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Sometime in the next decade, an economic historian will write the definitive account of the 2008 credit crisis. Possessing better data and greater distance from the still current turmoil, this author will do a far better job than anyone can hope to do today. A critical issue that such a history must face will be the extent to which there was a regulatory failure. Indeed, this issue is sufficiently pressing that even at this early point columnists need to address it. Little doubt exists that there were private market failures, as some CEOs (O'Neal at Merrill, Lynch, Cayne at Bear Stearns, and Fuld at Lehman) recklessly increased leverage and concentrated their firm's assets in illiquid real estate investments. But what responsibility does the SEC bear for not resisting the steady slide of the major investment banks into insolvency?

Here, views predictably differ. Some journalists view the SEC as simply having been "captured" by the industry, particularly with regard to the SEC's 2004 decision to relax its traditional "net capital" rule.[FOOTNOTE 1] Apologists for the investment banking industry, in turn, view the crisis as the result of a bubble in the real estate sector, which sank investment banks when the public panicked. Under this interpretation, the crisis was like the 1,000-year flood for which no one could prepare and for which no level of precautions would suffice. Both interpretations oversimplify.

Let's start with the industry's view. Bubbles do not necessarily absolve the participants of responsibility for their decisions. Bubbles fall into two basic categories: (1) demand-driven, and (2) supply-driven. The collapse in 2000 of the Internet bubble represents the more common demand-driven variety; investors simply overestimated the impact of the Internet, and eventually "dot.com" companies that had gone public at ridiculously high price/earnings multiples crashed back to earth when investors belatedly realized that the Internet did not revolutionize everything.[FOOTNOTE 2] But the 2008 bubble arose instead in the debt markets and was clearly supply driven.

Abundant evidence shows that between 2001 and 2006, an extraordinary increase occurred in the supply of mortgage funds, with much of this increased supply being channeled into poorer communities in which previously there had been a high denial rate on mortgage loan applications.[FOOTNOTE 3] Housing prices rose rapidly. But at the same time, a corresponding increase in mortgage debt relative to income levels in these same communities made these loans precarious. Two University of Chicago Business School professors have found that two years after this period of increased mortgage availability began, a corresponding increase started in mortgage defaults -- in exactly the same zip code areas where there had been a high previous rate of mortgage loan denials.[FOOTNOTE 4] They determined that a one standard deviation in the supply of mortgages from 2001 to 2004 produced a one standard deviation increase thereafter in mortgage default rates.[FOOTNOTE 5]

Even more striking, however, is their finding that the rate of mortgage defaults was highest in those neighborhoods that had the highest rates of securitization. Not only did securitization correlate with a higher rate of default, but that rate of default was highest when the mortgages were sold by the loan originator to financial firms unaffiliated with the loan originator.[FOOTNOTE 6] Other researchers have reached similar conclusions, finding in one study that a loan portfolio that is more likely to be securitized defaults by about 20 percent more than a similar risk profile loan portfolio that is less likely to be securitized.[FOOTNOTE 7] Why? The most plausible interpretation is that securitization adversely affects the incentives of lenders to screen their borrowers.

Such a conclusion should not surprise. It simply reflects the classic "moral hazard" problem that arises once loan originators do not bear the cost of default by their borrowers. In short, irresponsible lending in the mortgage market was not the cause of the crisis, but rather appears to have been caused, itself, by the capital markets' increasingly insatiable demand for financial assets to securitize. If underwriters were willing to rush deeply flawed asset-backed securitizations to the market, mortgage loan originators had no rational reason to resist them.

Thus, the real mystery is not why loan originators made unsound loans, but why underwriters bought them. Anecdotal evidence suggests that due diligence efforts within the underwriting community slackened in asset-backed securitizations after 2000.[FOOTNOTE 8] Others have suggested that the SEC contributed to this decline by softening its disclosure and due diligence standards for asset-backed securitizations,[FOOTNOTE 9] in particular by adopting in 2005 Regulation AB, which simplified the issuance of asset-backed securities.[FOOTNOTE 10] All this provides at least some arguable corroboration for those asserting a regulatory failure.

Still, focusing just on real estate investment risks tunnel vision. If we instead take a broader "before and after" perspective, the most striking fact about this crisis is that the United States, as of the beginning of 2008, had five major investment banks that were not owned by a larger commercial bank: Merrill Lynch, Goldman Sachs, Morgan Stanley, Lehman Brothers and Bear Stearns. By the late Fall of 2008, all of these investment banks had either failed or abandoned their status as independent investment banks. Two (Bear Stearns and Merrill Lynch) had been forced at the brink of insolvency to merge with larger commercial banks in transactions orchestrated by banking regulators. One -- Lehman Brothers -- had filed for bankruptcy, and the two remaining investment banks -- Goldman Sachs and Morgan Stanley -- had converted into bank holding companies under pressure from the Federal Reserve Bank, thus moving from SEC to Federal Reserve supervision. Each of these firms had survived prior recessions, market panics, and repeated turmoil and had long histories extending back as far as the pre-Civil War era.

If their uniform collapse was not enough to suggest the possibility of regulatory failure, one additional common fact unites them: each of these five firms voluntarily entered into the SEC's Consolidated Supervised Entity ("CSE") program, which was established by the SEC in 2004 for only the largest investment banks.[FOOTNOTE 11] Indeed, these five investment banks were the only free-standing investment banks permitted by the SEC to enter the CSE program. A key attraction of the CSE program was that it permitted its members to escape the SEC's traditional net capital rule, which placed a maximum ceiling on their debt to equity ratios, and instead elect into a more relaxed "alternative net capital rule" that contained no similar limitation.[FOOTNOTE 12] The result was predictable: all five of these major investment banks increased their debt-to-equity leverage ratios significantly in the period following their entry into the CSE program.[FOOTNOTE 13] That higher leverage, coupled with a high concentration of their assets in subprime mortgages and related real estate assets, left them exposed and vulnerable when market conditions soured in 2007-2008. For example, at the time of its insolvency, Bear Stearns' gross leverage ratio had hit 33 to 1, and press reports placed Merrill Lynch's debt/equity ratio at the time of its merger at 40 to 1.[FOOTNOTE 14].

But does the adoption of this relaxed net capital rule show that the SEC was "captured"? The problem with this simple hypothesis is that the SEC's adoption of the CSE program in 2004 was not intended to be deregulatory. Rather, the program was intended to compensate for earlier deregulatory efforts by Congress that had left the SEC unable to monitor the overall financial position and risk management practices of the parent companies controlling these investment banks. Still, if the 2004 net capital rule changes were not intended to be deregulatory, they worked out that way in practice. The ironic bottom line is that the SEC unintentionally deregulated by introducing an alternative net capital rule that it could not effectively monitor.

The events leading up to the SEC's decision to relax its net capital rule for the largest investment banks began in 2002, when the European Union adopted its Financial Conglomerates Directive.[FOOTNOTE 15] The main thrust of the E.U.'s new directive was to require regulatory supervision at the parent company of financial conglomerates that included a regulated financial institution (e.g., a broker-dealer, bank or insurance company). The E.U.'s entirely reasonable fear was that the parent company might take actions that could jeopardize the solvency of the regulated subsidiary. The E.U.'s directive potentially applied to both U.S. investment and commercial banks because all did substantial business in London. But the E.U.'s directive contained an exemption for foreign financial conglomerates that were regulated by their home countries in a way that was deemed "equivalent" to that envisioned by the directive. For the major U.S. commercial banks (several of which operated a major broker-dealer as a subsidiary), this afforded them an easy means of avoiding group-wide supervision by European regulators, because they were subject to group-level supervision by U.S. banking regulators. But U.S. investment banks had no similar escape hatch, as the SEC had no similar oversight over their parent companies. Thus, fearful of hostile regulation, U.S. investment banks lobbied the SEC for a system of "equivalent" regulation that would be sufficient to satisfy the terms of the directive and give them immunity from European oversight.[FOOTNOTE 16] For the SEC, this offered a serendipitous opportunity to oversee the operations of investment bank holding companies, and the commission unanimously approved the program without any partisan disagreement.[FOOTNOTE 17]

But the CSE program came with an added (and unnecessary) corollary: Firms that entered the CSE program were permitted to adopt an alternative and more relaxed net capital rule governing their debt to net capital ratio. Under the traditional net capital rule, a broker-dealer was subject to fixed ceilings on its permissible leverage. Specifically, it either had to (a) maintain aggregate indebtedness at a level that could not exceed 15 times net capital,[FOOTNOTE 18] or (b) maintain minimum net capital equal to not less than two percent of "aggregate debit items."[FOOTNOTE 19] For most broker-dealers, this 15 to 1 debt to net capital ratio was the operative limit within which they needed to remain by a comfortable margin.

Why did the SEC allow the major investment banks to elect into an alternative regime that placed no outer limit on leverage? Most likely, the commission was principally motivated by the belief that it was only emulating the more modern, advanced standards "Basel II" standards used by the Federal Reserve Bank. To be sure, the investment banks undoubtedly knew that adoption of Basel II standards would permit them to increase leverage (and they lobbied hard for such a change). From the SEC's perspective, however, it designed the CSE program to be broadly consistent with the Federal Reserve's oversight of bank holding companies, and it even incorporated the same capital ratio that the Federal Reserve mandated for bank holding companies.[FOOTNOTE 20] In addition, the CSE program required its participants to maintain "tentative net capital" of at least $1 billion and to notify the commission if tentative net capital fell below $5 billion.[FOOTNOTE 21]

So what went wrong? The SEC's inspector general examined the failure of Bear Stearns and the SEC's responsibility therefor and reported that Bear Stearns had remained in compliance with the CSE program's rules at all relevant times.[FOOTNOTE 22] Thus, if Bear Stearns had not cheated, this implied (as the inspector general found) that the CSE program, itself, had failed. That seems fair enough, but this conclusion still does not mean that the retention of the standard net capital rule (with its 15 to 1 debt to net capital ratio) would have saved any of the CSE program's investment banks from the liquidity crisis that overwhelmed them. A close reading of the inspector general's report suggests that the real problem lay less in the specific terms of CSE's Program's rules than in SEC's staff inability to monitor the participating investment banks closely or to demand specific actions by them. Basel II contemplated close monitoring and supervision by regulators. Thus, the Federal Reserve assigns members of its staff to maintain an office within a regulated bank holding company in order to provide constant oversight. In the case of the SEC, a team of only three SEC staffers were assigned to each CSE firm[FOOTNOTE 23] (and a total of only 13 individuals comprised the SEC's Office of Prudential Supervision and Risk Analysis that oversaw and conducted this monitoring effort).[FOOTNOTE 24] From the start, it was a mismatch: three SEC staffers to oversee an investment bank the size of Merrill Lynch, which could easily afford to hire scores of highly quantitative economists and financial analysts, implied that the SEC was simply outgunned.

This mismatch was compounded by the inherently individualized criteria upon which Basel II relies. Instead of applying a uniform standard (such as a specific debt to equity ratio) to all financial institutions, Basel II contemplated that each regulated financial institution would develop its own individualized computer model that would generate risk estimates for the specific assets held by that institution and that these estimates would determine the level of capital necessary to protect that institution from insolvency. But in generating this model and crunching historical data to evaluate how risky its portfolio assets were, each investment bank gave itself a discretionary opportunity to justify higher leverage. Because each model was ad hoc, specifically fitted to a unique financial institution, no team of three SEC staffers was in a position to contest these individualized models or the historical data used by them. Thus, the real impact of the Basel II methodology was to shift the balance of power in favor of the management of the investment bank and to diminish the negotiating position of the SEC's staff. Basel II may offer a sophisticated tool, but it was one beyond the capacity of the SEC's largely legal staff to administer effectively.

Equally important, because the CSE program was voluntary, the SEC appears to have been constrained in the actions it could take against investment banks that were manipulating their models to justify increased leverage. In his Sept. 23, 2008 testimony before the Senate Banking Committee, SEC Chairman Christopher Cox acknowledged the infeasibility of voluntary compliance, expressing his frustration with attempts to negotiate issues such as leverage and risk management practices with the CSE firms. In a remarkable statement for a long-time proponent of deregulation, he testified:

"[B]eyond highlighting the inadequacy of the ... CSE program's capital and liquidity requirements, the last six months -- during which the SEC and the Federal Reserve worked collaboratively with each of the CSE firms ... -- have made abundantly clear that voluntary regulation doesn't work."[FOOTNOTE 25]

His point was that the SEC had no inherent authority to order a CSE firm to reduce its debt to equity ratio or to keep it in the CSE program.[FOOTNOTE 26] Although the SEC probably was overreached by the industry, it overstates to say that it was "captured." The real lesson is that the SEC's authority must be express and not consensual.

For Congress, which is about to consider regulatory reform, there are clear lessons to be drawn from this episode. In its April 2008 "Blueprint for a Modernized Financial Regulatory Structure," the Treasury Department proposed a consolidation of regulatory agencies and a shift towards greater reliance on self-regulation. Treasury may be correct on the first score: consolidation would make sense, as the United States has the most fragmented, and indeed Balkanized, regulatory structure for financial institutions of any major nation. But on the second score -- i.e., Treasury's proposed emphasis on self-regulation and greater reliance on broad "principles," instead of "rules" -- the investment bank's self-destructive race to increase to leverage under a vague principle that the SEC could not monitor should be instructive. Chairman Cox essentially got it right in his Senate testimony. Because increasing leverage is the simplest way for a financial institution to increase profitability, financial institutions will predictably exploit vague principles to do so. Only bright-line standards (such as the traditional net capital rule with its 15 to 1 ratio) can enable the SEC to constrain them. The moral may be: simple tools work better than complex power tools that you cannot handle.

For the future, the SEC no longer has any remaining investment banks of any size to monitor for capital adequacy. But institutions that are "too big to fail" must be regulated. This category includes many entities -- hedge funds, insurance companies and others -- that currently escape federal regulation. Who should supervise their capital adequacy? Recent experience suggests that the SEC's strengths are in the areas of disclosure, consumer protection, and anti-fraud enforcement, but also that its capacity as a prudential financial regulator is open to doubt. At this latter task, the Federal Reserve probably has the comparative advantage and deserves to be the Congressional choice.

John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and director of its Center on Corporate Governance.

:::::FOOTNOTES:::::

1 See Stephen Labaton, "SEC Concedes Oversight Plans Fueled Collapse," New York Times, September 27, 2008 at p. 1.

2 A classic example was the IPO of Pets.com, which briefly had a market capitalization over $1 billion, but then went bankrupt when it became clear that families preferred to buy pets at a pet store, where they could see (and handle) the merchandise, instead of buying them on the Internet.

3 For a good overview, see Atif Mian and Amir Sufi, "The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis," (http://ssrn.com/abstract=1072304) (May 2008) at 11 to 13.

4 Id. at 18-19.

5 Id. at 19.

6 Id. at 20-21.

7 See Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru, and Vikrant Vig, "Did Securitization Lead to Lax Screening? Evidence from Subprime Loans," (http://ssrn.com/abstract=1093137) (April, 2008).

8 Investment banks formerly relied on "due diligence" firms that they employed to determine whether the loans within a particular loan portfolio fell within standard parameters. These firms would investigate and inform the underwriter as to the percentage of the loans that were "exception" loans (i.e., loans outside the investment bank's normal guidelines). Subsequent to 2000, the percentage of "exception loans" in portfolios securitized by these banks appears to have risen from the former level of 25 percent to as high as 80 percent. Also, the underwriters scaled back the intensity of the investigations that they would authorize the "due diligence" firm to conduct, reducing from 30 percent to as few as 5 percent the number of loans in a portfolio that the firm was to check. See Vikas Bajaj & Jenny Anderson, "Inquiry Focuses on Withholding of Data on Loans," N.Y. Times, Jan. 12, 2008 at p. A-1.

9 See Richard Mendales, "Collateralized Explosive Devices: Why Securities Regulation Failed to Prevent the CDO Meltdown And How To Fix It" (Working Paper 2008) at 36.

10 See Securities Act Release No. 8518 ("Asset-Backed Securities") (January 7, 2005), 79 Fed. Reg. 1506. Regulation AB codified a series of "no action" letters and established disclosures standards for all asset-backed securitizations. See 17 C.F.R. §§ 229.1100-1123 (2005). Professor Mendales argues that government sponsored entities, such as Ginny Mae, had required higher due diligence standards, particularly as to documentation, but the SEC undercut these standards. See Mendales, supra note 9, at 36.

11 See Securities Exchange Act Release No. 34-49830 (June 21, 2004), 69 Fed. Reg. 34428 ("Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities").

12 The SEC's "net capital rule," which dates back to 1975, governs the capital adequacy and aggregate indebtedness permitted for most broker-dealers. See Rule 15c3-1 ("Net Capital Requirements for Brokers and Dealers"). 17 C.F.R. § 240.15c3-1.

13 For a chart showing the dramatic increases in leverage at all five of these firms between mid-2006 and early 2008, see U.S. Securities and Exchange Commission, Office of the Inspector General, "SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program ("Report No. 446-A, September 25, 2008) (hereinafter "SEC Inspector General Report") at Appendix IX at p. 120.

14 For the Bear Stearns ratio, see SEC Inspector General Report at 19; for the Merrill Lynch figure, see Dave Michaels, "Financial Meltdown: Credit creativity outpaced oversight; Regulators, lawmakers allowed companies to police themselves," The Dallas Morning News, Sept. 21, 2008, at p. 1A.

15 See Council Directive 2002/87, Financial Conglomerates Directive, 2002 O.J. (L 35) of the European Parliament and of the Council of 16 December 2002. For an overview of this directive and its rationale, see Jorge E. Vinuales, The International Regulation of Financial Conglomerates: A Case Study of Equivalence as an Approach to Financial Integration, 37 Cal. W. Int'l L.J. 1, at 2 (2006).

16 See Stephen Labaton, "Agency's '04 Rule Let Banks Pile Up Debt and Risk," New York Times, Oct. 3, 2008 at A-1 (describing major investment banks as having made an "urgent plea" to the SEC in April 2004).

17 See Securities Exchange Act Release No. 34-49830, supra note 11.

18 See Rule 15c3-1(a)(1)(i)("Alternative Indebtedness Standard"), 17 C.F.R. § 240.15c3-1(a)(1).

19 See Rule 15c3-1(a)(1)(ii)("Alternative Standard"), 17 C.F.R. §240.15c3-1(a)(1)(ii).

20 See SEC Inspector General Report at 10-11.

21 Id. at 11.

22 Id. at 10.

23 Id. at 2.

24 Id. Similarly, the Office of CSE inspectors had only seven staff. Id.

25 See Testimony of SEC Chairman Christopher Cox before the Committee on Banking, Housing, and Urban Affairs, United States Senate, Sept. 23, 2008 ("Testimony Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions"), at p. 4 (available at www.sec.gov) (emphasis added). Chairman Cox has repeated this theme in a subsequent Op/Ed column in the Washington Post, in which he argued that "Reform legislation should steer clear of voluntary regulation and grant explicit authority where it is needed." See Christopher Cox, "Reinventing A Market Watchdog," The Washington Post, Nov. 4, 2008 at A-17.

26 This is true, but if a CSE firm left the CSE program, it would presumably become subject to European regulation; thus, the system was not entirely voluntary and the SEC might have used the threat to expel a non-compliant CSE firm to induce compliance.

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