There is a great post by Bethany McLean at Reuters debunking a major “what caused the crisis” urban legend. Many, including Joe Stiglitz and Alan Blinder, have claimed that an SEC 2004 rule change regarding the leverage of securities firm holding companies allowed the leverage of major investment banks to skyrocket, helping to trigger the crisis. McLean’s article demolishes this idea.
McLean also asks why the myth still lives, and I can tell you why. Opinions are set. I had wanted to take this idea on in ECONNED, since all you had to do was look at investment bank leverage over time, and you could see it had been as high in 1997 and 1998 as it was immediately before the crisis. Even after sending both BIS charts and a separate analysis one of my book helpers put together, I still got resistance from some of my draft readers. I realized I’d have to spill a lot of ink to cut through the prejudice on an argument that wasn’t essential to the thesis. So I avoided the topic entirely and discussed what I found to be the drivers.
McLean provides an in-depth account, although some NC readers might have preferred she get to the meat rather than anchor her story in a narrative on how the idea first gained a following and the efforts to correct the record. The big issue is the SEC never regulated the leverage at the holding company level (remember, the failure of Drexel was a holding company insolvency). Its authority extends only to the broker-dealer subsidiaries. As McLean notes:
There was never any explicit leverage limit at the holding company level before or after the rule change. Even at the broker-dealer subsidiaries, a 12:1 limit [cited by some former SEC staffers] didn’t exist. Smaller broker-dealers had an early warning at the 12:1 ratio, and an actual limit of 15:1 — but even these ratios didn’t exist in the way the economists seemed to interpret them, because they were calculated in a way that excluded big chunks of debt. In any event, since 1975, the broker-dealer subsidiaries of the big five investment banks had been using a different method, which had nothing to do with 12:1 or 15:1, to calculate their leverage limit. That method was unchanged in 2004. (Interestingly enough, the holding companies for the big investment banks might actually have made it under the 15:1 limit if you calculate the ratios by excluding the debt that the SEC does.)
McLean also describes that the 2004 rule change did allow for changes in the calculation of net capital at the broker-dealer level, but other provisions of the rule change undermined the way they would have taken advantage of it, namely, by sending dividends to the holding company. Oh, and Goldman and Merrill started using the rule only in 2005, and Bear, Lehman, and Morgan Stanley began in 2006. McLean again:
Overall, the SEC says that capital, as measured before most of the expected impact of the rule change, stayed stable or even increased after 2004. Several people at the broker-dealers at the time also tell me that the new rule was totally inconsequential in how they managed their capital levels…For example, in both 2006 and 2007, Bear Stearns had seven times the amount of capital that the SEC required, or more than $3 billion in excess net capital. This might suggest that the amount of capital the broker-dealers kept was boosted by factors other than the SEC’s requirements, like business needs, or rating agency and customer demands.
So why have perceptions remained so stubborn? A big one seems to be the human desire to have tidy explanations of complex phenomena. Leverage is much easier to understand as a culprit, and it is true that all the major financial firms were running with much too little in the way of risk buffers relative to the risks they were taking. One the culprit was that securities firms, and big banks that were running major securities and derivatives businesses, kept holding more and more of their exposures in illiquid, hard to value instruments, yet were financing them with repo, which is relatively short term funding. Historically, securities dealers held only assets that traded actively or had prices that were established readily and reliably with reference them (corporate bonds were the classic example).
Dealers are structurally long financial assets. Particular firms might be able to hedge single positions or even (in the case of Goldman) a large book, but the big players are too large to be anything other than net long the major markets they trade. As the Fed and other central banks engineered a long-term fall in interest rates from 1983 onward, banks and securities dealers benefitted from a gradual rising tide. That plus the Greenspan put (the Fed rushing in to limit the downside of a market decline) emboldened dealers to take more risk. But at least as far as US securities firms were concerned, it took place much more via an increasing mismatch between the illiquidity of many of their assets versus their heavy reliance on short-term funding rather than nominal leverage. The change in the composition of their exposures should have led the authorities to require them to carry more capital, but in the era of “markets know best” that sort of intervention would have been seen as overreaching and a proof that the regulator was a Luddite. The Greenspan-Rubin-Summers pillorying of Brooksley Born over her effort to regulate credit default swaps no doubt had a chilling effect on any other regulators who might have challenged the destructive orthodoxy they put in place. As McLean concludes her piece, quoting Andrew Lo: “If we haven’t captured the killer, then the real killer is still out there somewhere.”