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How SEC Regulatory Exemptions Helped Lead to Collapse

Posted By Barry Ritholtz On September 18, 2008 @ 6:00 am In Bailouts,Credit,Legal,Markets,Taxes and Policy | Comments Disabled

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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 [1], former director, SEC trading and markets division.

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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 [2], 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 [3] 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 . . .

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Source:
SEC’s Old Capital Approach Was Tried – and True [1]
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 [4]
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 [1]:

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.


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2008/09/how-sec-regulatory-exemptions-helped-lead-to-collapse/

URLs in this post:

[1] Lee Pickard: http://www.americanbanker.com/article.html?id=20080807ZAXGNH3Y&queryid=2110207978&

[2] NY Sun: http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130/

[3] clueless pension fund managers: http://bigpicture.typepad.com/comments/2008/09/idiot-of-the-da.html

[4] Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers: http://www.ritholtz.com/blog http://www.nysun.com/business/ex-sec-official-blames-agency-for-blow-up/86130/

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