Net Capital Rule - Net Capital Rule in Financial Crisis Explanations Since 2008

Net Capital Rule in Financial Crisis Explanations Since 2008

Since 2008, the conclusion that the 2004 rule change permitted dramatically increased leverage at CSE Holding Companies has become firmly embedded in the vast literature commenting on the financial crisis of 2007-2009 and in testimony before Congress. In This Time is Different Professors Carmen M. Reinhart and Kenneth S. Rogoff characterize the 2004 rule change as the SEC's decision "to allow investment banks to triple their leverage ratios." In Too Big to Save Robert Pozen writes "the fundamental problem" for the CSE Holding Companies "resulted primarily from the SEC's decision to permit them to more than double their leverage ratio, combined with the SEC's ineffective efforts to implement the consolidated supervision" of the CSE Holding Companies. Jane D'Arista testified to the House Financial Services Committee in October, 2009, that the 2004 rule change constituted a "relaxation of the leverage limit for investment banks from $12 to $30 per $1 of capital." The issue entered military theory when Gautam Mukunda and Major General William J. Troy wrote, in the US Army War College Quarterly, that the 2004 rule change allowed investment banks "to increase their leverage to as high as 40 to 1" when previously "the SEC had limited investment banks to a leverage ratio of 12 to 1."

In reviewing similar statements made by former SEC chief economist Susan Woodward and, as cited in Section 1.1, Professors Alan Blinder, John Coffee, and Joseph Stiglitz, Professor Andrew Lo and Mark Mueller note 1999 and 2009 GAO reports documented investment bank leverage ratios had been higher before 2000 than after the 2004 rule change and that "these leverage numbers were in the public domain and easily available through company annual reports and quarterly SEC filings." Lo and Mueller cite this as an example of how "sophisticated and informed individuals can be so easily misled on a relatively simple and empirically verifiable issue", which "underscores the need for careful deliberation and analysis, particularly during periods of extreme distress when the sense of urgency may cause us to draw inferences too quickly and inaccurately." They describe how mental errors that contributed to the financial crisis and that now contribute to mistaken understandings of that crisis flow from "mental models of reality that are not complete or entirely accurate" but that lead us to accept, without critical review, information that "confirms our preconceptions."

Lo and Mueller note the New York Times has not corrected the 2008 NY Times Article. At least two of the scholars mentioned in Section 1.2 have (by implication) corrected their 2008 statements that before 2004 investment bank leverage was limited to 12 to 1. In the July–August 2009 issue of the Harvard Business Review, Niall Ferguson noted information that from 1993 to 2002 Bear Stearns, Goldman Sachs, Merrill Lynch, and Morgan Stanley reported average leverage ratios of 26 to 1 (with Bear Stearns having an average ratio of 32 to 1 during those years). In his 2010 book, Freefall, Joseph Stiglitz noted that in 2002 leverage at the large investment banks was as high as 29 to 1. He also directed readers to the 2009 Sirri Speech and the 2008 NY Sun Article for different views on the role of the 2004 rule change in investment bank difficulties.