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THE CDO MACHINE
dealing, investments, securitization, and similar activities on top of their traditional
investment banking functions. Recall that at Bear Stearns, trading and investments ac-
counted for more than of pretax earnings in some years after .
The investment banks also owned depository institutions through which they
could provide FDIC-insured accounts to their brokerage customers; the deposits pro-
vided cheap but limited funding. These depositories took the form of a thrift (super-
vised by the OTS) or an industrial loan company (supervised by the Federal Deposit
Insurance Corporation and a state supervisor). Merrill and Lehman, which had
among the largest of these subsidiaries, used them to finance their mortgage origina-
tion activities.
The investment banks’ possession of depository subsidiaries suggested two obvi-
ous choices when they found themselves in need of a consolidated supervisor. If a
firm chartered its depository as a commercial bank, the Fed would be its holding
company supervisor; if as a thrift, the OTS would do the job. But the investment
banks came up with a third option. They lobbied the SEC to devise a system of regu-
lation that would satisfy the terms of the European directive and keep them from
European oversight —and the SEC was willing to step in, although its historical fo-
cus was on investor protection.
In November , almost a year after the Europeans made their announcement,
the SEC suggested the creation of the Consolidated Supervised Entity (CSE) program
to oversee the holding companies of investment banks and all their subsidiaries. The
CSE program was open only to investment banks that had large U.S. broker-dealer
subsidiaries already subject to SEC regulation. However, this was the SEC’s first foray
into supervising firms for safety and soundness. The SEC did not have express leg-
islative authority to require the investment banks to submit to consolidated regula-
tion, so it proposed that the CSE program be voluntary; the SEC crafted the new
program out of its authority to make rules for the broker-dealer subsidiaries of in-
vestment banks. The program would apply to broker-dealers that volunteered to be
subject to consolidated supervision under the CSE program, or those that already
were subject to supervision by the Fed at the holding company level, such as JP Mor-
gan and Citigroup. The CSE program would introduce a limited form of supervision
by SEC examiners. CSE firms were allowed to use a new methodology to calculate
the regulatory capital that they were holding against their securities portfolios—a
methodology based on the volatility of market prices. This methodology, referred to
as the “alternative net capital rule,” would be similar to the standards—based on the
Market Risk Amendment to the Basel rules—that large commercial banks and
bank holding companies used for their securities portfolios.
The traditional net capital rule that had governed broker-dealers since had
required straightforward calculations based on asset classes and credit ratings, a
bright-line approach that gave firms little discretion in calculating their capital. The
new rules would allow the investment banks to create their own proprietary Value at
Risk (VaR) models to calculate their regulatory capital—that is, the capital each firm
would have to hold to protect its customers’ assets should it experience losses on its
