Net capital rule

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The U.S. Securities and Exchange Commission (“SEC”) made a change to its net capital rule in 2004 that is widely believed to have permitted Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley to increase their leverage.

The net capital rule, however, never limited leverage at those firms.^[1] In addition, annual financial reports filed by four of those five firms showed leverage in recent years before the 2004 rule change higher than shown in such reports filed after the change.^[2]

The 2004 rule change was expected to increase net capital computations for brokerage subsidiaries of the firms affected by the rule change. While this would permit the firms to withdraw capital from those brokerage subsidiaries, the limited information publicly available on the SEC and firm websites concerning those brokerage subsidiaries does not indicate any significant withdrawal of capital.^[3]There does not appear to be any publicly available study of this issue.

Contents 1 The net capital rule and the financial crisis of 2007-2009 1.1 2008 explanation 1.2 SEC response 1.3 Status of 2004 rule change 2 Background to and adoption of net capital rule 2.1 Rule applies to broker-dealers, not their parent holding companies 3 Goals and tests of net capital rule 3.1 Self liquidation principle 3.2 Basic Method as partial unsecured debt limit 3.3 Alternative Method as customer receivable limit 3.4 Broker-dealer leverage increased after SEC enacted net capital rule 3.5 Large broker-dealers use Alternative Method 4 2004 change to net capital rule 4.1 Issues addressed by rule change 4.2 Delayed use of rule change by CSE Brokers 4.3 Possible effects of use of rule change 5 The collapses of Bear Stearns and Lehman Brothers 5.1 Bear Stearns 5.2 Lehman Brothers 5.3 Leverage at CSE Holding Companies and capital withdrawals 5.3.1 Higher leverage in 1990s 5.3.2 No evidence of capital withdrawals from CSE Brokers 6 References 7 See also

[edit] The net capital rule and the financial crisis of 2007-2009

[edit] 2008 explanation

Beginning in 2008, many observers remarked that a 2004 change to the SEC’s net capital rule permitted investment banks to increase their leverage and this played a central role in the financial crisis of 2007-2009.

This position appears to have been first described by Lee A. Pickard, Director of the SEC’s Division of Market Regulation (the former name of the current Division of Trading and Markets) at the time the SEC’s net capital rule was adopted in 1975. In an August 8, 2008, commentary Mr. Pickard wrote that before the 2004 rule change broker-dealers were limited in the amount of debt they could incur to a ratio of about 12 times their net capital but that they operated at significantly lower ratios. He concluded that, if they had been subject to the net capital rule as it existed before the 2004 rule change, broker-dealers would not have been able to incur their high debt levels without first having increased their capital bases. Separately, Mr. Picard has been quoted as stating the SEC’s 2004 rule change is the primary reason large losses were incurred at investment banks.^[4]

Perhaps the most influential review of the 2004 rule change was an October 3, 2008, front page New York Times article titled “Agency’s ’04 Rule Let Banks Pile Up New Debt.” That article explained the net capital rule applied to the “brokerage units” of investment banks and stated the 2004 rule change created “an exemption” from an old rule that limited the amount of debt they could take on. 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.^[5]

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.^[6]

[edit] SEC response

In connection with an investigation into the SEC’s role in the collapse of Bear Stearns, in late September, 2008, the SEC’s Division of Trading and Markets responded to an early formulation of this position by maintaining (1) it confuses leverage at the Bear Stearns holding company, which was never regulated by the net capital rule, with leverage at the broker-dealer subsidiaries covered by the net capital rule, and (2) before and after the 2004 rule change the broker-dealers covered by the 2004 rule change were subject to a net capital requirement equal to 2% of customer receivables not a 12 to 1 leverage test.^[7]

In an April 9, 2009, speech Erik Sirri, then Director of the SEC’s Division of Trading and Markets, expanded on this explanation by stating (1) the 2004 rule change did not affect the “basic” net capital rule that had a leverage limit (albeit one that excluded much broker-dealer debt), (2) an “alternative” net capital rule established in 1975 that did not contain a leverage limit applied to the broker-dealer subsidiaries of the five largest investment banks (and the other large broker-dealers), and (3) neither form of the net capital rule was designed (nor operated) to constrain leverage at the investment bank holding company level, where leverage and, more important, risk was concentrated in business units other than broker-dealer subsidiaries.^[8]

[edit] Status of 2004 rule change

It has been widely noted that all five of the investment bank holding companies affected by the 2004 rule change no longer exist as independent companies or have converted into bank holding companies.^[9]Less noted is that the five broker-dealers originally owned by those investment bank holding companies continue to compute their compliance with the SEC’s net capital rule using the alternative net capital computation method established by the 2004 rule change.^[10]Under the 2004 rule change the difference is that those CSE Brokers (like Citigroup Global Markets Inc. and JP Morgan Securities Inc. before them) are now owned by bank holding companies subject to consolidated supervision by the Federal Reserve, not by the SEC under the CSE Program described below.^[11]

[edit] Background to and adoption of net capital rule

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 1967-1970. In the same 1975 release that adopted the Basic Method, the SEC established the “Alternative Net Capital Requirement for Certain Brokers and Dealers” (the “Alternative Method”).^[12]

[edit] Rule applies to broker-dealers, not their parent holding companies

Both the Basic Method and the Alternative Method applied to broker-dealers. At no time did the SEC impose a net capital requirement on the holding company parent of a broker-dealer.^[13]Brokers buy and sell securities for the account of customers.^[14]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.^[15]

Holding companies that owned broker-dealers were treated like other “unregulated” companies to which parties extend credit based on their own judgments without the assurance provided by regulatory oversight of a company’s financial condition. In practice, the “independent check” on such financial condition became the rating agencies. In order to conduct their wide-ranging financial activities, the large investment bank holding companies managed their leverage and overall financial condition to achieve at least the “A” credit rating considered necessary for such activities.^[16]

[edit] Goals and tests of net capital rule

[edit] Self liquidation principle

The SEC has stated the net capital rule is intended to require “every broker-dealer to maintain at all times specified minimum levels of liquid assets, or net capital, sufficient to enable a firm that falls below its minimum requirement to liquidate in an orderly fashion.”^[17]The Basic Method tries to reach this goal by measuring such “liquid assets” of the broker-dealer against most of its unsecured indebtedness. The “liquid assets” serve as the “cushion” to cover full repayment of that unsecured debt. The Alternative Method instead measures the “liquid assets” against obligations owed by customers to the broker-dealer. The “liquid assets” serve as the “cushion” to cover full payment of the customer receivables.

Although the Basic and Alternative Methods end with these different tests, both begin by requiring a broker-dealer to compute its “net capital.” To do so, the broker-dealer computes its equity under Generally Accepted Accounting Principles (“GAAP”) and adjusts that amount by making certain additions and subtractions, including percentage reductions (“haircuts”) in the value of securities it owns.^[18]In theory, a calculation of “net capital” greater than zero would mean the “liquid assets” owned by a broker-dealer could be sold to repay all its obligations, even those not then due, other than any qualifying subordinated debt that the net capital rule treated as equity.^[19]Nevertheless, both the Basic and Alternative Method imposed a second step under which broker-dealers were required to compute a “cushion of liquid assets in excess of liabilities to cover potential market, credit, and other risks if they should be required to liquidate.” This cushion could also be used to pay continuing operating costs while the broker-dealer liquidated, an issue particularly important for small broker-dealers with small absolute dollar amounts of required net capital.^[20]

Because the required net capital amount is a “cushion” or “buffer” to cover a broker-dealer’s continuing operating costs as it liquidates and any exceptional losses in selling assets already discounted in computing net capital, the required level of net capital is measured against a much more limited amount of liabilities or assets than described (or assumed) by the commentators in Section 1.1 above. The “second step” in both the Basic Method and the Alternative Method makes this measurement.^[21]

[edit] Basic Method as partial unsecured debt limit

For this second step, the Basic Method adopted the traditional liability coverage test that had long been imposed by the New York Stock Exchange (“NYSE”) and other “self regulatory” exchanges on their members and by the SEC on broker-dealers that were not members of such an exchange.^[22]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.” This is commonly referred to as a 15 to 1 leverage limit, because it meant “aggregate indebtedness” could not be more than 15 times the amount of “net capital.”^[23]“Aggregate indebtedness”, however, excluded “adequately secured debt”, subordinated debt and other specified liabilities, so that even the Basic Method did not limit to 15 to 1 a broker-dealer’s overall leverage computed from a GAAP financial statement.^[24]

In practice, broker-dealers are heavily financed through repurchase agreements and other forms of secured borrowing. Their leverage computed from a GAAP balance sheet would, therefore, usually be higher (possibly much higher) than the ratio of their “aggregate indebtedness” to “net capital”, which is the “leverage” ratio tested by the Basic Method.^[25]

[edit] Alternative Method as customer receivable limit

The Alternative Method was optional for broker-dealers that computed “aggregate debit items” owed by customers in accordance with the “customer reserve formula” established by the SEC’s 1972 segregation rules for customer assets. Under its second step, a broker-dealer using the Alternative Method was required to maintain “net capital” equal to at least 4% of “aggregate debit items” owed by customers to the broker-dealer.^[26]This approach assumed receipts from amounts owed by customers would be used, along with the net capital cushion consisting of “liquid assets”, to satisfy the broker-dealer’s obligations to its customers, and to meet any administrative costs, in a liquidation of the broker-dealer’s business. The net capital in the form of “liquid assets” of the broker-dealer, however, was not required to be separately escrowed for the exclusive benefit of customers.^[27]

The Alternative Method did not directly regulate the overall leverage of a broker-dealer. As the SEC explained in adopting the net capital rule, the Alternative Method “indicates to other creditors with whom the broker or dealer may deal what portion of its liquid assets in excess of that required to protect customers is available to meet other commitments of the broker or dealer.”^[28]

In 1982 the net capital required under the Alternative Method was reduced to 2% of customer indebtedness. This meant customer receivables could not exceed 50 times the broker-dealers net capital.^[29]Neither at 2% nor at 4% required net capital did the resulting implicit 25-1 or 50-1 leverage limit on assets apply to a broker-dealer’s overall assets. The 2% or 4% capital requirement was solely for customer assets (i.e. amounts owed by customers to the broker-dealer).^[30]

[edit] Broker-dealer leverage increased after SEC enacted net capital rule

Following enactment of the SEC’s net capital rule in 1975 reported overall leverage at broker-dealers actually increased. In a 1980 Release proposing changes in the “haircuts” used for net capital computations, the SEC noted aggregate broker-dealer leverage had increased from 7.44 and 7.45 to 1 debt to equity ratios in 1974 and 1975 to a ratio of 17.95 to 1 in 1979. The GAO found that by 1991 the average leverage ratio for thirteen large broker-dealers it studied was 27 to 1. The average among nine was even higher.^[31]

[edit] Large broker-dealers use Alternative Method

The same 1980 SEC Release noted a clear distinction in the application of the net capital rule. Most broker-dealers used the Basic Method. Large broker-dealers, which increasingly held the great majority of customer balances, used the Alternative Method.^[32]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.^[33]

There are two recognized obstacles to adopting the Alternative Method. First, the $250,000 absolute minimum net capital requirement under the Alternative Method can be lower under the Basic Method if a broker-dealer limits its customer activities. This keeps many small broker-dealers from adopting the Alternative Method.^[34]

Second, to adopt the Alternative Method a broker-dealer must compute the “aggregate debit balances” owed by customers under the “customer reserve formula” specified by SEC Rule 15c3-3. 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. These exemptions impose strict limits on a broker-dealers ability to handle customer funds and securities.^[35]

Neither consideration applied to the CSE Brokers. They held net capital in the billions, not hundreds of thousands, of dollars. They conducted customer brokerage activities that required full computation of the customer reserve formula under Rule 15c3-3. They used the Alternative Method and had done so for many years before the adoption of the CSE Program. This reduced their net capital requirement.^[36]

[edit] 2004 change to net capital rule

In 2004 the SEC amended the net capital rule to permit broker-dealers with at least $5 billion in “tentative net capital” to apply for an “exemption” from the established method for computing “haircuts” and to compute their net capital by using historic data based mathematical models and scenario testing authorized for commercial banks by the “Basel Standards.”^[37]According to Barry Ritholtz, this rule was known as the Bear Stearns exemption.^[38]This “exemption” from the traditional method for computing “haircuts” ultimately covered Bear Stearns, the four larger investment bank firms (i.e. Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs), and two commercial bank firms (i.e. Citigroup and JP Morgan Chase).^[39] It has been suggested Hank Paulson, the then CEO of Goldman Sachs, “led” in “the lobbying charge” for the rule change permitting these “exemptions.”^[40]

The SEC expected this change to significantly increase the amount of net capital computed by those broker-dealers. This would permit the parent holding companies of the broker-dealers to redeploy the resulting “excess” net capital in other lines of business. To lessen this effect, the SEC adopted a new $500 million minimum net capital (and $1 billion “tentative net capital”) requirement for such brokers and, more important, required each to provide the SEC an “early warning” if its “tentative net capital” fell below $5 billion.^[41]

[edit] Issues addressed by rule change

The 2004 change to the net capital rule responded to two issues. First, the European Union (“EU”) had adopted in 2002 a Financial Conglomerate Directive that would become effective on January 1, 2005, after being enacted into law by member states in 2004.^[42]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). If the relevant holding company was not located in an EU country, an EU member country could exempt the non-EU holding company from the supplemental supervision if it determined the holding company’s home country provided “equivalent” supervision.^[43].

The second issue was whether and how to apply to broker-dealers capital standards based on those applicable internationally to competitors of US broker-dealers. Those standards (the “Basel Standards”) had been established by the Basel Committee on Banking Supervision and had been the subject of a “concept release” issued by the SEC in 1997 concerning their application to the net capital rule.^[44]

In the United States there was no consolidated supervision for investment bank holding companies, only for their broker-dealer subsidiaries and other specified entities such as investment advisors. The Gramm-Leach-Bliley Act, which had eliminated the vestiges of the Glass-Steagall Act separating commercial and investment banking, had established an optional system for investment bank firms to register with the SEC as “Supervised Investment Bank Holding Companies.”^[45]Commercial bank holding companies had long been subject to consolidated supervision by the Federal Reserve as “bank holding companies.”^[46]

To address the approaching European consolidated supervision deadline, the SEC issued two proposals in 2003, which were enacted in 2004 as final rules. One (the “SIBHC Program”) established rules under which a company that owned a broker-dealer, but not a bank, could register with the SEC as an investment bank holding company. The second (the “CSE Program”) established a new alternative net capital computation method for a qualifying broker-dealer (a “CSE Broker”) if its holding company (a “CSE Holding Company”) elected to become a “Consolidated Supervised Entity.”^[47]The SEC estimated it would cost each CSE Holding Company approximately $8 million per year to establish a European sub-holding company for its EU operations if “equivalent” consolidated supervision were not established in the United States.^[48]

Both the SIBHC and the CSE Programs laid out programs to monitor investment bank holding company market, credit, liquidity, operational and other “risks.”^[49]The CSE Program had the added feature of permitting a CSE Broker to compute its net capital based on Basel Standards.

[edit] Delayed use of rule change by CSE Brokers

Ultimately, five investment bank holding companies (The Bear Stearns Companies Inc., The Goldman Sachs Group, Inc., Lehman Brothers Holdings Inc., Merrill Lynch & Co., Inc. and Morgan Stanley) entered the CSE Program. The SEC was thereby authorized to review the capital structure and risk management procedures of those holding companies. In addition two bank holding companies (Citigroup Inc. and JP Morgan Chase & Co.) entered the CSE Program.^[50]

A broker-dealer subsidiary of Merrill Lynch was the first to begin computing its net capital using the new method, beginning January 1, 2005. A Goldman Sachs broker-dealer subsidiary began using the new method after March 23, but before May 27, 2005. 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.^[51]

[edit] Possible effects of use of rule change

By permitting CSE Brokers to compute their net capital using Basel Standards, the SEC stated it had expected roughly a 40% reduction in the amount of “haircuts” imposed in computing a CSE Broker’s “net capital” before giving effect to the $5 billion “tentative net capital” early warning requirement added in the final rule.^[52] The SEC also noted, however, it was unclear whether this would lead to any reduction in actual capital levels at broker-dealers, because broker-dealers typically maintain net capital in excess of required levels.^[53]In part this is because broker-dealers using the Alternative Method are required to report when net capital falls below 5% of “aggregate customer debit balances.” At that level, a broker-dealer is prohibited from distributing excess capital to its owner.^[54]As a 1998 GAO Report noted, however, the excess net capital in large broker-dealers greatly exceeds even those “early warning” requirements and is best explained by the requirements imposed by counterparties in order to transact business with the broker-dealer.^[55]Nevertheless, to protect against significant reductions in CSE Broker net capital, the SEC imposed an additional "early warning" requirement that required a CSE Broker to notify the SEC if its "tentative net capital" dropped below $5 billion.^[56].

Thus, the 2004 change to the Alternative Method raised the possibility increased net capital computations based on the same assets would weaken customer protections in a CSE Broker liquidation. It also raised the possibility capital would be withdrawn from CSE Brokers and used in the non-broker/dealer business of CSE Holding Companies.^[57]It did not change the test against which net capital was measured. That test had never directly limited overall leverage of either a broker-dealer or its parent holding company.

[edit] The collapses of Bear Stearns and Lehman Brothers

[edit] Bear Stearns

Bear Stearns was the first CSE Holding Company to collapse. 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 that took ownership of various assets of Bear Stearns with a quoted market value of $30 billion as of March 14, 2008.^[58]

The broker-dealer operations of Bear Stearns were absorbed by JP Morgan. The reported net capital position of the Bear Stearns CSE Broker (Bear Stearns & Co. Inc) was adequate and, it appears, would have been adequate under the pre-2004 “haircuts” as well.^[59]

[edit] Lehman Brothers

Lehman Brothers Holdings Inc entered bankruptcy on September 15, 2008. Its CSE Broker (Lehman Brothers Inc (“LBI”)) was not included in the bankruptcy filing and continued to operate until its customer accounts and other assets were acquired by Barclay’s Capital Markets Inc. As a condition to that acquisition the Securities Investor Protection Corporation (“SIPC”) commenced a liquidation of LBI on September 19, 2008, in order to complete the transfer of LBI customer accounts and resolve disputes about the status of accounts.^[60]

Although there has been controversy about two overnight loans to LBI guaranteed by the FRBNY, it appears those loans funded intraday or overnight exposures of LBI to its customers in connection with settlements of customer transactions and that the collateral supporting those loans (i.e. customer settlement payments) repaid the loans on the day they were made or the following day.^[61]Reports indicate the “troubled assets” held by Lehman were commercial real estate assets.^[62]

[edit] Leverage at CSE Holding Companies and capital withdrawals

While the CSE Brokers of Bear and Lehman may have remained solvent and liquid after the 2004 net capital rule change, it has been suggested the change had the effect of permitting a large expansion of the non-broker/dealer operations of Bear, Lehman, and the other CSE Holding Companies because they were able to extract excess net capital from their broker-dealers and use that capital to acquire dangerously large exposures to “risky assets.”^[63]

[edit] Higher leverage in 1990s

There does not appear to have been any study published that reviews whether this suggestion can be supported. Studies of Form 10-K and Form 10-Q Report filings by CSE Holding Companies have shown their overall reported year-end leverage increased during the period from 2003 through 2007^[64]and their overall reported fiscal quarter leverage increased from August 2006 through February 2008.^[65]Form 10-K Report filings for the same firms reporting fiscal year-end balance sheet information for the period from 1993 through 2002 show reported fiscal year-end leverage ratios in one or more years before 2000 for 4 of the 5 firms higher than their reported year-end leverage for any year from 2004 through 2007. Only Morgan Stanley had higher reported fiscal year-end leverage in 2007 than in any previous year since 1993.^[66]The ratios of 38.2 to 1 for Lehman in 1993, 34.2 to 1 for Merrill in 1997, and of 35 to 1 for Bear and 31.6 to 1 for Goldman in 1998 were all reached before the 2004 rule change.

The fact the investment banks that later became CSE Holding Companies had leverage levels well above 15 to 1 in the 1990s was noted before 2008. The President’s Working Group on Financial Markets pointed out in its April 1999 report on hedge funds and the collapse of Long-Term Capital Management that those five largest investment banks averaged 27 to 1 leverage in 1998. 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.”^[67]

[edit] No evidence of capital withdrawals from CSE Brokers

It is also not clear significant capital was withdrawn from CSE Brokers after the 2004 rule change. The only CSE Holding Company that provided separate financial information for its CSE Broker, through consolidating financial statements, in its Form 10-K Report filings was Lehman Brothers Holdings Inc, because that CSE Broker (LBI) had sold subordinated debt in a public offering. Those filings show LBI’s shareholders’ equity increased after it became a CSE Broker.^[68]Goldman Sachs provides on its website an archive of the periodic Consolidated Statement of Financial Condition reports issued for its CSE Broker, Goldman Sachs & Co. Those statements show 2004 fiscal year-end GAAP total partners’ capital of $4.211 billion, before Goldmans Sachs & Co. became a CSE Broker, growing to $6.248 billion by fiscal year-end 2007.^[69]As noted in Section 1.2 above, Erik Sirri, former Director of the SEC’s Division of Trading and Markets, has stated CSE Broker capital levels were stable or, in some cases, increased substantially after they CSE Brokers began operating under the 2004 rule change.^[70]

[edit] References

1. ^ As is explained in Section 2.1 below (and documented in note 13), this is because investment bank holding companies were never subject to the net capital rule. Even the broker-dealer subsidiaries of these holding companies were not subject to a debt to equity leverage limitation. Instead, as detailed in Section 3.5 and its supporting notes below, these subsidiaries were restricted to holding customer receivables not greater than 50 times the amount of their net capital under the Alternative Method described in Section 3.3 below.
2. ^ See Section 5.3.1 and note 66 below.
3. ^ See Sections 4.3 and 5.3.2 below.
4. ^ Lee A. Pickard, “Viewpoint: SEC’s Old Capital Approach Was Tried--And True”, American Banker, August 8, 2008, at page 10 (Before the rule change “the broker-dealer was limited in the amount of debt it could incur, to about 12 times its net capital, though for various reason broker-dealers operated at significantly lower ratios…If, however, Bear Stearns and other large broker-dealers had been subject to the typical haircuts on their securities positions, an aggregate indebtedness restriction, and other provisions for determining required net capital under the traditional standards, they would not have been able to incur their high debt leverage without substantially increasing their capital base.”). See also Julie Satow, “Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers”, The New York Sun, September 18, 2008 (“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.” This article quotes Mr. Pickard as stating “The SEC modification in 2004 is the primary reason for all of the losses that have occurred.”). A further report stated Mr. Pickard “estimated that prior to the 2004 program most firms never exceeded an 8-to-1 debt-to-net capital ratio” Ben Protess, “’Flawed’ SEC Program Failed to Rein in Investment Banks”, ProPublica, October 1, 2008. Despite the contrary leverage information described below in Section 3.4 (for broker-dealers) and 5.3 (for holding companies), at least as late as February 18, 2009, Mr. Pickard was still being quoted as recalling “banks rarely exceeded gross leverage over about 6% on his own watch at the SEC in the late 1970’s. In the following decades, leverage generally ranged around 12%, comfortably beneath the rule’s 15% ceiling.” Vanessa Drucker, “The SEC Killed Wall Street On April 28, 2004”, Real Clear Markets, February 18,2009.
5. ^ Stephen Labaton, “Agency’s ’04 Rule Let Banks Pile Up New Debt”, New York Times, October 3, 2008, page A1.
6. ^ Niall Ferguson,“Wall Street Lays Another Egg”, Vanity Fair, December 2008, at page 4. (“It was not unusual for investment banks’ balance sheets to be as much as 20 or 30 time larger than their capital, thanks in large part to a 2004 rule change by the Securities and Exchange Commission that exempted the five largest of those banks from the regulation that had capped their debt-to-capital ratio at 12 to 1.”) John C. Coffee, “Analyzing the Credit Crisis: Was the SEC Missing in Action?” (hereinafter “Was the SEC Missing in Action?”), New York Law Journal, (December 5, 2008) (“For most broker-dealers this 15 to 1 debt to net capital ratio was the operative limit within which they needed to remain by a comfortable margin”… [after the rule change] “The result was predictable: all five of these major investment banks increased their debt-to-equity leverage ratios significantly in the period following their entry into the CSE program.”) Joseph E. Stiglitz, “Capitalist Fools”, Vanity Fair, January 2009, at page 3. (“There were other important steps down the deregulatory path. One was the decision in April 2004 by the Securities and Exchange Commission, at a meeting attended by virtually no one and largely overlooked at the time, to allow big investment banks to increase their debt-to-capital ratio (from 12:1 to 30:1, or higher) so that they could buy more mortgage-backed securities, inflating the housing bubble in the process.”) Alan S. Blinder, “Six Errors on the Path to the Financial Crisis”, New York Times, January 25, 2009, page BU7. (“The second error came in 2004, when the S.E.C. let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the S.E.C. and the heads of firms thinking? Remember, under 33-to-1 leverage, a mere 3 percent decline in asset values wipes out a company. Had leverage stayed at 12 to 1, these firms wouldn’t have grown as big or been as fragile.”)
7. ^ U.S. Securities and Exchange Commission Office of Inspector General, Office of Audits (hereinafter “SEC OIG”), “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program,” Report No. 446-A, September 25, 2008 (hereinafter the “OIG Bear Stearns CSE Report”), at page 87 of the full Report.
8. ^ April 9, 2009, speech, Erik Sirri, Director of the SEC’s Division of Trading and Markets (the “Sirri Speech”). In the speech Director Sirri notes four “fatal flaws” in the belief that the 2004 rule change was a “major contributor to the current crisis”: (1) the rule change “did not undo any leverage restriction”; (2) the “’12-to-1’ restriction” was not affected by the rule change and, in any case, the CSE Brokers “had been using a different financial ratio since the late 1970s”; (3) broker-dealers subject to the “’12-to-1’ restriction” were required to give an “early warning” if their “aggregate indebtedness” exceeded 12 times their net capital, but “aggregate indebtedness” excluded “substantial portions of the balance sheets” of broker-dealers, because much of their indebtedness arose from “securities financing transactions”, such as repurchase transactions, not included in “aggregate indebtedness”, so that even the “’12-to 1’ restriction” was “not an absolute constraint on leverage”; and (4) the net capital rule never constrained leverage at the investment bank holding company level, and “many of the investment banks’ activities--including those with the highest level of inherent risk-- such as OTC derivatives dealing and the originating and warehousing of real estate and corporate loans occurred outside the US broker-dealer subsidiary.” Finally, Mr. Sirri noted “leverage restrictions can provide false comfort” because “The degree of risk arising from leverage is dependent on the type of assets and liabilities making up the balance sheet.” Along with identifying the “early warning” requirement under the “aggregate indebtedness” ratio test as the probable source for the otherwise mysterious misconception that the CSE Brokers had been subject to a “12-to-1” leverage limit before 2004, Mr. Sirri’s speech emphasized that the CSE Brokers were subject to an “early warning” requirement to notify the SEC if their “tentative net capital” fell below $5 billion and that this requirement “was designed to ensure that the use of models to compute haircuts would not substantially change the amount of capital maintained by the broker-dealers.” Consistent with the CSE Broker net capital and other financial information described in Section 4.3 (particularly note 55) and in Section 5.3.2 (particularly notes 68 and 69) below, Mr. Sirri also stated the “capital levels in the broker-dealer subsidiaries remained relatively stable after they began operating under the 2004 amendments, and, in some cases, increased significantly.” The importance of the $5 billion tentative net capital “early warning” trigger was emphasized repeatedly at the April 28, 2000, Open Meeting at which the SEC voted to adopt the 2004 rule change. In the Windows Player audio tape of the hearing the rule change is item 3 on the agenda of the 2 hour meeting. Starting 1:20 into the audio, Annette Nazareth, Director Market Regulation, and Michael Macchiaroli, Assistant Director, explain that without the $5 billion early warning requirement the reduction in haircuts could be more than 50%, but that after giving effect to the early warning requirement the haircuts would, in effect, be limited to about 20-30% less than before. 1:50 into the audio they explain that the $5 billion early warning was also what the broker-dealers themselves thought their customers would expect. The eventual CSE Brokers were described as not wanting a rule in which minimum net capital levels would be below that amount, because of the effect it could have on the confidence of their customers. The SEC release adopting the rule change explained the $5 billion “early warning” requirement was not included in the October 2003 proposed rule change, but was added “based on staff’s experience and the current levels of net capital maintained by the broker-dealers most likely to apply to use the alternative method of computing net capital.” 69 Federal Register 34431 (June 21, 2004). Media reports of the April 28, 2000, Open Meeting have noted the moment 1:44 into the Windows Player version where Commissioner Goldschmid points out that, because the rule change will affect only the largest broker-dealers, “if anything goes wrong, its going to be an awfully big mess” followed by what has been described as “nervous laughter.” See Kevin Drawbaugh, “US SEC Clears New Net-Capital Rules for Brokerages”,Reuters, April 28, 2004 (“SEC Commissioner Paul Atkins said monitoring the sophisticated models used by the brokerages under the CSE rules -- and stepping in where net capital falls too low -- ‘is going to present a real management challenge’ for the SEC. Since the new CSE rules will apply to the largest brokerages without bank affiliates, SEC Commissioner Harvey Goldschmid said, ‘If anything goes wrong, it's going to be an awfully big mess.’"). Stephen Labaton, “Agency’s ’04 Rule Let Banks Pile Up New Debt”, New York Times, October 3, 2008 (“”We’ve said these are the big guys,’ Mr. Goldschmid said, provoking nervous laughter, ‘but that means if anything goes wrong, it’s going to be an awfully big mess.”). Moments later, after Director Nazareth answers the question introduced by that comment, just short of 1:45 into the audio, Professor Goldschmid responds “No, I think you have been very good at thinking this through carefully and working it through with skill.” At the beginning of his questioning (1:41 into the audio) Professor Goldschmid had commented on how he and staff had “talked a lot on this”, and later (at 1:47) he remarks on the “well more than 400 page” briefing book prepared by staff concerning the proposed rule change. At 1:48 he concludes his remarks by stating “Congratulations, I think you’re in very good shape.” At the end of the tape the five Commissioners unanimously approve the rule change.
9. ^ See “Was the SEC Missing in Action? (“the United States, as of the beginning of 2008, had five major investment banks that were not owned by a larger commercial bank: Merrill Lynch, Goldman Sachs, Morgan Stanley, Lehman Brothers and Bear Stearns. By the late Fall of 2008, all of these investment banks had either failed or abandoned their status as independent investment banks. Two (Bear Stearns and Merrill Lynch) had been forced at the brink of insolvency to merge with larger commercial banks in transactions orchestrated by banking regulators. One -- Lehman Brothers -- had filed for bankruptcy, and the two remaining investment banks -- Goldman Sachs and Morgan Stanley -- had converted into bank holding companies under pressure from the Federal Reserve Bank, thus moving from SEC to Federal Reserve supervision. Each of these firms had survived prior recessions, market panics, and repeated turmoil and had long histories extending back as far as the pre-Civil War era. If their uniform collapse was not enough to suggest the possibility of regulatory failure, one additional common fact unites them: each of these five firms voluntarily entered into the SEC's Consolidated Supervised Entity ("CSE") program, which was established by the SEC in 2004 for only the largest investment banks. Indeed, these five investment banks were the only free-standing investment banks permitted by the SEC to enter the CSE program.”)
10. ^ The continued use by the five CSE Brokers of the alternative net capital computation method established by Appendix E of SEC Rule 15c3-1 (which is in SEC Release 34-49830 identified and linked in note 37 below) is confirmed (1) for the Bear Stearns CSE Broker acquired by JP Morgan Chase on pages 72-73 of JP Morgan Chase’s Form 10-K Report for 2008 and on page 58 of its Form 10-Q Report for the third quarter of 2009; (2) for the Goldman Sachs CSE Broker on page 24 of the Goldman Sachs Form 10-K Report for 2008 and on page 70 of its Form 10-Q Report for the third quarter of 2009; (3) for the Lehman Brothers CSE Broker acquired by Barclays Capital on pages 32-34 of the Barclays Capital 2008 Consolidated Statement of Financial Condition and in SEC Release 34-58612 granting Barclays temporary relief to continue using the Appendix E alternative net capital computation method for the positions it acquired from that CSE Broker (“LBI”) contingent upon continuing to make such computations in accordance with the procedures employed by LBI, using employees familiar with LBI’s procedures, and notifying the SEC if Barclays Capital’s tentative net capital drops below $6 billion, rather than the $5 billion applicable to the other CSE Brokers; (4) for the Merrill Lynch CSE Broker acquired by Bank of America on page 153 of Merrill’s Form 10-K Report for 2008 and on page 80 of its Form 10-Q Report for the third quarter of 2009; and (5) for the Morgan Stanley CSE Broker on page 158 of Morgan Stanley’s Form 10-K Report for 2008 and on page 68 of its Form 10-Q Report for the third quarter of 2009.
11. ^ SEC News Release 2008-230 “Chairman Cox Announces End of Consolidated Supervised Entities Program”, September 26, 2008 (“With each of the major investment banks that had been part of the CSE program being reconstituted within a bank holding company, they will all be subject to statutory supervision by the Federal Reserve. Under the Bank Holding Company Act, the Federal Reserve has robust statutory authority to impose and enforce supervisory requirements on those entities. Thus, there is not currently a regulatory gap in this area. The CSE program within the Division of Trading and Markets will now be ending.”). While no action has been taken or proposed to alter the net capital computation method authorized for CSE Brokers by the 2004 net capital rule change, the Treasury Department has proposed eliminating the Supervised Investment Bank Holding Company program described below in Section 4.1. Treasury Department, “Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation” at 36.
12. ^ Jerry W. Markham and Thomas Lee Hazen, Broker-Dealer Operations Under Securities and Commodities Law, (West Group, 2002, supplemented through Supplement 8, October 2008) Volume 23 Securities Law Series (hereinafter “Markham/ Hazen BD Law”) at pages 4-4.1 to 4-17. The 1967-70 crisis had led to the creation of the Securities Investor Protection Corporation (“SIPC”) after New York Stock Exchange (“NYSE”) member firms contributed $140 million to a trust fund to compensate customers of failed fellow members of the NYSE. See SEC Release 34-9891. 38 Federal Register 56 (January 3, 1973). While the SEC had required capital tests for broker-dealers since the 1930s, it had permitted “self-regulatory” exchanges such as the NYSE to impose and supervise specific standards before the 1967-70 crisis. That crisis had led to legislation requiring the SEC to “establish minimum financial responsibility requirements for all brokers and dealers.” Steven L. Molinari and Nelson S. Kibler, “Broker-Dealers’ Financial Responsibility under the Uniform Net Capital Rule--A Case for Liquidity,” 72 Georgetown Law Journal 1 (1983) (hereinafter “Molinari/Kibler Financial Responsibility”), at 9-18 (quoted statutory language at 15).
13. ^ See General Accounting Office (“GAO”) Report, “Risk-Based Capital, Regulatory and Industry Approaches to Capital and Risk,” GAO/GGD-98-153, July 1998 (hereinafter “GAO Risk-Based Capital Report”), at pages 54-55 and 130-131 (“The net capital rule applies only to the registered broker-dealer and does not apply to the broker-dealer’s holding company or unregulated subsidiaries or affiliates”), and GAO Report, “Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk,” GAO/GGD-00-3, October 1999 (hereinafter “GAO LTCM Report”), at 24-25, for discussions of the SEC’s lack of authority over affiliates of broker-dealers before the repeal of the Glass-Steagall Act. See GAO Report, “Financial Market Regulation: Agencies Engaged in Consolidated Supervision Can Strengthen Performance Measurement and Collaboration,” GAO-07-154, March 2007 (hereinafter “GAO Consolidated Supervision Report”), at 11-15 and 22-25, for a description of supervision after the repeal of Glass-Steagall in 1999 and the introduction of the CSE Program described below. For a general description of the lack of holding company regulation, see GAO Report, “Securities Firms: Assessing the Need to Regulate Additional Financial Activities,” GAO/GGD-92-70, April 1992 (hereinafter “GAO Financial Activities Report”). For the introduction of more limited capital requirements (“Broker-Dealer Lite”) for broker-dealers engaged solely in over-the-counter (“OTC”) derivatives activities, in order to encourage not continuing to engage in those activities outside the United States (in the case of derivatives classified as “securities”) or outside the broker-dealer structure (in the case of non-securities), see SEC Release No. 34-40594 (October 23, 1998), which provided for the use of value at risk computations similar to those provided by the Basel Standards described below in establishing net capital.
14. ^ A dealer buys and sells securities for its own account (i.e the “proprietary trading” account of a broker). In practice, brokers are typically also dealers, so the term broker-dealer is ubiquitous.
15. ^ GAO Risk-Based Capital Report at 53-54. Markham/Hazen BD Law at pages 4-4.
16. ^ See the Management’s Discussion and Analysis of Financial Condition and Results of Operations section of the Form 10-K Reports filed by the CSE Holding Companies referenced in note 66 below. See also Standard and Poor’s, “Why Was Lehman Brothers Rated ‘A’?” (September 24, 2008) and July 24, 1998 Hearing before the House Committee on Banking and Financial Services, Testimony of Alan Greenspan at 152 (in describing the over-the-counter-derivatives market, Mr. Greenspan describes the credit requirements by parties in that market as “they have insisted that dealers have financial strength sufficient to warrant a credit rating of A or higher.”)
17. ^ Markham/Hazen BD Law at page 4-5, fn. 2. See also Michael P. Jamroz, “The Net Capital Rule,” 47 Business Lawyer 863 (May 1992) (hereinafter “Jamroz Net Capital”), at 867 (“Because the Commission designed the Net Capital Rule to provide a fund from which liquidation expenses may be paid, the Rule, unlike GAAP, assumes the firm will liquidate.”).
18. ^ Norman S. Poser and James A. Fanto, Broker-Dealer Law and Regulation, (Aspen Publishers 4th Edition, through 2008 Supplement) (hereinafter “Poser/Fanto BD Regulation”) at pages 12-4 to 12-12 ; Nelson S. Kibler and Steven L. Molinari, “The SEC’s Recent Revisions to its Uniform Net Capital Rule and Customer Protection Rule,” 10 Securities Regulation Law Journal 141 (1982) (hereinafter “Kibler/Molinari Recent Revisions”) at 143-144. In practice, the most important addition is qualifying subordinated debt. "Tentative net capital" is determined after the deduction of “illiquid assets” such as fixtures, unsecured receivables or non-marketable securities. This "tentative net capital" is then reduced by “haircuts” applied to securities based on their perceived liquidity and price volatility to yield "net capital." While the “haircuts” were generally the same for the Basic and Alternative Methods, an important distinction was that the Alternative Method required a 3% haircut in the value of customer receivables rather than the 1% imposed by the Basic Method. See GAO Risk-Based Capital Report at 148-153 for sample calculations, including (at 151) the 3% haircut for customer receivables.
19. ^ In practice, the “haircuts” proved inadequate to deal with sharp interest rate movements in the late 1970s. By 1980 the SEC issued revisions to the “haircuts” to account for this experience. SEC Release No. 34-17209, 45 Federal Register 69911 (October 22, 1980), at 69912 (“The data show that the month-end to month-end price movements in most debt securities in the months of January 1977, October 1979, January 1980 and February 1980 were greater than the existing haircuts for the securities.”) That SEC Release has been cited as an early use of value at risk methodology to assess market value volatility. Glyn A. Holton, “History of Value-at-Risk: 1922-1998”, Working Paper, July 25, 2002, at page 9 (“In 1980, extraordinary volatility in interest rates prompted the SEC to update the haircut percentages to reflect the increased risk. This time, the SEC based percentages on a statistical analysis of historical security returns. The goal was to establish haircuts sufficient to cover, with 95% confidence, the losses that might be incurred during the time it would take to liquidate a troubled securities firm--a period the SEC assumed to be 30 days. Although it was presented in the archaic terminology of ‘haircuts’, the SEC’s new system was a rudimentary VaR measure.”) VaR methodology was a key component of the Basel Standards used in the 2004 net capital rule change as described below.
20. ^ GAO Risk-Based Capital Report at 131. Molinari/Kibler Financial Responsibility at 22 (“it is critical for broker-dealers to have both working capital and a cushion to allow for certain market and credit risks.”). For the significance of the net capital “cushion” in paying continuing operating costs of a liquidating broker, see Jamroz Net Capital at 865-6 (in describing the staffing of a liquidation, it states “The salaries of these employees, as well as the costs associated with maintaining the premises and shipping and transferring the securities, are paid from the broker-dealer’s remaining capital”) and SEC Release No. 34-31511, 57 Federal Register 56973, December 2, 1992, at 56975 (“During a self liquidation, the expenses of a firm continue while its revenues drop significantly, often to zero.”)
21. ^ Jamroz Net Capital at 866 (“Although the Rule’s minimum requirements serve as a benchmark against which a base amount of required capital can be determined, the clause defining net capital has the most impact in achieving the purpose of the Rule.”) This is because the computation of net capital should determine, conservatively, the current liquidation value of the broker-dealer’s assets. So long as that amount at least equals the broker-dealer’s liabilities,
22. ^ See note 12 above, particularly Markham/Hazen BD Law at page 4-16 for the Basic Method’s “continuation” of the “aggregate indebtedness” test. In its adopting release the SEC stated: “The rule, as adopted, continues the basic net capital concept under which the industry has operated for many years” SEC Release 34-11497, 40 Federal Register 29795, at 29796 (July 16, 1975)
23. ^ Markham/Hazen BD Law at page 4-16. See Poser/Fanto BD Regulation at pages 12-12 to 12-17 for a detailed description of the Basic Method, including minimum dollar requirements up to $250,000 (which are not relevant for the large broker-dealers) and the 8 to 1 “leverage limit” for the first year of a broker-dealer’s operation. For a more basic explanation see GAO Risk-Based Capital Report at 133-4.
24. ^ Jamroz Net Capital at 866 (“Generally, because aggregate indebtedness includes most of the unsecured borrowings of the broker-dealer, the aggregate indebtedness test limits the firm’s leverage.”) . Poser/Fanto BD Regulation at page 12-16. To the extent a broker-dealer funds its ownership of securities through secured borrowings, such as repurchase agreements, this means the “capital charge” (beyond “haircuts”) for such borrowings, and therefore the “leverage constraint” beyond “haircuts”, is the “margin” (i.e. excess collateral) received by the lender. For a description of the use of securities lending by a broker-dealer to finance securities and how this operates under the net capital rule, see SIPC/Deloitte and Touche, “Study of the Failure of MJK Clearing, the Securities Lending Business and the Related Ramifications on the Securities Investor Protection Corporation”, (2002)
25. ^ For the significance of secured debt through repurchase agreements, see Peter Hoerdahl and Michael King, “Developments in Repo Markets During the Financial Turmoil”, Bank for International Settlements Quarterly Review (December 2008) at 39 (“top US investment banks funded roughly half of their assets using repo markets”). Page 48 of the Lehman Brothers Holdings 2006 Form 10-K contains the following typical description of investment bank funding of “liquid assets”: “Liquid assets (i.e., assets for which a reliable secured funding market exists across all market environments including government bonds, U.S. agency securities, corporate bonds, asset-backed securities and high quality equity securities) are primarily funded on a secured basis.” As an example of the difference between GAAP based leverage (which is the statistic addressed by the scholars cited in note 6 above) and “leverage” under the Basic Method, see the FOCUS Reports filed by Seattle-Northwest Securities Corporation, a small broker-dealer that used the Basic Method for FOCUS Reports filed before 2009. While broker-dealer net capital compliance reports (contained within a Financial and Operational Combined Uniform Single Report (“FOCUS”) Form X-17A-5) are not generally available on the internet, the Seattle-Northwest website contains an SNW Financial Statements page that has links to that broker-dealer’s recent FOCUS Reports. In its June 30, 2007, FOCUS Report, Seattle-Northwest’s GAAP liabilities were $275,609,044, as shown on page 8, line 26, of the Report. Its GAAP equity was $10,576,988, as shown on page 8, line 30, of the Report. This yields a GAAP leverage ratio (computed in the manner applied to CSE Holding Companies by the scholars referenced in note 6 above) of 26 to 1. The “leverage” ratio under the Basic Method, however, is less than 1 to 1 (0.59 to 1) as shown on page 20, line 20, because “Aggregate Indebtedness” is only $2,829,783, as shown above item 1230 on line 26 of page 8, and “Net Capital” is $4,769,005, as shown on page 19, line 10, of the Report. Only slightly more than 1% of the GAAP liabilities of this broker-dealer qualified as “Aggregate Indebtedness” under the Basic Method. Later FOCUS Reports for Seattle-Northwest available on the SNW Finanacial Statements webpage referenced above show a much smaller balance sheet with GAAP leverage of less than 10 to 1. Those same reports, however, show “leverage” under the Basic Method of less than 1 to 1, as in the case of the June 30, 2007, report. Seattle-Northwest’s March 31, 2007, FOCUS Report shows less than one-half of 1% of its GAAP liabilities constituted Aggregate Indebtedness ($1,327,727 of Aggregate Indebtedness out of $305,607,345 of GAAP liabilities). The Report shows a GAAP leverage ratio of 27 to 1 ($305,607,345 of liabilities to $11,285,875 of equity) but a ratio of Aggregate Indebtedness ($1,327,727) to Net Capital ($6,663,364) of 1 to 5 (i.e. 0.199 to 1). These FOCUS Reports demonstrate the great difference between GAAP leverage and the “leverage” tested under the Basic Method (even accounting for subordinated debt being treated as equity under the Basic Method). Yet, all of the scholars cited in note 6 above referenced post 2004 leverage computations based on GAAP liabilities as if that were the limit imposed by the Basic Method (which itself was not the method that applied to any CSE Broker, let alone the CSE Holding Companies discussed by those scholars).
26. ^ Molinari/Kibler Financial Responsibility at 16-18. Markham/Hazen BD Law at pages 4-17 to 4-18. Poser/Fanto BD Regulation at pages 12-17 to 12-20. While not the traditional “leverage test” based on indebtedness, this “leverage test” based on assets is similar to a bank asset leverage test and had been used by the NYSE in the 1930s. Markham/Hazen BD Law at page 4-7, fn. 12.
27. ^ Molinari/Kibler Financial Responsibility at 16-17 (describing assumption) and at 21 (describing the lack of escrow). While the broker-dealer’s required net capital was not escrowed for the benefit of customers over other creditors, customer assets were required to be segregated from the broker-dealer’s assets and a cash escrow account was required to hold net cash balances owed by the broker-dealer to customers. Markham/Hazen BD Law at page 4-18.
28. ^ SEC Release 34-11497, 40 Federal Register 29795 (July 16, 1975), at 29798. See also Molinari/Kibler Financial Responsibility at 26
29. ^ Molinari/Kibler Financial Responsibility at page 17.
30. ^ Molinari/Kibler Financial Responsibility at 26, fn. 154 (“while the alternative requires a broker-dealer to maintain specified levels of net capital in relation to aggregate debit items under the customer protection rules, it places no restriction on the liabilities a broker-dealer can incur.”). Because the Alternative Method measures the required level of net capital solely against customer assets, when Drexel Burnham’s broker-dealer shed most of its customer business the unit’s required net capital became very low, although its “proprietary” (or dealer) account held a large amount of securities. To address this issue, the SEC restricted the ability of the owner to extract capital from a broker-dealer using the Alternative Method if the net capital would thereby be reduced to less than 25% of the “haircuts” on the securities held in the proprietary account of the broker-dealer. Jamroz Net Capital at 895. Of course, if a broker-dealer’s liabilities outside its customer business exceeded the value of its assets in that business (after “haircuts”) that would reduce the broker-dealer’s overall “net capital” and indirectly limits its customer business (i.e. the amount of “aggregate debit items” it could support). FOCUS Reports are described in note 25 above. The June 2007 FOCUS Report filed by Bank of America Securities LLC provides an example of how net capital rule compliance under the Alternative Method is computed. Bank of America Securities did not become a CSE Broker, so its computation of compliance is under the Alternative Method without the 2004 rule change affecting CSE Brokers. As in the case of two Seattle-Northwest FOCUS Reports cited in note 25 above, this Report shows GAAP leverage higher than 15 to 1. GAAP leverage would be 64 to 1 (i.e. $261,672,884,443/ $4,071,281,721). Treating subordinated debt as equity (which would be the more appropriate comparison to holding company leverage cited in note 6 above) leverage would still be over 20 to 1 (i.e. $253,364,884,440/$12,379,281,721=20.47 to 1).
31. ^ In proposing in 1980 revisions to the Alternative Requirement, the SEC cited financial information for NYSE member firms showing the overall average leverage ratio of such broker-dealers computed as total liabilities to equity capital rose from 7.61 to 1 in 1972 to 17.95 to 1 in 1979. The annual ratios were: 1972: 7.61 to 1; 1973: 7.18 to 1; 1974: 7.44 to 1; 1975: 7.45 to 1; 1976: 11.13 to 1; 1977: 12.74 to 1; 1978: 14.73 to 1; and 1979: 17.95 to 1. SEC Release No. 34-17208 (“SEC Release 34-17208”), 45 Federal Register 69915 (October 22, 1980), at 69916. Molinari/Kibler Financial Responsibility, at 26, fn. 157, cites a Lipper study that “industry leverage increased from 17 to 1 in September 1982 to 19 to 1 in September 1983.” In 1992 the GAO stated “The use of leverage has increased in the securities industry as firms rely more on liabilities than equity capital to fund their activities. A common measurement of leverage is the ratio of total liabilities to total equity.” According to SEC annual reports, this ratio increased for all registered broker-dealers from about 13 to 1 in 1980 to about 18 to 1 in 1990.” GAO Financial Activities Report at 40-41. The report studied in particular thirteen firms and found (at 41) that as of the second quarter of 1991: “The average total liabilities to total equity ratio among these thirteen broker-dealers was 27 to 1.” Even the 27 to 1 leverage ratio is misleading, because the Report notes (also at 41) only nine of the thirteen firms studied had leverage higher than the overall average of “about 18 to 1.” This means the average leverage of those nine firms must have been significantly higher than 27 to 1, particularly if the average was an unweighted arithmetic average of the leverage ratios of the thirteen firms. The thirteen firms studied included the ten largest broker-dealers. Thomas W. Joo, “Who Watches the Watchers? The Securities Investor Protection Act, Investor Confidence, and the Subsidization of Failure,” 72 Southern California Law Review 1071 (1999) at 1092, fn. 107. These data indicate broker-dealer leverage (measured as GAAP total liabilities to equity) increased after the introduction of the uniform net capital rule, although it is unclear from this data whether broker-dealer leverage ratios were unusually low in the period from 1972 through 1975. This is entirely possible given the background of the broker-dealer crisis of 1967-1970 that led to the rule and the financial market conditions in the early 1970s. Molinari/Kibler Financial Responsibility at 10 states that in 1970 overall leverage of all broker-dealers was 10-1, but that leverage was “much higher” at larger NYSE firms. The factor that likely most influenced post-1975 leverage at broker-dealers was the elimination of fixed commissions, which led to a large expansion in the “proprietary trading” activities of broker-dealers. See Poser/Fanto BD Regulation at pages 1-20 to 1-23. Since the 1980 Release shows a significant decrease in the amount of subordinated debt as a percentage of total liabilities of broker-dealers, it appears qualifying subordinated debt serving as net capital did not replace equity to mitigate the increase in leverage. The Release shows (45 Federal Register at 69916) aggregate subordinated debt of $909 million out of $17.46 billion in total liabilities in 1974 versus $1.04 billion out of $71 billion in 1979.
32. ^ SEC Release 34-17208 (“Most broker-dealers utilize the basic method for complying with the net capital rule…all ten National Full Line firms elected the alternative capital approach” and while “only 44 of the 2,066 broker-dealers that conducted a public business as of December 31, 1979 and were not members of the NYSE used the alternative method” those “44 firms were, on average, substantially larger than the 2,022 firms using the basic method.” 45 Federal Register at 69917. These data are discussed in Markham/Hazen BD Law at page 4-19, which adds that by 1985 “approximately 90 percent of all customer funds in securities held by broker-dealers were covered by the alternate net capital method. Still about two-thirds of all broker-dealers used the basic capital method; they were mostly small firms.” It has long been recognized that large broker-dealers use the Alternative Method because they operate under the SEC customer asset segregation rules, which allows them to use the Alternative Method, and that method produces lower net capital requirements. See GAO Risk-Based Capital Report at 134. (“most commonly used by large broker-dealers because it can result in a lower net capital requirement than under the basic method”).
33. ^ As cited in note 7 above, the SEC stated Bear Stearns and the other CSE Brokers used the Alternative Method. This is confirmed by the descriptions of “Regulatory Requirements” contained in the Form 10-K Reports filed by the CSE Holding Companies before and after the 2004 net capital rule change. Links to the pre and post-2004 Form 10-K Reports for each of the five CSE Holding Companies supervised by the SEC are available at these links for Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley.
34. ^ Markham/Hazen BD Law § 4:5, especially at page 4-62, with fn. 15 describing cases of broker-dealers receiving SEC permission to return to the Basic Method from the Alternative Method because the Basic Methods lower minimum dollar net capital requirement became their effective requirement. Poser/Fanto BD Regulation at page 12-19 (“a broker-dealer that chooses to have its ratio requirement calculated under the alternative standard cannot take advantage of the lower minimum dollar requirement for an introducing firm or for a firm that does not hold customer’s funds or securities.”
35. ^ Markham/Hazen BD Law § 4:5 at page 4-60 (“The computation of aggregate debit items must be conducted on a weekly basis”, but explaining in footnote 5 that “A broker-dealer using the alternative method must remain in compliance between computation periods” under the NYSE rules). Poser/Fanto BD Regulation at 12-17 (describing the formula minimum as “2 percent of the aggregate debit items computed in accord with” the Rule 15c3-3 reserve formula). Deloitte, "Broker-Dealer Customer Protection Compliance", March, 2005 (“Deloitte Compliance Report”) ("By changing to the fully computing methodology for customer protection, minimum net capital required would be computed as the greater of 2% of aggregate debit items as derived from the Customer Reserve Formula or $250,000 (the Alternative Method). Not only would the broker-dealer no longer have to consider whether its liabilities need to be classified as Aggregate Indebtedness or not but for a firm with significant liabilities, the minimum net capital requirement may decrease dramatically.") The complexities of the customer reserve formula and Rule 15c3-3’s effects on Bear Stearns access to funds are discussed in Kate Kelly, Street Fighters (Portfolio 2009) at 29 (the segregated funds were known as “15c3-3 funds” which “to save time and effort” were “calculated only once a week.”) Street Fighter states at 29 the SEC said it might be able to waive a 48 hour waiting period for accessing excess customer funds in order to increase Bear’s liquidity.
36. ^ GAO Risk-Based Capital Report at 134, as cited in note 32 above, and Deloitte Compliance Report in note 35 above, for the lower net capital requirement under the Alternative Method. GAO Risk Based Capital Report at 59 (as referenced in note 55 below) for net capital levels over $1 billion among the large broker-dealers. Sirri Speech at page 4 (“the CSE broker-dealers…had been using a different financial ratio since the late 1970s”, where that different ratio is the Alternative Method). SEC Release 34-17208, as referenced in note 32 above, stated all ten “National Full Line firms” used the Alternative Method at the end of 1979.
37. ^ For the use of the term “exemption” see OIG CSE Report at v (“A broker-dealer becomes a CSE by applying to the Commission for an exemption from computing capital using the Commission’s standard net capital rule”) and 2 (which explains “By obtaining an exemption from the standard net capital rule, the CSE firms’ broker-dealers are permitted to compute net capital using an alternative method” that, in footnote 23, is described as “based on mathematical models and scenario testing.”) SEC Release 34-49830, 69 Federal Register 34428 (June 21, 2004) (“SEC Release 34-49830”) at 34428 (“a broker-dealer that maintains certain minimum levels of tentative net capital and net capital may apply to the Commission for a conditional exemption from the application of the standard net capital calculation” and “Under the alternative method, firms with strong internal risk management practice may utilize mathematical modeling methods already used to manage their own business risk, including value-at-risk (“VaR”) models and scenario analysis, for regulatory purposes.”
38. ^ Barry Ritholtz, Bailout Nation (Wiley 2009) (“Bailout Nation”) at 144 (“At the time [i.e. 2004], it was (ironically) called “the Bear Stearns rule.”)
39. ^ See Section 4.2 below.
40. ^ Labaton ’04 Rule Article (“The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later he left to become Treasury Secretary.”). Bailout Nation at 144 (“the five biggest investment banks—Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley—got their wish. Led by Goldman Sachs CEO Hank Paulson—the future Treasury Secretary/bailout king—the SEC acquiesced to grant them (and only them) a special exemption.”) Mr. Labaton does not assert that Paulson played any role in leading “the charge,” only that he was CEO of Goldman Sachs at the time. Bailout Nation does not cite any source for its statement Paulson “led.” The SEC’s website contains the comment letters received for SEC Release No. 34-48690, which proposed the 2004 rule change. It contains the comment letter filed for Goldman Sachs by David Viniar, then Chief Financial Officer, which lists Mark Holloway and Jay Ryan as the other Goldman contacts for the matter. The same webpage containing comments on SEC Release 34-48690 contains file memoranda from three different SEC staff members documenting meetings held by the SEC with industry members. The highest level meeting is documented by the March 10, 2004, Memorandum from Annette L. Nazareth, Director Division of Market Regulation, covering a January 15, 2004, meeting she, SEC Chairman Donaldson, and Patrick Von Bargen held with Philip Purcell, CEO of Morgan Stanley, and Stephen Crawford, the CFO. A December 19, 2003, Memorandum from Matthew J. Eichner, Assistant Director, Division of Market Regulation covers a meeting that day attended by Mr. Eichner and several other Division staff members below the Director level and numerous Merrill Lynch personnel, not including its then CEO Stan O’Neil. A January 6, 2004, Memorandum from Bonnie Gauch records a December 18, 2004, meeting among SEC staff and numerous industry firms including Goldman Sachs, which was represented by Mark Holloway and Steve Kessler.
41. ^ See note 56 below.
42. ^ GAO Consolidated Supervision Report at 15. Freshfields Bruckhaus Deringer, “Financial Conglomerates: the new EU requirements” (January 2004)
43. ^ Michael Gruson, “Supervision of Financial Conglomerates in the European Union” (June 23, 2004) (hereinafter “Gruson”)
44. ^ SEC Release No. 34-39456 (December 17, 1997) For a general description of the SEC’s lengthy involvement with the Basel Standards, see GAO Risk-Based Capital Report and GAO Report, “Financial Regulation: Industry Changes Prompt Need to Reconsider U.S. Regulatory Structure,” GAO-05-61, October 2004, at 102-103. For broker-dealers the most significant, and most controversial, element of the Basel Standards is the “market risk” standard promulgated in 1996.
45. ^ See Section 2.1 above (especially sources cited in note 13 above) and Gruson at 33.
46. ^ GAO Consolidated Supervision Report at 13.
47. ^ See GAO Consolidated Supervision Report at 13-14 and Gruson at 32-35. For the 2003 proposals, see SEC Release 34-48690 (the CSE proposal) and SEC Release 34-48694 (the SIBHC proposal). For the final 2004 rules see SEC Release 34-49830 (the CSE rule) and SEC Release 34-49831 (the SIBHC rule). To qualify for the CSE Program a broker-dealer needed to show it had “tentative net capital” (i.e. GAAP shareholders’ equity capital plus subordinated debt, minus “illiquid assets” such as fixtures, but not minus illiquid securities) of at least $5 billion. The alternative net capital computation method is specified in Appendix E to SEC Rule 15c3-1 (17 CFR 240.15c3-1e). Because the SIBHC Program was only available to investment bank holding companies that did not own any type of bank, the CSE Holding Companies that were not bank holding companies were ineligible for this program because of their ownership of “specialty banks” such as industrial banks. Lazard Ltd. was the only investment bank that became a “supervised investment bank holding company” under the SIBHC Program. Erik Sirri, “Testimony Concerning Turmoil in the Credit Markets: Examining the Regulation of Investment Banks by the Securities and Exchange Commission”, Testimony Before the Subcommittee on Securities, Insurance and Investment, United States Senate, May 7, 2008
48. ^ see SEC Release 34-49830, 69 Federal Register at 34456. Bank holding companies such as Citigroup and JP Morgan Chase were already subject to such consolidated supervision, so this was not an issue for them.
49. ^ GAO Consolidated Supervision Report at 22-25. Gruson at 32-35.
50. ^ GAO Consolidated Supervision Report at 12. OIG Bear Stearns CSE Report at iv. The SEC’s website maintains copies of the approvals of firms to become CSE Brokers and CSE Holding Companies. Bear’s order was effective November 30, 2005, Goldman’s March 23, 2005, Lehman’s, November 9, 2005, Merrill’s December 23, 2004, and Morgan’s July 28, 2005. Two commercial bank holding companies (Citigroup Inc. and JP Morgan Chase & Co.) were also approved for the CSE Program on August 11, 2006, for Citigroup Global Markets Inc., and on December 21, 2007, for JP Morgan Securities Inc.. Their consolidated supervision continued to be conducted by the Federal Reserve.
51. ^ The SEC orders authorizing individual firms to use the new method and their dates of issuance are in note 50 above. The Merrill Lynch 2004 Form 10-K Report states (at 16) that “effective January 1, 2005” its CSE Broker (Merrill Lynch Pierce Fenner & Smith Incorporated (MLPF&S)) would begin using the alternative method to compute capital charges. The Goldman Sachs May 27, 2005, Form 10-Q Report shows (at 33) its CSE Broker (Goldman Sachs & Co. (GS&Co.)) reporting its net capital compliance for the first time based on the alternative method, including the requirement to report to the SEC if its tentative net capital fell below $5 billion. Its earlier February 25, 2005 Form 10-Q Report had not included (at 32) a discussion of that requirement, which was only imposed by the 2004 rule change. The Bear Stearns 2005 Form 10-K Report states (at 17) that “effective December 1, 2005,” its CSE Broker (Bear Stearns & Co., Inc.) would begin using the alternative method for computing market and credit risk. The Lehman Brothers 2005 Form 10-K Report states (at 11) that “effective December 1, 2005,” its CSE Broker (Lehman Brothers Incorporated (LBI)) would begin using the alternative method for computing capital requirements. The Morgan Stanley 2005 Form 10-K Report states (at 11) that “effective December 1, 2005,” its CSE Broker (Morgan Stanley & Co. (MS&Co.)) would begin using the new method to calculate net capital charges for market and credit risk. Broker-dealers must be in compliance with the net capital rule every day (Makrham/Hazen BD Law § 4:5 at page 4-60) and must notify the SEC if they breach any of the SEC Rule 17a-11 “early warning” triggers. Markham/Hazen BD Law § 4:39. Before it began computing its net capital in accordance with the new method, each CSE Broker had a daily requirement to determine whether under the “standard” method of haircuts its net capital was at least 5% of aggregate customer debits, the “early warning” trigger for the Alternative Method. Ibid at page 4-178. Because of this on-going significance of net capital rule compliance, until the CSE Brokers began using the new method for computing compliance their operational activities would still be dictated by the old method. This means any effect the rule change had on leverage levels at the CSE Holding Companies through releases of capital from CSE Brokers would not have begun until long after April 2004 and, in the case of Bear Stearns, Lehman, and Morgan Stanley, not until the beginning of their 2006 fiscal years. By its terms the 2004 rule change became effective on August 20, 2004, 60 days after its publication in the Federal Register. SEC Release 34-49830, 69 Federal Register at 34428.
52. ^ See SEC Release 34-49830 at 69 Federal Register 34455-34456 and the discussion of the “early warning” requirement in note 8 above.
53. ^ Ibid. For the excess capital levels of broker-dealers see also note 55 below.
54. ^ Molinari/Kibler Financial Responsibility at 17, fn. 103.
55. ^ GAO Risk Based Capital Report at 58 and 136 (market participants “told us that the largest broker-dealers typically hold $1 billion or more in excess of their required capital levels because, among other reasons, their counterparties require it for conducting business with them.”). That Report shows (at 59) required net capital levels at the five large broker-dealers studied ranging from $73 million to $433 million and actual net capital levels from $1.047 billion to $2.249 billion. The three firms with required net capital of $400-433 million all had actual net capital of at least $1.77 billion. The two firms with less than that amount of net capital had required net capital levels of $125 million and $73 million with actual net capital of over $1 billion each. The GAO Financial Activities Report found (at 53) that as of June 1991 the thirteen broker-dealers in its study (which, as cited in note 31, included the 10 largest) held net capital ranging from highs of 12 or more times the required minimum to lows of roughly 4-5 times). More recent data from Form 10-K Reports for Bear Stearns and Lehman Brothers show reported required and actual net capital levels at their CSE Broker subsidiaries (i.e. Bear Stearns & Co. Inc. and Lehman Brother Inc) as follows: 2002: Bear $50 million required/$1.46 billion actual, Lehman $128 million required/$1.485 billion actual; 2003: Bear $40 million required/$2.04 billion actual, Lehman $180 million required/$2.033 billion actual; 2004: Bear $80 million required/$1.8 billion actual, Lehman $200 million required/$2.4 billion actual; 2005: Bear $90 million required/$1.27 billion actual, Lehman $300 million required/$2.1 billion actual; 2006: Bear $550 million required/$4.03 billion actual, Lehman $500 million required/$4.7 billion actual; 2007: Bear $550 million required/$3.6 billion actual, Lehman $ 600 million required/$ 2.7 billion actual. The information is in the Bear Stearns Form 10-K reports and Lehman Form 10-K Reports for 2002 through 2007. In each case the information is available by searching “Regulatory Requirements” or “net capital” in the Form 10-K Reports. In the case of Bear, exhibit 13 to each 10-K (the Annual Report) contains the information. For Lehman Exhibit 13 is only used for 2002 and 2003. In later years the information is in the full 10-K file.
56. ^ See SEC Release 34-49830, 69 Federal Register at 34431, and other sources cited in note 8 above.
57. ^ SEC Release 34-49830, 69 Federal Register at 34455 (“We estimated that a broker-dealer could reallocate capital to fund business activities for which the rate of return would be approximately 20 basis points (0.2%) higher”). The change could also lead to a decline in the quality of assets not shown on a GAAP financial statement. See, however, notes 58 and 59 below on this issue. See note 8 above for the importance of the $5 billion tentative net capital "early warning" trigger in preventing significant reductions in CSE Broker net capital.
58. ^ CRS Report for Congress, Bear Stearns:” Crisis and ‘Rescue’ for a Major Provider of Mortgage-Related Products” (Updated March 26, 2008). Timothy F. Geithner, “Testimony before the U.S. Senate Committee on Banking, Housing and Urban Affairs” (April 3, 2008) (the “Geithner Testimony”). While most speculation has assumed these were “toxic assets”, the Geithner Testimony asserted the FRBNY selected the assets, that all securities included were investment grade rated, and that individual loans (i.e. “whole loans”) included were all “performing.” While the estimation of the market value of these assets has dropped below $30 billion, as of December 31, 2008, this value was still estimated at $25.86 billion. See part 3 of Federal Reserve Statistical Release H.4.1 for February 5, 2009, listing Maiden Lane LLC net portfolio holdings. The November 5, 2009, H.4.1 shows that as of September 30, 2009, this value was estimated at $26.321 billion. The earliest description of the portfolio on the FRBNY website indicates that as of December 30, 2008, 80% of the market value of securities held by Maiden Lane LLC was in agency CMOs.
59. ^ SEC OIG, “SEC’s Oversight of Bear Stearns and Related Entities: Broker Dealer Risk Assessment Program,” Report No. 446-B (September 25, 2008). At 10 this Report states the Bear Stearns liquidity crisis occurred at the holding company level. Some or all of the securities funded by the FRBNY described in the Geithner Testimony may have been booked at the Bear Stearns CSE Broker as part of its proprietary trading book. Because the Geithner Testimony indicates the securities included in the portfolio were all investment grade rated, it appears they would have been subject to “haircuts” of between 2% and 9% (depending upon maturity) as investment grade rated debt securities under the pre-2004 traditional haircuts (see 17 CFR 240.15c3-1(c)(2)(vi)(F)(1) for eligible investment grade debt securities). Since the Maiden Lane LLC portfolio reports indicate 80% of the value of those securities was in agency CMOs it is possible the great majority of the securities would have been subject to the government agency haircuts under the traditional haircut rules in 17 CFR 240.15c3-1(c)(2)(vi)(A)(1), which range from 0% to 6%. These securities haircuts can be found on pages 316-317 (for government and agency securities) and 318-320 (for investment grade rated debt securities) of the 4-1-09 published version of Title 17, chapter II, of the Code of Federal Regulations. As cited in note 55 above, the last public report of the required year-end net capital of Bear’s CSE Broker was $550 million as of November 30, 2007. The Bear Stearns Form 10-Q Report for the period ending February 29, 2008, shows the same $550 million required net capital. The SEC [1] estimated the CSE Broker's required net capital was $560 million as of March 14, 2008, and that the CSE Broker had excess net capital of more than $2 billion. It is hard to see how the CSE Broker’s net capital could have been reduced below $560 million using the pre-2004 haircuts. For example, as described above, if any of the net capital consisted of the securities described in the Geithner Testimony, their maximum haircut under the pre-2004 traditional haircuts would have been 2%-9% as investment grade securities (depending on maturity) with perhaps a majority subject to the lower haircuts for agency securities. Under Appendix E to SEC Rule 15c3-1, the actual Bear haircuts would have been 3x the VaR then in effect for those securities following the preceding 2007-2008 volatility in mortgage backed securities.
60. ^ Financial Industry Regulatory Authority (“FINRA”) News Release, “FINRA Advises Customers on How to Safeguard Their Brokerage Accounts,” (September 15, 2008) (“While Lehman Brothers Holdings Inc. filed for protection under Chapter 11 of the bankruptcy laws this morning, the firm's U.S. regulated broker-dealer, Lehman Brothers, Inc., is still solvent and functioning. The broker-dealer has not filed for bankruptcy, and it is expected to close only after the orderly transfer of customer accounts to another registered and SIPC-insured broker-dealer.”). SIPC News Release, “SIPC Issues Statement on Lehman Brothers Inc: Liquidation Proceeding Now Anticipated,” (September 18, 2008) (“SIPC has decided that such action is appropriate for the protection of customers and to facilitate the transfer of customer accounts of LBI and an orderly unwinding of the business of the brokerage firm.”). Jack Herman and Yvette Shields, “Barclays to Acquire Lehman’s Broker-Dealer”, The Bond Buyer, (September 18, 2008) (“The acquisition includes trading assets valued at $72 billion and liabilities of $68 billion, with little mortgage exposure reported.”). Gibbons P.C., “The Stock Broker Liquidation of Lehman Brothers Inc”, (October 22, 2008) (“While it is expected that LBI had sufficient securities and cash to cover customer accounts, a customer will need to file a claim to resolve any discrepancy between what was transferred to Barclays or Neuberger Berman for his or her account and what should have been transferred.”).
61. ^ Andrew Ross Sorkin, “How the Fed Reached Out to Lehman”,New York Times, (December 16, 2008), at page B1 (“Mr. Paulson said Lehman had lacked the collateral for the government to backstop a deal between Lehman and Barclays. But then the Fed turned around and lent a Lehman subsidiary billions, based on the same collateral”). John Blakely, “Resolving Lehman’s $138B mystery loan”,Dealscape, (December 17, 2008) (“Under the agreement, which is typical for broker-dealers such as Lehman, J.P. Morgan reimburses Lehman’s ‘repo investors” that finance the brokerage’s securities trades overnight. Because securities do not usually change hands immediately, a clearing agent for these trades--such as J.P. Morgan--reimburses the overnight investors each morning.”). For J.P. Morgan’s explanation of the procedures, see “Statement of JP Morgan Chase Bank, N.A. In Support of Motion of Lehman Brothers Holding Inc. for Order, Pursuant to Section 105 of the Bankruptcy Code, Confirming Status of Clearing Advances”, September 16, 2008, docket item #31 in Chapter 11 Case No. 08-13555 (JMP), United States Bankruptcy Court Southern District of New York.
62. ^ William Cohan, “Three Days That Shook the World”,Fortune, (December 16, 2008)
63. ^ Stephen Labaton, “Agency’s ’04 Rule Let Banks Pile Up New Debt”, New York Times,October 3, 2008, page A1 (“The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.”).
64. ^ See “Leverage Ratios of Investment Banks Increased Significantly 2003-2007”, Source data for the graph in Leverage (finance). Leverage is there computed as debt to equity.
65. ^ OIG Bear Stearns CSE Report at page 120 of the full report. Leverage is there computed as assets to equity, so is 1 numeral higher than debt to equity. (i.e. assets equal debt plus equity, so a 15 to 1 debt to equity ratio equals a 16 to 1 asset to equity ratio).
66. ^ For Bear the “Selected Financial Data” in Exhibit 13 of the 1997 10-K shows leverage over the preceding 5 year period as: 1993: 31.3 to 1; 1994: 28.1 to 1; 1995: 28.8 to 1; 1996: 30.8 to 1; and 1997: 32.5 to 1, and of the 2002 10-K shows leverage as: 1998: 35.0 to 1; 1999: 30.1 to 1; 2000: 28.8 to 1; 2001: 32.0 to 1; and 2002: 28.0 to 1. For Lehman the “Selected Financial Data” in Exhibit 13.3 of the 1997 10-K shows leverage as: 1993: 38.2 to 1; 1994: 31.4 to 1; 1995: 30.2 to 1; 1996: 32.2 to 1; and 1997: 32.5 to 1 and in Exhibit 13.01 of the 2002 10-K shows leverage as: 1998: 27.4 to 1; 1999: 29.6 to 1; 2000: 27.9 to 1; 2001: 28.3 to 1; and 2002: 28.1 to 1. For Merrill the “Selected Financial Data” in Item 6 of the full 1997 10-K shows leverage as: 1993: 26.9 to 1; 1994: 27.1 to 1; 1995: 27.8 to 1; 1996: 29.9 to 1; and 1997: 34.2 to 1 and in Exhibit 13 of the 2002 10-K shows leverage as: 1998: 28.3 to 1; 1999: 24.2 to 1; 2000: 22.2 to 1; 2001: 20.8 to 1; and 2002: 18.6 to 1. For Morgan Stanley the “Selected Financial Data” in Exhibit 13.2 of the 1997 10-K shows leverage as: 1993: 20.8 to 1; 1994: 17.6 to 1; 1995: 17.2 to 1; 1996: 19.4 to 1; and 1997: 20.7 to 1 and in Item 6 of the 2002 10-K shows leverage as: 1998: 21.5 to 1; 1999: 20.6 to 1; 2000: 20.9 to 1; 2001: 22.3 to 1; and 2002: 23.2 to 1. Goldman Sachs only became a corporation in 1999. Financial information to 1995 is available in Goldman’s 1999 Form 10-K. Leverage before 1999 is computed as debt to partners’ equity rather than shareholders’ equity. For Goldman the “Selected Financial Data” in Item 6 of the 1999 10-K shows leverage as: 1995: 19.3 to 1; 1996: 27.5 to 1; and 1997: 28.1 to 1 and in Exhibit 13.4 of the 2002 10-K shows leverage as: 1998: 31.6 to 1; 1999: 23.5 to 1; 2000: 16.2 to 1; 2001: 16.1 to 1; and 2002: 17.7 to 1. The leverage reported for 1998 and 1999 was higher in the 1999 10-K, but the debt and asset figures were adjusted in the 2002 10-K. Leverage is here calculated as debt (i.e. total liabilities) to equity (i.e. shareholders’ equity). To find this leverage ratio, search for “Selected Financial Data” in each linked Form 10-K or exhibit to that Form. Only Goldman reports total liabilities separately in its Selected Financial Data. For the other CSE Holding Companies total liabilities have been computed as total assets minus shareholders’equity. The Form 10-K Reports for all five CSE Holding Companies describe, in the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” section, their approaches to leverage and highlight an adjusted asset to tangible net worth ratio that the rating agencies use. As an example of a CSE Holding Company’s approach to leverage, see page 56 of the Merrill Lynch & Co. Inc Form 10-K Report for 2007 (“As leverage ratios are not risk sensitive, we do not rely on them to measure capital adequacy. When we assess our capital adequacy, we consider more sophisticated measures that capture the risk profiles of the assets, the impact of hedging, off-balance sheet exposures, operational risk, regulatory capital requirements and other considerations.”) In its response to the OIG Bear Stearns CSE Report (at page 93 of the full Report) the SEC Division of Trading and Markets argued a GAAP balance sheet leverage ratio is “a crude measure, and implicitly assumes that every dollar of balance sheet involves the same risk, whether due to a treasury bond or an emerging market equity.” For an earlier discussion of the limitations of balance sheet leverage ratios and the importance of assessing “economic capital” see also Sherman J. Maisel, Risk and Capital Adequacy in Commercial Banks, (University of Chicago Press 1981).
67. ^ “Hedge funds, Leverage, and the Lessons of Long-Term Capital Management”, Report of the President’s Working Group on Financial Markets, April 1999, at 29 (“At year-end 1998, the five largest commercial bank holding companies had an average leverage ratio of nearly 14-to-1, while the five largest investment banks’ average ratio was 27-to-1.”). Frank Partnoy, Infectious greed: how deceit and risk corrupted the financial markets (H. Holt 2003 (First Owl books ed. 2004)) at 262 (“In many ways the top investment banks looked just like LTCM. They had an average debt-to-equity ratio of 27-to-1—exactly the same as LTCM’s”). Actually, page 29 of the PWG Report cited by Professor Partnoy for this information presents a slightly higher 28-to-1 leverage ratio for LTCM at the end of 1997 and does not present a year-end 1998 leverage ratio (which would have been after the “rescue” of LTCM). As Professor Partnoy noted, as he continued on page 262, the investment bank leverage ratio “did not include off-balance-sheet debt associated with derivatives—recall that swaps were not recorded as assets or liabilities—or additional borrowings that occurred within a quarter, before financial reports were due.”
68. ^ As explained in note 51 above, LBI became a CSE Broker effective December 1, 2005. Lehman’s last Form 10-K filed before it became a CSE Holding Company was for November 30, 2005. That report showed LBI’s shareholders’ equity as $3.788 billion. For the first two years in which Lehman was a CSE Holding Company the November 30 LBI shareholders’ equity was $4 billion and $4.446 billion. For the three fiscal year-end periods before November 30, 2005, LBI’s shareholders’ equity was reported as $3.281 billion at year-end 2004, $3.306 billion at year-end 2003, and $3.152 billion at year-end 2002. The Lehman Form 10-Ks for these years can be found at the link provided in note 55 above. The LBI reported shareholders’ equity can be found by searching “consolidating balance sheet” in the10-Ks for the years from 2003 through 2007. The 2003 10-K shows LBI’s shareholders’ equity for fiscal year-end 2003 and 2002. For years before 2002, the LBI shareholders’ equity can be found in LBI’s Form 10-Ks filed for its subordinated debt. Broker-dealers are required to file Form X-17A-5 FOCUS Report (i.e. Financial and Operational Combined Uniform Single Report) forms with the SEC showing their computation of net capital and compliance with the net capital rule, as referenced in note 25 above. These filings are only available in paper form from the SEC for the Bear, Merrill, and Morgan Stanley CSE Brokers. 17 CFR 240.17a-5(e)(3) provides that the financial information in Part II or Part IIA of such reports is publicly available. The filing information for those reports is available at these links: Bear Stearns, Merrill Lynch, and Morgan Stanley
69. ^ The fiscal year-end capital for 2005 was $4.536 billion and for 2006 was $4.686 billion. Goldman Sachs & Co. financial reports from 2004 through 2008. These reports show large subordinated debt for Goldman Sachs & Co. as does the Bank of America Securities LLC FOCUS Report referenced in note 30 above. Qualifying subordinated debt is overall an important component of broker-dealer net capital. Aside from showing increases in its equity capital after the 2004 rule change, Goldman Sachs & Co also shows an increase in subordinated debt from $12 billion at year-end 2004 to $18.25 billion at year-end 2007.
70. ^ See the Sirri Speech in note 8 above.

[edit] See also

• Paul S. Atkins
• Christopher Cox
• William H. Donaldson
• Economic crisis of 2008
• Financial crisis of 2007-2009
• Financial regulation
• Harvey Goldschmid
• Investment bank
• Leverage (finance)
• U.S. Securities and Exchange Commission