[4] On April 28, 2004, the SEC voted unanimously to permit the largest broker-dealers (i.e., those with "tentative net capital" of more than $5 billion) to apply for exemptions from this established "haircut" method.
[5] Upon receiving SEC approval, those firms were permitted to use mathematical models to compute the haircuts on their securities based on international standards used by commercial banks.
[9] Beginning in 2008, many observers remarked that the 2004 change to the SEC's net capital rule permitted investment banks to increase their leverage and this played a central role in the 2007–2008 financial crisis.
According to the article, the rule change unshackled "billions of dollars held in reserve against losses" and led to investment banks dramatically increasing their leverage.
[12] In late 2008 and early 2009, prominent scholars such as Alan Blinder, John Coffee, Niall Ferguson, and Joseph Stiglitz explained (1) the old net capital rule limited investment bank leverage (defined as the ratio of debt to equity) to 12 (or 15) to 1 and (2) following the 2004 rule change, which relaxed or eliminated this restriction, investment bank leverage increased dramatically to 30 and even 40 to 1 or more.
[13] Daniel Gross wrote in Slate magazine: "Going public allowed investment banks to get bigger, which then gave them the heft to mold the regulatory system to their liking.
Perhaps the most disastrous decision of the past decade was the Securities and Exchange Commission's 2004 rule change allowing investment banks to increase the amount of debt they could take on their books—a move made at the request of the Gang of Five's CEOs."
The letter states that the CSE Broker "tentative net capital" levels "remained relatively stable after they began operating under the 2004 amendments, and, in some cases, increased significantly.
[20] In her prepared testimony for a January 14, 2010, hearing before the Financial Crisis Inquiry Commission ("FCIC"), SEC Chair Mary Schapiro stated SEC staff had informed CSE Brokers in December 2009 that "they will require that these broker-dealers take standardized net capital charges on less liquid mortgage and other asset-backed securities positions rather than using financial models to calculate net capital requirements.
"[21] In her prepared testimony for an April 20, 2010, hearing before the House Financial Services Committee, Chairman Schapiro repeated this explanation and added that the new requirements took effect January 1, 2010.
[22] The SEC's "Uniform Net Capital Rule" (the "Basic Method") was adopted in 1975 following a financial market and broker record-keeping crisis during the period from 1967 to 1970.
[26] The Securities Exchange Act of 1934 had given the SEC authority to regulate the financial condition of broker-dealers to provide customers some assurance that their broker could meet its obligations to them.
[35] Using that approach, the SEC required that a broker-dealer subject to the Basic Method maintain "net capital" equal to at least 6-2/3% of its "aggregate indebtedness."
The contemporaneous elimination of fixed commissions is often cited as reducing broker profitability and leading to a greater emphasis on "proprietary trading" and other "principal transactions.
[49] Reflecting this division, all of the large broker-dealers owned by investment bank holding companies that would become CSE Brokers after the 2004 rule change described below used the Alternative Method.
Many small broker-dealers prefer to comply with one of the three exemptions from the Rule 15c3-3 requirements rather than create the operational capabilities to "fully compute" compliance with the customer reserve formula.
[56] It has been suggested Henry Paulson, the then chief executive officer of Goldman Sachs, "led" in "the lobbying charge" for the rule change permitting these "exemptions.
[61] This Directive required supplemental supervision for unregulated financial (i.e., bank, insurance, or securities) holding companies that controlled regulated entities (such as a broker-dealer).
Broker-dealer subsidiaries of Bear Stearns, Lehman Brothers, and Morgan Stanley all began using the new method on December 1, 2005, the first day of the 2006 fiscal year for each of those CSE Holding Companies.
It was "saved" through an "arranged" merger with JP Morgan Chase & Co. ("JP Morgan") announced on March 17, 2008, in connection with which the Federal Reserve Bank of New York ("FRBNY") made a $29 billion loan to a special purpose entity (Maiden Lane LLC) that took ownership of various assets of Bear Stearns with a quoted market value of $30 billion as of March 14, 2008.
As described in Section 1.2 above, the SEC has stated "tentative net capital" levels at the CSE Brokers remained stable, or in some cases increased, after the 2004 rule change.
At a more popular level, that finding was noted by Frank Partnoy in his 2004 book Infectious greed: how deceit and risk corrupted the financial markets.
"[104] Since 2008, the conclusion that the 2004 rule change permitted dramatically increased leverage at CSE Holding Companies has become firmly embedded in the vast literature commenting on the financial crisis of 2007-2009 and in testimony before Congress.
In This Time is Different Professors Carmen M. Reinhart and Kenneth S. Rogoff characterize the 2004 rule change as the SEC's decision "to allow investment banks to triple their leverage ratios.
[106] Jane D'Arista testified to the House Financial Services Committee in October, 2009, that the 2004 rule change constituted a "relaxation of the leverage limit for investment banks from $12 to $30 per $1 of capital.
"[108] In reviewing similar statements made by former SEC chief economist Susan Woodward and, as cited in Section 1.1, Professors Alan Blinder, John Coffee, and Joseph Stiglitz, Professor Andrew Lo and Mark Mueller note 1999 and 2009 GAO reports documented investment bank leverage ratios had been higher before 2000 than after the 2004 rule change and that "these leverage numbers were in the public domain and easily available through company annual reports and quarterly SEC filings."
Lo and Mueller cite this as an example of how "sophisticated and informed individuals can be so easily misled on a relatively simple and empirically verifiable issue", which "underscores the need for careful deliberation and analysis, particularly during periods of extreme distress when the sense of urgency may cause us to draw inferences too quickly and inaccurately."
He also directed readers to the 2009 Sirri Speech and the 2008 NY Sun Article for different views on the role of the 2004 rule change in investment bank difficulties.
Because they all only entered the CSE Program at the beginning of their 2006 fiscal years, the delay eliminates the 2004 rule change from playing a role in any 2005 leverage increases reported by Bear Stearns, Lehman Brothers, or Morgan Stanley.
"[118] As a more serious indication of continuing misunderstanding of the 2004 rule change, on the day the FCIC issued its report (January 27, 2011) economist Robert Hall addressed an MIT symposium on economics and finance.