't believe what he was hearing--SEC overreach? No wonder the White House had backed off from...medicine for crooked executives...ceded the corporate governance debate to Congress."

Posted by: Dave L | Sep 18, 2008 12:02:15 PM

Regulatory exemptions do not equal deregulation, and certainly not "excess deregulation." The question is, if there were no regulation of anyone in this area, would the market police itself? Firms may have still failed, but would private-sector mechanisms (or the simple working of the sections of the legal code directly based in common law) take care of the situation?

Because of the exemptions, I would assume that the executives of these banks cannot be sued for negligence given the blatant violations of Finance 101. Thus, the SEC actually removed the best recourse that shareholders have to keep their executives in check, which would have made others more cautious in the future.

Posted by: Caleb S | Sep 18, 2008 12:20:43 PM

Barry - can you have someone dig up the public comments prior to SEC rule change? Could be interesting reading.

I agree - time to name names and point fingers. Whomever was drunk at the helm when we hit the iceberg needs to be called out. Fired at minimum.

Posted by: Kurt Milne | Sep 18, 2008 12:24:57 PM

Insightful and lucid commentary along the lines of this thread from the Christian Science Monitor:

http://www.csmonitor.com/2008/0917/p08s01-comv.html

Excerpt:

"Like Americans with too much credit-card debt, investment banks have been allowed by Congress to take on debt with very little backup capital. That's why so many have fallen, unlike commercial banks that are required to keep reserves against potential losses.

"Investment banks and many other financial players, such as mortgage brokers, now need enforced discipline to avoid a new era of risky debtmaking.

"The Federal Reserve also needs to learn from its mistake of keeping interest rates too low in 2003 to prevent a housing bubble.

"A credit-based economy that turns short-term money into long-term investments needs safeguards, such as capital reserves and transparency. These help handle the greed side of markets. When panic sets in, government must step in and perhaps take over private assets and resell them. That helps handle the fear side of markets.

"Wall Street is now in fear mode, even as it learns lessons from its recent greedy era. One lesson is that bundling home loans and reselling them without anyone being held responsible for the risk of those loans creates financial black holes.

"At Wall Street's big bang more than 200 years ago, when financiers first gathered under a buttonwood tree in Manhattan to buy and sell, the basics for creating wealth on good credit were established.

"It's time for a return to basics that can create true value."

Posted by: babycondor | Sep 18, 2008 12:34:02 PM

Insightful and lucid commentary along the lines of this thread from the Christian Science Monitor:

http://www.csmonitor.com/2008/0917/p08s01-comv.html

Excerpt:

"Investment banks and many other financial players, such as mortgage brokers, now need enforced discipline to avoid a new era of risky debtmaking.

"The Federal Reserve also needs to learn from its mistake of keeping interest rates too low in 2003 to prevent a housing bubble.

"It's time for a return to basics that can create true value."

Posted by: babycondor | Sep 18, 2008 12:34:46 PM

How about this?
Cox resigns now
Elisse Walter the only Commissioner of any stature with a strong understanding of the regulatory structure and a true math brain is appointed Interim Chair.
Some confidence restored.

Posted by: dd | Sep 18, 2008 12:35:21 PM

Regulators may have opened the door, but it was the Wall Street houses that decided to walk through.
The real culprit, IMO, is the failure of the quanty types to heed their own warnings. As we all know, past performance is no guarantee of future results. And yet, the entire financial system was dependent on assuming the opposite in their VAR models.
Here's a link to what I wrote about it on my blog.

Posted by: CounterClckWise | Sep 18, 2008 12:42:44 PM

going back to the Obama comments, I don't think he is going to want to make this a huge issue simply because Bill Donaldson was head of the SEC at the time and guess what! Donaldson backs Obama. Could get sticky if it is made an issue...

Posted by: Doug | Sep 18, 2008 1:22:27 PM

Alfred,

I agree with your thoughts completely. The Fed's lowering of the cost of money for non-macroeconomic reasons goes a very long way toward explaining why we find ourselves here.

It is very similar to another statement I read in this thread somewhere about 'being careful for what you ask for'. By applying too much gasoline (cheap money) to the fire over the last 20 years, the whole damn thing eventually just blew up.

IMHO, a more balanced cost of money (~5% to 7.5%) has an excellent side-effect of preventing a lot of speculation before it even starts. It acts as a market moderator in effect; while providing investors with a broader range of viable asset classes to invest in.

Posted by: BG | Sep 18, 2008 1:28:47 PM

Of course, another way to look at this is that the free market is working. Three pretty large firms just got some fairly stiff penalties from Mr. Smith.

Rob

Posted by: Rob | Sep 18, 2008 2:50:24 PM

I am trying to confirm this story - it could alter my political perspective in a big way. Could someone please identify the rule that was issued in 2004 to withdraw the requirement? Or was this accomplished informally?

http://www.sec.gov/divisions/marketreg/bdnetcapital.htm

Is this it: Securities Industry Association, re: Temporary Relief from Certain Provisions of the Net Capital Rule, (Feb. 19, 2004)?

Posted by: James Pitts | Sep 18, 2008 3:11:59 PM

In response to the comment by Doug on Donaldson being part of the Obama campaign, guess who Obama has hired as an "economic advisor" -- Franklin Raines former corrupt head of Freddie Mac.

http://en.wikipedia.org/wiki/Franklin_Raines

Posted by: Jason | Sep 18, 2008 4:02:47 PM

The exemptions are here
www.sec.gov/rules/final/34-49831.pdf

Basically the SEC gave permission to the 5 big B/Ds to opt to have (their home brew version of) consoldiated supervision as IBHCs. The 2004 rules are a bastardisation of parts of the Basel framework, so they for instance use VAR for market risk but they do not include an operational risk capital charge.

Posted by: regwonk | Sep 18, 2008 4:07:28 PM

" Three pretty large firms just got some fairly stiff penalties from Mr. Smith."

Yay Adam Smith. Is he going to pay for the bailouts?

The rest of us would be far better off if companies were *blocked* from competing for Darwin Awards as if starring in an episode of Wall Street Jackass.

Posted by: Jon H | Sep 18, 2008 4:13:06 PM

The chairman of the SEC at the time of this decision was William H. Donaldson. According to his profile on sourcewatch he was a non-managing director of the board of Phillip Morris, Chairman, President, and CEO of Aetna as well as a fellow member of the Skull & Bones.

http://www.sourcewatch.org/index.php?title=William_H._Donaldson

Posted by: Jakub Olesiak | Sep 18, 2008 6:30:19 PM

Allow me to ask the question: what is the purpose of the regulatory capital requirements?

The SEC has a charter to help investors make wise choices to not be defrauded. They force clear disclosure, and set an environment where contracts -- buys and sells, we call 'em -- will be good.

It does NOT have a separate charter to keep firms from running themselves into the ground, does it?

It does NOT have responsibility to keep stock prices up, and in fact, it is responsible for helping all investors consider whether a stock's price is too high, and should be passed over.

The old capital adequacy rules were intended to ensure that the brokerage couldn't suddenly find itself with no money in its vault to pay people who had accounts -- even flim-flam artists would have to put a lot of time and money into their endeavor, directing them to ply their trade elsewhere. But they were pretty simplistic and did not account for the modern instruments that investors favor these days. They needed rewriting.

So the accounting, finance, economics, politics and risk management professions, with high hopes and the best of intentions, brought out Regulations 2.0 and got it seriously wrong, and firms that normally were merely aggressive suddenly found themselves out of business.

Time for Version 3.0, and like MSFT, maybe 3.1 will be usable.

My personal view is that ANY bank-like business -- which holds money that clients can take away on short notice, but invests in long-term investments -- is subject to runs on credit unless it has full backing from an FDIC-like arm of the Feds.

If that's true, then our next round of regulation will SHRINK the role of government regulation in many ways, while charging insurance premiums or "charter fees" to banks, brokers, mutual funds and all the other financial intermediaries. It'll remove the moral hazard of taking too much risk, since faking your risk levels will now be a case of fraud, for which the govt will be able to pursue you to the grave.

And life will go on!

Posted by: Walt French | Sep 18, 2008 9:54:17 PM

but was this rule the endgame? Now they are taking down the restrictions on using depositor's money in merchant banking, just as every major commercial bank picks up an investment bank on the cheap.

Would the american public ever tolerate a bank as big as bac buying the country's largest mortgage originator and the country's largest investment bank during calmer times?

Posted by: m | Sep 18, 2008 9:55:30 PM

This is hilarious. I have just been informed that excess freedom destroyed Wall Street.

I own a gun: a Mossberg 500 12 gauge shotgun. Funny, I've not stuck it in my mouth yet.

So, if Fannie Mae and Freddie Mac were NOT given this obscenely dangerous freedom, how did THEY blow up?

(signed) Curious in Kalamazoo

Posted by: somercet | Sep 19, 2008 7:51:00 AM

Read Kenneth Galbraith's 'The Great Crash, 1929' to read exactly the same story.

Leverage is the name of the game while things are going good, but a helluva problem when they go bad.

Posted by: richard | Sep 19, 2008 8:20:21 AM

An earlier posting noted:

[from nearby thread:

"...The crooks found their way into the government they despised and winked at their cronies while the nation was raped.]

Which reminds me of the way my wife describes the difference between the Republican's and Democrats.

The Democrats can't keep their pants on. They're out screwing women one at a time.
The Republicans are screwing the whole country.

Think about it. The Republican's were all after Clinton because he lied about getting oral sex in the Oval Office. The only reason the Democrats haven't tried to impeach Bush over having lied about WMD in Iraq is that we would have ended up with Chaney as President.

Posted by: Steve | Sep 19, 2008 9:13:42 AM

We [yes us, individuals, not corporations] need to get a grip on these situations, foster positive solutions and preventive future actions because, the insurance industry is next.

Posted by: not-the-coast N FL | Sep 19, 2008 9:16:47 AM

This is no surprise. The same firms were behind the recent funding of lobbyists which led to the change in bankruptcy laws in 2005. This coupled with the anti-regulation ideology of the current Administration help create the perfect storm for profiteering at the expense of the marketplace.

Posted by: Kevin Fisher | Sep 19, 2008 9:17:49 AM

"In response to the comment by Doug on Donaldson being part of the Obama campaign, guess who Obama has hired as an "economic advisor" -- Franklin Raines former corrupt head of Freddie Mac."

Uh, that is yet another untrue McCain talking point.

Posted by: inthewoods | Sep 19, 2008 1:28:46 PM

Yeah, W had a real compliant Congress (NOT!) that received hundreds of millions of dollars of campaign contributions from FNMA and FRE. No way they were going to empty that trough.

Posted by: anonoymous | Sep 20, 2008 2:47:43 AM

I see the same problem here that exists in our country as a whole...an unwillingness to hold ALL people accountable.

If you are democrat, you blame all this on Republicans. If you are a republican, you blame it all on Democrats.

How about we look at the facts and associations of all the people involved and hold them accountable - regardless of political party. There are plenty of corrupt people to blame in both private industry and the government.

Don't be suckered by revisionist history. Don't fall for the double-speak and out-right-lies. And last but not least - don't be distracted by "I didn't start it, he did" and other childish crap like that.

We need individuals to be honest, ethical, and who will do the right thing (not the easy or greedy) in management of companies and in our government. If you believe a company is making bad decisions or operating unethically, don't do business with them. There are almost always choices. If you believe the same of our political leaders, get the them hell out of office and vote in someone that you trust to do the right thing (remember not the easy or greedy).

Just my 2 cents.

Posted by: Michael | Sep 20, 2008 9:33:50 AM

None of these firms really liked MBSs or CDOs; they just kept cranking them out because of the fees. We're talking in the tens of billions, maybe over a hundred billion, all taken home as bonuses and presumed unrecoverable. The narcisistic stupidity thinking they could get away with it being par for the course for these reckless pompous idiots. And to the McCainiacs who yammer on about Fannie and Freddie, are you so fact-impaired by your tribe loyalty that you've completely forgotten who's been running the country for the last 8 years?

Posted by: tony c. | Sep 23, 2008 12:39:56 AM

I emailed Senator Feinstein, Boxer, and Rep. Pelosi about Sec rules change would lead to this in 2004,,,,but I never even received a reply from these people.

I said the rules change where directed related to the first depression as Wall street companies got involved with mortgages.

Posted by: mthomas | Oct 3, 2008 9:11:05 PM

what complete stupidity you are responsible for spreading simply to divert blame from Barney Frank. Anyone ever consider that maybe the Regulatory exemptions were an attempt to have these five firms absorb the losses? In other words, an attempt to have the private sector do what the federal government was forced to do when they failed...
Jackasses...

Posted by: brad | Oct 21, 2008 11:16:56 AM

...:"these people" are not "boneheads". "jackasses" or "fools", these Bush approved appointees, these corporate-frequently multi national named officers & their willing brown nosers are selfish...given the power to manipulate the system for self serving purposes, friends in political power, of course they acted out...we are an ignorant people, trained by our gov't. & ed system to serve, not to think, bring critical thinking to bear, flexible ever progresssive systems, ever fine tuning to serve as many people as possible, not just the ones we foolishly choose to make decisions "for us".

Posted by: steve | Oct 25, 2008 10:54:16 AM