Saturday, October 04, 2008

Throwing the Bank babies out with the bathwater...

You scrub my back, I'll scrub yours.

We have a good deal of comfort about the capital cushions at these firms at the moment.” — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.

I've been sitting here this week watching this whole market mess, scratching my head and trying to figure something out. How did these damn banks get so over-leveraged in the first place? I distinctly remember our firm having to comply with a net capital rule that required us to maintain levels of capital based on our trading positions. $ that would serve as a cushion in the event of market craziness or unexpected market downturns. This would have gone a long way in preventing the collapse of the investment banks and the current condition of the commercial banks.

It's been bugging me so I did a little google scratching and I found out why John McCain was calling for the head of Chris Cox, the chairman of the Securities and Exchange Commission. And why John McCain probably has a valid point.

The SEC threw that rule out the window and with it went any hope that sanity would prevail on Wall Street.

More about the net capital rule:
"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 tradeable 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."

What happened when the rule got thrown out the window:
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.

How the rule got thrown out the window. (Why on Earth would we be following the EU's lead in this matter? I'm sure it had something to do with competition, but I still find it curious.)
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. (gadzooks!) 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.The SEC justified the less stringent capital requirements by arguing it was now able to manage the consolidated entity of the broker dealer and the holding company, which would ensure it could better manage the risk.

Well, it looks like they were wrong. Another case of bad mathematical modeling and even worse judgment. To further complicate matters:

The SEC said it has no plans to re-examine the impact of the 2004 changes to the net capital rule, and last week, it put out a proposal to revise the rule once again. This time, it is looking to remove the requirement that broker dealers maintain a certain rating from the ratings agencies.

Now, I'm sure this is because of some pissing match between the SEC and the ratings agencies but this action even FURTHER erodes controls. (The failures of the rating agencies throughout this debacle are a WHOLE OTHER STORY, but that is getting off in the tall weeds for Dinah).

Look for this rule change to be the focus of the Dem show trials against the Repubs. You know they're coming. I'm starting to wonder if John McCain saw this handwriting on the wall and called for Chris Cox's head as a pre-emptive strike. If W would have gone along with him - it would have taken the issue off the table for the Dems. Or at least given John a leg to stand on when it comes up - and you know this is going to come up. You can already see the vague outlines taking shape in the Dems squawking points about DEREGULATION. I hate to admit it - but in this case they're right.

It was sheer lunacy to unleash the capital requirement constraints from these guys. And now I'm wondering who was behind the push for the rule change to begin with. Hmmm. Time to do more google scratching.

If you're still interested in learning about this clusterphuk, a more indepth article
can be found here.