Bethany McLean

Although our understanding of what instigated the 2008 global financial crisis remains at best incomplete, there are a few widely agreed upon contributing factors. One of them is a 2004 rule change by the U.S. Securities and Exchange Commission that allowed investment banks to load up on leverage.

This disastrous decision has been cited by a host of prominent economists, including Princeton professor and former Federal Reserve Vice- Chairman Alan Blinder and Nobel laureate Joseph Stiglitz. It has even been immortalized in Hollywood, figuring into the dark financial narrative that propelled the Academy Award-winning film Inside Job.

As Blinder explained in a Jan. 24, 2009 New York Times op-ed piece, one of what he listed as six fundamental errors that led to the crisis came “when the SEC let securities firms increase their leverage sharply.” He continued: “Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the SEC and the heads of the firms thinking?”

More recently, Simon Johnson, a former chief economist at the IMF, said last November that the decision “by the Bush administration, by the SEC to allow investment banks to massively increase their leverage … in terms of the big mistakes in financial history, that’s got to be in the top 10.”

It is certainly true that leverage at the investment banks zoomed between 2004 and 2007, before the near collapse. And this narrative of the rule change has plenty of appeal — it serves up villains. Stupid SEC people! Greedy bankers! It also suggests regulators were in the pockets of the big banks, and it offers support for the narrative of financial deregulation that many put at the center of the crisis.

There’s just one problem with this story line: It’s not true. Nor is it hard to prove that. Look at the historical leverage of the big five investment banks — Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley. The Government Accountability Office did just this in a July 2009 report and noted that three of the five firms had leverage ratios of 28 to 1 or greater at fiscal year-end 1998, which not only is a lot higher than 12 to 1 but also was higher than their leverage ratios at the end of 2006. So if leverage was higher before the rule change than it ever was afterward, how could the 2004 rule change have resulted in previously impermissible leverage?

The blame-the-2004-rule position made its first appearance in August 2008, when a former director of the SEC’s trading and markets division named Lee Pickard wrote an op-ed in the American Banker arguing that the SEC contributed to the crisis when it changed something known as the “net capital rule” in 2004. The net capital rule, which governs how much capital broker-dealers have to hold and how that capital is measured, is technical, but Pickard made it simple: Prior to 2004, the broker-dealers’ debt had been limited “to about 12 times its net capital,” but thanks to the change, the investment banks were now able to avoid “limitations on indebtedness.”

That October, the New York Times ran a front-page piece by Stephen Labaton entitled, “Agency’s ’04 Rule Let Banks Pile Up New Debt.” Labaton wrote that the big banks had made an “urgent plea” to the SEC that would exempt their brokerage units “from an old regulation that limited the amount of debt they could take on” and would “unshackle billions of dollars held in reserve as a cushion against losses.” This was essentially what the banks demanded in exchange for submitting their holding companies to oversight by the SEC. Previously, there had been no oversight, but the European Union was threatening to impose its own regulations unless the U.S. did so. With the loosened capital rules, billions could then “flow up to the parent company,” enabling increased leverage. Indeed, Labaton wrote, “Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measure of how much the firm was borrowing compared with 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.” There were 157 comments on the Web version of this piece, most along the lines of remarks by a “Vietnam-era vet” who called the 2004 rule change “the financial equivalent of Patient Zero.”

On Jan. 3, 2009, at the annual meeting of the American Economic Association, Susan Woodward, a former SEC chief economist, highlighted the rule change in a presentation, a slide for which read:  “2004 — SEC eliminated capital rules for investment banks” and “Average I-bank ratios of capital to assets: before 2004: 1 to 12. After 2004: 1 to 33.”

A number of prominent academics who were there went on to repeat a version of Woodward’s claim. They include Robert Hall, who was then the incoming president of the American Economic Association, Ken Rogoff, and Alan Blinder. In the highly regarded book This Time is Different, which Rogoff co-authored with Carmen Reinhart, the authors write that “huge regulatory mistakes” like the “2004 decision of the SEC to allow investment banks to triple their leverage ratios (that is, the ratio measuring the amount of risk to capital) appeared benign at the time.”

Other prominent people who have blamed the SEC’s 2004 rule change for the increase in leverage at the (former) big five investment banks include historian Niall Ferguson; Joseph Stiglitz, who wrote in his book Freefall that “in a controversial decision in April 2004, [the SEC] seems to have given them [the big investment banks] even more latitude, as some investment banks increased their leverage to 40 to 1”); and Nouriel Roubini, who with his co-authors wrote in their book Crisis Economics that “investment banks reacted to this [2004] deregulation by massively increasing their leverage … to ratios of 20, 25 or even more…”

Thus did the “fact” become part of the conventional wisdom about the crisis.

***

Jacob Goldfield, a Harvard physics major turned Goldman Sachs partner (he left in 2000) noticed the claim that leverage had been limited to 12 before 2004, and then soared to 33. He thought it was strange that he hadn’t heard of this when it happened. He’d also noticed what he calls “quite a few” other pieces of conventional, but inaccurate, wisdom about the crisis, so he didn’t take for granted that this one was right. Instead, he checked. He looked at the 2003 leverage of two investment banks and found that it was much higher than 12. (In fact, there’s only one firm whose leverage in 2006 or 2007 was higher than it had ever been before 2004, and that’s Morgan Stanley. Nor was the leverage for the two firms that were hit the hardest by the crisis out of historical bounds when the world went to hell: Bear’s leverage (as measured by liabilities over equity capital) at year-end 2001 was 32, versus 32.5 at year-end 2007, Lehman’s at year-end 2001 was 28.3, versus 29.7 at year-end 2007.)

Halfway across the country, a semi-retired lawyer in Chicago named Bob Lockner began reading about the 2004 rule change, too. Lockner, who specialized in commercial bank capital markets activities, was suspicious because everyone kept citing the holding company leverage — but the rule applied only to the broker-dealer subsidiaries, and so didn’t include any international business, over-the-counter derivatives, or holdings of corporate or real estate loans, for instance. He also noticed that the rule hadn’t actually been implemented in 2004. The broker-dealer subsidiaries of Merrill and Goldman began using it in 2005, but the broker-dealer subs of Bear, Lehman and Morgan Stanley didn’t begin using the rule until their fiscal 2006 years. In other words, while leverage at the holding companies had started to climb in 2004 and 2005, the rule change clearly couldn’t be the reason.

After reading the Wikipedia entry for the “net capital rule,” which mostly cited the New York Times piece, Lockner decided to rewrite it, hoping that an accurate version would force people to acknowledge the old version was wrong. When I ask why he spent his time that way, he chuckles and says: “You mean, why am I insane?”

Lockner’s rewrite of the Wikipedia entry, at least as it existed on Mar. 13, 2012, describes in great technical detail the SEC’s net capital rule and the 2004 changes. But there are a few simple points. There was never any explicit leverage limit at the holding company level before or after the rule change. Even at the broker-dealer subsidiaries, a 12:1 limit didn’t exist. Smaller broker-dealers had an early warning at the 12:1 ratio, and an actual limit of 15:1 — but even these ratios didn’t exist in the way the economists seemed to interpret them, because they were calculated in a way that excluded big chunks of debt. In any event, since 1975, the broker-dealer subsidiaries of the big five investment banks had been using a different method, which had nothing to do with 12:1 or 15:1, to calculate their leverage limit. That method was unchanged in 2004. (Interestingly enough, the holding companies for the big investment banks might actually have made it under the 15:1 limit if you calculate the ratios by excluding the debt that the SEC does.)

There is another, more subtle point. The SEC did change the way the big broker-dealers calculated their net capital in 2004 in a way that could have allowed them to reduce the capital they held (by making it easier for them to meet the minimum requirements). This could indeed have had the effect of increasing the leverage, at least at the broker-dealer level. But it’s not axiomatic that that would result in higher leverage at the holding company — and it’s not even clear what the effect of the rule change was at the broker-dealer level.

One way the broker-dealers could have reduced capital would have been, as Labaton wrote, by paying big dividends to the holding company. But when the SEC changed the rule, it also put in place a new requirement that each of the broker-dealers have $5 billion in liquid capital before the major effects of the rule change; the SEC says that would have made it harder for the broker-dealers to pay out big dividends, and in fact, it required one firm to add capital to its broker-dealer. Overall, the SEC says that capital, as measured before most of the expected impact of the rule change, stayed stable or even increased after 2004. Several people at the broker-dealers at the time also tell me that the new rule was totally inconsequential in how they managed their capital levels

Skeptics may discount what the SEC and the broker-dealers say. But the data does show that over the years, the broker-dealers, contrary to perceptions that they must have wanted their capital to be as low as possible, actually kept much more capital on hand than they were required to hold. For example, in both 2006 and 2007, Bear Stearns had seven times the amount of capital that the SEC required, or more than $3 billion in excess net capital. This might suggest that the amount of capital the broker-dealers kept was boosted by factors other than the SEC’s requirements, like business needs, or rating agency and customer demands.

Various measures of leverage at the broker-dealer level do reach fresh peaks subsequent to the rule change. But it’s not obvious that that’s because of the rule change. The increases aren’t big in all cases, nor do they follow immediately after the firms implemented the new rules, and there’s enormous volatility from year to year, which may argue that the driving factor wasn’t the loosening of a preexisting constraint. Interestingly enough, one measure of leverage at the best-performing firm’s broker-dealer — Goldman Sachs — was higher before the rule change than at any other firm’s broker-dealer after the rule change.

***

The funny thing is that this is a mistake that no one has corrected. Although Erik Sirri, who was then the director of the SEC’s division of trading and markets, rebutted the claim in 2009, the New York Times didn’t cover it. Lockner says he wrote to a handful of economists; only Niall Ferguson responded and was chagrined to find out he was wrong. Of the people I cited earlier, only Blinder, Johnson, Kwak and Susan Woodward responded to my calls or emails.  Blinder now says: “It’s true that very high leverage was a big source of the problem, but the net capital rule does not appear to have changed that much.” (The New York Times hasn’t issued a correction to his op-ed.)  Woodward now says that while she doesn’t think the 2004 change is even on the top ten list of the most important contributors to the crisis, it doesn’t really matter, because “everyone agrees that too much leverage was a key cause.” Pickard, for his part, believes that the rule change hasn’t gotten enough blame yet, and he says that if leverage at the holding companies was higher in the 1990s, then the investment banks must have been playing games with their books.

More recently, Andrew Lo, the director of MIT’s Laboratory for Financial Engineering, wrote a paper analyzing 21 books on the financial crisis. In his paper, he pointed out the fallacy of blaming increased leverage on the 2004 rule change. Although Lo’s paper was picked up by the Economist, even that didn’t spur any of the academics who made the mistake to correct it. Why?

The best reason was voiced by James Kwak, who co-authored the book Thirteen Bankers with Simon Johnson. The book also links the increased leverage at the holding companies to the SEC’s rule change (although Johnson and Kwak never say the leverage was limited to 12:1 beforehand.) In a blog response to Lo’s paper, Kwak argues that Lo is making too big a deal out of this, because the rule change “very well might” have played a role in the increased leverage even if “we can’t tell how much.” In a conversation with me, Simon Johnson, Kwak’s co-author, argued that even if the broker-dealers kept excess capital on hand, well, they might have kept more excess capital had the rule change not occurred. This is indeed possible, although over time, the excess capital that the broker-dealers kept varied wildly, making it hard to see that they were targeting a specific amount of excess. In any event, Kwak and Johnson have a point: What happened at the broker-dealer level is murky and should be better understood. But the problem is that saying the rule change “might” have caused increased leverage just at the broker-dealer level is very different from saying it was an important cause of the crisis (especially since Lehman’s broker-dealer stayed solvent after its bankruptcy — it wasn’t the root of Lehman’s problems). At this point, the burden of proof should be on those who have claimed that the rule change was seminal.

Another reason that was suggested to me is that it’s politically incorrect to challenge the conventional wisdom about the rule change, because doing so might be construed as a defense of the SEC or the investment banks. That’s ridiculous: Facts are facts, and those who supposedly traffic in them should have respect for them. In addition, it’s far from a defense of the SEC to say that the rule change has been misrepresented. It may well have had pernicious effects that aren’t well understood yet. The broader context of the 2004 rule change was that, as Labaton pointed out, the SEC agreed to supervise the investment bank holding companies, and it clearly failed in those responsibilities. While the 2004 rule change offered a lovely explanation for that failure — blind incompetence is easily fixable — the real failings might be harder to fix, especially if we’re not looking for them.

A third reason I was given for why this mistake is no big deal is that because high leverage was surely to blame for the crisis, it’s beside the point whether the 2004 rule change made things worse or not. That’s silly — saying cancer killed the patient and saying the water he drank gave him the cancer are two very different claims. And it’s also dangerous, because if the rule change wasn’t behind the increased leverage at the investment banks, or the broker-dealers, then what was? If our goal is to prevent another crisis, isn’t it important to understand what actually happened? Or as Lo said to me: “If we haven’t captured the killer, then the real killer is still out there somewhere.”

PHOTOS: The U.S. Securities and Exchange Commission logo adorns an office door at the SEC headquarters in Washington, June 24, 2011. REUTERS/Jonathan Ernst; Princeton University Professor of Economics Alan Blinder speaks during a presentation at the American Economic Association Conference in Atlanta, January 3, 2010. REUTERS/Tami Chappell

Ever since the $25 billion settlement over foreclosure abuses between five of the nation’s biggest banks and the state attorneys-general was announced, there’s been a steady drumbeat of naysayers who’ve asserted the deal does more for the banks than it does for homeowners. And barring some happy accident in which the settlement somehow inspires banks to behave, they’re probably right: In comparison with the estimated $700 billion difference between what people owe on their mortgages and what those homes are actually worth, $25 billion is peanuts.

But the problem isn’t that the settlement is part of some grand plan by the government to help out the banks. Rather, the problem is that the government doesn’t seem to have a grand plan for the banks.

For all the current and well-deserved bank bashing, few question that a well-functioning economy is predicated on a well-functioning banking system. And few question that confidence is a critical ingredient. So then the issue becomes: What kind of banking system do you want to have, and how do you inspire confidence in it?

At two major junctures, our government (Congress went along with the Bernanke-Paulson-Geithner triumvirate) made the call that it wanted the banking system we had, not a radically reshaped one. First, the government bailed the big banks out in the fall of 2008. Perhaps more critically, the Obama administration made the call not to break them up or nationalize them in early 2009. In a sense, this new settlement is a continuation of that call. As Yves Smith at Naked Capitalism has pointed out, it’s a bailout for the banks: It will reduce the amount that people owe on their mortgages, thereby helping them afford their home equity lines of credit, roughly $400 billion of which are parked on the balance sheets of the big banks. And Scott Simon, the head of the mortgage business at bond giant Pimco, has argued that investors, not banks, will bear the brunt of the cost of any mortgage modifications.

But most important, the settlement lets the banks off the hook for repeatedly breaking the law in the foreclosure process. One analyst who has studied this tells me that their legal transgressions alone could have been used to rip apart the banking system, had the government desired to do so. Even if it’s true that the banks merely violated technical aspects of the law, and didn’t kick anyone out of a house who deserved to stay, that still flies in the face of everything we’re supposed to believe about the importance of the rule of law. Next time you get a ticket for running a red light, try arguing that you shouldn’t have to pay because you didn’t hit anyone.

But at the very same time, the government is doing a host of other things that look like they’re designed to undermine confidence in the banking system, if not the system itself. The news of the settlement broke at about the same time President Obama announced a new task force that would delve into the crimes of the bubble era. It’s not clear how this task force will differ from the one he announced in 2009, but the point — look out below, banks and bank investors! — is consistent with his anti-bank rhetoric. And the settlement is only a small piece of the litigation facing the banks. As Obama said: “This settlement also protects our ability to further investigate the practices that caused this mess … we’re going to keep at it until we hold those who broke the law fully accountable.” Indeed, multiple other investigations and lawsuits are ongoing; the Wall Street Journal also reported that the SEC might soon bring cases involving the packaging of mortgages.

The litigation isn’t all. Investors express a whole host of other worries, including Dodd-Frank’s so-called resolution authority — which dictates the way big banks in crisis are supposed to be unwound and, some say, basically means that politicians will pick the winners and losers in the next crisis. These concerns also include new capital requirements, President Obama’s proposed $61 billion bank tax, and the Volcker Rule. It’s death by a thousand cuts. All those things, plus a much tougher operating environment, help explain the continuing dismal performance of bank stocks. Yes, they’re up from the lows of last fall, thanks to the general market rally, but bank stocks are still depressed, thanks in part to the political risk they face. And the mere fact that political risk exists is a big problem in and of itself. (One smart investor uses the phrase “political finance” to describe the dangerous intertwining of two spheres that should be separate.)

You might say: So what? Surely the banks deserve to die for the agony they’ve inflicted on our economy! Which is probably true. But that’s a reaction, not a policy. Now, the prudent policy might well be to kill the big banks. Plenty of very smart people, like Simon Johnson, the former chief economist of the IMF, Mervyn King, governor of the Bank of England, Paul Volcker, and Thomas Hoenig, the next vice-chairman of the FDIC, have inveighed against the dangers posed by banks that are too big to fail. So then, let’s kill them outright! While we’ve missed our best chance, there would still seem to be some fairly simple ways to do that, like reinstating the Depression-era Glass-Steagall law separating commercial and investment banking or mandating sky-high capital requirements for any firm over a certain size. That would bring its own set of challenges — most notably a drift of activities to the shadow banking system — but I’m not sure anything could be more challenging than regulating today’s big banks, given not just their complexity but also their well-oiled political and regulatory influence machine.

There’s an argument that articulating a clear policy, let alone executing it, is simply beyond Washington’s capabilities. Which is scary, because right now, we have the worst of both worlds: A banking system that the population at large abhors, and one that investors can’t trust.

PHOTO: A man walks past a Wells Fargo Bank branch on a rainy morning in Washington January 17, 2012. REUTERS/Gary Cameron

The Republican candidates for president have some major differences in their policies and their personal lives. But they have one striking thing in common—they all say the federal government is responsible for the financial crisis. Even Newt Gingrich (pilloried for having been a Freddie Mac lobbyist) says: “The fix was put in by the federal government.”

The notion that the federal government, via the Community Reinvestment Act (CRA) and by pushing housing finance giants Fannie Mae and Freddie Mac to meet affordable housing goals, was responsible for the financial crisis has become Republican orthodoxy. This contention got a boost from a recent lawsuit the Securities and Exchange Commission (SEC) filed against six former executives at Fannie and Freddie, including two former CEOs. “Today’s announcement by the SEC proves what I have been saying all along—Fannie Mae and Freddie Mac played a leading role in the 2008 financial collapse that wreaked havoc on the U.S. economy,” said Congressman Scott Garrett, the New Jersey Republican who is chairman of the financial services subcommittee on capital markets and government-sponsored enterprises (GSEs).

But the SEC’s case doesn’t prove anything of the sort, and in fact, the theory that the GSEs are to blame for the crisis has been thoroughly discredited, again and again. The roots of this canard lie in an opposition—one that festered over decades—to the growing power of Fannie Mae, in particular, and its smaller sibling, Freddie Mac. This stance was both right and brave, and was mostly taken by a few Republicans and free-market economists—although even President Clinton’s Treasury Department took on Fannie and Freddie in the late 1990s. The funny thing, though, is that the complaint back then wasn’t that Fannie and Freddie were making housing too affordable. It was that their government-subsidized profits were accruing to private shareholders (correct), that they had far too much leverage (correct), that they posed a risk to taxpayers (correct), and what they did to make housing affordable didn’t justify the massive benefits they got from the government (also correct!). Indeed, in a 2004 book that recommended privatizing Fannie and Freddie, one of its authors, Peter Wallison, wrote, “Study after study has shown that Fannie Mae and Freddie Mac, despite full-throated claims about trillion-dollar commitments and the like, have failed to lead the private market in assisting the development and financing of affordable housing.”

When the bubble burst in the fall of 2008, Republicans immediately pinned the blame on Fannie and Freddie. John McCain, then running for president, called the companies “the match that started this forest fire.” This narrative picked up momentum when Wallison joined forces with Ed Pinto, Fannie’s chief credit officer until the late 1980s. According to Pinto’s research, at the time the market cratered, 27 million loans—half of all U.S. mortgages—were subprime. Of these, Pinto calculated that over 70 percent were touched by Fannie and Freddie—which took on that risk in order to satisfy their government-imposed affordable housing goals—or by some other government agency, or had been made by a large bank that was subject to the CRA. “Thus it is clear where the demand for these deficient mortgages came from,” Wallison wrote in a recent op-ed in The Wall Street Journal, which has enthusiastically pushed this point of view in its editorial section since the crisis erupted.

But Pinto’s numbers don’t hold up. The Financial Crisis Inquiry Commission (FCIC)—Wallison was one of its 10 commissioners— met with Pinto and analyzed his numbers, and concluded that while Fannie and Freddie played a role in the crisis and were deeply problematic institutions, they “were not a primary cause.” (Wallison issued a dissent.) The FCIC argued that Pinto overstated the number of risky loans, and as David Min, the associate director for financial markets policy at the Center for American Progress, has noted, Pinto’s number is far bigger than that of others—the nonpartisan Government Accountability Office estimated that from 2000 to 2007, there were only 14.5 million total nonprime loans originated; by the end of 2009, there were just 4.59 million such loans outstanding.

The disparity stems from the fact that Pinto defines risky loans far more broadly than most experts do. Min points out that the delinquency rates on what Pinto calls subprime are actually closer to prime loans than to real subprime loans. For instance, Pinto assumes that all loans made to people with credit scores below 660 were risky. But Fannie- and Freddie-backed loans in this category performed far better than the loans securitized by Wall Street. Data compiled by the FCIC for a subset of borrowers with scores below 660 shows that by the end of 2008, 6.2 percent of those GSE mortgages were seriously delinquent, versus 28.3 percent of non-GSE securitized mortgages.

To recap: If private-sector loans performed far worse than loans touched by the government, how could the GSEs have led the race to the bottom?

Another problematic aspect to Pinto’s research is that he assumes the GSEs guaranteed risky loans solely to satisfy affordable housing goals. But many of the guaranteed loans didn’t qualify for affordable housing credits. The GSEs did all this business because they were losing market share to Wall Street—their share went from 57 percent in 2003 to 37 percent by 2006. As the housing bubble grew larger, they wanted to recapture their share and boost their profits.

Indeed, the SEC lawsuit specifically says Fannie and Freddie began to do more risky business not to meet their goals, but rather to recapture market share—and they began to do so aggressively in 2006, when the market was already peaking. So while the GSEs played a huge role in blowing the bubble bigger than it otherwise would have been—and the numbers in the SEC complaint are huge—they followed, rather than led, the private market.

It’s also very hard to look at what happened in the crisis and conclude that nothing went wrong in the private sector. Note that the other Republican members of the FCIC refused to sign on to Wallison’s dissent. Instead, they issued their own dissent. “Single-source explanations,” they said, were “too simplistic.”

Yet despite all that, the one-note Republican refrain hasn’t changed. The explanation is obvious: The “government sucks” rant polls well with conservatives. Mix in an urge to counter the equally simplistic story from the left—that the crisis was entirely the fault of greedy, unscrupulous bankers—and you get a strong resistance to the facts. Maybe there’s a deeper reason, too. For many, belief in the all-knowing market was (and is) almost a religion. This financial crisis challenged that faith by showing the market would indeed allow loans to be made that could never be paid back, and by showing that highly paid financial services executives aren’t gods, and that many of them are stupid and venal and all too human.

So maybe the Republican orthodoxy is understandable, but that doesn’t mean it isn’t scary. Of course, there’s the great line from Edmund Burke: “Those who do not know history are destined to repeat it.” Our housing market is a mess that threatens to drag down the entire economy, and whoever is president in 2013 needs to have a plan. Denying the facts is not a good start.

PHOTO: Republican presidential candidates (L-R) former U.S. Senator Rick Santorum (R-PA), former Massachusetts Governor Mitt Romney, former Speaker of the House Newt Gingrich and U.S Representative Ron Paul (R-TX) arrive on stage before the Republican presidential candidates debate in Tampa, Florida January 23, 2012.  REUTERS/Brian Snyder

Juries are sometimes told that in the eyes of the law, all Americans are created equal. But if that’s the case, then why does the Securities and Exchange Commission’s treatment of former top Fannie and Freddie executives seem to be so much harsher than its treatment of Citigroup and its senior people for what appear to be similar infractions?

Recall that on Dec. 16, the SEC charged six former executives at mortgage giants Fannie Mae and Freddie Mac with fraud for not properly disclosing the companies’ exposure to risky mortgages. In Fannie’s case, the SEC alleges that former CEO Dan Mudd and two other executives made a series of “materially false and misleading public disclosures.” The SEC says, for instance, that at the end of 2006, Fannie didn’t include $43.3 billion of so-called expanded approval mortgages in its subprime exposure and $201 billion of mortgages with reduced documentation in its Alt-A exposure. In Freddie’s case, the SEC alleges that while former CEO Dick Syron and two other executives told investors it had “basically no” subprime exposure, they weren’t including $141 billion in loans (as of the end of 2006) that they internally described as “subprime” or “subprime like.”

There are some gray areas in the SEC’s case. Start with the fact that there is no single definition of what constitutes a subprime or Alt-A loan, or as Mudd said in a speech in the fall of 2007, “the vague, prosaic titles that pass for market data — ‘subprime,’ ‘Alt A,’ ‘A minus’ — mean different things to the beholders.” In Fannie’s 2006 10(k), Mudd noted that apart from what Fannie was defining as subprime or Alt-A, the company also had “certain products and loan attributes [that] are often associated with a greater degree of credit risk,” like loans with low FICO scores or high loan-to-value ratios. And in a letter to shareholders in 2006, Mudd noted that “to provide an alternative to risky subprime products, we have purchased or guaranteed more than $53 billion in Fannie Mae loan products with low down payments, flexible amortization schedules, and other features.” These are the very holdings that the SEC says should have been disclosed as subprime exposure.

The SEC’s case on the Alt-A mortgages is equally tricky. As blogger David Fiderer points out, “reduced documentation” can refer to a loan for which the borrower proves his income with a W-2 for last year in addition to a 1040 for the previous year. Or “reduced documentation” can refer to a “stated income/stated asset” loan, otherwise known as a liar loan.” As of September 2008, the default rate on the loans that the SEC says Fannie should have labeled Alt-A was less than a third of the default rate on those Fannie did call Alt-A. In other words, you could argue that if Fannie had mixed those two groups of loans together, thereby lowering the reported default rate, the company could have been criticized — or possibly even sued — for making the default rate on its Alt-A loans look artificially low.

Be that as it may, the SEC, which has been under fire for not being aggressive enough, brought its charges. “Fannie Mae and Freddie Mac executives told the world that their subprime exposure was substantially smaller than it really was,” said Robert Khuzami, director of the SEC’s Enforcement Division, in the press release. “These material misstatements occurred during a time of acute investor interest in financial institutions’ exposure to subprime loans … all individuals, regardless of their rank or position, will be held accountable for perpetuating half-truths or misrepresentations about matters materially important to the interest of our country’s investors.”

The companies themselves entered into non-prosecution agreements and agreed to cooperate with the SEC’s litigation against the former executives. (The SEC said it “considered the unique circumstances presented by the companies’ current status,” meaning that because the companies were wards of the state following the government takeover in the fall of 2008, it wasn’t in taxpayers’ best interests to go after them.) The SEC didn’t charge any of the more junior employees who were presumably involved in the actual drafting of the disclosures. But the SEC is throwing the book at the former executives, charging them with securities fraud — its most serious charge — and seeking financial penalties plus a bar on any of the six serving as an officer or director of a publicly traded company. It’s one of the harshest treatments of big corporate executives in the aftermath of the financial crisis.

Just weeks earlier, a judge in New York had thrown a wrench in another SEC proceeding. Judge Jed Rakoff refused to approve a settlement in which Citigroup (or rather, its shareholders) would have paid $285 million to settle SEC charges that the bank misled investors when it sold a $1 billion subprime CDO, made itself a profit of about $160 million and cost investors about $700 million. The charge involved only negligence, not fraud. In his rejection of the settlement, Rakoff wrote: “If the allegations of the Complaint are true, then Citigroup is getting a very good deal; even if they are untrue, it is a mild and modest cost of doing business.” Separately, the SEC filed a complaint against a former Citigroup employee named Brian Stoker, who the SEC describes as “primarily responsible” for the deal’s marketing documents. Stoker was charged with fraud — but Stoker was a relatively junior guy.

That attempted settlement, though, isn’t the only deal the SEC has cut with Citigroup. In 2010, Citigroup’s shareholders paid $75 million to settle charges that Citigroup — get this — misled investors over its exposure to risky mortgages. According to the SEC, Citi repeatedly told investors that its exposure was only $13 billion and declining, when in reality it was more than $50 billion and not declining. Citi neither admitted nor denied the charges, as was the standard convenience afforded to companies until Judge Rakoff began to derail the settlement machine.

There is probably gray in the Citi complaint as well, but at least on the surface, it’s harder to find. The allegedly undisclosed exposure consisted of “super senior” tranches of subprime mortgage-backed securities (the stuff that was supposed to be really safe, but wasn’t) and “liquidity puts” (which required Citi itself to buy outstanding commercial paper that was backed by subprime mortgage-backed securities if the paper couldn’t be sold to investors). According to the SEC’s complaints, Citi executives didn’t feel they had to disclose these exposures because they felt the risk of default was low. Yet by the fall of 2007, Citi had had to buy “substantially all” of the $25 billion in commercial paper and had started taking losses on the super-seniors. Even then, Citi still didn’t disclose its exposure, but rather bundled these losses in with others. According to the SEC, “senior management was aware” that the super-senior tranches were a source of the losses, but the company “nevertheless continued to exclude” the additional exposure. Only on Nov. 4, 2007, did Citi issue a press release in which it acknowledged the existence of this junk — and the after-tax losses of $5 billion to $7 billion it would have to take as a result of all of its subprime exposure.

In its own press release announcing the settlement, the SEC summed it up this way: “Even as late as fall 2007, as the mortgage market was rapidly deteriorating, Citigroup boasted of superior risk management skills in reducing its subprime exposure to approximately $13 billion. In fact, billions more in CDO and other subprime exposure sat on its books undisclosed to investors,” said Khuzami. “The rules of financial disclosure are simple — if you choose to speak, speak in full and not in half-truths.” Added Scott Friestad, the associate director of the SEC’s Enforcement Division: “Citigroup’s improper disclosures came at a critical time when investors were clamoring for details about Wall Street firms’ exposure to subprime securities.”

In addition to the fine paid by Citi’s shareholders, the SEC gave two executives, Citi’s former CFO, Gary Crittenden, and its former head of investor relations, Arthur Tildesley, light slaps on the wrist for their roles in causing Citigroup to make the misleading statements. Crittenden and Tildesley agreed to “cease and desist” from anymore violations of the securities laws, and they paid $100,000 and $80,000, respectively. That’s a far cry from being charged with fraud and being barred from serving as an officer or director of a publicly traded company. Neither man admitted or denied the charges. Tildesley continued to work at Citi.

The SEC doesn’t comment on enforcement cases. But it might be worth noting that the Citi charges came at the end of a settlement process, whereas the charges against the Fannie and Freddie executives might be just the beginning of a process that could end in something far less extreme than fraud charges. Nor is the SEC a monolithic agency, meaning that there may not be any coordination between the teams in charge of each case. And there could, of course, be differences between the cases that can’t be gleaned from the surface of the complaints.

Still, given the leniency seemingly accorded Citigroup’s people, it’s hardly surprising that some would charge that Citi received special treatment. In fact, the SEC’s Office of the Inspector General investigated an anonymous complaint that there were “serious problems with special access and preferential treatment” in the Citi affair. While the OIG did not find that that was the case, its redacted report still offers insight into the vagaries of the SEC’s process.

Most notably, Tildesley had agreed to settle to a lesser charge of fraud than that faced by the former Fannie and Freddie executives — but it was still fraud. Crittenden, however, wouldn’t settle. After SEC officials had meetings not just with Crittenden and Citi’s lawyers but even one in which Dick Parsons, Citigroup’s then-chairman, “made a personal pitch,” the SEC agreed to the slap on the wrist for Crittenden. So Tildesley’s settlement was changed to match Crittenden’s. The SEC enforcement staff had notified other individuals that it planned to recommend charges against them, the report said, but their identities are blacked out, and the non-redacted text doesn’t explain why those individuals weren’t charged. But an unidentified SEC official testified that Citigroup was “trying to use whatever leverage they had … to get us to … lay off the individuals.”

These days, Fannie and Freddie, far from having any “leverage,” are political punching bags. And they deserve to be punched: The companies were disasters. In the wake of a crisis the magnitude of the one we experienced, it’s also probably better that the SEC is too aggressive, rather than not aggressive enough. But above all, the SEC has a duty to be fair. Which means making sure that there can’t even be the perception that a company’s “leverage” influences the treatment accorded its employees.

By Bethany McLean
The opinions expressed are her own.

There were a lot of things that were supposed to save Europe from potential financial Armageddon. Chief among them is the EFSF, or European Financial Stability Facility.

In the spring of 2010, European finance ministers announced the facility’s formation with great fanfare. In its inaugural report, Standard & Poor’s described the EFSF as the “cornerstone of the EU’s strategy to restore financial stability to the euro zone  sovereign debt market.”  The facility itself said in an October 2011 date presentation that its mission is to “safeguard financial stability in Europe.”

That of course hasn’t happened. And the evidence suggests that the EFSF may have only exacerbated the problems.

In theory, the facility is supposed to provide a way for a country that the market perceives as weak to still borrow money on good terms. The initial idea was that instead of the financially troubled country itself trying to sell its debt to live another day, the EFSF would be the one to raise the money and lend it to the country in question. The logic was simple: country X might be shaky, but the EFSF deserved a triple-A rating.

For all of its would-be financial firepower, the EFSF isn’t much to see—it’s just an office in Luxembourg with a German-born economist CEO named Klaus Regling, who oversees a staff of about 20. Its power—and that rating—is derived from the assumption that any debt it issues is guaranteed by the members of the euro zone. Initially, each member pledged unconditionally to repay up to 120% of its share of any debt the EFSF issued. (A country’s share is determined by the amount of capital it has in the European Central Bank.)

On paper, it all sounded great. The reality is that the EFSF wasn’t meant to be an active institution; it was supposed to be a fire extinguisher behind glass: never to be used. “The EFSF has been designed to bolster investor confidence and thus contain financing costs for euro zone member states,” wrote Standard & Poors in its initial report granting the triple A rating. “ If its establishment achieves this aim, we would not expect EFSF to issue a bond itself.”  Moody’s, for its part, wrote that the EFSF “reflects the political commitment of the euro zone member states to the preservation of the euro and the European Monetary Union.” That show of commitment alone was supposed to be enough to reassure the market.

In granting the EFSF the all-important triple-A rating, the rating agencies were somewhat cautious. They weren’t willing to assume, as they did with subprime mortgages, that any subset of debt guarantees—no matter how small—made by countries that weren’t themselves triple-A rated would be worthy of the gold-plated standard. Instead, they insisted that the EFSF’s loans had to be covered by guarantees from triple-A rated countries and cash reserves that the EFSF would deduct from any money it raised before it passed those proceeds on to the borrowing country. Based on that, euro zone members initially pledged a total of 440 billion euros ($650 billion) in guarantees. However, S&P said in its initial report that the EFSF would be able to raise less than $350 billion of triple-A rated proceeds.

Of course the euro zone did break the glass: the fire extinguisher was used, first in support of Ireland, and then Portugal, and then Greece. This summer, the European Powers That Be agreed to bolster the EFSF’s lending capacity by increasing the maximum guarantee commitments of the member states to 165%, instead of 120%. That was supposed to enable the EFSF to borrow up to 452 billion euros “without putting downward pressure on its ratings,” according to S&P.

As we now know, that’s not nearly enough money to end the crisis, especially given that the EFSF’s commitments to Ireland, Greece and Portugal leave the facility with a lending capacity of just 266 billion euros, according to a recent report from Moody’s. (I found it difficult to add up where the money went.)

Hence the politicians’ latest idea: leverage the EFSF’s remaining ability to borrow. Either have the EFSF offer first-loss insurance when a country issues debt, or turn its remaining capacity into the first-loss tranche of a collateralized debt obligation, which would raise money by selling bonds to other countries like China.

Besides being undersized for the job, there’s a core structural problem with the EFSF: It is only as strong as its triple-A members—not just Germany, which according to that October 2011 EFSF presentation contributes 29% of the total value of the EFSF’s guarantees, but also France, which contributes 22%, and the Netherlands, which contributes 6%.

Some financial analysts have questioned why any European country deserves a triple-A rating, seeing as EU members can’t print their own currency to pay off their debts.  As the financial turmoil has unfolded, it’s become clear that the only EU country the market views as a bona-fide triple-A is Germany. So as much of Europe crumbles, the EFSF’s triple-A, in the eyes of the market, is supported by a lone country. As one bond market participant says, “Eventually, only the German guarantee will matter, and it isn’t big enough to cover this.”

Indeed, Germany represents less than a quarter of the EU’s GDP, and obviously the nation’s economic health is to no small degree dependent on other members of the EU buying German goods. (Such interconnectedness was the whole point of the European Union—and that helps explain why the cost to insure against a German default has more than doubled since the summer, to $93,655 a year to insure $10 million of 5-year German debt.)

Not surprisingly, the EFSF’s last 3 billion euro bond sale, on Monday, November 7, met with what Moody’s called “significantly less demand” than a similar issue last spring. The issue was originally supposed to be 5 billion euros, and the spread, relative to German debt, that was required to lure investors was over three times the spread that was needed last spring. As Moody’s wrote in its report, “the demand for the EFSF bond issuance was dampened by a lack of confidence over the credit resilience of its guarantors.” Another way to think about this is that since the strength of the EFSF is dependent on the strength of its parts, the more individual countries have to pay to raise money, the more the EFSF itself has to pay.

In fact, it’s the definition of a vicious cycle. The EFSF’s funding costs rise along with those of its guarantors, and perversely, bond market participants say that the very existence of the facility also causes its guarantors’ cost to rise. That’s because there aren’t many investors who are interested in buying European sovereign debt these days. Those who are demand a very high premium if they’re going to buy, say, Italian debt instead of EFSF debt. This is why the EFSF was going to be hurtful, rather than helpful, if it had to be used: it competes with its very creators for investment, driving spreads higher and higher. One hedge fund manager calls the EFSF  a “self-inflicted killer” of Europe’s bond markets.”

The EFSF is due to expire, and is supposed to be replaced by the European Stability Mechanism, or ESM, in mid-2013.  But the ESM looks like it’s going to have same problem the EFSF does: Its finances depend on the very same countries that it is supposed to bail out.  In other parts of the world, this isn’t called stability; this is called a Ponzi scheme.

Photo: Men climbs steps next to a share price ticker at the London Stock Exchange in the City of London. REUTERS/Andrew Winning

By Bethany McLean
The opinions expressed are her own.

On Monday morning, MF Global, the global brokerage for commodities and derivatives, filed for bankruptcy.  The firm’s roots go back over two centuries,  but in less than two years under CEO Jon Corzine, whose stellar resume includes serving as the chairman of Goldman Sachs, as New Jersey’s U.S. Senator, and as New Jersey’s governor, MF Global collapsed, after buying an enormous amount of European sovereign debt. The instant wisdom is that he made a big bet as part of his plan to transform MF Global into a firm like Goldman Sachs, which executes trades on behalf of its clients, and also puts its own money at stake. Although the size of the wager has received a great deal of scrutiny, the accounting and the disclosure surrounding it have not–and may have played a role in the firm’s demise.

In the 24 hours since the filing, more ugly questions have piled up, with the New York Times reporting that hundreds of millions of dollars of customer money have gone missing, and the AP saying that a federal official says that MF Global has admitted to using clients’ money as its problems mounted. Whether this was intentional or sloppy remains to be seen; MF Global didn’t respond to a request for comment by press time.

At the root of MF Global’s current predicament was a simple problem:  the profits in its core business had declined rapidly.  That core business was straightforward, even pedestrian; what the firm calls in filings a “significant portion” of total revenue came from the interest it generated by investing the cash clients had in their accounts in higher yielding assets and capturing the spread between that return and what was paid out to clients. As interest rates declined sharply in recent years, so did MF Global’s net interest income, from $1.8 billion in its fiscal 2007 second quarter to just $113 million four years later. MF Global’s stock, which sold for over $30 a share in late 2007, couldn’t climb above $10 by 2009.

Enter Corzine in the spring of 2010, who had just lost his job as New Jersey’s governor to Chris Christie. He was brought in by his old pal and former Goldman partner Chris Flowers, whose firm had invested in MF Global. Fairly quickly, Corzine accumulated a massive net long sovereign debt position that eventually totaled $6.3 billion, or five times the company’s tangible common equity as of the end of its fiscal second quarter. I’m told Corzine’s move was highly controversial within the firm.  But no one overruled him, maybe because after all, he was Jon Corzine. In a mark of just how much Corzine mattered to the market, in early August, MF Global filed a preliminary prospectus for a bond deal, in which the firm promised to pay investors an extra 1% if Corzine was appointed to a “federal position by the President of the United States” and left MF Global.

Buying European sovereign debt may not have been just a bet that the bonds of Italy, Spain, Belgium, Portugal and Ireland would prove attractive. An additional allure may have been the way MF Global paid for the purchases, and thereby, the way the accounting worked. MF Global financed these purchases, as its filings note, using something called “repo-to-maturity.” That means the bonds themselves were used as the collateral for a loan, and MF Global earned the spread between the rate on the bonds, and the rate it paid its repo counterparty, presumably another Wall Street firm. The bonds matured on the same day the financing did.

The key part is that for accounting purposes, MF Global’s filings say the transaction was treated as a sale. That means the assets and liabilities were moved off MF Global’s balance sheet, even though MF Global still bore the risk that the issuer would default; that means the exposure to sovereign debt was not included in MF Global’s calculation of value-at-risk, according to its filings. And that also means MF Global recognized a gain (or loss) on the transaction at the time of the sale. The filings do not say how much of the gain was recognized upfront.  But if it were a substantial portion, then these transactions would have frontloaded the firm’s earnings.  That, in turn, may have helped cover the fact that MF Global’s core business was struggling.

MF Global’s public filings also don’t say how much this contributed to earnings. But one indication of the size of the repo-to-maturity deals comes in this small excerpt from MF Global’s most recent 10K, under the heading of “Off balance sheet arrangements and risk”:  “At March 31, 2011, securities purchased under agreements to resell and securities sold under agreements to repurchase of $1,495.7 million and $14,520.3 million, respectively, at contract value, were de-recognized.” (“De-recognized” means moved off the balance sheet.) Of that $14.5 billion, 52.6% was collateralized with sovereign debt. One way to get a sense of the ramp-up of “repo to maturity” transactions is to compare the figures to those as of March 31, 2010:  The securities sold under agreements to repurchase increased by some $9 billion.

Once the regulators and rating agencies began to zero in on all of this, it didn’t matter that the trade itself may not have been that risky. (The debt all matured by the end of 2012, and MF Global, of course, had financing in place until it matured.) But it was European sovereign debt, after all, and the trade was huge—and it appears that part of the concern may have been the accounting, and certainly the lack of disclosure. On September 1, MF Global said in a filing that the Financial Industry Regulatory Authority (FINRA) was requiring it to “modify its capital treatment” of the European sovereign debt trades.  According to an affidavit filed by MF Global’s president on the day of the bankruptcy, FINRA was “dissatisfied” with the September filing and  “demanded” that MF Global announce that it “held a long position of $6.3 billion in a short-duration European sovereign portfolio financed to maturity.” Words like “dissatisfied” and “demanded” aren’t good in the context of a regulator!

By the time the market opened on Monday, October 24^th, MF Global’s stock had already fallen 62% from its high of almost $10 following the announcement that Corzine was joining the firm. Then, Moody’s downgraded the firm’s debt, citing MF Global’s “inability to generate $200 million to $300 million in annual pretax earnings and keep its leverage within acceptable range.” In other words, Moody’s was concerned about the real profitability of the business. The next day, MF Global reported its $6.3 billion position, per FINRA’s demand, and also reported that it had lost almost $200 million in the quarter ended in September—in large part because the firm had reduced its deferred tax assets by $119.4 million, a sign that the accountants were saying there wouldn’t be a return to big profits any time soon. By the end of the week, all three rating agencies had downgraded MF Global debt to junk. Moody’s wrote that its downgrade “reflects our view that MF Global’s weak core profitability contributed to it taking on substantial risk in the form of its exposure to European sovereign debt.” MF Global’s stock finished the week down 67%.

The actual details of the run aren’t clear yet, but according to the CFO’s affidavit, the ratings downgrades “sparked an increase in margin calls,” which drained cash. Plans to sell all or part of the business fell through, reportedly because of the discovery of the missing cash. Another part of the explanation might be that potential buyers found out just how weak the core business was.

Of course, if Corzine made the trades for an accounting play, there’s a deeper question of why he would feel the need to do this. And isn’t that always the question in situations like this?

PHOTO: Jon Corzine, MF Global Holdings Ltd. CEO, leaves the office complex where MF Global Holdings Ltd have an office on 52nd Street in midtown Manhattan, October 31, 2011. REUTERS/Brendan McDermid