5.Homeownership preservation: The Treasury said that when
it purchases mortgages and mortgage-backed securities it will look for every
opportunity possible to help homeowners. This goal is consistent with other
programs - such as Hope Now - aimed at working with borrowers, counselors and
servicers to keep people in their homes. In this case, the Treasury is working
with the Department of Housing and Urban Development to maximize these
opportunities to help as many homeowners as possible while also protecting
taxpayers.
Yet none of the government programs launched so far has been effective in
helping homeowners because ready opportunities to help them have not been
found. The bottom line is that it is not possible to help distressed homeowners
and protect taxpayer
money at the same time.
6.Executive compensation: The law sets out important
requirements regarding executive compensation for firms that participate in the
TARP. This team is working hard to define the requirements for financial
institutions to participate in three possible scenarios: One, an auction
purchase of troubled assets; two, a broad equity or direct purchase program;
and three, a case of an intervention to prevent the impending failure of a
systemically significant institution.
Management would opt for bankruptcy protection if executive compensation should
be more liberal under bankruptcy than participation in the TARP. Also, the
interconnected nature of financial markets nowadays has produced a large number
of "systemically significant institutions".
7.Compliance: The law establishes important oversight and
compliance structures, including establishing an Oversight Board, on-site
participation of the General Accounting Office and the creation of a Special
Inspector General, with thorough reporting requirements. The Treasury said it
welcomes this oversight and has a team focused on making sure it gets it right.
Asset price, leverage and de-leverage
The accumulation of assets via massive amounts of debt is known in finance as
leverage, expressed as debt-equity ratio. Leveraging can push up the price of
assets so acquired and de-leveraging can push down the price of such assets.
A broker-dealer trades securities for customers as well as for proprietary
accounts. In US markets, a broker-dealer must register with the Financial
Industry Regulatory Authority, a self-regulating organization under the
Security Exchange Act of 1934 as part of the New Deal. When executing trade
orders on behalf of a customer, the institution is said to be acting as a
broker. When executing trades for its own account, the institution is said to
be acting as a dealer.
Many broker-dealers had been routinely leveraged to over 30 times during the
credit bubble released by the Fed under Alan Greenspan. Firms are now
frantically trying to bring leverage down to below 20 times, still twice as
high as what was considered prudent by the SEC since 1975 until the net capital
rule was exempted for five major institutions in 2004.
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. They had to 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 maintaining margin
requirements. But regulators, led by Alan Greenspan when Fed chairman, 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 change in the net capital rule 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 and 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.
The leverage ratio - a measurement of how much the companies were borrowing
compared to their total assets - rose sharply at Bear Stearns, to 33 to 1. In
other words, for every dollar in equity, it had $33 of debt. The ratio at the
other firms also rose significantly. This advantage enabled the Big Five to go
on a frenzy of acquisitions, expanding risk to the entire financial system. The
abuse of leverage was particularly severe in the hedge-fund industry in which
the Big Five were big players both in proprietary funds and as broker-dealers
for large hedge funds that in turn were highly leveraged.
The SEC did reexamine its efficacy after the Bear Stearns collapse early in
2008. "Immediately after the events of mid-March, when the run-on-the-bank
phenomenon to which Bear Stearns was exposed demonstrated the importance of
incorporating loss of short-term secured funding into regulatory stress
scenarios, the Consolidated Supervised Entities program revised the analysis of
liquidity risk management, with enhanced focus on the use and resilience of
secured funding," SEC chairman Cox testified at a July 2008 hearing. "The SEC
has also worked closely with the Federal Reserve in directing this additional
stress testing."
Trigger for massive losses
Two months after Cox testified, two more broker-dealers collapsed, and one of
the two remaining broker-dealers - Morgan Stanley - was in talks to merge with
Wachovia, which itself was in trouble and had to be taken over by Wells Fargo.
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 September 26, 2008, 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. 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 a recent Memorandum of Understanding (MOU) between the SEC and the Fed.
Cox made the following statement along with the SEC announcement on ending the
CSE program: "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 SEC said it has no plans to re-examine the impact of the 2004 changes to
the net capital rule, yet it put out a proposal to revise the rule once again.
This time, it is looking to remove the requirement that broker-dealers maintain
a certain rating from the ratings agencies.
On September 26, the commission formally ended the 2004 program, acknowledging
that it had failed to anticipate the problems at Bear Stearns and the four
other major investment banks.
When the need to de-leverage is triggered by insufficient revenue, asset prices
fall and insolvency can result. Undercapitalization is merely a euphemism for
insolvency unless new capital can be raised quickly. Recapitalization is a
euphemism for dilution of sunk equity with new capital. Recapitalization alters
the capital structure of a corporation and is often accomplished by an exchange
of bonds for stocks. Pending bankruptcy is a common reason for
recapitalization. Debentures might be exchanged for reorganization bonds that
pay interest only when earned.
Under US law, a healthy company might seek to save taxes by replacing preferred
stock with bonds to gain interest deductibility from its tax liabilities. In
corporate finance, in-substance
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
