It started with reading Abnormal Returns, something I do daily, and innocent enough. But the article mentioned at SSRN was significant, and far more than a set of book reviews. It cited a GAO study and a speech given by SEC Director Erik R. Sirri, which showed that the SEC did not materially modify its capital requirements for investment banks in 2004. So in one sense, the SEC is not to blame for the failures of the investment banks.
But in another sense, they are very much to blame. Why? As Buffett has said, he thinks about the things others say “can’t happen.” Secured lending fits into another aspect of the “net capital rule,” an aspect less noticed. That can be geared up 50 times, not the 12 times commonly considered. Who would have thought that secured lending would be so overlent that it would push up asset prices, and that so many would rely on holding assets via short-term loans via repo?
Well, I fingered some of it at the time, but not all of it. So the argument shifts — the SEC was not wrong for shifting its standards in 2004, which had little impact — it was wrong long before then with the net capital rule 15c3-1 by being too lenient with secured lending.
Secured lending often fails colossally, because lenders think the current value of the asset is a guarantee, when it is really subject to the conditions of the market. When many lenders rely heavily on collateral, it proves to be less than valuable. Also, secured lending tends to be done by leveraged entities, who think they can do it because it is safer. When it fails, it can be like a string of dominoes.
We need to abandon the idea that the SEC made some grand shift in 2004, and rather, take up the idea that the SEC had the net capital rule wrong in the first place — it should have been tighter with respect to secured lending. Given the short-term nature of the repo markets, and the correlated nature of changes in repo haircuts, maybe the SEC should ban investment banks from using repo financing. Yes, it will kill profits, but no regulator should care about that. Regulators should care about solvency under all scenarios.
Short-dated financing of long-term assets is at the root of most financial crises. Let the regulators move to a strict asset-liability matching framework for regulating the investment and commercial banks, where they look through the financing arrangement to the ultimate asset being financed. Long assets deserve long financing.
[...] – Asset liability mismatches and the role of the SEC. [...]
[...] David Merkel, “Short-dated financing of long-term assets is at the root of most financial crises.” (Aleph Blog) [...]
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Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures. Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions. Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of. 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I look at the change in total equity minus intangibles and goodwill...cold.as.ice: You could say the same thing about calls. Over the long run the retail of buy and holding calls is a...David Merkel: That may be, but if only the primary market is offering, liquidity is diminished.JoshK: And one minor correction. Leveraged etfs, just like regular ones, have market makers offering them. Sell them...JoshK: Leveraged eggs do a great job of delivering exposure efficiently to investors. I hate this routine where we...Recent TrackbacksAbnormal Returns: Wednesday links: long financingFT Alphaville: Further readingAbnormal Returns: Tuesday links: a buy and sell priceSunday links: energized bidders: The case for eliminating leveraged ETFs. (Aleph Blog)Sunday links: energized bidders: Expectations, growth and value investing. (Aleph Blog)Subscribe in a reader
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