By David Merkel of Aleph Blog
It started with reading Abnormal Returns, something I do daily, and innocent enough. But the article mentioned at SSRN was significant, and far more than a set of book reviews. It cited a GAO study and a speech given by SEC Director Erik R. Sirri, which showed that the SEC did not materially modify its capital requirements for investment banks in 2004. So in one sense, the SEC is not to blame for the failures of the investment banks.
But in another sense, they are very much to blame. Why? As Buffett has said, he thinks about the things others say “can’t happen.” Secured lending fits into another aspect of the “net capital rule,” an aspect less noticed. That can be geared up 50 times, not the 12 times commonly considered. Who would have thought that secured lending would be so overlent that it would push up asset prices, and that so many would rely on holding assets via short-term loans via repo?
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Well, I fingered some of it at the time, but not all of it. So the argument shifts — the SEC was not wrong for shifting its standards in 2004, which had little impact — it was wrong long before then with the net capital rule 15c3-1 by being too lenient with secured lending.
Secured lending often fails colossally, because lenders think the current value of the asset is a guarantee, when it is really subject to the conditions of the market. When many lenders rely heavily on collateral, it proves to be less than valuable. Also, secured lending tends to be done by leveraged entities, who think they can do it because it is safer. When it fails, it can be like a string of dominoes.
We need to abandon the idea that the SEC made some grand shift in 2004, and rather, take up the idea that the SEC had the net capital rule wrong in the first place — it should have been tighter with respect to secured lending. Given the short-term nature of the repo markets, and the correlated nature of changes in repo haircuts, maybe the SEC should ban investment banks from using repo financing. Yes, it will kill profits, but no regulator should care about that. Regulators should care about solvency under all scenarios.
Short-dated financing of long-term assets is at the root of most financial crises. Let the regulators move to a strict asset-liability matching framework for regulating the investment and commercial banks, where they look through the financing arrangement to the ultimate asset being financed. Long assets deserve long financing.