Great article in The New York Times today: “The Reckoning,” written by Steven Labaton, says the current Wall Street disaster traces back to a key meeting on April 28, 2004 of the Securities and Exchange Commission (SEC). At that meeting, the SEC acquiesced to a request by big investments banks to change the regulation limiting the amount of debt such banks could accumulate.

According to the Times article, only one person, Leonard D. Bole, objected.  Bole, “a software consultant and expert on risk management — from Indiana,”  sent a two-page letter and said the computer models run by the firms — which the regulators would be relying on — could not anticipate moments of severe market turbulence. He wrote, “With the stroke of a pen, capital requirements are removed! Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?”

Mr. Bole, who earned a master’s degree in business administration at the University of Chicago, helps write computer programs that financial institutions use to meet capital requirements. He was never called by anyone from the commission.

Excerpts from the article:

• “We have a good deal of comfort about the capital cushions at these firms at the moment.” — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.  How could Mr. Cox have been so wrong?
• Decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.
• 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. 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.
• The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.
• A lone dissenter — a software consultant and expert on risk management — weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington.
• The proceeding was sparsely attended. None of the major media outlets, including The New York Times, covered it. After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The Times, the chairman, William H. Donaldson, a veteran Wall Street executive, called for a vote. It was unanimous. 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.
• 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.
• The supervisory program under Mr. Cox, who arrived at the agency a year later, was a low priority. The commission assigned seven people to examine the parent companies — which last year controlled financial empires with combined assets of more than $4 trillion. Since March 2007, the office has not had a director. And as of last month, the office had not completed a single inspection since it was reshuffled by Mr. Cox more than a year and a half ago.
• The commission’s decision effectively to outsource its oversight to the firms themselves fit squarely in the broader Washington culture of the last eight years under President Bush.
• “It’s a fair criticism of the Bush administration that regulators have relied on many voluntary regulatory programs,” said Roderick M. Hills, a Republican who was chairman of the S.E.C. under President Gerald R. Ford. “The problem with such voluntary programs is that, as we’ve seen throughout history, they often don’t work.”
• “We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing,” said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox). “Letting the firms police themselves made sense to me because I didn’t think the S.E.C. had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We’ve all learned a terrible lesson,” he added.
• In letters to the commissioners, senior executives at the five investment banks complained about what they called unnecessary regulation and oversight by both American and European authorities.
• A once-proud agency with a rich history at the intersection of Washington and Wall Street, the Securities and Exchange Commission was created during the Great Depression.  When President Franklin D. Roosevelt was asked in 1934 why he appointed Joseph P. Kennedy, a spectacularly successful stock speculator, as the agency’s first chairman, Roosevelt replied: “Set a thief to catch a thief.”
• Christopher Cox had been a close ally of business groups in his 17 years as a House member from one of the most conservative districts in Southern California. Mr. Cox had led the effort to rewrite securities laws to make investor lawsuits harder to file. He also fought against accounting rules that would give less favorable treatment to executive stock options.
• Under Mr. Cox, the commission responded to complaints by some businesses by making it more difficult for the enforcement staff to investigate and bring cases against companies. The commission has repeatedly reversed or reduced proposed settlements that companies had tentatively agreed upon. While the number of enforcement cases has risen, the number of cases involving significant players or large amounts of money has declined.
• Mr. Cox dismantled a risk management office created by Mr. Donaldson that was assigned to watch for future problems.
• “In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the S.E.C. didn’t oversee well enough,” Mr. Goldschmid said in an interview. He and Mr. Donaldson left the commission in 2005.

Interesting article in Slate Magazine today, “We’re Down $700 Billion. Let’s Go Double or Nothing! How the financial markets fell for a 400-year-old sucker bet,” written by Jordan Ellenberg, warns that the prospect of a bail out may have contributed to reckless behavior on Wall Street.

Ellenberg is Associate Professor of Mathematics at The University of Wisconsin.  He has a Ph.D from Harvard. As a teenager Ellenberg became known as a math prodigy, winning many math competitions. When he was 17 (in 1988) The National Enquirer featured him in an articled entitled,  “America’s Top Math Whiz Kid.”  He writes a regular column for Slate.

Jordan Ellenberg

Ellenberg explains the math of his thinking in detail in the article and says that Wall Street’s recent behavior resembles a betting strategy that involves doubling one’s bet, until you win — a strategy that comes down through history and is called “the matingale.”  He writes, “Here’s how to make money flipping a coin. Bet 100 bucks on heads. If you win, you walk away $100 richer. If you lose, no problem; on the next flip, bet $200 on heads, and if you win this time, take your $100 profit and quit. If you lose, you’re down $300 on the day; so you double down again and bet $400. The coin can’t come up tails forever! Eventually, you’ve got to win your $100 back.

“This doubling game offers something for nothing—certain profits, with no risk. You can see why it’s so appealing to gamblers. But five more minutes of thought reveals that the martingale can lead to disaster. The coin will come up heads eventually—but “eventually” might be too late. Most of the time, one of the first few flips will land heads and you’ll come out on top. But suppose you get 10 tails in a row. Just like that, you’re out $204,700. The next step is to bet $204,800—if you’ve got it. If you’re out of cash, the game is over, and you’re going home 200 grand lighter. …

“But wait a minute, maybe somebody will loan you the $200,000 you need to stay in the game. After all, you’ve got a great track record; up until this moment, you’ve always ended up ahead! If people keep staking you money, you can just keep betting until, eventually, you win big time.”

Ellenberg continues, “The carefully synthesized financial instruments now seeping toxically from the hulls of Lehman Bros. and Washington Mutual are vastly more complicated than the martingale. But they suffer the same fundamental flaw: They claim to create returns out of nothing, with no attendant risk. That’s not just suspicious. In many cases, it’s mathematically impossible.”

Ellenberg concludes his article by saying, “This is what makes some people queasy about the federal bailout of the banks. It just might be that the prospect of a bailout—which could make a total collapse no worse for the banks than a garden-variety bear market—could have helped cause the martingale boom. There seems to be little question that the country needs the bailout now. But unless some real pain for the martingalers is built in, we’d better be ready for a return to maverick finance down the road.”