Up The Ante, Just Like Poker

Green with Envy, Wall Street Leverages Up
Wall Street’s biggest and brightest investment banks have grown rich in recent years, feeding hedge funds' and private equities' insatiable desires for risk taking.
Typically, hedge funds rely on Wall Street firms for trading and for providing the most vital financial commodity of all: Leverage. It’s not unusual for a hedge fund or private equity firm to leverage its own capital many times over: 30, 50, or even 100 to 1. That way, these largely unregulated firms are free to make additional emerging market investment and buyout bids – all of it financed at low rates courtesy of Wall Street.
Well, apparently seeing all these hedge funds grow rich on leverage, Wall Street has grown a bit green with envy, and is now moving to ratchet up its own leverage and profits, according to Bloomberg .
Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns have the potential to earn an extra US$4.4 billion in profits as a result of basically playing a shell-game with their own books. They’re shifting capital out of safe investments like cash and into high-return (and high-risk) bets on derivatives. And the whole shell-game is legally sanctioned by Wall Street’s pals at the S.E.C.
Due in large part to intense lobbying by Wall Street, the S.E.C. recently allowed several big firms to up the ante on their own internal leverage. They made this happen by changing the rules for calculating “net capital.” Under these guidelines, Wall Street firms must reserve a certain percentage of every dollar of capital at risk to help satisfy old-fashioned notions...like solvency in the face of a financial market crisis, or the blow-up of a major client.
These reserve requirements have been around for decades, and have been strengthened in the past (typically AFTER some disaster like Long Term Capital Management’s bankruptcy) to help provide insurance against massive financial losses on Wall Street.
But since such a scandalous event hasn’t happened in Wall Street’s recent memory (which stretches back at least to last quarter), the S.E.C. deems it appropriate to ease the rules.
After all, how else can Wall Street be expected to compete with the likes of London or Hong Kong as a major money-raising center?
The tide on Wall Street has certainly turned toward less regulation making it easier for U.S. firms to compete, but there’s something rather unsettling about loosening the standards by which these firms calculate their own risk levels, and decide how much reserve capital is sufficient.
One particularly disturbing provision of the rule change allows brokerage firms to use non-cash assets – including derivative contracts – as part of their capital reserves to offset risk!
To me, this all sounds a bit too much like allowing the fox to guard the hen-house. But money talks on Wall Street, and it’s all about the bottom line these days.