Today, the House Oversight Committee held a hearing on the causes and effects of the failure of Lehman Brothers, the investment bank that filed for bankruptcy on September 15. This is the first of five hearings aimed at unraveling the causes of the current financial crisis.
The report goes on to discuss the net-capital rule, which is a regulation limiting the amount of debt that financial institutions are allowed to take on. In the report, House Republicans argue that there should be no such rule, because bankers will just “find ways around” it:
Banking regulations require financial institutions to limit their asset risk per unit of capital, but writing regulations that simply mandate an appropriate level is unlikely to work for very long because it is in the interest of bankers to find ways around these requirements in pursuit of profit.
However, the report completely fails to note that financial institutions carrying huge debt-to-capital ratios contributed to the recent meltdown. Furthermore, it was the Bush administration, through the auspices of the Securities and Exchange Commission, that actively relaxed the debt-to-capital regulation.
In 2004, the SEC loosened the rule mandating “that broker dealers limit their debt-to-net capital ratio to 12-to-1.” The five investment banks that qualified for an alternative rule – Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley – were allowed “to increase their debt-to-net capital ratios, sometimes, as in the case of Merrill Lynch, to as high as 40-to-1.”
According to the New York Times, the investment banks themselves lobbied for the rule change, because it would “unshackle billions of dollars held in reserve as a cushion against losses on their investments.” However, when the subprime mortgage bubble burst, the investment firms no longer had enough cash on hand “to weather the storm.”
Chairman of the Oversight Committee, Rep. Henry Waxman (D-CA), said this lax regulation “proved to be a temptation” that the investment firms “could not resist,” but “when asset values decline — as the subprime market did — leverage rapidly consumes a company’s capital and jeopardizes its survival.
Barry Ritholz wrote that the SEC exemption is “in large part responsible for the huge build up in financial sector leverage over the past 4 years — as well as the massive current unwind“:
The current excess leverage now unwinding was the result of a purposeful SEC exemption given to five firms. You read that right — the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules.
So bankers don’t really need to “find ways around” regulations, when the Bush administration is willing to knock the regulations out of the way.