Bear Bryant, the Net Capital Rule, Henry Paulson and Leadership on Wall Street
Legendary college football coach Paul "Bear" Bryant gave a rather simple explanation for his success as a coach. He said,
"If anything goes bad, I did it.
If anything goes semi-good, we did it.
If anything goes really good, then you did it.
That's all it really takes to get people to win football games for you."
In the military this outlook on leadership and accountability is summed up in the maxim, "Officers eat last."
In what should surprise no one, these leadership fundamentals are non-existent on Wall Street. A particularly glaring example of this absence is provided by former Goldman Sachs CEO and Treasury Secretary, Henry Paulson. (1) Paulson's post-crisis memoir is called On the Brink. Outside of calling Fannie Mae and Freddie Mac "the most egregious example of the flawed policies that inflated the housing bubble and set off the financial crisis," (2), the book is virtually devoid of merit. Its only value is as a diary or day-by-day account of what happened during the crisis, particularly immediately before and after Lehman Brothers' failure.
In On the Brink, Paulson bemoans the enormous increase in leverage on Wall Street and rightly judges it to be one of the leading causes of the crisis. Two examples of this are the following;
"All of this (increasing complexity in credit markets - PCS) was complicated by the rapidly growing levels of leverage in the financial system and by the efforts of many financial institutions to skirt regulatory capital constraints in their quest for profits. Excessive leverage was evident in nearly all quarters." (3)
In recent years banks had borrowed more than ever - without increasing their capital enough. Much of the borrowing to support this increase in leverage was done in the market for repurchase agreements, or repos, where banks sold securities to counterparties for cash and agreed to buy them back later at the same price plus interest." (4)
All this increased leverage didn't just spontaneously occur; it had a primary cause. The primary cause was changes to the SEC's 'net capital rule.' As described in a recent blog post, (5), the SEC's net capital rule limited the leverage (borrowing) that financial service firms could employ. The SEC changed its net capital rule in 2004. For the sake of discussion, it is likely that the changes to the net capital rule allowed financial leverage to be increased from 12:1 to about 30:1 - that's $30 of borrowing for each $1 of capital! Whatever the actual increase in leverage was - and I believe these numbers are reasonably accurate - three of the five broker dealers governed by the net capital rule ceased to exist as independent companies as a result of the 2008 crisis; Bear Stearns, Lehman Brothers and Merrill Lynch. Indeed, in the immediate aftermath of Lehman’s collapse a former SEC official, Lee Pickard, called the 2004 changes to the net capital rule, “the primary reason for all of the losses (among broker-dealers) that have occurred.”
However, conspicuously absent from Paulson's criticism of all the borrowing on Wall Street that concerned him in On the Brink, was Paulson admitting to his enormous role in creating these obscene levels of short-term debt! In 2000 - and as CEO of Goldman Sachs - Paulson testified to the SEC as part of the SEC's hearings on the 'financial marketplace of the future.' Paulson stated of the net capital rule,
In addition, we (Goldman Sachs) and other global firms have, for many years, urged the (SEC) to reform its net capital rule to allow for more efficient use of capital. This is the single most important factor in driving significant parts of our business offshore.” (6)
'More efficient use of capital' simply means more leverage and more borrowing.
In short, in his memoir Paulson repeatedly bemoaned the enormous Wall St. leverage that played a major role in the crisis. However, he failed to admit to his equally enormous role in creating the regulatory environment that made this increased leverage possible. This example is hardly an isolated case of the total lack of accountability among the financial elite of this country, but is perhaps the most telling by virtue of its sheer brazenness. Whatever it is, the example of Henry Paulson and the net capital rule is in complete contrast to the simple-homespun wisdom latent in Bear Bryant's thoughts on leadership, That Henry Paulson's version of 'leadership' was able to propel him to the top of Wall Street as Goldman CEO should surprise no one.
Peter Schmidt
Sugar Land, TX
October 13, 2019
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ENDNOTES
(1) http://www.the92ers.com/dunce/henry-paulson
(2) Henry Paulson, On the Brink, Business Plus, New York City, p. xxxiii
(3) Paulson, On the Brink, p. 69
(4) Paulson, On the Brink, p. 98
(5) "Changes to the Net Capital Rule - William Donaldson, Useful Idiots and Today's Repo Market," http://www.the92ers.com/blog/changes-net-capital-rule-william-donaldson-useful-idiots-todays-repo-market
(6) Prepared testimony of Henry A. Paulson, Chairman and CEO of Goldman Sachs and Company, Securities and Exchange Commission (SEC) Hearing on the "Financial Marketplace of the Future," February 29, 2000