What Did the SEC Really Do in 2004?

By James Kwak

Andrew Lo’s review of twenty-one financial crisis books has been getting a fair amount of attention, including a recent mention in The Economist. Simply reading twenty-one books about the financial crisis is a demonstration of stamina that exceeds mine. I should also say at this point that I have no arguments with Lo’s description of 13 Bankers.

Lo’s main point, which he makes near the end of his article, is that it is important to get the facts straight. Too often people accept and repeat other people’s assertions—especially when they are published in reputable sources, and especially especially when those assertions back up their preexisting beliefs. This is a sentiment with which I could not agree more. One of the things I was struck by when writing 13 Bankers was learning that nonfiction books are not routinely fact-checked (Simon and I hire and pay for fact-checkers ourselves). As technology and the Internet produce a vast increase in the amount of writing on any particular subject, the base of actual facts on which all that writing rests remains the same (or even diminishes, as newspapers cut back on their staffs of journalists).

I’m not entirely convinced by Lo’s example, however. He focuses on a 2004 rule change by the SEC. According to Lo, in 2008, Lee Pickard claimed that “a rule change by the SEC in 2004 allowed broker-dealers to greatly increase their leverage, contributing to the financial crisis” (p. 33). That is Lo’s summary, not Pickard’s original. This claim was picked up by other outlets, notably The New York Times, and combined with the observation that investment bank leverage ratios increased from 2004 to 2007, leading to the belief that the SEC’s rule change was a crucial factor behind the fragility of the financial system and hence the crisis.

Not so fast, Lo says (pp. 34–35):

While these “facts” seemed straightforward enough, it turns out that the 2004 SEC amendment to Rule 15c3–1 did nothing to change the leverage restrictions of these financial institutions. In a speech given by the SEC’s director of the Division of Markets and Trading on April 9, 2009 (Sirri, 2009), Dr. Erik Sirri stated clearly and unequivocally that “First, and most importantly, the Commission did not undo any leverage restrictions in 2004”. . . .

[T]wo aspects of this story are especially noteworthy: (1) the misunderstanding seems to have originated with Mr. Pickard, a former senior SEC official who held the very same position from 1973 to 1977 as Dr. Sirri did from 2006 to 2009, and who was directly involved in drafting parts of the original version of Rule 15c3–1; and (2) the mistake was quoted as fact by a number of well known legal scholars, economists, and top policy advisors.*

However, the statement that “the Commission did not undo any leverage restrictions in 2004″ is true only in a very narrow sense. Lo is correct that the allowable leverage ratio did not change. He is also correct that the real issue for broker-dealer firms is not a traditional leverage ratio (assets to equity), but net capital (a measure of financial position). But the rule did change the way that broker-dealers were allowed to calculate their net capital; in other words, it changed the way you calculate the denominator. In fact, Sirri concedes this (quoted in Lo, p. 34, note 26.):

The net capital rule requires a broker-dealer to undertake two calculations: (1) a computation of the minimum amount of net capital the broker-dealer must maintain; and (2) a computation of the actual amount of net capital held by the broker-dealer. The ‘12-to-1’ restriction is part of the first computation and it was not changed by the 2004 amendments. The greatest changes effected by the 2004 amendments were to the second computation of actual net capital.

You can read the rule (and I did, while writing 13 Bankers): the SEC rule change is at SEC release 34-49830, and the current rules are here. In particular, Rule 15c3-1(c)(2) defines net capital as “net worth” subject to various adjustments. Paragraph 15c3-1(c)(2)(vi) says that you have to take deductions (“haircuts”) for different types of securities; conceptually, it’s like the risk weightings for Basel capital adequacy ratios.

The 2004 rule change said that certain broker-dealers could stop using the haircuts in 15c3-1(c)(2)(vi) and, instead, could use their own internal mathematical models to calculate haircuts, according to the rules in what is now Appendix E to Rule 15c3-1. The Summary to the rule change (p. 34428) says, “This alternative method permits a broker-dealer to use mathematical models to calculate net capital requirements for market and derivatives-related credit risk.”

And the whole purpose of the rule was to allow broker-dealers to take smaller deductions when calculating net capital. It’s also in the Summary (p. 34428):

These amendments are intended to reduce regulatory costs for broker- dealers by allowing very highly capitalized firms that have developed robust internal risk management practices to use those risk management practices, such as mathematical risk measurement models, for regulatory purposes. A broker-dealer’s deductions for market and credit risk probably will be lower under the alternative method of computing net capital than under the standard net capital rule.

(We quoted the first sentence of that passage as the epigraph for chapter 5 of 13 Bankers). How much smaller? Well, the SEC worked that out, too, when estimating the “benefits” of the rule change (p. 34455):

A major benefit for the broker-dealer will be lower deductions from net capital for market and credit risk that we expect will result from the use of the alternative method. . . . In the Proposing Release, we estimated that broker-dealers taking advantage of the alternative capital computation would realize an average reduction in capital deductions of approximately 40%. 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.

In summary, a broker-dealer could increase its net capital, for the same portfolio of assets and liabilities, by switching to the new calculation method. Since it now had excess net capital in the broker-dealer business, its holding company could transfer capital out of the broker-dealer and into other businesses. So without raising more capital, it could now expand its operations in those other businesses, and hence its balance sheet.

How much did this rule change contribute to rising leverage ratios between 2004 and 2007? I don’t know; perhaps not that much. In any case, while high leverage contributed to the fragility of the big investment banks and hence the fragility of the financial system, the banks could also have done plenty of damage to the world without high leverage—simply by manufacturing toxic securities and selling all of them to investors (instead of eating their own dog food, as Citi and Merrill notably did). So I would not argue that the SEC rule change caused the financial crisis all on its own. But I also would not say that the rule change did not affect leverage at all.**

Now let’s go back to the “mistake” that people allegedly made describing this rule change. This is what Pickard said, as quoted by Lo (p. 33, emphasis added by me):

[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.

I’m not sure there’s a mistake here, except perhaps for the word “substantially,” since I don’t know how big an impact this rule change had. There might be one, but I don’t see it.

Now, it’s entirely possible that other people picked up the story, repeated it, and added their own errors. It’s also possible that the rule change has been blown entirely out of proportion. That’s one of Lo’s arguments (pp. 34–35): leverage was as high in 1998 as in 2007, so what’s the big deal? That’s the essence of this chart from the Economist article:

But two things stand out for me here. One is that leverage did go up after 2004 for every bank. Second, 1998 was when we had the LTCM crisis, so for me a return to 1998 leverage levels is bad—not a justification for 2007 levels.

Still,  at the end of the day, we have correlation without causation: the rule change very well might have contributed to higher leverage, but we can’t tell how much. It was certainly not the sole cause of the financial crisis. But if I were looking for a clear factual “mistake” that got picked up and circulated by the press and academics, I would not have chosen this one.

* I should point out here that Lo does not include Simon and me among the people quoting this “mistake.” We did refer to the SEC rule change—probably because we referred to it (correctly) as a change in the way net capital was calculated, not an increase in the allowable leverage ratio. So I have no dog in this fight.

** On p. 34, note 26, Lo says, following Sirri, that the 2004 rule change was mainly about increasing regulatory supervision: “By subjecting themselves to broader regulatory supervision—becoming designated “Consolidated Supervised Entities” or CSEs—these U.S. firms would be on a more equal footing with comparable European firms.” Lo quotes Sirri saying that the rule change added “an additional layer of supervision.” We all know how that ended up—with the SEC’s Inspector General calling the CSE program a complete failure—although that’s neither here nor there for this blog post.

14 responses to “What Did the SEC Really Do in 2004?

  1. Huh? 38 pages and all we get are a bunch of quick summaries, some hardly-backed up assertions that generalize from the fact that the authors thinks them insufficiently defended in the analyzed books to cover all explanations so far, a bunch of self-congratulatory pats on the back (it’s not at all strange that the crisis is still little-understood, since it’s so darned complex), and then a minimal attempt at substantive criticism of the accounts provided in the last two pages; which, however, amounts to little more than a ‘hey look this effect that is suggested to be law-like by critics is in fact not law-like, so it cannot have been relevant at all.’
    What a let-down.

  2. Apologies for my own grammatical incompetence.
    At the beginning of the paper (1-2), Lo provides three propositions that he suggests are pushed, but inadequately defended, by the authors of the books he has reviewed. Yet he says nothing definitive to prove that they are indeed incorrect in holding those propositions.
    Luckily, I don’t even understand why he thinks his disproof of the first proposition works. It seems fairly clear, though, that he hasn’t read Yves Smith’s Econned, or Steve Keen’s Debunking Economics, and that he has no intention of doing so.
    With regard to the second proposition, all he does by way of a disproof is to provide a non sequitur, by implicitly arguing that the fact that some CEOs lost out some of their own money towards the beginning of the crisis proves that they didn’t make that money by gambling with other people’s money while the crisis was still developing. Moreover, he seems to believe that there is a causal relationship between ‘investing’ your own money and engaging in risk-averse behavior (hasn’t he got any gamblers in his circle of friends?), and that economic actors are always acting rationally (please).
    As for the third proposition: its ‘refutation’ is problematic for a different reason, namely because the author doesn’t seem to appreciate that highly interconnected systems can be more unstable even if the individual actors are slightly less leveraged. Having said that, the measure of leverage he uses as far as I can tell simply ignores off-balance-sheet items, as well as the whole shadow banking system, so I’m really not sure what the author hoped to accomplish by writing this article (well, except to up his publication count).

    In all, though, i get the distinct feeling that he’s picked the books to review for very specific reasons (namely because he doesn’t feel threatened by the accounts presented in them); and that his main interest is to simply score points for mainstream economic theory, by trying to convince his readers that there aren’t accounts out there yet that “really” get at the “fundamental” issues.

  3. Bruce E. Woych

    Burden of proof…defies gravity.

  4. April 28, 2004… that´s the day the SEC basically delegated its functions to the Basel Committee


  5. I think this post is a pretty good post, and I’m a little surprised it hasn’t gathered more comments.

    There are many things that strike me as very twisted about this discussion (not the post specifically, but the way these conversations are conducted in general). The way finance and accounting language, definitions or words have been mangled over the last at least 13 years shows how effective big banker propaganda has been. CNBC anchors have contributed to this murder of finance and accounting language in a major way and passed it on to their breast ogling, Caruso Cabrera slobbering audience. It’s not enough I have to listen to Joe Kernen’s non-indicated political commentary in the middle of the “business news”. These idiots also have to murder finance language.

    My specific point of contention here comes in Mr. Kwak’s third quotation block, the “Summary” of the rule change. Which I guess was written by some Jacka.s.s. Republican like Phil Gramm or some broker/dealer lapdog such as Mary L. Schapiro.

    “These amendments are intended to reduce regulatory COSTS for broker- dealers by allowing very highly capitalized firms that have developed robust internal risk management practices to use those risk management practices, such as mathematical risk measurement models, for regulatory purposes.”

    Let me decipher this heapload of Elephant CRAP for those of you who have been listening to the likes of Joe Kernen and David Faber give their political ramblings in the guise of “business news” over the years.

    Disallowing banks from taking excessive risks with customer accounts is NOT a “cost” of doing business.

    “INTERNAL” risk management practices are in fact nothing of the kind. They are “INTERNAL” rationalizations for taking extreme risks with other people’s money.

    Let me explain to those who slobber over Caruso-Cabrera before going braindead listening to Joe Kernen what an “INTERNAL” risk management model is. It goes something like this at a broker/dealer of some place such as Bear Stearns, AIG, LTCM. Trader Tom talking to Trading Floor Manager Phil:

    Trader Tom:“Uuuuh I don’t think it’s risky if we take Customers’ money and put it into garbage investments that have been rehypothecated 30+ times, do you Phil??”

    Trading Floor Manager Phil: “F*CK NO!!!! Stupid question. Just make some Bullcrap ‘INTERNAL’ risk measurement model we can show the public after we lost their money”

    Trader Tom: “Yeah, what the hell was I thinking to even ask that??”

    Trading Floor Manager Phil: “Don’t worry, it’ll be our secret. Just have that ‘INTERNAL’ risk measurement model on my desk later today and you and I will hereafter refer to that question as your ‘INTERNAL’ [Phil uses hands to indicate quotations around internal, with a big grin] ‘brainfart’ “.

    Trader Tom: You rock dude.

  6. Off topic question: Does anyone remember when Dean Shepherd and Sue Herera co-anchored CNBC and they had folks like Hillary Johnson scooping merger deals etc??? You know, like when CNBC was actually useful and gave a crap???
    Flashback: http://appliedbrainpower.net/pdf/cnb.pdf
    I mean, when was the exact point it was decided a pack of degenerates whoring options trading and using slide rulers to indicate future market prices was more useful for business news TV ratings???

    Just asking…..

  7. Here is a video which discusses Mitt Romney’s past, that Romney is trying very hard to hide. Unfortunately for Romney, those American workers who were fired and kicked to the curb are still around to talk. This has gotten notice from media such as BBC. Worth your time if you’re voting soon in the Republican primaries.

  8. Amen Moses!, and thanks for the insight.
    Am on the Joe K’s shut-the-hell-up-you-smug-b-tard bandwagon. Being a shill is nothing new for CNBC, but Joe’s act is so blatant is does cause heeves.
    Do love how he throws his kid into the mix just to show that the ruling class have families, and are just like you and me…Except he goes on private-payolla golf junkets, has his skis waxed at Davos, and has an unobstructed propaganda platform to spew.

  9. @Moses – “….These amendments are intended to reduce regulatory COSTS for broker- dealers by allowing very highly capitalized firms that have developed robust internal risk management practices to use those risk management practices, such as mathematical risk measurement models, for regulatory purposes.”

    Let me decipher this heapload of Elephant CRAP for those of you who have been listening to the likes of Joe Kernen and David Faber give their political ramblings in the guise of “business news” over the years….”

    So I guess the question is not the right question….basically the SEC approves “mathematical risk measurement models” that rationalize how investors are given approval to go ahead and take extreme risks with other people’s $$$$ – “slam dunk” wars, for instance…

  10. There is a revolving door between the regulatory authorities (like the SEC) and wall street so no one should be the least bit surprised when we get questionable actions from the likes of the SEC. And please be mindful that the head of an agency doesn’t have to come from wall street for it to to be controlled by wall street. All it takes is a couple of key staffers.

  11. “A euro break-up could be a 7 standard deviation event. A 6.5 standard deviation event occurs once every 34 million years, while a 50 percent fall in the Eurostoxx would be a 21 standard deviation event. This just highlights the flaws in a standard statistical approach.”

    This is pretty heady risk management? Huh!

  12. @weeklyoptions “be mindful that the head of an agency doesn’t have to come from wall street for it to to be controlled by wall street. All it takes is a couple of key staffers.”

    That is precisely one of the main sources of problems. Bank regulations need to be so easy that any chief regulator and any CEO of a bank understand them without the need of staffers.

  13. As a former SEC employee who had nothing to do with this issue, let me share my basic understanding of what happened in 2004 and otherwise. It appears that the revisions to the net capital rules did allow larger firms to increase leverage, albeit modestly, in their broker-dealer subsidiaries. These broker-dealer subsidiaries were the only part of the firms (absent an investment advisor or investment company subsidiary – which most firms had, but they were not part of the problem) the SEC regulated. The huge increase in leverage occurred at the unregulated (but purportedly reported and never reviewed) holding company level. While the SEC constructively knew of this, assuming the unreviewed documents submitted be the holding companies were accurate, but the fact is that the SEC had no jurisdiction to regulate the holding companies. Does anyone really think the Congress, between 2004 and and 2008 would have taken any action had the SEC discovered and reported the alarming levels of leverage at the holding companies? Of course not! Does anyone think the Fed would have acted (or will act in the future, when history is repeated)? The problem is much larger than the SEC in 2004. The real problem is that no one in government is prepared to prevent history from repeating. Most regulators, especially bank regulators, will give banks the benefit of every doubt if bank management insists it has a plan to resolve such problems.