Donaldson is little known to most people but he played an enormous role in the financial crisis. That said, like most of the other, better known, prime movers of the financial crisis, Donaldson was never taken to task over his role in the crisis. As chair of the Securities and Exchange Commission, he authorized enormous changes to the “net capital rule.” The net capital rule was created in 1975. It forced firms to value their “net assets” on the basis of current market prices and the potential of having to sell assets in an emergency. The net capital rule also made distinctions between different types of assets to account for risk. For example Treasury bonds – which are subject to interest rate risk – might have their “net asset” value reduced by only 5%. On the other hand, stocks - which are generally considered riskier than government bonds - might have their net asset value reduced by 15%. Finally the net capital rule limited a firm’s debt to net capital ratio to 12:1. The goal of the net capital rule was to ensure that securities firms always had enough liquid assets – i.e. assets that could be sold quickly if need be without having to be sold at fire sale prices - to remain solvent.
The net capital rule had been a bone of contention between the SEC and the Wall Street banks from the beginning. Wall Street disliked the rule because it limited the leverage banks could use and this cut into their potential for profits. As a result of the myopia fueled by decades of subsidy and succor provided by the Fed to Wall Street – which would eventually be given a name, “the Greenspan put” - Wall Street had long stopped associating increased leverage with increased risk. Henry Paulson, the then CEO of Goldman Sachs spoke for many on Wall Street when he testified to the SEC in 2000,
“In addition, we (Goldman Sachs) and other global firms have, for many years, urged the SEC to reform its net capital rule to allow for more efficient use of capital. This is the single most important factor in driving significant parts of our business offshore.”
In 2004 and as a result of industry “urgings” from the likes of Henry Paulson and others, the net capital rule was changed. In its place, the SEC decided to allow the largest Wall Street firms, the broker-dealers, to use “an alternative risk-based approach to satisfy the Commission’s regulatory capital requirements, instead of using the current net capital rule.” On a purely practical basis, the changes allowed much higher amounts of leverage. In fact, Merrill Lynch, Bear Stearns and Lehman Brothers were likely leveraged at least 30:1 just before they each went down in flames. The SEC’s tolerance for much higher levels of leverage seemed to be based in large part on supposedly more accurate and more sophisticated computer models. The idea was these models would allow the broker-dealers to better measure and assess the risks they were running, and greater amounts of leverage could thus be used. As it turned out – and like the computer models Gary Gorton (#27) used to manage AIG’s trade in mortgage bond insurance - the models the broker-dealers relied on to measure their risk were no more accurate than using a monkey to throw darts at a newspaper’s business section to figure out what stocks to purchase.
Whatever the rationale behind them, the changes to the net capital rule and the attendant reliance on a “risk-based” approach was an unmitigated disaster. Of the five broker-dealers who qualified for the relaxed standards resulting from the changes to the net capital rule – Bear Stearns, Lehman Brothers, Goldman Sachs, Merrill Lynch and Morgan Stanley – only Goldman and Morgan Stanley would survive the financial crisis intact. In the immediate aftermath of Lehman’s collapse a former SEC official, Lee Pickard, called the 2004 changes to the net capital rule, “the primary reason for all of the losses (among broker-dealers) that have occurred.”
See Gary Gorton (#27) for his equally disastrous attempt at modeling the risks AIG incurred with its trade in mortgage bond insurance. See Alan Greenspan (#29) for the Greenspan put. See Henry Paulson (#38) for additional examples of what “leadership” means on Wall Street.