This SECs

Guambat missed this story last week, but caught up via John Mauldin via Barry Ritholtz. Before proceeding, recall that America started out this year with 5 large broker-dealers: Goldman Sachs, Morgan Stanley, Merrill Lynch, Bear Stearnes and Lehman Bros. The last 3 have left the building, the remaining 2 are buckled but standing, so far.

Ex-SEC Official Blames Agency for Blow-Up of Broker-Dealers

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.

That rule was so relaxed it fell asleep in 2004 under the Bush Administration's SEC.

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.

The SEC justified the less stringent capital requirements by arguing it was now able to manage the consolidated entity of the broker dealer and the holding company, which would ensure it could better manage the risk.

"The Commission's 2004 rules strengthened oversight of the securities markets, because prior to their adoption there was no formal regulatory oversight, no liquidity requirements, and no capital requirements for investment bank holding companies," a spokesman for the agency, John Heine, said.

In addition to computerizing the risk calculations, the new program required time-consuming oversight of the broker dealers by SEC officials, and in many cases, the use of subjective judgment calls.

"An important component of the CSE program is the regular interaction of Commission staff with senior managers in the firm's own control functions, including risk management, treasury, financial controllers, and the internal auditor, as well as onsite testing to determine whether the firms are implementing robustly their documented controls," SEC chairman Christopher Cox testified in a hearing of the House Committee on Financial Services in July.

Guambat rather doubts that it is mere coincidence that the only broker-dealers who qualified to take advantage of those 2004 rules were those same 5 Names.

For its part,

The SEC said it has no plans to re-examine the impact of the 2004 changes to the net capital rule....

Conclusion?:

"The SEC modification in 2004 is the primary reason for all of the losses that have occurred," former SEC official, Lee Pickard,, who is now a senior partner at the Washington, D.C.-based law firm Pickard & Djinis, said.

FOLLOW UP:

Bloomberg has quite an extensive examination of Chairman Cox, which includes an aside about Paulson, in this Exclusive: Cox `Asleep at Switch' as Paulson, Bernanke Encroach (Update1).

The article points out that Cox has received judgments of about $100 million against violators, chiefly the easy to pick stand-outs from the stock option back dating days. But that sounds like a pretty good record.

Until you consider his predecessor:

Cox is the third SEC chief appointed by Bush. Unlike his two predecessors -- Pitt, a prominent securities lawyer, and William Donaldson, former CEO of the New York Stock Exchange -- Cox had little background in the securities industry when he took office in August 2005.

Cox was named head of the SEC -- Vice President Dick Cheney offered him the job -- in the wake of years of scandal that led to the Sarbanes-Oxley law and a raft of new regulations.

Donaldson, who served from 2003 to '05, also battled with Republican commissioners Paul Atkins and Cynthia Glassman over their opposition to imposing multimillion-dollar fines on public companies for fraud, misrepresentation and accounting violations.

Under Donaldson, total penalties increased 10-fold to $3.1 billion in fiscal 2005 from two years earlier.

According to a person who worked with him, Donaldson was pressured by aides to Cheney to jettison a proposal to make it easier for shareholders to pick corporate board members.

The message, one former top Donaldson staff member says, was that this was not the policy of the Republican Party.

As for Paulson, he took office determined to relieve the financial services industry of some of the burden of the new regulations imposed by Cox's predecessors, as he made clear in his first speech as Treasury secretary in August 2006.

The next month, he issued a statement backing the Committee on Capital Markets Regulation, a group that sought to amend the 2002 Sarbanes-Oxley Act, which imposed new strictures on corporate boards and managers.

In 2007, Paulson set up a panel to examine the pressures on the auditing industry, another area under the SEC's jurisdiction. The group is co-chaired by ex-SEC Chairman Arthur Levitt and Donald Nicolaisen, who headed the agency's accounting office from 2003 to '05. "It seems clear the Treasury Department is intruding," says former SEC chief accountant Turner.

Then, in March of this year, came the Treasury Department's ``blueprint'' for restructuring federal regulation of the financial industry, which called for the merger of the SEC with the Commodity Futures Trading Commission.

Since then, Paulson the deregulator has evolved into Paulson the interventionist, with his shepherding of the Bear Stearns takeover by JPMorgan and the government's appropriation of American International Group Inc. and federally backed mortgage packagers Fannie Mae and Freddie Mac.

Cox says he wasn't consulted about Treasury's plan for merging the SEC with the CFTC and doesn't think Congress will enact it.

Meanwhile, Henry Paulson is moving ahead with his plan for a regulatory overhaul that would abolish the SEC.

The SEC will celebrate its 75th anniversary in 2009.