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Changes to the Net Capital Rule - William Donaldson, Useful Idiots & Today's Repo Market


Recently, the financial news has been dominated by the Federal Reserve's massive intervention in the 'repo' market.  Repo is short for repurchase, and the repo market is essentially a market dedicated to huge volumes of very short term - often overnight - loans.  The loans are not used to fund legitimate wealth producing activities.  Instead, their purpose is to allow financial service firms and investment banks to keep their trade books open.  In the repo market, banks sell securities to counterparties and agree to buy the securities back at the same price, plus interest.  The obvious flaw in this system - immediately obvious to anyone not affiliated with a Wall St. bank - is the volatility latent in such short-term interest rates.  Short-term rates can spike very quickly - just think of the recent attack on the Saudi oil processing plant from a few weeks ago - and these spikes can grind this type of short-term financing to a halt.  Indeed, as they were flirting with bankruptcy in September 2008, Tim Geithner briefed Henry Paulson that Lehman needed $230 billion in overnight repo financing - $230-billion!  How could this possibly make sense?  What sort of business needs to borrow $230-billion every few days just to keep its doors open. 

For many years on Wall Street, this type of financing didn't make sense, and it wouldn't have been possible to implement it even if someone thought it did.  The reason being, the 'Net Capital Rule' prevented it.  The net capital rule placed limits on how much leverage a Wall St. firm could use.   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

Historically, Wall St. firms, particularly when the large investment banks were partnerships, were cautious using leverage.  Sure, returns increase with an increase in leverage.  However, losses increase too.  When it was the partners' money at stake - and when the notion of the Fed bailing out the richest people in the country was a completely inconceivable notion - Wall St. firms exercised a considerable amount of caution when it came to leverage.  They had to, their survival depended on it.  While the net capital rule gave legal standing to the notion of limiting leverage, the privately held firms on Wall St. didn't need the government to tell them to watch their money! 

However,the Wall St. banks went public in the late 1990s.  No longer was the partners' money at risk, it was the public's.  Perhaps even more importantly, the Fed - particularly in the person of Alan Greenspan  - displayed an obsequious willingness to do Wall Street's bidding. (1)  The factors which had served to limit leverage on Wall St. were in the process of being eclipsed, and Wall St. soon began agitating for a change in the net capital rule to allow more leverage.  For example, here is Henry Paulson (Dunce #38), then the chairman of Goldman Sachs and the future Treasury Secretary, testifying to the Securities and Exchange Commission (SEC) for the ability to take on more and more leverage.
“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.”  (2)

The net capital rule was a regulation, and its was within the power of the SEC to change it.  The SEC chair while much of the back and forth on the net capital rule took place was William Donaldson, a useful idiot straight of central casting.  Donaldson graduated from both Yale (1953) and Harvard (1958).  After spending a few years in the Marine Corps,he never spent a day of his 45-year professional life working in this country's wealth producing industries.  Instead, he became the typical Rockefeller republican and carried water for both Richard Nixon and Nelson Rockefeller.  Later, he was president of the NY Stock Exchange and founded a Wall Street firm.  By the time he became SEC chair in 2003, Donaldson was completely incapable of looking at a problem objectively.  Instead, he was hard-wired to advance the interests of the people he had gone to school with and spent his entire working life with.  Unsurprisingly, this is exactly what he did. 

In 2004 and as a result of industry “urgings” from the likes of Henry Paulson and others, the net capital rule was changed - by voice vote no less.  In its place, Donaldson and the SEC allowed 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.”  (3)  Basically, the Wall Street firms argued that now that they had computers, computers would allow them to manage much greater amounts of leverage.  (A completely bogus argument, proved most recently - and spectacularly - by the failure of LTCM in September 1998.)

Avoiding the legalese of the regulation, the practical impact of the changes were they 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 in 2008, just four years after the net capital rule was changed.  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.”

Amazingly, even after the financial crisis of 2008, the enormous amounts of leverage that played such a major role in the 2008 crisis are still being used.  The Fed's massive intervention in today's repo market proves this conclusively.  What other industry - besides Wall St. finance - could trip over the same set of mistakes that they tripped over just a few years ago? 


Peter Schmidt
Sugar Land, TX
September 29, 2019

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(1) See Alan Greenspan and his intervention in the Long-Term Capital Management (LTCM) debacle.

(2) Prepared testimony of Henry A. Paulson, Chairman and CEO of Goldman Sachs and Company, Securities and Exchange Commission (SEC) Hearing on the "Financial Marketplace of the Future," February 29, 2000

(3) Alternative Net Captial Requirements for Broker Dealers that are Part of Consolidated Supervised Entities, Securities and Exchange Commission,