Two articles worth reading on the 2004 change in net capital rules for investment banks are highlighted in today’s links. I think these two articles capture the latest thinking on how regulatory changes helped to shift portfolio preferences or leverage amongst investment banks leading up to the crisis. What’s interesting about the crisis is that it was not necessarily a crisis of Glass-Steagall deregulation i.e. caused by the repeal of Glass-Steagall. After all, the biggest casualties were the broker-dealers. What we did see was an orgy of mortgage financing and this financing was centered not just on the books of traditional lending originators i.e. the banks but in great measure at the broker dealers, Bear Stearns, Lehman Brothers, and Merrill Lynch and to a lesser degree Goldman Sachs and Morgan Stanley to be specific.
I think John Carney’s article captures some of the elements driving this. He writes:
So guess what happened when the SEC decided to supervise the Wall Street CSEs using the same Basel criteria beginning in 2004? The Wall Street firms dramatically increased their exposure to the very same kinds of loans that the commercial banks had been gobbling up.
[…]
What the 2004 amendments accomplished, then, was not a dramatic unleashing of leverage but a reorientation of the balance sheets of the Wall Street investment banks toward mortgage-backed securities. Instead of “originating to distribute,” the investment banks now had a regulatory incentive to hold mortgage-securities instead of other assets.
[…]
It’s easy to see what happened once both amendments were in place. Investment banks now could collateralize securities borrowings with an asset type that received favorable capital treatment. It’s a recipe for insatiable craving for mortgage-backed securities.
The rotation of the entire financial world toward mortgage risk was accompanied by well-meaning if misguided regulatory changes. In retrospect, it seems unwise to have put in place rules that tended to homogenize the balance sheets of our commercial banks and our investment banks. The financial crisis would not have been anywhere near as severe if different supervisory rules had encouraged different types of investment banks to adopt different strategies. But at the time, this homogenization was regarded as a feature and not a bug.
In short, the regulatory changes in the US incented banks and investment banks alike to load up on AAA-rated mortgage backed securities, exactly the toxic sort of securities which caused the greatest losses during the bust. What I would like to see is more commentary on why companies like UBS also loaded up on these securities. Basel rules seem to have been a factor, one reason that peripheral debt has now become a thorn in the side of euro zone banks. What I believe happened is that the Basel II capital requirements shifted portfolio preferences toward higher rated and nominally AAA securities that carried higher coupons but greater hidden risk. And eventually we came to see that the capital requirements mandated to compensate for the risk in these securities were wholly inadequate, both for US mortgage backed securities as well as for euro zone peripheral bonds.
That’s it. Here are the links.
Legend has it that a 2004 change to a rule governing capital adequacy at Wall Street firms allowed broker-dealers to double their leverage, making them highly fragile and likely to fail in a crisis. As McLean explains, this explanation never made all that much sense and has always been fairly easy to disprove. But I’m not sure that we should really let the Securities and Exchange Commission off the hook. As it turns out, it is very likely that the 2004 changes actually did contribute to the financial crisis-albeit in a very different way than the people cited in McLean’s article wrongly suspect.
U.S. government finances might look Zimbabwe-esque, but a look back at some of history’s worst hyperinflation episodes show why goldbugs’ fears are completely unfounded now.
I argue that everyone who says this is wrong and that the politicians have put the rights of stockholders above those of the tax payer. I will also prove that we can indeed write down mountains of debt, without the tax payer having to pay anything.
Look at the historical leverage of the big five investment banks – Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley. The Government Accountability Office did just this in a July 2009 report and noted that three of the five firms had leverage ratios of 28 to 1 or greater at fiscal year-end 1998, which not only is a lot higher than 12 to 1 but also was higher than their leverage ratios at the end of 2006. So if leverage was higher before the rule change than it ever was afterward, how could the 2004 rule change have resulted in previously impermissible leverage?
If wealth is relative, so is thrift.