Wednesday, October 29, 2008
Leverage and Deleverage 10302008
The Impact of Leverage and De-leverage on Asset Price
The net capital rule created by the SEC in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1, and they must issue early warnings if they began approaching this limit, and were forced to stop trading if they exceeded it, so broker-dealers often kept their debt-to-net capital ratios much lower than 12-1. The rule allowed the SEC to oversee broker-dealers, and required firms to value all of their tradable assets at market prices. The rule applied a haircut, or a discount, to account for the assets’ market risk. Equities, for example, had a haircut of 15%, while a 30-year Treasury bill, because it is less risky, had a 6% haircut. But a 2004 SEC exemption -- given only to five big firms -- allowed them to lever up 30 and even 40 to 1.
The five big firms wanted for their brokerage units an exemption from the 1975 regulation that limited the amount of debt they could take on to $12 for every dollar of equity. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those equity 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, credit default swaps - a form of insurance for bond holders - and other exotic structured finance instruments
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. Ever since the Great Depression, the government has tried to limit the leverage available to the public in the US stock market by maintain margin requirements. But regulators, led by former chairman of the Federal Reserve Alan Greenspan, thought financial innovation would be hampered, and financial activity driven to unregulated market overseas, if there were any attempts to impose limits on leverage in the unregulated credit and capital markets. After all, innovation was viewed as the driving force in US prosperity. The global financial system embarked on a race to assume more risk under a mentality of “if I don’t smoke, somebody else will.”
This brave new approach, which all five qualifying broker-dealers - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley - voluntarily adopted, altered the way the SEC measured their capital. The five big firms led the charge for the net capital rule change to promote financial innovation, spearheaded by Goldman Sachs, then headed by Henry Paulson, who two years later, would leave Goldman to become the Treasury Secretary, who now has to deal with the global mess created by high leverage.
Using computerized models provided by the five big firms, the SEC, under its new Consolidated Supervised Entities (CSE) 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 computerized model for calculating risk that led to a much smaller discount.
The SEC justified the less stringent capital requirements by arguing it was now able to manage the consolidated entity of the broker-dealer and the holding company, which would ensure better management of risk. “The Commission’s 2004 rules strengthened oversight of the securities markets, because prior to their adoption there was no formal regulatory oversight, no liquidity requirements, and no capital requirements for investment bank holding companies,” a spokesman for the agency rationalized.
In loosening the capital rule, which was supposed to provide a buffer in turbulent times, the SEC also decided to rely on the five big firms’ own computer risk models, essentially outsourcing the job of monitoring risk to the banks it was supposed to supervise. Over subsequent years, all would take advantage of the looser capital rule to increase leverage.
It is now clear that the SEC leverage modification in 2004 is a primary reason for the massive losses that have occurred in 2008.
On Sept. 26, 2008, Chairman Cox announced a decision by the SEC Division of Trading and Markets to end the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation. Chairman Cox also described the agency’s plans for enhancing SEC oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on the recent Memorandum of Understanding (MOU) between the SEC and the Fed.
The net capital rule created by the SEC in 1975 required broker-dealers to limit their debt-to-net-capital ratio to 12-to-1, and they must issue early warnings if they began approaching this limit, and were forced to stop trading if they exceeded it, so broker-dealers often kept their debt-to-net capital ratios much lower than 12-1. The rule allowed the SEC to oversee broker-dealers, and required firms to value all of their tradable assets at market prices. The rule applied a haircut, or a discount, to account for the assets’ market risk. Equities, for example, had a haircut of 15%, while a 30-year Treasury bill, because it is less risky, had a 6% haircut. But a 2004 SEC exemption -- given only to five big firms -- allowed them to lever up 30 and even 40 to 1.
The five big firms wanted for their brokerage units an exemption from the 1975 regulation that limited the amount of debt they could take on to $12 for every dollar of equity. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those equity 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, credit default swaps - a form of insurance for bond holders - and other exotic structured finance instruments
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. Ever since the Great Depression, the government has tried to limit the leverage available to the public in the US stock market by maintain margin requirements. But regulators, led by former chairman of the Federal Reserve Alan Greenspan, thought financial innovation would be hampered, and financial activity driven to unregulated market overseas, if there were any attempts to impose limits on leverage in the unregulated credit and capital markets. After all, innovation was viewed as the driving force in US prosperity. The global financial system embarked on a race to assume more risk under a mentality of “if I don’t smoke, somebody else will.”
This brave new approach, which all five qualifying broker-dealers - Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley - voluntarily adopted, altered the way the SEC measured their capital. The five big firms led the charge for the net capital rule change to promote financial innovation, spearheaded by Goldman Sachs, then headed by Henry Paulson, who two years later, would leave Goldman to become the Treasury Secretary, who now has to deal with the global mess created by high leverage.
Using computerized models provided by the five big firms, the SEC, under its new Consolidated Supervised Entities (CSE) 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 computerized model for calculating risk that led to a much smaller discount.
The SEC justified the less stringent capital requirements by arguing it was now able to manage the consolidated entity of the broker-dealer and the holding company, which would ensure better management of risk. “The Commission’s 2004 rules strengthened oversight of the securities markets, because prior to their adoption there was no formal regulatory oversight, no liquidity requirements, and no capital requirements for investment bank holding companies,” a spokesman for the agency rationalized.
In loosening the capital rule, which was supposed to provide a buffer in turbulent times, the SEC also decided to rely on the five big firms’ own computer risk models, essentially outsourcing the job of monitoring risk to the banks it was supposed to supervise. Over subsequent years, all would take advantage of the looser capital rule to increase leverage.
It is now clear that the SEC leverage modification in 2004 is a primary reason for the massive losses that have occurred in 2008.
On Sept. 26, 2008, Chairman Cox announced a decision by the SEC Division of Trading and Markets to end the Consolidated Supervised Entities (CSE) program, created in 2004 as a way for global investment bank conglomerates that lack a supervisor under law to voluntarily submit to regulation. Chairman Cox also described the agency’s plans for enhancing SEC oversight of the broker-dealer subsidiaries of bank holding companies regulated by the Federal Reserve, based on the recent Memorandum of Understanding (MOU) between the SEC and the Fed.
Chairman Cox made the following statement along with the SEC announcement on ending the CSE:
The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act [on November 12, 1999 to repeal the Glass-Steagall Act of 1933 which had prohibited a bank from offering investment banking and insurance services], it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.
The last six months have made it abundantly clear that voluntary regulation does not work. When Congress passed the Gramm-Leach-Bliley Act [on November 12, 1999 to repeal the Glass-Steagall Act of 1933 which had prohibited a bank from offering investment banking and insurance services], it created a significant regulatory gap by failing to give to the SEC or any agency the authority to regulate large investment bank holding companies, like Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns.
Government Backing of Bank-issued debt will make all other forms of debt riskier and more expensive.
The government’s intervention has created a relative advantage for companies to raising funds through guaranteed bank paper versus the asset-backed markets. The ability of banks and other financial groups to raise money via government guarantees means funding through more traditional routes like asset-backed securities will be much more expensive. In the short-term, the government moves is having an effect. There has not been any issuance in credit cards because all the major banks now have another, cheaper option. In addition to offering banks cheaper sources of funding, the explicit government guarantees on many bank securities has led to a sell-off in bonds issued by mortgage financiers like Fannie Mae and Freddie Mac, as well as asset-backed securities. As a result, the cost of borrowing in asset-backed markets has soared, with the premiums over US government bonds at record highs. This makes private sector funding even less attractive.
# posted by MobyGrape : 12:26 PM
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