The SEC Killed Wall Street On April 28, 2004

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In the long run, when we are all dead, historians will be debating the root causes behind the global financial meltdown of 2008. They will join up multiple dots, just as they did after the September 11 terror attacks. Among the precipitating factors, toxic mortgage debt securities grossly inflated banks’ balance sheets and investors’ portfolios. Credit rating agencies blessed those assets’ illusory values. Real estate tumbled in a vicious downward spiral, while steep oil prices helped reverse the business cycle.

Inadequate regulation, in America and elsewhere, clearly exacerbated all the other drivers. Specifically, when regulators permitted major American investment banks to take on more leverage, they “made the dollar amounts larger and the margin of safety less,” describes Barry Ritholtz, director of Equity Research at Fusion IQ. Imagine climbing up the outside of a building. The leverage lets you climb higher, and also takes away the safety equipment.

While regulatory frameworks often take decades to build, in this unusual case, one particular afternoon, on April 28, 2004, drastically changed the equation. The Securities and Exchange Commission agreed to allow the five major American investment banks to compute their capital adequacy requirements according to a revised methodology, hugely increasing their leverage In consequence, those five giants no longer exist in their former incarnations.

On that fateful day, the five SEC commissioners met for just under an hour at the SEC headquarters in F Street in Washington D.C. The Commission, one of the constellation of agencies that oversees the American financial industry, was established in 1933, to restore confidence in shattered financial markets. It now oversees securities firms, brokers, investment advisors and rating agencies. At the April 2004 meeting, the commissioners considered several proposals, including one to consolidate the supervision of broker dealers (who trade securities both for their own and their clients;’ accounts) along with that of their holding companies.

The broker dealers – Bear Stearns, Merrill Lynch, Goldman Sachs, Morgan Stanley and Lehman Brothers – were all keen to see their holding companies monitored by the SEC under a new Consolidated Supervised Entities (CSE) program. Their alternative would have been to submit to European regulation, because the EU had adopted a Financial Conglomerates Directive in 2002, which affected the Americans, who all had operations in London. The EU, would accept as another option equivalent foreign regulation. Yet since no other agency was regulating the American holding companies in 2004, that left a gap. Both sides needed one another: the SEC wanted to extend its purview, while the broker dealers required a new foster parent.

“The SEC thought that, with the added oversight of the holding companies, it could offer more effective protection,” says Lee Pickard, an attorney at Pickard and Djinis in Washington. “Yet it didn’t get enough for that oversight, and in return it gave up tremendous restraints.” As part of the deal, the broker dealers would enjoy a much more relaxed framework for maintaining their capital cushions. With looser capital requirements, they could reallocate those resources and use the leverage to generate additional profits.

During the 55-minute 2004 meeting, the commissioners questioned the SEC staff. They were concerned to be sure the agency had the requisite resources to monitor the holding companies under a new regime, and were assured that the SEC had access to the “best minds” and quantitative skills. An early warning system would also be imposed, whereby the participants must alert the Commission if capital limits were ever breached. Besides, the voluntary program would only be open to the largest institutions, commanding at least $5 billion in net capital. Those comments provoked a short discussion over the fairness of precluding smaller firms from joining the program. After a few collegiate chuckles, and a round of congratulations on everybody’s work, the Commission voted unanimously and the proposals passed.

As the theoretical quid pro quo, the former Net Capital Rule, devised in 1975, was replaced. How had it worked before, during the previous 29 years? Pickard, who was one of the original architects of that rule, recalls that banks rarely exceeded gross leverage over about 6% on his own watch at the SEC in the late 1970’s. In the following decades, leverage generally ranged around 12%, comfortably beneath the rule’s 15% ceiling. Under the old rule, broker dealers took precise, arithmetic charges, or “haircuts”, deducted from their net worth. For example, long government treasuries only lost 6%, while riskier equities lost 15%, and illiquid assets were 100% reduced.

After the 2004 revision, brokers were no longer constrained by any gross leverage limit. Instead, they could evaluate their assets according to their own internal models, in keeping with the principles of the Basel II accord, considered the cutting edge model for bank regulation. The danger lay in the nature of assets they held. “If they had mainly been invested in government securities, even 30 times leverage would not have been so risky,” says George Simon, an attorney at Foley & Lardner, who worked at the SEC from 1976 to 1981. “But the leverage became fatal, with small haircuts for particular securities, and with the risk of default inadequately addressed. As it turned out, triple A-rated received smaller haircuts than they deserved.”

Miscalculations were compounded, as banks gained a free hand to assess their own risk positions based on internal value-at-risk models. Now the fox was loose in the henhouse. The revised framework, which embraced the more “modern” principles of Basel II, both lowered the haircut percentages and allowed extra offsets for cross margining. Guy Erb of LECG pinpoints the internal portfolio modeling as the “common element,” with reliance on Basel II as a significant cause of the malfunctions.

Patrick Daugherty, a fellow partner at Foley & Lardner, and chief strategy partner at the firm’s business law development department, criticizes the weaknesses of the banks’ proprietary mathematical systems. For example, he points out, it may be harder to assess the market risk than the credit risk for distressed debt securities. “When many tranches of asset backed securities and whole mortgage loans are so thin, it’s difficult to gage the market risk. Since you don’t take 100% for illiquidity any more, you are allowed to place a value greater than zero, and the writedown may not be severe enough.”

Once more, we return to the climber who is scaling the building without the safety net. To what extent did the added leverage directly lead to the end of the five giant banks? Bear Stearns sold its decimated stock to JP Morgan in March, on September 15, Lehman Brothers filed for bankruptcy and Merrill Lynch sold itself to Bank of America, and on September 22 Goldman Sachs and Morgan Stanley converted themselves into commercial banks. “I’d call it res ipsa loquitur – in other words the thing speaks for itself,” Ritholtz comments. “It’s no coincidence that since the SEC created the exemption, all five are now gone.”

It is well understood that banking by its nature is a confidence game. The entire business of lending depends on ensuring that borrowers believe in both words and assets. Any business that is predicated on confidence must be certain nothing threatens that trust – such as levering up to over 30 times.

In a letter on March 20, 2008, SEC Chairman Cox wrote to Dr. Nout Wellink, Chairman of the Basel Committee on Banking Supervision, “…the fate of Bear Stearns was a result of a lack of confidence, not a lack of capital.” Consider, however, that a run on the bank would not have occurred if investors did not perceive the firm to be weak.

Banks finance themselves short term in the repo markets. When a bank’s capital comes under siege, lenders’ confidence declines fast. What happened in 2008 was that the investment banks lost their funding when the repos could no longer be rolled. Says Daugherty, “market downturns can quickly destabilize an institution with thirty to one leverage, and which relies on short term funding.”

Firms can fail fast, and it is not so easy to rebuild them by recapitalizing under extremely stressful scenarios. Last autumn, once-plentiful capital suddenly became scarce as credit conditions worsened across the world. Even sovereign wealth funds, formerly hungry to invest, drew in their horns. “Now it was harder to get the needed recapitalization, since so many entities were in the same spot,” says Erb.

There is ample blame to go around for the failed CSE program. Already, many salvos have been leveled at Christopher Cox, who in 2005 succeeded William Donaldson as SEC Chairman. Although the 2004 ruling was not during Cox’s tenure, critics have emphasized his pro-business, conservative leanings, and lambasted him for the insufficient oversight during the course of the program.

Cox himself admitted on September 26, 2008, that the CSE experiment had been “an utter failure”, as the SEC ended the program. Meanwhile, the remaining investment banks were flailing. The Chairman attributed the breakdown to the voluntary aspect of the arrangement, whereby the banks could opt in and out of supervision at will. He said, “The fact that the investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate of the CSE program, and weakened its effectiveness.” In ending the program, Cox was plainly stating that self regulation had fallen far short. “He was implicitly saying that the oversight of the regulators had failed,” says Daugherty.

Only two months earlier, in July, Cox had sounded considerably more positive and confident when he testified at a hearing of the House Committee on Financial Services. He acknowledged the importance of the “regular interaction of Commission staff with senior managers in the firms’ own control functions, including risk management, treasury, financial controllers and the internal auditor…” A month before that, Erik Sirri, director of Trading and Markets at the SEC, had outlined various steps the agency was taking in the wake of the Bear Stearns collapse, such as strengthened liquidity requirements and additional stress testing..

Despite such intentions, the SEC lacked the resources to perform the required surveillance. “That was a serious misjudgment. They had one small unit, whereas the banks had thousands of people on the other side,” Pickard says. The SEC allotted a mere three staffers to each CSE, hardly enough for the keen monitoring the Basel II framework would contemplate.

A glance back in history indicates that the SEC was not well prepared to oversee the banks’ entire investment portfolios. After Drexel Burnham Lambert – once the fifth largest American investment bank – filed for bankruptcy in 1990, Congress adopted risk assessment rules that permitted the SEC to look at the finances of broker dealers’ parent companies and material associated persons. Those rules required that parents and affiliates file limited financial statements. “And what did the SEC then do?” Simon asks. “It filed those statements carefully in a big file cabinet and did – absolutely nothing! If you are looking for signs that the SEC was not equipped to deal with comprehensive oversight, that should have been the first red flag.”

The reports were not even being filed in a timely manner. Since 2005, the SEC had established an electronic filing system, but as of August 2008, only 20 out of 146 firms were actually using it. The remainder still relied on old fashioned paper documents.

Paper was in theory becoming a relic of the past, but the financial industry looked to a future based on the rationality and objectivity of mathematical models. Even if investors did not trust, say, Bear Stearns, they still devoutly trusted Bear’s models. With the same fervor, the creed took hold that it would be in the interest of major firms to police themselves.

While the SEC cannot abjure responsibility, the entire CSE episode must be observed in the light of the laissez faire culture that held sway for decades in all developed financial markets. To put the free market ideology in context, after World War II both government involvement and bureaucracy galloped apace. It became increasingly complex, expensive and time consuming for businesses to maintain full regulatory compliance. That onus led to a legitimate move to reduce some of the burden of red tape. “The pendulum seems to have swung too far,” argues Ritholtz. There are good reasons for not allowing 5-year olds to cross the street alone. A couple may be run over, and Darwin suggests the rest may learn the hard way to manage. Perhaps free marketers left out the drastic part of the calculus, as the broker dealers got crushed.

Since Reagan’s presidency in the 1980’s, an almost theological faith in free market solutions developed, with the conviction that the government should refrain from intervention. Many still espouse it, despite last year’s upheavals. “We can only imagine there must be high levels of cognitive dissonance among libertarians right now,” Daugherty notes dryly.

Alan Greenspan, maestro among libertarians, had the grace to take some responsibility for an exuberant reliance on self-policing. Last October, he testified that he had “found a flaw in the model that I perceived is the critical functioning structure that defines how the world works.” Scott Mosley, owner of Mosley, an independent investment firm in Austin, Texas, sums up the mea culpa: “Couldn’t Greenspan just have said, ‘I was wrong’?” Mosley reinforces the theme that the underlying concept, which ran through decades, was to pare back the regulatory agencies until they were “basically neutered”, so they could not interfere with the market’s workings.

As a new administration rolls up its sleeves in Washington, it may inherit a rare opportunity, a blank check to rewrite regulation on a grand scale. The debate will be intense. Should the regulators be more robust? Should the SEC and other agencies be aggregated into a single structure? Where is the dividing line between regulation and oversight? Mosley believes that simply adding more rules may not be the answer, “but oversight and enforcement go a long way to preventing excesses.” He also suggests that regulators could benefit from “sitting side by side with traders and risk management experts.”

The quagmire will continue to bedevil the financial industry until the SEC revises its entire approach to risk. “The statute does need to be revised, but the agency also needs to take a different view of itself,” says Simon. In its entire history, the agency has never effectively enforced its mandate and ability to manage the risks of large firms with unregulated affiliates. At this juncture, financial institutions still have access to plenty of unregulated entities, where they can place securities and other instruments off balance sheet, which creates systemic risk. That potential for damage remains unaddressed. Simon warns that the problem will not go away, “until the SEC starts to look at firms on a more global basis.”

Ms. Drucker, a former practicing lawyer in the United States, is U.S. editor of Fund Strategy (, and the author of two business novels published by Crown.

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