Debunking the Myth That an SEC Capital Rule Change Helped Cause the Crisis

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.”

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  1. Conscience of a conservative

    There’s a ton here to digest, but didn’t the banks lobby for this change and wasn’t it not just about leverage but about switching to models vs standard weights? I’ve seen the net-capital rule mentioned time and time again in the times,forbes, it appeared on Ritholtz’s site etc.

  2. nonclassical


    What do you think of the often spoke assertion that Lehman failed due to leverage of 100-1?

    Was the Lehman failure directly a result of Goldman attempting to drive them out as major competitor?

    How do these scenarios relate?

    1. Kakko

      The liquidity crunch that followed the Lehman collapse nealy ended BS(C) as well. Only government bailouts and government guaranteed bailouts by Buffett saved Goldman.

      The only two scenarios in which what you suggest are possible are either
      1) Goldman had no idea how bad the fallout would be
      2) Goldman knew the government bailout gravy train, both direct and indirect, as well as guaranteed money from Buffett would be flowing.

      Both of those scenarios are scary in their own right, one for the incompetence that controls the world’s flow of money and the other for the level of corruption that controls the world’s flow of money.

    2. sgt_doom

      Lehman and Bear Stearns were both involved in fraudulent activities, Lehman more so, but both their endings did have something to do with “bear runs” against them by the trio of Goldman Sachs, JPMorgan Chase & Deutsche Bank.

      Remember, Lehman created R3 Capital Partners to hide their massive debt just before their demise; an extravagant fraud if there ever was one.

      This was simply a replay of what occurred in the 1920s, a 7-year ultra-leveraged bank run (bankster run), involving more details this time, but still securitizations (in bond form this time around, instead of stock form back in the 1920s, which ended with the Securitization Act of 1933 passage.

      But this time, there has been zero change, and they restarted another ultra-leveraged bankster run around 2009….

  3. jake chase

    There isn’t enough capital in the universe to absorb the risk generated by credit derivatives. Greece alone was enough to stagger the banks’ exposure on credit default swaps. The game will continue only for so long as the peripheral soverigns can be blackmailed to continue voluntary rollover of their debt loads, which means only for so long as their politicians can bamboozle populations into acceptance of austerity disaster capitalism. Anyone who thinks he knows how long this will continue doesn’t understand the problem.

    1. nonclassical

      ..won’t this “go on” so long as banks can hold back, dribbling out, off ledger, a bit at a time? It seems that’s what they are up to…an attempt to maintain “value”…

      1. psychohistorian

        Or an attempt to rip off that last little bit before the big reset.

        And about those soverign rulers not rolling the debt and beating the austerity bandwagon. That is what they are hired and payed to do. When we get ones in there that are not paid to do that we will get different results.

        What pieces need to be in place for the big reset to occur? For the global inherited rich that is probably right after the US election when a mandate can be asserted in response……

  4. Conscience of a Conservative

    I tend to disagree. Wall Street is full of quants who believed that assets can be negatively correlated and even worse base those judgments not on the prices or performance of those assets but on the prices of the CDS tracking those assets. We saw that in CDO’s. I can see Wall Street arguing and the SEC agreeing to Wall Street models that are based on a model’s reaction to risk and allow for risk to net out. It allowed Wall Stret to lever up and make more money. Unfortunatley correlation is asymetric and in a big down move seemingly uncorrelated assets are correlated. This is what we saw in 2008.

    So the question may be why I believe this to be so, well it’s to the advatage of wall street, in which the players don’t know if they’ll be alive in a few years, so they want it all today, and the regulators have a tough counter-argument to make if the last few years have been tame, and most people frankly don’t get this stuff.

    In the end you have to ask why would Wall Street want the net capital rule if it weren’t to lever up? And most of these guys are not that smart. They base risk on what they’ve seen over their recent experience and not what could go wrong. Plus they are naturally conflicted with the desire to make a buck.

    1. MacCruiskeen

      Indeed, one question that comes right to mind is, if the banks didn’t need the rule change, why did they ask for it? Also, I’m not entirely convinced that the high leverage of 1998 meant that this wasn’t a problem, since that was also in the middle of an investment bubble that, as I recall, ended rather badly.

  5. chris m

    my own suspicion is that shadow banking was far more central to the crisis then many are willing to admit.

    1. nonclassical

      “stress tests” are an unacceptable alternative to actual audits; given economic destruction, audits are in order…

      William Black often discusses what was done-how many investigated-prosecuted in S& L…

    2. sgt_doom

      Exactly, endless leveraging upon leveraging upon leveraging, so that one must understand when so-called experts and pundits proclaim a ratio of leveraging such as 67:1, or 100:1, they frequently have gotten it completely wrong, as a closer examination of all those credit derivatives (and various thousands of categories involved) shows many multiple layers, plus ABCP, CPDOs (since discontinued, I believe) and a host of other structured financial deals and swaps.

  6. mlnberger

    I do hope you find reasons to return to and explain further this issue. I fit squarely in the group that believed over-leveraging (of disastrously mispriced assets) was integral to the financial crisis and am eager to work my through this cognitive dissonance. My initial reaction is that this adds heft to Bernanke’s view the crisis was one of liquidity, and not an issue of solvency.

    1. James Cole

      In highly-leveraged highly-correlated environment, the distinction between liquidity and solvency is without much difference, so I wouldn’t worry too much about defining the problem as one or the other.

  7. Paul Tioxon

    Hm, Naked Capitalism inadvertently or deliberately lets us view from the commanding heights of capitalism. Not from the noisy floor of the trading pits or the clamoring boiler room bucket operations, but from where the power of capital resides. So of course, having laid bare capitalism for what it is, without expressing the love that dare not speak its name, uh ya know, the M Word, er ah well YOU KNOW! Of course, once the crisis has has subsided just a bit, it’s time to fire up the process of false consciousness or PR propaganda or Machiavellianism or Kubuki theater or Plutocratic media manipulation to manufacture the consent necessary to maintain the patina of widely held public legitimacy.

    So, each and every demographic must be appealed to in order to sustain the social order. Big Lies Inc. rolls out this years model of the welfare queen: The Government Mandated Fannie Mae and Freddie Mac loans, from GSEs that forced normally ethical and shrewd bankers to drop their underwriting defenses and give $400k mortgages to strawberry pickers and postal clerks who simply lied to get the loan. Of course, we know who this appeals to.

    Then there is the Capitalism had too much to drink, made a lot of bad decisions, and one too many lost weekends with Mr Bad To The Bone!! This also goes by the corrupted capitalism excuse. You know, for the thinking citizen with an MBA or even at least a couple Econ courses. This usually is generated by writers, journalists and maybe even a high level insider or two who provides advanced voodoo econ mumbo jumbo that sounds plausible, is supported by real bar graphs from real data sets, but which signify a limited causal mechanism, that couldn’t possibly bring down the entire world economy all at once, to the scale of what happened.

    When the full scale and scope of the disaster is quantified, trillions of dollars and even the tens of trillions of dollars are needed to measure the event. When we get into this large a scale, it is no longer revealing a complex event. When the social sciences chooses to measure something with research, the unit of analysis is rigorously defined. The individual in psychology, the group in organization development, the society as a whole in sociology, International Relations for inter nation state and macro/global economics for the scale beyond the lone firm. But when the unit of analysis is on the magnitude of scale of this crisis in the global social order, there is not a lot going that can bring a theoretical understanding. It is the econ analog to using bill paying at the kitchen table to talk about the US Federal budget, it is a joke. But one played on rubes.

    It is hard to believe the SEC can destroy the world banking system with a few bureaucratic levers over capital requirements. This of course is a variation on the “crafty small band of Jews run the world via control of banking”, disguised this time as “unelected technocrats use the coercive power of state to bring down the world”. Why, because in time of crisis, when they take out the private sector, they come to power, but alas, they also come out into broad daylight and are unmasked as our occluded overlords. Without big noses, horns or pointy devil tails of course. And besides, why would the presumed rich and powerful leave any power in their hands? Isn’t that what the Bilderberg Group is for?

    The systemic and global nature of the crisis of the financial sector quickly spread to society by collapsing business activity, shrinking payrolls, and consumer spending, government tax revenue and last but not least, the all important repayment of debts to the rightful owners of contracts held as sacred property, but alas, also denied rightful due proceeds. The magnitude in terms economic, societal and political is such that we are looking the structure of the social order in toto and its broken components. It’s structural integrity had been eroding for decades, propped up by one compromise after another which produced an economy that was supported by 40% of the profits of its production coming from financial services. And apparently, that was the toxic dosage level which shut down the circulation of capital that runs the whole system.
    The last great big grasp at financialized profits based upon fictitious capital profits from preceding derivative trading activity brought about the conclusion of an unsustainable business model. Sub prime loans from new housing construction or old housing stock churned through the refi machine for the 3rd or 4th time were not flowing in at enough velocity to feed the Wall ST appetite for the high returns, buried in with the lesser ROI but AAA tranches of pooled loans. But the profits were too good to be true and sure enough, the synthetic or fictitious capital of Wall St was substituted for what the real economy could no longer produce. Tens of trillions, and even hundred trillion, of dollars of contracts from AIG and its compatriots could not have possibly been referencing a world whose sum total GNP was no more than $60TRILLION/YR. And when the worthless, the toxic nature of the assets being offered from one bank to the other became apparent, the inability for sub prime loans at 100% LTV based on fraudulently manufactured appraisal values to be repaid, even on the very first payment due, what bank would take on anything like that and be caught with that exposure just when the whole expanding bubble seemed to stop its expansion?

    The endless pursuit of profits is capitalism, and the ability of capitalism to remove any barrier to such pursuit, political, social or even economic is what causes it to exceed the carrying capacity of the civilization it feasts off of. It is a world wide system of power based on control and creation of money. And capitalism converts the currency issued by governments, no matter how finite the amount of currency issued, no matter how little the stock of gold or silver, into a greater sum of money. Capitalism makes money in excess of the money in circulation and can at times extract nearly all of the currency from circulation causing economic depressions. Now is such a time.

    But this is the description of the system at work, pushed to the limit and self destructing. It is a process as it operates, not a dropped ball by a bureaucrat or 3 at the SEC. These diversion articles are a result of many things, the greatest of which is the lack of capacity to see at the scale of magnitude or even admit the scale exists at all.

    That is why the Economics profession has shrunk in the scale of what it discusses and obfuscates with mathematical modeling. To accurately measure and publish readable research upon which policy can be discussed and constructed would be a democratically transparent process. And of course, democracy in charge of a republic in regard to the economy, the political economy is another way of saying socialism. I just call it what is was constructed as: a government of, by and for the people. I can’t be more transparent than that.

    1. K Ackermann

      This is one of those all-encompassing, over-simplifications drawn out to excessive lengths using elevate prose (possibly written with a smirk or even a sneer) as a means to reinforce what is believed to be the correcter description of what the hell heappened to us all.

      Yes, shit happens.

      And hunger is a self-correcting problem, as is death in general. Why try and diagnose? We know what the inevitable results will be if we wait long enough. It’s damn near certain.

  8. Frank in midtown

    Interesting because I have a distinct memory of the recording of a Treasury meeting on this topic being made available on the NYT. So no, the SEC wouldn’t have approved an increase in leverage, it would have been the Treasury. Now I have to go wade through the NYT to find the audio.

  9. Expat

    I don’t see any mention of the repeal of provisions of the Glass Steagall Act in 1999 or 2000 which effectively ended the separation of commerical and investor banking. Perhaps it isn’t the amount of leverage per se but who was allowed to increase leverage (and who’s money was at risk) that precipitated the crisis.

    1. James Cole

      I concur. Why should the collapse of Goldman/Morgan/Citi/BofA etc. have mattered to anyone (other than their employees and shareholders) if the banks weren’t also performing public-utility-like functions of deposit-taking and running the infrastructure of the global payment system?

  10. sgt_doom

    Stiglitz is simply an idiot (that’s why it took him so long to figure what was going on, and they only hand out that Swedish Central Bank Prize in the Economic Scienes in Memory of Nobel to economists who are pure idiots), while Blinder is one of those classic disinformation specialists on their payroll…

  11. Blissex

    «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.»

    That’s one of the big deals, the ever more generous rules as to what counts as “unsafe” debt, and what counts as “prime” capital to reserve against “unsafe” debt.

    Amazingly I got a very interesting pointer as to a more significant regulatory relaxtion than the broker-dealer one, for banks in general, via an article of Luskin (I know, I know…) pointing to one by a goldbug (I know, I know…):
    «The key event that happened around 1995 is that the fractional reserve ratio was not only lowered, it was effectively eliminated entirely. You read that right. The net result of changes during that period is that banks are not required to back assets which largely correspond to M3 or “broad money” with cash reserves. As a consequence, banks can effectively create money without limitation. I know that sounds hard to believe, but let’s look at the facts.»

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