The Good Old Net Capital Rule

One of the major catalysts for our present mortgage meltdown. NYTimes (10.03.08), via Kevin Drum:

"On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on."

The Reckoning - Agency’s ’04 Rule Let Banks Pile Up New Debt

"The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments."

And flow they did.

"In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves."

"Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measurement of how much the firm was borrowing compared to its total assets — rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly."

Oh man they was fun times, they was.

The First Of Many

Man, you just know this went on all over the place. And not just with Merrill, either. Bloomberg (02.01.08):

"Merrill Lynch & Co. agreed to pay Springfield, Massachusetts, $13.9 million to settle a dispute over collateralized debt obligations that tumbled in value.

The money will reimburse Springfield for the cost of the CDOs, securities tied to home loans and other debts shunned by investors as losses on subprime mortgages mounted."

Merrill to Repay Massachusetts City for CDO Purchase

"New York-based Merrill said it agreed to the refund after discovering the purchase was made without the city's consent."

More from the Boston Globe (02.01.08):

"Springfield invested about $50 million in cash-management accounts with Merrill Lynch starting in November of 2006. In the spring of 2007, $13.9 million of that was placed in the risky collateralized debt obligations - which are securities linked to bonds and loans, including subprime mortgages.

The Globe reported earlier this week that Merrill failed to inform the city that it had purchased the debt obligations until last July, when it suddenly changed the names of three investments on the city's monthly statement to indicate that they were CDOs."

Merrill to repay Springfield for losses

It appears that "(t)wo Merrill Lynch brokers in Albany used city cash funds to purchase the complex investments without telling Springfield officials".

Ooopsie.

Some Skullduggery Afoot

Bloomberg (01.04.07):

"U.S. regulators, concerned brokerages may have sold clients money-losing securities tied to subprime mortgages, are seeking information about how the investments were marketed, a person familiar with the situation said.

The Financial Industry Regulatory Authority, which polices about 5,100 brokerages, sent letters Dec. 14 to more than a dozen firms that sell collateralized mortgage obligations, a type of security linked to home-loan payments, said the person, who declined to be identified because the inquiry isn't public."

Brokers Probed by Finra on Mortgage Security Sales, Person Says

Gee. About time they noticed, huh. "Mounting losses from securities tied to home loans are prompting regulators to examine how Wall Street firms valued and promoted the products. Finra Chief Executive Officer Mary Schapiro said in September the agency was scrutinizing sales of mortgage-backed products to retirees, and had sent a round of letters seeking information on the transactions."