THIS MODERN WORLD

It would be excellent if—when Arnold Schwarzenegger arrives at the White House to ask for a $7 billion loan for California—George Bush put on an Austrian accent and told him “Don’t be an economic girlie-man!”

I bet Schwarzenegger would really get a kick out of it.

SCHWARZENEGGER: There is another way you can tell you’re a Republican. You have faith in free enterprise, faith in the resourcefulness of the American people, and faith in the U.S. economy. To those critics who are so pessimistic about our economy, I say: Don’t be economic girlie men!

Edit: All done.

The New York Times has a long story today about the disastrous 2004 change to the SEC’s “net capital rule.” The rule change allowed America’s five largest investment banks to greatly increase their leverage ratios, from 12-1 to as much as 40-1. All five investment banks have since either collapsed or transformed themselves into commercial banks.

The Times story mentions that “The five investment banks led the charge [to change the rule], including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.”

However, the story does NOT mention Paulson’s 2000 testimony to the SEC, which I posted yesterday. In it, Paulson specifically lobbied the SEC to make the net capital rule change:

[W]e and other global firms have, for many years, urged the SEC to reform its net capital rule to allow for more efficient use of capital. This is the single most important factor in driving significant parts of our business offshore, so that our firms can remain competitive with our foreign competitors risk-based capital standards must become the norm.

In the same testimony, Paulson also called on the SEC to change to more “voluntary regulation”—exactly what the SEC chair Christopher Cox now says “does not work.” (No kidding.)

Here are some relevant sections from today’s Times story, although it’s well worth reading it all:

Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control…

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 exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments.

The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr…

The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.

With that, the five big independent investment firms were unleashed.

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.

Back in 2000, when Hank Paulson was CEO of Goldman Sachs, he testified in front of the Security and Exchange Commission. Among other things, he lobbied the SEC to enact a “change to self-regulation” for Wall Street. He also urged them to change the “net capital rule” which governed the amount of leverage investment banks could use. The net capital rule was indeed changed in 2004, and is now blamed for the investment banks’ collapse.

PAULSON: The Challenge of Technology and Change to Self-Regulation in the United States

The third area for re-examination and reform is the structure of broker/dealer regulation, a function now shared by the SEC and the self regulatory organizations (“SROs”), principally the New York Stock Exchange and NASD Regulation Inc.

[W]e and other global firms have, for many years, urged the SEC to reform its net capital rule to allow for more efficient use of capital. This is the single most important factor in driving significant parts of our business offshore, so that our firms can remain competitive with our foreign competitors risk-based capital standards must become the norm. The SEC has made it clear that risk-based capital rules can be implemented only when the Commission is confident that firms employing value-at-risk models have robust credit and risk management policies in place.

For these reasons we think it is time to seriously consider the creation of a single, independent SRO to adopt, examine and enforce a core body of financial responsibility, customer protection and margin rules. We hope and expect that there would be savings generated by economies of scale.

How did Paulson’s recommendation to let investment banks borrow much, much more work out?

Here’s a story from two weeks ago:

The Securities 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 Lynch.

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…

The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers…The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1…

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 holding companies.

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 smaller discount.

Who murdered the American economy? It was the CEO, in the 13th Floor Conference Room, with the Prepared Testimony.

The slow motion train wreck continues.