Thursday, October 30, 2008

Insane SEC policy that, perhaps more than anything else, led to the banking crisis . . .

An "unbelievable" SEC [Securities and Exchange Commission] policy agreed to in 2004 led to massive over-leveraging of the United States' largest brokerage and investment banking houses.

I don't understand why I never heard of this before. But it is certainly upsetting . . . and, in my opinion, worthy of criminal censure of the primary participants--both those who profited directly from it as well as those who obviously abdicated their oversight responsibilities.
“We have a good deal of comfort about the capital cushions at these firms at the moment,” [said] Christopher Cox, chairman of the Securities and Exchange Commission, [on] March 11, 2008.

As rumors swirled that Bear Stearns faced imminent collapse in early March, Christopher Cox was told by his staff that Bear Stearns had $17 billion in cash and other assets — more than enough to weather the storm.

[But then, d]rained of most of its cash three days later, Bear Stearns was forced into a hastily arranged marriage with JPMorgan Chase — backed by a $29 billion taxpayer dowry.

Within six months, other lions of Wall Street would also either disappear or transform themselves to survive the financial maelstrom — Merrill Lynch sold itself to Bank of America, Lehman Brothers filed for bankruptcy protection, and Goldman Sachs and Morgan Stanley converted to commercial banks.

How could Mr. Cox have been so wrong?
Read the story of an April 28, 2004, meeting of the five-member Securities & Exchange Commission at which the biggest brokerage and banking houses asked for an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on.
One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told — those with assets greater than $5 billion.

“We’ve said these are the big guys,” Mr. Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.” . . .

After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The Times, the chairman, William H. Donaldson, a veteran Wall Street executive, called for a vote. It was unanimous. The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.

With that, the five big independent investment firms were unleashed.

In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.

Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measurement of how much the firm was borrowing compared to its total assets — rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt.
In other words, if the market declined by only 3%, Bear Stearns would become completely devoid of all assets.

Other firms didn't quite leverage to the same degree, but they went far beyond what they had been permitted to do prior to the decision. . . .

You can read the entire stinking story at the New York Times.
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