2008 September 21 Sunday
SEC Leverage Rule Change Contributed To Investment Bank Failure

Julie Satow of the New York Sun reports a 2004 US Securities and Exchange Commission rules change contributed to the failure of investment banks.

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.

Keep in mind that this is not the main cause of the financial crisis. Countrywide Financial, Washington Mutual, Fannie Mae, and Freddie Mac (among others) got into trouble due to the mortgage bubble and poor lending practices.

Barry Ritholtz says this rules change helps explain the extreme amounts of leverage in the crashing investment banks.

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.

In the Winter 2000 edition of the City Journal Howard Husock reported how Bill Clinton's Administration forced banks to loan large sums of money to high risk projects in inner cities. This is part of a multi-decade trend where the Democrats in Congress and the White House forced banks to lower their investment standards in order to supposedly help poor people.

The Clinton administration has turned the Community Reinvestment Act, a once-obscure and lightly enforced banking regulation law, into one of the most powerful mandates shaping American cities—and, as Senate Banking Committee chairman Phil Gramm memorably put it, a vast extortion scheme against the nation's banks. Under its provisions, U.S. banks have committed nearly $1 trillion for inner-city and low-income mortgages and real estate development projects, most of it funneled through a nationwide network of left-wing community groups, intent, in some cases, on teaching their low-income clients that the financial system is their enemy and, implicitly, that government, rather than their own striving, is the key to their well-being.

The CRA's premise sounds unassailable: helping the poor buy and keep homes will stabilize and rebuild city neighborhoods. As enforced today, though, the law portends just the opposite, threatening to undermine the efforts of the upwardly mobile poor by saddling them with neighbors more than usually likely to depress property values by not maintaining their homes adequately or by losing them to foreclosure. The CRA's logic also helps to ensure that inner-city neighborhoods stay poor by discouraging the kinds of investment that might make them better off.

Fannie Mae and Freddie Mac had accounting scandals in 2003 and 2004. Wall Street Journal editor Paul Gigot got wind of an accounting scandal at Fannie and Fannie mobilized many allies on Wall Street to hit back at the WSJ for reporting the scandal. The reporting turned out to be highly accurate.

My battles with Fan and Fred began with no great expectations. In late 2001, I got a tip that Fannie's derivatives accounting might be suspect. I asked Susan Lee to investigate, and the editorial she wrote in February 2002, "Fannie Mae Enron?", sent Fannie's shares down nearly 4% in a day. In retrospect, my only regret is the question mark.

Mr. Raines reacted with immediate fury, denouncing us in a letter to the editor as "glib, disingenuous, contorted, even irresponsible," and that was the subtle part. He turned up on CNBC to say, in essence, that we had made it all up because we didn't want poor people to own houses, while Freddie issued its own denunciation.

The companies also mobilized their Wall Street allies, who benefited both from promoting their shares and from selling their mortgage-backed securities, or MBSs. The latter is a beautiful racket, thanks to the previously implicit and now explicit government guarantee that the companies are too big to fail. The Street can hawk Fan and Fred MBSs as nearly as safe as Treasurys but with a higher yield. They make a bundle in fees.

At the time, Wall Street's Fannie apologists outdid themselves with their counterattack. One of the most slavish was Jonathan Gray, of Sanford C. Bernstein, who wrote to clients that the editorial was "unfounded and unsubstantiated" and "discredits the paper." My favorite point in his Feb. 20, 2002, Bernstein Research Call was this rebuttal to our point that "Taxpayers Are on The Hook: This is incorrect. The agencies' debt is not guaranteed by the U.S. Treasury or any agency of the Federal Government." Oops.

Massachusetts House Democrat Barney Frank has been one of Capitol Hill's biggest defenders of Fannie and Freddie. Frank has consistently tried to make Fannie and Freddie even bigger - putting taxpayers on the hook for even bigger real estate bubbles and bigger losses.

Mr. Frank contends that he favored "very strong reform" of Fannie Mae and Freddie Mac, even before Democrats took over Congress after the 2006 elections. To adapt a famous phrase, this depends on what the meaning of "reform" is. Mr. Frank did support a bill that he and others on Capitol Hill described as reform. But on the threshold reform issue -- limiting the size of the portfolios of mortgage-backed securities (MBS) that the two companies could hold -- Mr. Frank was a stalwart opponent.

In fact, Mr. Frank was publicly arguing for an increase in the size of their combined $1.4 trillion portfolios right up to the day they were bailed out. Even now, after he's been proven wrong about a taxpayer guarantee, he opposes Treasury's planned reduction in the size of the portfolios starting in 2010, according to a quote attributed to him in this newspaper last week. "Good luck on that," he reportedly said. Mr. Frank's spokeswoman hung up the phone when we sought confirmation Tuesday.

Arnold Kling says Fannie and Freddie were under pressure from Congress (primarily Democrats like Barney Frank) to buy more of the subprime mortgages that led to their massive losses. If Fannie and Freddie (Government Sponsored Enterprises or GSEs) had purchased fewer of those mortgages then fewer of those mortgages would have been issued.

However, the GSEs have recently suffered large credit losses on loans that were not of investment quality. These low-down-payment loans were similar to the subprime mortgage loans that fueled the boom and bust cycle in housing. It is not clear why the GSEs chose to purchase these loans, since they are outside of the GSE charters. One story has it that they were afraid of losing market share. Another story I have heard is that the GSEs were under pressure from Congress to do more to provide funds for “affordable housing,” and the GSEs interpreted this as requiring more high-risk lending.

As a result of these high-risk loans, the GSEs ran into difficulty, reporting large losses. This in turn made investors nervous, so that the interest rates that the GSEs had to pay to borrow in order to fund their portfolios went up. Historically, the GSEs had been able to pay unusually low interest rates so that they could afford to hold assets with lower rates of return than other institutions, such as banks, could afford.

I see Congress as the biggest author of this crisis. But Congress critters are pointing at Wall Street. Barney Frank in particular deserves to lose his seat in the election this fall.

Update: The investment banks had huge leverage and therefore an enormous capacity to lose money.

When it collapsed, Lehman had about a 30:1 debt-to-equity ratio, meaning it had borrowed $30 for every dollar in capital it held. Morgan Stanley currently has a debt-to-equity ratio of 30:1, while Goldman Sachs has one of about 22:1.

Bank of America, on the other hand, currently has about an 11:1 leverage ratio, while JPMorgan has about 13:1 and Citigroup about 15:1.

Share |      By Randall Parker at 2008 September 21 06:14 PM  Economics Financial Regulation


Comments
Jorge said at October 9, 2008 8:57 AM:

I notice that the heads of most of these failed institutions are Jews. Jews make up 2% of our population but control our media and financial institutions and Harvard. They have been evicted many times from past cultures. Maybe there is a good reason to be anti-Semitic but, there are many Jewish sects and some are great citizens so it is hard to out the evil ones.


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