2008 Financial Crisis

and Leverage

at Investment Banks

Thomas J. HealeyMarch 10, 2011

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Who Are the Players?• Bank holding company: Owns and/or controls one or more…banks….The Board of Governors

is responsible for regulating and supervising bank holding companies, even if the bank owned by the holding company is under the primary supervision of a different federal agency (OCC or FDIC).

• Commercial bank: A financial institution that is owned by stockholders, operates for a profit, and engages in various lending activities.

• Financial holding company: A financial entity engaged in a broad range of banking-related activities, created by the Gramm-Leach-Bliley Act of 1999. These activities include: insurance underwriting, securities dealing and underwriting, financial and investment advisory services, merchant banking, issuing or selling securitized interests in bank-eligible assets, and generally engaging in any non-banking activity authorized by the Bank Holding Company Act. The Federal Reserve Board is responsible for supervising the financial condition and activities of financial holding companies.

• Investment bank: Acts as underwriter or agent that serves as intermediary between issuer of securities and the investing public.

• Securities Broker-dealer: Entities primarily engaged in acting as agents (i.e., brokers) between buyers and sellers in buying or selling securities on a commission or transaction fee basis.

Source: http://www.ffiec.gov/nicpubweb/Content/HELP/Institution%20Type%20Description.htm

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“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 ratio at the other firm also rose significantly.”

- Stephen Labaton (10/2/2008)New York Times

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In his testimony before the Financial crisis

Inquiry Commission, JP Morgan Chase

Chairman and CEO Jamie Dimon remarked:

“Basel II Capital Standards, which were

adopted by global banks and U.S. investments

banks, allowed too much leverage.”- Jamie Dimon

JP Morgan Chase Chairman and CEO

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Net Capital Rule

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“We 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, so that our firms

can remain competitive with our foreign

competitors risk-based capital standards must

become the norm.”- Henry M. Paulson (2000)

Chairman & CEO, Goldman Sachs & Co.

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“We’ve said these are the big guys, but

that means if anything goes wrong, it’s

going to be an awfully big mess.”- Harvey Goldschmid (4/28/2004)

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“We have a good deal of

comfort about the capital

cushions at these firms at the

moment.”- Christopher Cox (3/11/2008)

Former Chairman of the Securities and Exchange Commission

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December/200810

Firm Current Status

Lehman Brothers Insolvent

Bear Stearns Part of JP Morgan

Merrill Lynch Part of Bank of America

Goldman Sachs Bank Holding Company

Morgan Stanley Bank Holding Company

“The losses incurred by Bear Stearns and other large broker-

dealers were not caused by ‘Rumors’ or a ‘crisis of

confidence,’ but rather by inadequate net capital and the

lack of constraints on the incurring of debt.”

- Lee A. Pickard, a former SEC official

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“The levels of capital in the Broker-dealer

subsidiaries remained relatively stable

after they began operating under the 2004

amendments, and, in some cases,

increased significantly.”-Erik Sirri (4/29/2009)

SEC Official

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Conclusions of

the financial crisis commission

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THE FINANCIAL CRISIS

INQUIRY COMMISSION uses

the word “leverage” 182

times.

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Commission Conclusions

Phil AngelidesBrooksley BornBryon GeorgiouBob GrahamHeather MurrenJohn W. Thompson

Bill ThomasKeith HennesseyDouglas Holtz-Eakin

Peter J. Wallison

5 Causes

10 Causes

1 Cause(Different)

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The data on

leverage

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Amount of debt outstanding

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Total Big Five Investment Bank Liabilities

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Percent Change

1994 1997 2003 2007 1994-2003 2003-2007 1994-2007

Leverage

Bear Stearns 30 36 27 33 -9% 19% 8%

Goldman Sachs -- 26 18 25 -- 42% -5%

Lehman Brothers 31 33 23 30 -28% 31% 14%

Merrill Lynch 27 34 17 31 -38% 83% 14%

Morgan Stanley 24 21 23 32 -6% 40% 32%

Aggregate 28 28 20 29 -27% 44% 6%

Shareholders’ Equity USD Millions

Bear Sterns 2,167 3,276 7,470 11,793 245% 58% 444%

Goldman Sachs -- 6,537 21,632 42,800 -- 98% 555%

Lehman Brothers 3,395 4,523 13,174 22,490 288% 71% 562%

Merrill Lynch 5,818 8,329 27,651 31,932 375% 15% 449%

Morgan Stanley 4,555 13,956 24,867 31,269 446% 26% 586%

Total 15,934 36,621 94,794 140,284 495% 48% 780%

Liabilities USD Millions

Bear Stearns 65,075 118,007 204,698 383,569 215% 87% 489%

Goldman Sachs -- 171,864 380,886 1,069,731 -- 181% 522%

Lehman Brothers 106,552 147,182 298,887 668,573 181% 124% 527%

Merrill Lynch 157,932 284,490 466,867 988,118 196% 112% 526%

Morgan Stanley 112,139 288,331 577,976 1,014,140 415% 75% 804%

Total 441,698 1,009,874 1,929,314 4,124,131 337% 114% 834%

Source: Data from Standard & Poor’s, Compustat21

Liabilities, Shareholders’ Equity, and Leverage among the Big Five Investment Banks, Selected Years

1994 1998 1999 2003 2004 2007 1994-1998 1999-2003 2004-2007

Total Debt

Lehman Brothers 96,577 133,696 196,138 245,880 279,135 506,999 6.72% 7.77% 16.09%

Merrill Lynch 128,269 202,084 214,532 276,440 393,580 650,354 9.52% 5.20% 13.38%

Morgan Stanley 94,517 210,642 234,247 355,928 443,895 522,300 17.38% 8.73% 4.15%

Goldman Sachs -- 139,488 163,779 247,467 315,325 675,642 -- 8.61% 20.99%

Bear Stearns 46,483 94,527 101,473 117,954 137,134 238,722 15.25% 3.06% 14.86%

…of which Long Term Debt

Lehman Brothers 8,248 21,665 23,351 38,175 50,550 124,592 21.31% 10.33% 25.30%

Merrill Lynch 8,727 46,476 47,742 68,572 99,413 201,087 39.72% 7.51% 19.26%

Morgan Stanley 7,755 23,803 22,685 57,902 82,588 159,816 25.14% 20.61% 17.94%

Goldman Sachs -- 17,264 18,311 57,482 80,696 197,474 -- 25.71% 25.07%

Bear Stearns 3,037 11,832 12,424 25,126 30,675 58,952 31.26% 15.13% 17.74%

…of which Debt in Current Liabilities

Lehman Brothers 88,329 112,031 145,787 207,705 228,585 382,407 4.87% 7.34% 13.73%

Merrill Lynch 119,543 155,608 166,790 207,868 294,167 449,267 5.41% 4.50% 11.17%

Morgan Stanley 86,762 186,839 211,562 298,026 361,307 362,484 16.58% 7.09% 0.08%

Goldman Sachs -- 122,224 145,468 189,985 234,629 478,168 -- 5.48% 19.48%

Bear Stearns 43,446 82,694 89,049 92,828 106,459 179,770 13.74% 0.83% 13.99%

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Debt, Broken out into Long and Short-Term Debt

2007•US Non-financial corporate debt:

$6.7 trillion

•“Big Five” Debt:

$2.7 trillion

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Liquidity

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Short Term Debt AnalysisShort Term Debt

($Billion)Growth

RateEquities($Billion)

ST Debt / Equity

2004 2007 2007 2007

Lehman Brothers 229 382 13.7% 22 17.4x

Merrill Lynch 294 449 11.2% 32 14.1x

Morgan Stanley 361 362 0.08% 31 11.6x

Goldman Sachs 235 478 19.5% 43 11.2x

Bear Stearns 106 180 14.0% 12 15.2x

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“The losses incurred by Bear Stearns and other large broker-

dealers were not caused by ‘Rumors’ or a ‘crisis of

confidence,’ but rather by inadequate net capital and the

lack of constraints on the incurring of debt.”

- Lee A. Pickard, a former SEC official

Firm Current Status

Lehman Brothers Insolvent

Bear Stearns Part of JP Morgan

Merrill Lynch Part of Bank of America

Goldman Sachs Bank Holding Company

Morgan Stanley Bank Holding Company

December/2008

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