Quoth SEC Commissioner Daniel Gallagher:
In the banking sector, which features leveraged institutions operating in a principal capacity, capital requirements are designed with the goal of enhancing safety and soundness, both for individual banks and for the banking system as a whole. Bank capital requirements serve as an important cushion against unexpected losses. They incentivize banks to operate in a prudent manner by placing the bank owners’ equity at risk in the event of a failure. They serve, in short, to reduce risk and protect against failure, and they reduce the potential that taxpayers will be required to backstop the bank in a time of stress.
Capital requirements for broker-dealers, however, serve a different purpose, one that, to be fair, can be somewhat counterintuitive. The capital markets within which broker-dealers operate are premised on risk-taking – ideally, informed risks freely chosen in pursuit of a greater return on investments. In the capital markets, there is no opportunity without risk – and that means real risk, with a real potential for losses. Whereas bank capital requirements are based on the reduction of risk and the avoidance of failure, broker-dealer capital requirements are designed to manage risk – and the corresponding potential for failure – by providing enough of a cushion to ensure that a failed broker-dealer can liquidate in an orderly manner, allowing for the transfer of customer assets to another broker-dealer.
As I said, it’s counterintuitive, but the possibility – and the reality – of failure is part of our capital markets. Indeed, our capital markets are too big – as well as vibrant, fluid, and resilient – not to allow for failure.
A timely reminder from Matt Levine:
nobody owns stock, they just own interests in their brokers’ interests in DTCC’s interest in stock. “Oh I own AAPL shares,” you say, but you don’t; you own like a second derivative on Apple shares. A delta-one derivative but still.
Animal muck February 23, 2011 at
Am I the only one who finds the claim that Lehman described their collateral as goat poo unbelievable? Isn’t that just too nice, too inoffensive, too measured a term for a Lehman banker to use? ‘Camel shit': believable; ‘goat poo': not so much.
There is at least one piece of good news in troubles that the Obama administration are having with filling some jobs. As the WSJ reports, Annette Nazareth, who was expected to be tapped as deputy Treasury secretary, has withdrawn. Annette was responsible for the consolidated supervised entity program at the SEC that was so successful at supervising the big 5 broker/dealers that one failed, two were sold in conditions of distress (extreme distress in the Bear’s case) and two became banks. Why anyone thought that she should be Timmy’s deputy is beyond me.
From the FED, Information on Principal Accounts of Maiden Lane LLC as at Wednesday, Oct 22, 2008
Net portfolio holdings of Maiden Lane LLC: $26,802M
Outstanding principal amount of loan extended by the Federal Reserve Bank of New York: $28,820M
So the FED is a couple of billion underwater. On October 16th, the assets were valued at $29,492M.
Only four years too late, the New York Times has an article on the SEC CSE regime and how it didn’t do enough to constrain the broker/dealer’s risk taking. It’s nice the Times is finally getting around to this kind of thing, but no one was interested in financial regulation and the scandal that was the US broker/dealer capital regime when there actually were some big broker/dealers around to take advantage of it.
With Bloomberg reporting that the bailout has been agreed after days of intense debate, the last few days have been a great time to sneak out financial news that you do not want too well read. One would never suspect the SEC of acting that way, of course, but it is interesting that the audit of the SEC’s oversight of Bear Stearns came out on the 25th. The two parts are here and here, and they do not reflect very well on the SEC’s Trading and Markets Division (TM). For instance:
TM became aware of numerous potential red flags prior to Bear Stearns’ collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain Basel II standards, but did not take actions to limit these risk factors
The broker/dealer capital regime (CSE, introduced in 2004 by the SEC as an attempt to fend off EU regulation of the broker/dealer’s European subsidiaries) does not fare well either:
Bear Stearns was compliant with the CSE program’s capital and liquidity requirements; however, its collapse raises questions about the adequacy of these requirements
The SEC was in such a hurry to offer their 5 big clients a friendly capital regime that it approved their applications before it had even completed the inspection:
The Commission issued four of the five Orders approving firms to use the alternative capital method, and thus become CSEs (including Bear Stearns) before the inspection process was completed;
Go and read both the documents: they are peaches.
To be fair, the SEC admits there are problems. Chairman Cox released a statement saying `the CSE program was fundamentally flawed from the beginning’ and ending the program forthwith.
The US now has zero broker/dealer. Bloomberg reports:
Goldman Sachs Group Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken.
The Federal Reserve’s approval of their bid to become banks ends the ascendancy of the securities firms,
Now it gets interesting. I assume they will have to do bank capital adequacy calculations. And when they do, we will finally have a direct comparison of how inadequate the SEC’s regime was…
Linky goodness September 19, 2008 at
Some morning reading:
On the duty of auditors. A taxing matter addresses the inherent conflict of interest and suggests that it might be a good idea for auditors to be hired by the SEC rather than the company.
Ultimate loss projections are increased by Moody’s. MBIA and Ambac have not been in a train wreck for weeks and they are getting jealous of all the attention Fannie, Freddie, AIG, Lehman, Merrill and so on are getting. The FT has the details.
One aspect of a run on a broker/dealer. Dealbreaker points out how a B/D share price fall can push clients into moving money from non-seg’d to seg’d accounts. The result is akin to a run on a bank.
And finally, given that Cristiano Ronaldo is on a lot of people’s lists as `worst role model in sport’, please will the Treasury drop AIG’s sponsorship of Man U as a matter of urgency, or at very least demand that Ronaldo’s legs are pledged as long term collateral and lodged permanently in a vault at the New York FED?
Citibank was a large commercial bank which started to develop its own investment banking capability. Then a large capital markets broker/dealer, Salomon Brothers, got into trouble, so Citi bought them. And it snapped up Smith Barney too, so it had retail brokerage. The resulting behemoth tried to do too much and got into big trouble in the credit crunch with one of the largest write-offs of any bank. Using cheap funding from the commercial bank to fund credit assets in the broker/dealer was not a good idea.
Bank of America was a large commercial bank which started to develop its own investment banking capability but then more or less gave up. Merrill Lynch, a large capital markets and retail broker/dealer got into trouble and BofA have just bought them. Can we guess what might happen next readers? Are Universal Banks really the answer to every problem in the financial system?
…in investment banking. That, if you remember, was what Kenneth Lewis, Bank of America’s chief executive, said a year ago. Now it appears BofA is looking at Lehman. Fun, fun, fun. Still, broker/dealers almost never end up being sold to the people who would get the most from them — remember DLJ and Credit Suisse — but rather to those whose greed exceeds their fear by the largest amount. HSBC appears to be driven be fear: if BoA isn’t, it may end up with a rather better deal in its second crunch acquisition than it did in its first.
Update. Michael Lewis is most amusing on Bloomberg’s site:
KDB proved it may have finally grasped what should be for Asians a cardinal investment principle: Never buy anything an American investment banker is selling.
I’m glad I took profits on LEH and got out: it’s down 30% today. Dow Jones say that KDB are no longer interested, and the BBC thinks they have funding stress. Which they might well do. The WSJ reports heavy activity in the out of the money puts, while Reuters discusses the on again off again sale of Neuberger.
Surely this is a great time for a bid. Buying Lehman would finally catapult HSBC into the premier league of investment banking. BNP Paribas could use the US coverage, but they may be busy contemplating Fortis. It would be a fantastic trade for Unicredito too, and I wouldn’t put it past Ermotti — do they have the capital to spare though? And could they afford Lehman, even at current prices? RBS is sadly digesting ABN (what a silly purchase that was) and so probably isn’t interested. CIBC presumably had a look, as we know did RBC. I still like HSBC here…
LEH August 28, 2008 at
I am (1) above the waterline on Lehman and (2) starting to take it personally. This is usually a very bad sign for a position. There are doubtless hazards to navigate ahead but I think there may be more value there if Fuld can get something done soon. Despite Bloomberg’s (reasonable) concerns about Lehman’s mortgage assets and, according to FT alphaville, only three suitors remaining in the chase for the asset management unit I still there is the possibility of a surprise on the upside here.
No, not a post on Kristeva (although you might call it one on American Pragmatism). Rather — and this is a little cruel, so of course I am going to do it anyway — a link to a series of embarrassing pictures showing Citi’s research call on the broker/dealers and their actual performance. It’s not pretty, but then trying to make short term calls on the markets rarely is. That’s my excuse for Lehman being off 6% today, and I am sticking to it…
The WSJ reports that JP Morgan’s CEO is skeptical of the broker/dealer’s newly published capital ratios:
“I challenge those numbers,” Mr. Dimon said, throwing a verbal roundhouse at rivals Goldman Sachs Group, Morgan Stanley, Merrill Lynch and Lehman Brothers.
He went on to question whether the methods the investment banks used to calculate a measure of financial strength known as the Tier 1 ratio were the same as those used by commercial banks.
In fact Dimon wasn’t tough enough. He went on to say: “I’m not sure that those investment banks are using true Basel II type numbers, but we don’t know the detail.” In fact we do know that the SEC capital requirements are definitely not true Basel II type numbers. So Lehman’s “Tier 1 ratio”, say, at 13%, doesn’t mean what you might think it does. Caveat lector.
News flash: Bernanke has been speaking on consolidated supervision of US institutions. According to Bloomberg:
Federal Reserve Chairman Ben S. Bernanke said Congress should give a single federal regulator enhanced power to set standards for the capital, liquidity and risk management of investment banks.
(The emphasis is mine.)
Am I the only one to think that a more comprehensive solution to the fractured US regulatory landscape is needed than just to increase cooperation and information-sharing between the central bank and [the] SEC as the WSJ reports is in the offing? What about alignment of capital requirements? You need to rebuild the whole building, guys, not throw a tarp over it and call it fixed.
Mea Culpa June 10, 2008 at
Goodness was I wrong about MER and LEH vs. GS and MS… Experience sometimes is not cheap at any price.
Short LEH? June 5, 2008 at
Clearly there is a lot of money shorting Lehman, and I won’t deny it can’t go down further. But honestly, do you think the Americans will let another broker/dealer fail? They had five big ones before the Bear: now it’s four. Three feels like too few to me, and I suspect both the FED and the SEC agree. I think I might be a seller of the default swaps.
And by the way, in what possible world are Merrill and Lehman A- rated but Ambac and MBIA still AAA? Admittedly there are signs that Moody’s might finally (six months too late) be ready to do the right thing with the monolines, but really, these four ratings taken together make no sense.
Merrill and Lehman were downgraded to single A yesterday: Morgan Stanley is at A+ according to Bloomberg. If only one of them was being downgraded, the news would be catastrophic. As it is, is the new standard for a derivatives counterparty becoming single A? And if not, how will the broker/dealers derivatives business survive?