2008 Financial Crisis and Leverage at Investment Banks Thomas J. Healey March 10,

2

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 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: 3

“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 4

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 5

Net Capital Rule 6

“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. 7

“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) 8

“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 9

December/ FirmCurrent Status Lehman BrothersInsolvent Bear StearnsPart of JP Morgan Merrill LynchPart of Bank of America Goldman SachsBank Holding Company Morgan StanleyBank 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 11

“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 12

Conclusions of the financial crisis commission 13

THE FINANCIAL CRISIS INQUIRY COMMISSION uses the word “leverage” 182 times. 14

Commission Conclusions Phil Angelides Brooksley Born Bryon Georgiou Bob Graham Heather Murren John W. Thompson Bill Thomas Keith Hennessey Douglas Holtz-Eakin Peter J. Wallison 5 Causes 10 Causes 1 Cause (Different) 15

The data on leverage 16

17

18

Amount of debt outstanding 19

Total Big Five Investment Bank Liabilities 20

Percent Change Leverage Bear Stearns %19%8% Goldman Sachs %-5% Lehman Brothers %31%14% Merrill Lynch %83%14% Morgan Stanley %40%32% Aggregate %44%6% Shareholders’ EquityUSD Millions Bear Sterns2,1673,2767,47011,793245%58%444% Goldman Sachs--6,53721,63242, %555% Lehman Brothers3,3954,52313,17422,490288%71%562% Merrill Lynch5,8188,32927,65131,932375%15%449% Morgan Stanley4,55513,95624,86731,269446%26%586% Total15,93436,62194,794140,284495%48%780% LiabilitiesUSD Millions Bear Stearns65,075118,007204,698383,569215%87%489% Goldman Sachs--171,864380,8861,069, %522% Lehman Brothers106,552147,182298,887668,573181%124%527% Merrill Lynch157,932284,490466,867988,118196%112%526% Morgan Stanley112,139288,331577,9761,014,140415%75%804% Total441,6981,009,8741,929,3144,124,131337%114%834% Source: Data from Standard & Poor’s, Compustat 21 Liabilities, Shareholders’ Equity, and Leverage among the Big Five Investment Banks, Selected Years

Total Debt Lehman Brothers96,577133,696196,138245,880279,135506, %7.77%16.09% Merrill Lynch128,269202,084214,532276,440393,580650, %5.20%13.38% Morgan Stanley94,517210,642234,247355,928443,895522, %8.73%4.15% Goldman Sachs--139,488163,779247,467315,325675, %20.99% Bear Stearns46,48394,527101,473117,954137,134238, %3.06%14.86% …of which Long Term Debt Lehman Brothers8,24821,66523,35138,17550,550124, %10.33%25.30% Merrill Lynch8,72746,47647,74268,57299,413201, %7.51%19.26% Morgan Stanley7,75523,80322,68557,90282,588159, %20.61%17.94% Goldman Sachs--17,26418,31157,48280,696197, %25.07% Bear Stearns3,03711,83212,42425,12630,67558, %15.13%17.74% …of which Debt in Current Liabilities Lehman Brothers88,329112,031145,787207,705228,585382, %7.34%13.73% Merrill Lynch119,543155,608166,790207,868294,167449, %4.50%11.17% Morgan Stanley86,762186,839211,562298,026361,307362, %7.09%0.08% Goldman Sachs--122,224145,468189,985234,629478, %19.48% Bear Stearns43,44682,69489,04992,828106,459179, %0.83%13.99% 22 Debt, Broken out into Long and Short-Term Debt

2007 US Non-financial corporate debt: $6.7 trillion “Big Five” Debt: $2.7 trillion 23

Liquidity 24

Short Term Debt Analysis Short Term Debt ($Billion) Growth Rate Equities ($Billion) ST Debt / Equity Lehman Brothers %2217.4x Merrill Lynch %3214.1x Morgan Stanley %3111.6x Goldman Sachs %4311.2x Bear Stearns %1215.2x 25

“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

FirmCurrent Status Lehman BrothersInsolvent Bear StearnsPart of JP Morgan Merrill LynchPart of Bank of America Goldman SachsBank Holding Company Morgan StanleyBank Holding Company December/