Thursday, September 18, 2008

SEC Caused the Implosion?

Maybe it was SEC rule-changes which caused the Bear/Lehman/Merrill Lynch problem?

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. [Morgan Stanley is trying to sell itself to Wachovia as this is written.]

...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.

...In 2004, the European Union passed a rule allowing the SEC's European counterpart to manage the risk both of broker dealers and their investment banking holding companies. In response, the SEC instituted a similar, voluntary program for broker dealers with capital of at least $5 billion, enabling the agency to oversee both the broker dealers and the holding companies.

This alternative approach, which all five broker-dealers that qualified — Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley — voluntarily joined, altered the way the SEC measured their capital. Using computerized models, the SEC, under its new Consolidated Supervised Entities program, allowed the broker dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1. It also removed the method for applying haircuts, relying instead on another math-based model for calculating risk that led to a much smaller discount.

Here's a list of the SEC Commissioners serving in 2004:

Cynthia A. Glassman (R) Harvey J. Goldschmid (D) Paul S. Atkins (R) Roel C. Campos (D)
William H. Donaldson (R), Chairman

Just for fun, ask your friendly banker if you can borrow 30x the value of your house so that you can purchase a basket of debt securities from (e.g.) GM, Zimbabwe, Russia, Germany, FannieMae, the US Treasury, and 20,000 other mortgagees around the country.

HT: Rithotlz

No comments: