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The SEC Rule That Broke Wall Street

In a recent column for Reuters, Bethany McLean does an excellent job of demolishing one of the most widespread urban legends regarding the causes of the financial crisis.

The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.
Getty Images
The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.

Legend has it that a 2004 change to a rule governing capital adequacy at Wall Street firms allowed broker-dealers to double their leverage, making them highly fragile and likely to fail in a crisis. As McLean explains, this explanation never made all that much sense and has always been fairly easy to disprove.

But I’m not sure that we should really let the Securities and Exchange Commission off the hook. As it turns out, it is very likely that the 2004 changes actually did contribute to the financial crisis—albeit in a very different way than the people cited in McLean’s article wrongly suspect.

The key to understanding the 2004 regulatory change is to forget the narrative about deregulation. Look at it as an expansion of regulation, which is how the SEC saw it.

“The amendments should help the Commission to protect investors and maintain the integrity of the securities markets by improving oversight of broker-dealers and providing an incentive for broker-dealers to implement strong risk management practices. Furthermore, by supervising the financial stability of the broker dealer and its affiliates on a consolidated basis, the Commission may monitor better, and act more quickly in response to, any risks that affiliates and the ultimate holding company may pose to the broker-dealer,” the SEC says in the Federal Registrar entry encoding the law.

Even after the financial crisis, the SEC continued to see it this way.

“First, and most importantly, the Commission did not undo any leverage restrictions in 2004. Rather, I believe that the Commission sought to fill a gap in the statutory system of supervision by offering to the US investment banks, for the first time, a regime of comprehensive consolidated oversight by virtue of its conditions on the broker-dealers. Given pressures from Europe, it was expected that the five largest US investment banks would make the necessary one-time election to be supervised under this regime. Thus the Commission effectively added an additional layer of supervision at the holding company where none had existed previously,” Eric Siri, the director of the SEC’s Division of Markets and Trading, said in a 2009 speech.

In particular, what the 2004 amendments to the net capital rules did was bring the parent holding companies of the biggest investment banks under SEC supervision. Prior to the amendments, only the broker-dealer units were directly regulated by the SEC. After the amendments, the entire company structures of Lehman Brothers, Bear Stearns, Goldman Sachs, Morgan Stanley and Merrill Lynch came under regulatory purview as “consolidated supervised entities” or CSEs.

It’s helpful here to look back to a bit of the history of how these investment-bank holding companies had escaped regulation for so long. Prior to the 1970s, the broker-dealers were largely regulated only by the stock exchanges—particularly the New York Stock Exchange. But a series of financial calamities that came to be known as the “paperwork crisis” saw hundreds of Wall Street firms collapse, leaving investors with serious losses—both of funds and confidence.

To restore confidence, Congress enacted a form of deposit insurance for brokerages. Worried that insurance would lead to moral hazard and excess risk, Congress also imposed the original capital adequacy rules for Wall Street. But since these were only intended to cover the insured entities—the brokerages—they didn’t reach into the parent companies, investment banking arms, and so on. So Wall Street’s biggest firms were largely unsupervised entities with broker-dealer arms that fell under SEC purview.

As the securities business expanded in the 1980s and broker-dealers grew into large international financial conglomerates, regulators became increasingly worried that a broker-dealer could fail due to the insolvency of its parent holding company. This fear became a reality when the 1990 bankruptcy of Drexel Burnham Lambert led to the liquidation of its broker-dealer affiliate.

The 2004 amendments meant that the big five Wall Street firms now had to report financial data to the SEC in a manner consistent with the capital adequacy standards for U.S. bank holding companies. Which meant, at the time, a version of the Basel II risk-weighted asset approach that had been adopted by the FDIC, the Federal Reserve, the Office of Thrift Supervision and the Office of the Comptroller of the Currency. And that meant—cue ominous music—the big Wall Street firms were going to go crazy buying mortgage assets.

The original Basel financial regulations had a built-in mortgage bias that was intended to encourage banks to acquire mortgage-related assets. The German delegation to the original Basel meetings had urged a tilt toward mortgages in hopes of stimulating their domestic mortgage market. The Federal Reserve reluctantly agreed to accept that mortgages would get a 50 percent risk weighting.

What this meant was that a well-capitalized U.S. bank required to hold 10 cents of capital on for every $1 of commercial loans it made—representing a 10 percent capital requirement—would only have to hold 5 cents for each mortgage it made or bought. The deal was even better for mortgage bonds backed by Fannie Mae or Freddie Mac. They required regulatory capital of just 2 cents on the dollar.

The rules for US commercial banks were changed in 2001 to apply developing Basel II concepts. In order to encourage banks to hold more liquid assets, regulators wanted to encourage securitization and the holding of securities. The new banking rules applied a 200 percent capital requirement—or 20 cents on the dollar—to mortgage bonds rated B or lower; 100 percent—10 cents on the dollar—to mortgage bonds rated BB or BBB; 50 percent—5 cents on the dollar—to bonds rated A; and AA or AAA mortgage bonds got 20 percent—2 cents on the dollar.

The effect of this change on the mortgage-backed security market and commercial banks is told in “Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation,” by Jeffrey Friedman and Wladmir Kraus. As they explain, this change in capital requirements led to an explosion of issuance of private-label mortgage securities and a huge buildup of mortgage-related risk on the balance sheet of commercial banks.

So guess what happened when the SEC decided to supervise the Wall Street CSEs using the same Basel criteria beginning in 2004? The Wall Street firms dramatically increased their exposure to the very same kinds of loans that the commercial banks had been gobbling up.

This chart, from a 2009 Federal Reserve Bank of New York staff report by Tobias Adrian and Hyun Song Shin, shows both the steepening curve of the commercial bank acquisition of mortgages following the 2001 change and the parabolic rise of “ABS Issuers”—which means, for the most part, investment banks—acquiring mortgages following the 2004 change.


What the 2004 amendments accomplished, then, was not a dramatic unleashing of leverage but a reorientation of the balance sheets of the Wall Street investment banks toward mortgage-backed securities. Instead of “originating to distribute,” the investment banks now had a regulatory incentive to hold mortgage-securities instead of other assets.

The 2004 amendments to the net capital rules meant that investment banks could reduce their chance of crossing important regulatory thresholds by building up their balance sheets with mortgage-backed securities as opposed to other securities that received less favorable regulatory treatment. The amendments contributed to the financial crisis not by permitting too much leverage, but by cajoling the investment banks into adopting the view of risk held by international regulators and subsequently, loading up on mortgage-related securities.

To be sure, the 2004 amendments were not the sole regulatory contribution to Wall Street’s hunger for mortgage risk. A year earlier, the SEC had amended another rule in a way that rewarded broker-dealers for holding mortgage-backed securities.

The original rule was a customer protection rule also adopted in the 1970s. Its purpose was to prevent broker-dealers from putting customer assets at risk by borrowing their securities to trade on the broker’s proprietary account. It set compensation and notice requirements when brokers borrowed customer securities and had a very strict collateralization requirement. Brokers had to collateralize borrowed securities with cash, Treasurys, or irrevocable letters of credit worth 100 percent of the value of the securities.

In 2003, regulators decided to expand the range of collateral brokers could use to collateralize securities borrowings. It added several categories of collateral, including foreign sovereign debt and—ominous music again—highly rated mortgage-backed securities. Thus, following the 2003 amendment, brokers holding a portfolio of mortgage-backed securities could profit not just from the income stream they generated, but from their value as collateral for proprietary trading using customer securities.

Importantly, this wasn’t “deregulation” any more than adding an extra traffic lane to a government highway is privatization. In fact, the SEC went out of its way in explaining the new rule to show that this was part of its regulatory view of how markets should operate under supervision:

The Commission took into account several considerations in deciding whether to provide this exemptive relief and designate additional categories of permissible collateral. For example, the Commission considered whether the risks of customer losses associated with permitting a new category of collateral were sufficiently small relative to the benefits the additional kinds of collateral will provide. Those benefits include adding liquidity to the securities lending markets and lowering borrowing costs for broker-dealers. In issuing this Order, the Commission is drawing on its experience in assessing the liquidity of markets in a variety of contexts including, for example, the net capital requirements for broker-dealers.

It’s easy to see what happened once both amendments were in place. Investment banks now could collateralize securities borrowings with an asset type that received favorable capital treatment. It’s a recipe for insatiable craving for mortgage-backed securities.

The rotation of the entire financial world toward mortgage risk was accompanied by well-meaning if misguided regulatory changes. In retrospect, it seems unwise to have put in place rules that tended to homogenize the balance sheets of our commercial banks and our investment banks. The financial crisis would not have been anywhere near as severe if different supervisory rules had encouraged different types of investment banks to adopt different strategies. But at the time, this homogenization was regarded as a feature and not a bug.

“The CSE rule also requires monthly calculation at the holding company level of a capital adequacy measure that is designed to be consistent with the standards adopted by the Basel Committee on Banking Supervision. This should allow for greater comparability of a CSE firm's financial position to other international securities firms and banking institutions,” Robert L.D. Colby, then acting director of the SEC’s Division of Market Regulation, told a House subcommittee in 2006.

McLean’s article is right when it says that the 2004 changes didn’t cause the crisis by unleashing deadly leverage. But it’s wrong to extend this to an exoneration of the 2004 amendments. Those did have lethal consequences on Wall Street and nearly fatal results for the entire economy.

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