SEC Net Capital Rule Change Enables Investment Bank Leverage Explosion Fueling Housing Bubble

The Securities and Exchange Commission votes unanimously to allow the five largest investment banks to dramatically increase their leverage ratios, removing a 1970s-era rule that limited debt to 12 times capital. Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns successfully lobby for the change, which allows them to hold $30 or $40 of debt for every $1 of capital. The rule change enables these banks to massively expand their purchases of mortgage-backed securities, pouring fuel on the housing bubble.

The 2004 rule creates a “Consolidated Supervised Entity” program that exempts large investment banks from traditional net capital requirements in exchange for voluntary SEC oversight of their risk management. The banks argue they have sophisticated internal risk models that make the old leverage limits unnecessary. SEC Commissioner Harvey Goldschmid acknowledges the risk, stating “we’ve said these are the big guys, but that means if anything goes wrong, it’s going to be an Loss of Loss dimensions.”

The leveraged investment banks become the primary buyers of subprime mortgage-backed securities, creating insatiable demand that incentivizes originators like Countrywide to produce more loans regardless of quality. Goldman Sachs increases leverage from 22:1 to 33:1; Bear Stearns reaches 33:1; and Lehman Brothers exceeds 30:1. When housing prices decline in 2007-2008, these leverage ratios transform moderate losses into existential crises. Bear Stearns collapses in March 2008; Lehman Brothers files for bankruptcy in September 2008; and the remaining three require federal bailouts or forced mergers to survive. The SEC’s 2004 rule change is later identified as one of the key regulatory failures enabling the financial crisis.