Wednesday, November 5, 2008

Securites - Decision of SEC Set Stage for Financial Crisis

In a meeting on April 28, 2004, the SEC made decisions that may have led to this fall's financial crisis. On that date the SEC considered a request from large investment banks seeking an exemption for their brokerage arms from an existing rule, known as the net capital rule, which limited their amount of debt. Under the net capital rule, the brokerages had to maintain billions in reserve to counter losses on their investments. Amending the rule would allow the companies to use those billions to invest in various new and exotic offerings including mortgage-backed securities and credit derivatives.

Under the new proposed rules the SEC could restrict the companies from engaging in excessively risky investments. The commission never undertook this regulatory activity. Instead, the SEC allowed the banks to use their own computer models to evaluate the risk of their investments. The ultimate result was that the banks' leverage ratios - borrowed funds compared to total assets - rose exponentially.

Without the new regulatory structure in use, the SEC did not or was not able to act on any warning signs of excessive investment risk. Moreover, the system of brokerage self regulation or contra party regulation utterly failed as the market did not impose its own self discipline on the parties. Ultimately, the financial crisis took place.

In late September the SEC ended the program of self regulation by the investment houses.

For a more in depth analysis, please see, "The Reckoning -Agency's '04 Rule Let Banks Pile Up New Debt, and Risk," October 3, 2008.

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