Toxic Waste Build-Up: How Regulatory Changes Let Wall Street Make Bigger Risky Bets

An Interview with Lee Pickard

Lee Pickard was director of the Division of Trading and Markets of the Securities and Exchange Commission in the 1970s. He is founder and senior partner of Pickard and Djinis LLP, which specializes in securities and corporate law, regulation and related litigation.

Multinational Monitor: What is the net capital rule?

Lee Pickard: The net capital rule is and was the rule for ascertaining the financial condition of registered broker-dealers, sometimes called stock brokers or investment bankers.

MM: What was the rule that was set up when you were at the Securities and Exchange Commission (SEC)?

Pickard: When I was director of the Securities and Exchange Commission's Division of Trading and Markets, we were requested to formulate a uniform net capital rule, applicable to all broker-dealers. The rule adopted, and the rule that continues today, requires broker-dealers to have a minimum amount of net capital and to take specific charges [set-aside capital] based upon their activities. If, for instance, a broker-dealer decides to position a security or a bond, it would have to set aside a certain amount of net capital to sustain and hold that position. And there are specific amounts of net capital identified to be set aside, depending on the nature of the security to be acquired by the broker-dealer.

MM: So the rule establishes a baseline standard of how leveraged an investment bank can be and also establishes adjustments for the specific kind of securities they hold?

Pickard: Yes. The leveraging and the amount of securities to be held would be tested not only by the charges to be set aside, because the larger the position a firm takes, the more capital it must have to sustain that position. So there's a limit as to how far a firm can commit under the traditional net capital rule, in terms of acquiring either equity securities or bonds, or other types of financial instruments, because there are specific capital charges attendant to each position acquired by that broker-dealer.

There are also other tests that were imposed. For instance, for some broker-dealers who are not able to obtain exemptions or exceptions, they also must abide by an aggregate indebtedness ratio, which prohibits them from incurring indebtedness beyond a certain point, in comparison with their net capital. That is also a restraining item in terms of the net capital of the broker-dealer.

MM: What's the underlying rationale of this set of restraints?

Pickard: The underlying rationale is two fold. First, it is to make sure that the broker-dealer, who may have custody or possession of customer funds or securities, does not jeopardize his financial condition, and thereby jeopardize his responsibility to his customers. The broker-dealer must safely hold customer securities and also safely secure any receivables or cash of customers that might come into his orbit.

The second purpose is to insure that the broker-dealer, in dealing with the Street, or dealing with other dealers or other professionals, is able to complete his contracts in a timely manner.

So those are the two fundamental aspects of the net capital rule. Both are important. It's not just protecting customer assets, but also protecting other people who might deal with the broker-dealer in transactional activity.

MM: The rule was altered, at least for the large investment banks, in 2004?

Pickard: Yes. In 2004, the net capital rule was altered by virtue of an amendment that applied to broker-dealers, with essentially $5 billion or more of equity or net capital. Those firms were able to voluntarily come in and subscribe to the new program. The new program subjected them to different measures of financial responsibility. They were able to avoid, what we call required haircuts on particular positions - the need to hold capital based on the standardized assessment of risk of different instruments. In other words, they were able to avoid many of the objective standards of the net capital rule (e.g., percentage capital charges on a particular security position).

Under the traditional net capital rule, if you incur a position in a junk bond or a CMO [collateralized mortgage obligation], or some other debt security, you could have a capital charge, or haircut as we call it, of as much as 15 percent. If you incurred an equity security, again the charge was about 15 percent. In other words, you had to hold in capital 15 percent of the value of that bond or security, to insure against the risk that it would fail or of market movement. If the broker took a position in a 30-year Treasury bond, the charge was 6 percent. If you incurred commercial paper, it was lower, 1 percent or less.

These charges were excepted out for the new 2004 program. The large broker-dealers in the program were able to insert instead their own measures of risk - mainly computerized mathematical models which would test risk and were supposed to incorporate in them certain measures of a financial cushion for those securities. Whether they did it effectively or not is something we can argue about. But they didn't have the objective tests. Instead, they had their own measures of financial responsibility, which were submitted to the staff of the Securities and Exchange Commission for review and approval. Those were supposed to be the new measures in place for determining a broker dealer's net capital. In general, what we had was a substitute of subjective standards - presumably in good faith, and intended to be as effective as the traditional standards - in lieu of the objective standards of the net capital rule. The objective standards remain in place today for roughly 5,000 broker-dealers, all of whom are apparently surviving this financial crisis under the traditional net capital rule.

MM: What was the logic of the 2004 amendment?

Pickard: The basic logic of the amendment was that both European and U.S. regulators determined that it would be more appropriate in regulating these financial complexes as a whole. The U.S. regulator - the SEC - would have jurisdiction over the affiliates and the holding companies of these large broker-dealers, as well as the broker-dealers themselves.

There was somewhat of a trade-off here. The broker-dealers voluntarily gave up jurisdictional oversight for their parents or affiliates to the SEC, and in exchange the investment banks (broker-dealers) would get a different measure for their net capital responsibility. The SEC was supposed to be able to measure financial risk that might have existed in the affiliates and holding companies, as well as in the broker-dealers, thereby enabling better regulatory oversight of the financial condition of the complex as a whole.

There is some lack of wisdom or knowledge here, in my opinion. It is not clear to me why the holding company or the affiliates would have financial positions of any magnitude which would not be embodied in the broker-dealer itself. There are also questions in my mind as to if the holding company or the affiliates did get into financial difficulty, given the corporate separateness of broker-dealers from the affiliates, whether it would really matter in terms of the financial well-being of the broker-dealers.

In other words, it isn't clear to me that the SEC gained a great deal from having jurisdiction over these affiliates and holding companies. And it's also unclear to me as to whether the SEC had the resources to be able to monitor the mathematical models of such large financial institutions. As it turned out, apparently they did not.

MM: When you talk about these affiliates and holding companies, are these based outside the United States?

Pickard: Some of them are. The notion was if the SEC took jurisdiction over the financial condition of affiliates outside the United States, they would be exempted from European oversight. That was another aspect of this program that encouraged the subscribers who voluntarily committed to it.

MM: Can you say anything about the political process by which the amendment was adopted?

Pickard: It happened in 2004, and I wasn't at the SEC at that time. I can only understand that the SEC was encouraged to do this, and thought that it was strengthening its oversight of these firms. In fact, in my opinion, the oversight of financial responsibility was eroded.

I don't know what sector or group of people pushed for these changes. It is true that at least seven firms subscribed to this program.

The program has been terminated as to any new participants by the SEC.

MM: What was the impact of all these changes in practice and on the current crisis?

Pickard: As these firms voluntarily signed up in 2004 and 2005, their balance sheets continued to show more leverage and larger positions, particularly in some of the types of securities and other instruments that now are sometimes characterized as "toxic." The leverage that was incurred grew to a size that was much larger than what they had traditionally been able to do under the net capital rule, at least on my watch as Director of Trading and Markets. On my watch, big, major broker-dealers were not able to incur positions - and as a corollary, indebtedness - of much more than four-, five- or six-to-one, in terms of their ratios of net capital to indebtedness.

But under this new process, as I understand it, firms were able to incur leverage in the range of 30-to-one. I still don't understand why, as these firms continued to build up their positions and build up the indebtedness attendant to those positions, the regulators did not say, "Why are they able to do this under this new process and they were not able to do it under the normal net capital rule, and what is the implication of that?"

MM: What does it mean, and what has it meant, to have leverage of 30-to-one, as opposed to six-to-one?

Pickard: It has meant that if there's a mistake, or if there's error in terms of judgment of the underlying security that they're positioning, the consequences are much more severe.

As it turned out, a lot of the positions that these firms incurred are now of lesser value than the positions incurred by them at the inception. Consequently, the indebtedness remains but the value of the portfolio diminishes.

There were other restraints in the basic net capital rule that were avoided by the voluntary program. One of the restraints was a restraint on liquidity. There's a provision in the net capital rule that says if you take a position in a security or a debt instrument and that security or instrument doesn't have liquidity - that is, you can't readily sell it - then you have to take a 100 percent charge against your net capital. That restraint was removed. The requirements for green eye shade-type [detailed and scrutinized] computation of charges going down for each security were also removed.

MM: Can you explain what this means in context?

Pickard: In sum, they went from an objective standard to a subjective standard of measuring net capital requirements, and in the process, the restraints on incurring indebtedness and the restraints on incurring positions were significantly lessened.

I'm not sure they anticipated that result, but that was the end result of the 2004 amendment to the net capital rule.

Firms that continue to adhere to the traditional net capital rule have not had financial difficulties. In fact, the net capital rule has been one of the more successful programs for the government in the financial area. There have been very few failures of broker-dealers over the past 30 years since the net capital rule has been in place and almost no failures which involved customer assets or liabilities.

Consequently, you have to look at this and say to yourself, "What if the voluntary program had not been adopted, and the large broker-dealers had had to adhere to the traditional net capital rule? Could they have engaged in the kind of activities that they did engage in?"

They were making great profits by virtue of their ability to be able to position these large amounts of debt securities, but when the market went south, they incurred great losses.

MM: What lessons do you draw from that? Why did firms do things that ultimately destroyed them or drove them to the brink of ruin?

Pickard: We can't blame the results that occurred here solely on this amendment to the net capital rule. Under the rule, management was free to make its own judgments on the kind of instruments it might position and the amount of indebtedness that it might incur to support those positions.

Apparently, they repeatedly made bad judgments. What lessons can we draw from that?

MM: Going forward, presumably you would recommend that the amendment to the net capital rule be repealed, and that the large investment banks be brought back into the original framework.

Pickard: The original framework, with some modifications giving recognition to the fact that hedging may reduce risk to exposure, is appropriate. But I think I would tend to come back to the traditional net capital rule until someone comes up with a more efficient method of measuring risk.

The industry said that the standard net capital methodology is not appropriate for the new world of derivatives and other exotic instruments. But if it's not, I guess we need to come up with some other method other than the one we did in 2004.

MM: Are there other financial reforms that you would recommend?

Pickard: I think that it's absolutely necessary to deal with the issue of determining pricing. The notion that you can assess a security based upon factors other than what the current market might be, or what willing buyers and sellers might agree on as a price, is problematic. We shouldn't permit evaluations which are, for instance, predicated on what the instrument might bring to you upon maturity, assuming that the maturity occurs. We should be more rigorous in asking for exact valuations based upon market.

For net capital purposes, if something is not readily salable, then there ought to be a discount on the value of that particular product as well.