A Second Hand Conjecture

Continuing the discussion on tonight’s podcast, one of the recurring themes of much of the commentary on our current financial crisis is that the cause is too much deregulation. Possibly there is some truth to this, though the evidence is rather vague. The most disturbing figure in all this is Barney Frank.

“We need stricter standards on loans.”

Except, the problem here wasn’t lack of regulation, but that the regulations were not enforced, or fraud, by lenders, brokers and their clients. More laws doesn’t help. This was also a failure of long standing, not new. I would suggest simplifying and increased enforcement would be a better option.

“Restrict leverage”

Harder to say than do. Besides, the main institutions which took too much leverage were regulated (no matter how much Barney Frank and others try and obscure that fact.) Banks operate with leverage in the low double digits, but I have heard of no calls to restrict them to lower levels. So who does that leave? Well, in 2004 the SEC exempted five investment banks from the required 12-1 capital ratios, and no one else. Which five?

Goldman Sachs
Morgan Stanley
Merrill Lynch
Lehman Brothers
Bear Stearns

Two have ceased to exist, one has been merged into Bank of America, and the last two have have just become bank holding companies. Yep, it was just announced, Morgan and Goldman have become banks.

Back to that in a moment, first lets look at the relaxation of the net capital rule:

The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.

Making matters worse, according to Mr. Pickard, who helped write the original rule in 1975 as director of the SEC’s trading and markets division, is a move by the SEC this month to further erode the restraints on surviving broker-dealers by withdrawing requirements that they maintain a certain level of rating from the ratings agencies.

“They constructed a mechanism that simply didn’t work,” Mr. Pickard said. “The proof is in the pudding — three of the five broker-dealers have blown up.”

The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. It requires that firms value all of their tradable assets at market prices, and then it applies a haircut, or a discount, to account for the assets’ market risk. So equities, for example, have a haircut of 15%, while a 30-year Treasury bill, because it is less risky, has a 6% haircut.

The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower.

So what prompted this rule change?

In 2004, the European Union passed a rule allowing the SEC’s European counterpart to manage the risk both of broker dealers and their investment banking holding companies. In response, the SEC instituted a similar, voluntary program for broker dealers with capital of at least $5 billion, enabling the agency to oversee both the broker dealers and the holding companies.

This alternative approach, which all five broker-dealers that qualified — Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley — voluntarily joined, altered the way the SEC measured their capital. Using computerized models, 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. It also removed the method for applying haircuts, relying instead on another math-based model for calculating risk that led to a much smaller discount.

So much for the idea this issue is an American, unregulated, laissez faire model that has blown up and we should follow Europe’s lead. In fact, I recommend this link highly:

…the total liabilities of Deutsche Bank (leverage ratio over 50!) amount to around 2,000 billion euro, (more than Fannie Mai) or over 80 % of the GDP of Germany. This is simply too much for the Bundesbank or even the German state to contemplate, given that the German budget is bound by the rules of the Stability pact and the German government cannot order (unlike the US Treasury) its central bank to issue more currency. The total liabilities of Barclays of around 1,300 billion pounds (leverage ratio over 60!) surpasses Britain’s GDP. Fortis bank, which has been in the news recently, has a leverage ratio of “only” 33, but its liabilities are several times larger than the GDP of its home country (Belgium).

Part of the reason AIG was so important was because its insurance was being used to hide the true leverage of European banks which are far more leveraged than US banks, but used AIG’s guarantees as assets which masked that effect. Go ahead, read the whole thing.

This is not brain surgery. This is not an area where more regulation is needed, we just need to impose existing regulations across the board like we used to do, and pray that Europe doesn’t drag us down as they cannot deleverage without tanking their system.

The other area where ridiculous levels of leverage existed were, with the active and almost fanatical support of Barney Frank, the cases of Fannie and Freddie, which were leveraged 40-1 or more. Once again, there is no need for more regulation here, there was a need to shrink these monstrosities and remove their implicit government backing.

“Regulate hedge funds”

Uhh, hedge funds have done rather well in this environment. It isn’t hedge funds which have brought the financial system to its knees through their failure, it has been investment banks (Lehman, Bear) commercial banks (IndyMac, Washington Mutual)and Government Sponsored Entities (Fannie, Freddie being the largest.)

I chuckle every time I hear the activities of these groups being compared to “giant hedge funds.” What an insult to hedge funds, the majority of which use little to no leverage. Barney Frank keeps claiming that it is the unregulated sector which has gotten us in trouble, but it has been the least regulated which have done the best. Hedge funds don’t expect to be bailed out, and losses far smaller than a typical mutual fund has suffered (or heaven forbid, bank stocks) leads to massive redemptions by investors. The press sensationalizes that by calling it a “hedge fund blowup” but in fact it is the discipline and risk of sudden, uncompensated failure which keeps their leverage in check. Lose 15% in the hedge fund world and not only is your income cut drastically as performance fees disappear, but your assets flee. Lose 85% or more in the regulated world, like Washington Mutual, and the government is pulling out the stops to save you, and especially your creditors. Both hedge fund managers, and especially hedge fund investors, know the score. Lose money and you are on your own. This has led to losses on a far smaller scale than elsewhere, and in many cases out and out profits.

Bring Back Glass Steagall!

The most inane attack on financial deregulation is the constant drumbeat about the repeal of Glass-Steagall, which has the added appeal of being something you can pin on Phill Gramm. Unfortunately that simple rule change doesn’t help. It isn’t the large diversified commercial banks which have failed most spectacularly, it has been investment banks which lack the stability of banking deposits and banks too concentrated in particular lending markets. Exactly what has Glass Steagall’s supposed demise (and it really hasn’t changed that much anyway) contributed to this?

I can think of no way in which it is implicated at all, despite Kuttner, Krugman and Barney Frank’s heated, but unsupported, claims to the contrary. In fact, Glass-Steagall is now defacto dead anyway. The changes to Glass Steagall make it possible for Merrill to have merged with Bank of America and Bear Stearns to be acquired by JP Morgan. Barclays Bank now owns Lehman’s brokerage and Morgan Stanley and Goldman Sachs have just decided to turn themselves into bank holding companies:

Now, Goldman and Morgan Stanley, which have been the subject of merger speculation in recent weeks, can become direct competitors to larger firms like Citigroup, JPMorgan Chase and Bank of America. Those firms combine investment-banking operations with the larger capital cushions that come with retail deposits, giving them a stability that pure investment banks lack.

JPMorgan acquired Bear Stearns this spring in a fire sale brokered by the federal government, while Bank of America has agreed to buy Merrill Lynch for $50 billion. Barclays of Britain agreed to buy the core capital-markets business of Lehman Brothers out of bankruptcy late last week.

Announced without fanfare on Sunday night, the move signals the final end to the Glass-Steagall Act, the epochal legislation of 1933 that signaled a split between investment banks and retail banks. A law passed in 1999 repealed the earlier regulation, though Goldman and Morgan remained independent investment banks.

Morgan Stanley had sought other ways to bolster its capital, and had been in advanced talks with China’s sovereign wealth fund and others about raising as much as $30 billion, people briefed on the matter said Sunday night.

Actually, this is pretty sharp, and the kind of market based solution I far prefer to what the government is planning. They both need actual banking operations, and this opens up an opportunity:

By becoming bank holding companies, Goldman Sachs and Morgan Stanley gained some breathing room in the immediate term. But it likely lays the groundwork for additional deal making. Given the expected bank failures this year, it is possible Goldman and Morgan Stanley could seek to buy them cheaply in a “roll-up” strategy.

Prior to the move, federal regulations prohibited the two investment banks from pursuing such deals. Indeed, Morgan Stanley’s recent talks with Wachovia revolved around Wachovia buying Morgan Stanley.

Being a bank holding company would also give the two access to the discount window of the Federal Reserve. While they have had access to Fed lending facilities in recent months, regulators had planned to take away discount window access in January.

The regulation by the Federal Reserve brings a host of accounting rule changes that should benefit the two banks in the current environment.

Buying up failed banks? I certainly like that better than we taxpayers. Glass Steagall is dead, and this crisis has shown that we should be glad it is.

Tags: banks, Barney Frank, Bear Stearns, deregulation, Fannie Mae, finance, Freddie Mac, Glass-Steagall, Goldman Sachs, GSE, hedge funds, IndyMac, investment banks, Lehman Brothers, Morgan Stanley, Paul Krugman, regulation, Robert Kuttner

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