The Kudlow show on CNBC tonight discussed that now infamous decision by the SEC in 2004 that allowed investment banks to increase their leverage to previously unheard of levels, a move that soon proved fatal to them. Letting investment banks do this was one of the factors that precipitated the financial meltdown of 2008. The trigger for the discussion today was an article published at the Real Clear Markets web site yesterday by Vanessa Drucker titled “The SEC Killed Wall Street On April 28, 2004. She wrote (link):
In the long run, when we are all dead [a humorous nod to Keynes’s most famous quip], historians will be debating the root causes behind the global financial meltdown of 2008…. Among the precipitating factors, toxic mortgage debt securities grossly inflated banks’ balance sheets and investors’ portfolios. Credit rating agencies blessed those assets’ illusory values. Real estate tumbled in a vicious downward spiral, while steep oil prices helped reverse the business cycle. Inadequate regulation, in America and elsewhere, clearly exacerbated all the other drivers. Specifically, when regulators permitted major American investment banks to take on more leverage, they “made the dollar amounts larger and the margin of safety less”…. While regulatory frameworks often take decades to build, in this unusual case, one particular afternoon, on April 28, 2004, drastically changed the equation. The SEC [chaired by William Donaldson] agreed to allow the five major American investment banks to compute their capital adequacy requirements according to a revised methodology, hugely increasing their leverage. In consequence, those five giants no longer exist in their former incarnations.
On Kudlow’s show, Ms. Drucker commented further:
It’s very remarkable that in such a short time the seeds were sown for bringing down the big five [investment] banks. It essentially came down to changing the rules for leverage. Up until 2004, the [investment] banks were very restricted as to the amount of leverage that they could use. They could only go to 15%. What the SEC agreed to on that fateful afternoon was to really take away the ceiling so they [the investment banks] could lever up as far as they wanted, and they did. So you saw Bear Sterns, for example, going to 33% and you saw Merrill Lynch going to 40%. And what did the leverage do? It essentially amplified whatever was going on. KUDLOW: They [the SEC] basically took away the supervision of Wall Street. DRUCKER: Yes. It was a kind of deregulation.
Critics of the Bush administration, as Drucker seems to be in her article, lay part of the blame for the financial meltdown on inadequate regulatory supervision of Wall Street. Yes, that seems to have been a factor. In her article, though, Drucker omits some major drivers of the crisis like Democrat-led government pressure on banks to loan money to high-risk borrowers. All of this notwithstanding, I think that the root cause of this part of the mess occurred not too many years earlier when the large investment banks went public. No longer partnerships which took risks with their own money, the new public companies were filled with rich senior bosses who played with other people’s money. That was the first and fateful step. As partnerships they needed little regulation because they were naturally very cautious and conservative when the partners were risking their own money. But once public companies, the multimillionaire bosses of the investment banks could well decide to gamble with other people’s money, figuring if the risky bets went north they would become billionaires, but if they went south the public companies would fail, but they, the bosses, would still have their own millions socked away. The investment banking firms lasted a hundred years as partnerships, but as public companies they soon took unprecedented, reckless risks, to the great detriment of shareholders, yes, but much much more importantly, to the great detriment of our economy. That’s the real lesson here. With no real skin in the game, the already multi-millionaire bosses of the investment banks took insane risks with “other people’s money” that went south. And now while the former bosses lie comfortably ensconced in their estates and on their yachts, the rest of us lie gravely wounded.
Richard R Balsamo
