-SEC Official Blames Agency for Blow-Up of
and Exchange Commission can blame itself for the current crisis. That is the
allegation being made by a former SEC official, Lee Pickard, who says a rule change in
2004 led to the failure of Lehman Brothers, Bear
Stearns, and Merrill
The SEC allowed five firms the three that have collapsed plus Goldman Sachs and Morgan
Stanley to more than double the leverage they were allowed to keep on their
balance sheets and remove discounts that had been applied to the assets they had been
required to keep to protect them from defaults.
Making matters worse, according to Mr. Pickard, who helped write the original rule in
1975 as director of the SEC's trading and markets division, is a move by the SEC this
month to further erode the restraints on surviving broker-dealers by withdrawing
requirements that they maintain a certain level of rating from the ratings agencies.
"They constructed a mechanism that simply didn't work," Mr. Pickard said.
"The proof is in the pudding three of the five broker-dealers have blown
The so-called net capital rule was created in 1975 to allow the SEC to oversee
broker-dealers, or companies that trade securities for customers as well as their own
accounts. It requires that firms value all of their tradable assets at market prices, and
then it applies a haircut, or a discount, to account for the assets' market risk. So
equities, for example, have a haircut of 15%, while a 30-year Treasury bill, because it is
less risky, has a 6% haircut.
The net capital rule also requires that broker dealers limit their debt-to-net capital
ratio to 12-to-1, although they must issue an early warning if they begin approaching this
limit, and are forced to stop trading if they exceed it, so broker dealers often keep
their debt-to-net capital ratios much lower.
In 2004, the European Union passed a rule allowing the SEC's European counterpart to
manage the risk both of broker dealers and their investment banking holding companies. In
response, the SEC instituted a similar, voluntary program for broker dealers with capital
of at least $5 billion, enabling the agency to oversee both the broker dealers and the
This alternative approach, which all five broker-dealers that qualified Bear
Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley
voluntarily joined, altered the way the SEC measured their capital. Using computerized
models, the SEC, under its new Consolidated Supervised Entities program, allowed the
broker dealers to increase their debt-to-net-capital ratios, sometimes, as in the case of
Merrill Lynch, to as high as 40-to-1. It also removed the method for applying haircuts,
relying instead on another math-based model for calculating risk that led to a much