Government Policies and The Subprime Mortgage Crisis - Enforcement of Laws and Regulations - SEC and The Net Capital Rule

SEC and The Net Capital Rule

During the investment banking crisis in 2008, some analysts blamed the Securities and Exchange Commission (SEC) for its 2004 decision that, they claimed, allowed greater leverage. This leverage enabled investment banks to substantially increase the level of debt they were taking on, fueling the growth in mortgage-backed securities supporting subprime mortgages. Subsequent analysis brings these claims into question.

The critics note that the top five US investment banks each significantly increased their financial leverage during the 2004–2007 time period (see diagram), which increased their vulnerability to the MBS losses. These five institutions reported over $4.1 trillion in debt for fiscal year 2007, a figure roughly 30% the size of the U.S. economy. Three of the five either went bankrupt (Lehman Brothers) or were sold at fire-sale prices to other banks (Bear Stearns and Merrill Lynch) during 2008, creating instability in the global financial system. The remaining two converted to commercial bank models in order to qualify for Troubled Asset Relief Program funds (Goldman Sachs and Morgan Stanley).

While the nominal 8% capital requirements (i.e., 12.5 to 1 leverage ratio) had not been changed by the regulatory authorities, risk-based weighing allowed capital requirements to be reduced for A rated securities and higher. This change, still more stringent than the international Basel accords, was motivated by the goal of keeping American banks competitive with European banks. The reduced capital requirements encouraged banks to hold the less risky A rated securities (according to rating agency standards) rather than the more risky higher-leveraged (i.e. embedded leverage) first-loss tranches. The reduction in capital reserves (and increased explicit leveraged) was accompanied by the reduction of risky lower rated securities that had higher internal leverage.

At least one prominent official within the SEC has rejected the notion that the 2004 SEC changes caused the banks to reduce their capital reserves. In an April 9, 2009 speech, Erik Sirri, then Director of the SEC's Division of Trading and Markets, stated "he Commission did not undo any leverage restrictions in 2004," nor did it intend to make a substantial reduction. Although the SEC rule changes provided flexibility that could be used by banks to minimize their capital balances, Sirri explained that this was not applicable in the case of the 5 banks in the Consolidated Supervised Entity (CSE) program. Those 5 entities used an alternative standard, and had done so for decades. Specifically, they calculated capital requirements as a percentage of customer receivables (and not on the basis of the investments they held). Under the standard in use, the emphasis was on their ability to meet customer-related obligations - not on overall bank financial stability."

Some argue that leverage ratios did not change as dramatically as claimed by critics. Consider, for example, this statement made by the Government Accountability Office (GAO): "In our prior work on Long-Term Capital Management (a hedge fund), we analyzed the assets-to-equity ratios of four of the five broker-dealer holding companies that later became CSEs and found that three had ratios equal to or greater than 28-to-1 at fiscal year-end 1998, which was higher than their ratios at fiscal year-end 2006 before the crisis began."

Erik Sirri, then Director of the SEC's Division of Trading and Markets, concluded: "Since August 2008, commenters in the press and elsewhere have suggested that the 2004 amendments … allowed these firms to increase their debt-to-capital ratios to unsafe levels well-above 12-to1, indeed to 33-to-1…. While this theme has been repeated often in the press and elsewhere, it lacks foundation in fact."

The SEC is also responsible for establishing financial disclosure rules. Critics have argued that disclosure throughout the crisis was ineffective, particularly regarding the health of financial institutions and the valuation of mortgage-backed securities. The SEC is investigating these claims.

Read more about this topic:  Government Policies And The Subprime Mortgage Crisis, Enforcement of Laws and Regulations

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