Blameworthy

As far as current troubles go, most people would probably agree that there's plenty of blame to go around. Still, there was one group of individuals who were entrusted with ensuring that the system worked properly, but who appeared noticeably AWOL while the worst of the transgressions were taking place. In "Credit Crisis: Where Was The SEC?" Forbes' Liz Moyer asks a legitimate question.

Six years after the lessons of Enron and a decade after Long-Term Capital collapsed, regulators still can't seem to blunt the damage complex securities can have on financial markets. Why?

It's a fair question. Investment banks, mortgage brokers and ratings agencies are all being blamed for the subprime mortgage bubble and its sudden and stunning demise. But little has been said about the watchdogs at the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority, the regulators who oversee the activities of the banks. They have the power to stop fraud in the business of selling the complex credit derivatives, and they have jurisdiction over whether the complex securities sold by the banks met suitability requirements for the investors who bought them. Yet time and again, they've failed to do so.

Most notably, the SEC has the power to monitor whether the investment banks had adequate capital relative to their trading positions and balance sheets and the proper risk management systems to prevent catastrophic losses. More than $100 billion in write-downs later, several banks are scrounging for capital, and it's clear those risk management procedures weren't functioning very well, if at all.

One of the problems is the lack of clear information, outside the banks and trading floors, about the credit derivatives market. Collateralized debt obligations (CDO) and other structured finance products trade over-the-counter rather than on an exchange, at least in the United States. Many of them trade infrequently, meaning price information is limited.

Washington and Wall Street have been hesitant to clamp down on the over-the-counter market, the source of much profit-making. Last year, as the subprime market began its collapse, the President's Working Group, which includes the Treasury Department, the Federal Reserve, the SEC and the Commodities Futures Trading Commission, recommended against tighter oversight of the over-the-counter market, in the context of vetoing tighter regulation of hedge funds, saying the industry can self-police.

A counterparty risk group led by former New York Fed President Gerald Corrigan has also recommended industry "best practices" in lieu of tighter regulation of the derivatives trading market.

Leaving it up to Wall Street hasn't proven very effective, however. "The decision by the President's Working Group to recommend no detailed regulation of the over-the-counter market was wrong," says David Ruder, a former SEC chairman and now law professor at Northwestern University.

Regulators are taking a hard look at how banks structured, priced and sold mortgage-laden securities, but by the estimate of some it's too little and too late. "I don't think all the king's horses and all the king's men will put this together again," says Gary Aguirre, a former SEC lawyer.

There were warning signs.

In the summer of 2006, Jeff Kronthal, a senior executive in Merrill Lynch's structured products group, was fired after reportedly balking at then-Chief Executive Stanley O'Neal's demands that the firm get more aggressive in its risk-taking with mortgage securities. Kronthal was hired back by new Chief Executive John Thain in December to advise on the firm's risk management.

He wasn't the only one to sound alarms about the housing bubble and the explosion of the credit derivatives market. "Many credible people were public about their dissatisfaction with the mortgage loan market," says Janet Tavakoli, a structured finance expert with her own Chicago consulting firm.

She blames the ratings agencies for flawed ratings methodologies. The Fed and the SEC, among other regulators, are just packs of economists and lawyers. "I do not expect lawyers to be rigorous in their analysis."

Regulators saw warning signs as early as 2005, but failed to pursue them. Bear Stearns, in its first quarter 2005 financial disclosure, said it faced the threat of a civil enforcement action in connection with its pricing, valuation and analysis of $63 billion worth of CDOs. In the same filing, Bear Stearns said it was contacted by the New York State attorney general, then Eliot Spitzer, about $16 billion worth of CDOs it sold to an unnamed client.

The inquiries were brought up again in the August quarterly regulatory report and in the year-end 2005 filing, when Bear Stearns said it was "continuing to respond to subpoenas and other requests for information from regulatory and law enforcement officials."

But that's the last time Bear Stearns brought it up, suggesting the matter had been sidelined or dropped. Aguirre says it sounds fishy. "I find it troubling," he says.

Aguirre has his own beef with the SEC. He was fired in 2005 after aggressively pursuing an insider trading case against Pequot Capital, the powerful New York hedge fund. Aguirre, who says he was fired after trying to interview current Morgan Stanley Chief Executive John Mack in the matter, says the agency is too close to the industry it covers to be effective as a watch dog. A spokesman for the SEC wouldn't comment for this story.

Others say it's just a matter of things spiraling out of control more quickly than anyone could imagine. "It's very late in the game to be pointing fingers," said Howard Pitkin, Commissioner of Banking in Connecticut. "We all need to sharpen our pencils as far as spotting these problems."

On Friday, Massachusetts securities regulators filed a civil fraud suit against Merrill Lynch over $14 million worth of collateralized debt obligations it sold to the town of Springfield. The state claims the CDOs were unsuitable and sold without the town's consent. (Merrill has acknowledged the latter and paid the town back in full for the investment, which is now practically worthless.)

Earlier last week, the Federal Bureau of Investigation disclosed it had opened criminal fraud probes into 14 companies over their mortgage securitization activities, which includes everything from originating loans to buying them, packaging them and selling them to investors. The FBI didn't identify the companies.

Connecticut and New York attorneys general have also opened investigations into how Wall Street structured and sold mortgage-laden securities.

Goldman Sachs, Morgan Stanley and Bear Stearns have disclosed in their recent regulatory filings that they have been questioned by multiple regulators about their activities involving subprime mortgage securities. In November, Merrill Lynch said the SEC had initiated an inquiry into its subprime mortgage portfolio. All the banks have said they are cooperating. Maybe they should shore up their risk management while they're at it.

Comments

[Independent Accountant]

Give it up. The SEC is hopelessly corrupt. It is owned by Wall Street. Expect nothing good from the SEC. It pursues nickel and dime insider trading cases and does nothing about tens of billions of dollars in erroneously accounted for assets and liabilities by the banks. The (In)Justice Department is even worse. Look at the cases it pursues and those in which it claims to have insufficient evidence.

[Anna Browne]

The SEC and the regulations are a FRAUD!

Better to have NO REGULATIONS and then everyone know that they are on a tight rope without a net. They are anyway and they should know it.

Without the fraud of the SEC Wall Street would have a hard time selling their crap.

Buy Silver and Gold.

[TomK]

Since GW Bush came to power, he helped transform America to become a corporatist state. A corporatist state is one where corporate executives gain unprecedented powers to drive not only the growth and wealth of corporate business, but drive domestic and international politics, drive the military-industrial complex, drive key national security policy, drive the stock market, drive economics and wealth creation, drive technology and the media, and drive social and welfare policies. Under the corporatist mantra:

- All government functions must be outsourced to the private sector as much as possible, to the hands of the corporations so that there is more 'efficiency' and wealth creation.
- All government regulations must be minimized so that corporations gain maximum freedom.
- All military support functions should be outsourced to the corporations, even fighting and security in war zones such a Iraq.
- Government welfare must be kept to the absolute minimum. Such welfare programs simply transfer wealth from the corporations to the poor where it's simply wasted.
- Wall Street must have the maximum possible financial flexibility to serve the interests of corporations.
- The Fed must run the banking system to give maximum credit at the best terms to corporate needs, and when there is trouble, bail out the banks and their large corporate customers.
- Finally, the military most important roles are to defend the country from attack and to protect the business interests of corporations operating internationally.

Under GW Bush, the transformation of America to a corporatist state is complete. Now, even the government works for the corporations. The funny thing is I haven't heard he has told voters in two elections that he is going transform America into a corporatist state.

[Lady From Middle America]

Here's a pretty good link on "corporatist" strategy, from a 1995 Donald Rumsfeld speech.

http://www.heritage.org/Research/GovernmentReform/CB15.cfm

[Carl]

The OTC market was basically freed from regulatory oversight by the Commodity Futures Modernization Act of 2000 that was signed by Bill Clinton on December 21, 2000, thirty days before George Bush took office. This law which contains the infamous "Enron Loophole", exempts OTC energy trades and some kinds of credit swaps from regulatory oversight. This is the most important law deregulating OTC trading and the least understood. In fact, the recent Senate act to close the Enron loophole is going to be ineffective ( see this http://www.nefi.com/pdfs/NEFI_Press_Release_Enron_Loophole_Update.pdf). It appears that Enron's very expensive and successful lobbying efforts have contaminated a great body of U.S. law and will require a long period to root out if it is ever attempted at all.
I suppose it will take a "Financial Armageddon" to get at the root causes of the so called subprime crisis, but it seems clear from my research that the con men who created and bankrolled Enron have left in their wake a set of laws that invite commodity speculators and financiers to bid up prices in their respective markets until unsustainable bubbles burst. Enron's devious and clever leaders found a way to bypass the SEC, CFTC, and a host of other regulators to hide the fact that their company was just a con game reaping huge gains for the insiders and huge losses for retired employees and stockholders. The Enron debacle and the subprime crisis have at their root the unregulated trades on the OTC markets, failure to correct this flaw in the regulation of these markets will result in an even bigger crisis in the future. Key words for interested researchers: Enron loophole, dark pools.
Links:
http://www.alternet.org/story/74510/?page=entire
http://en.wikipedia.org/wiki/Timeline_of_the_Enron_scandal
http://radio.villagevoice.com/news/0203,ridgeway,31534,6.html
Quote:
"In June 2000, Senator Gramm co-sponsored the Commodity Futures Modernization Act, a measure aimed at deregulating certain kinds of futures trading, but not energy futures. That bill never made it to the floor, and thus quietly died. Six months later, on December 15, Gramm curiously turned up as co-sponsor of a bill with the same name, the Commodity Futures Modernization Act, which did deregulate energy futures and which, without undergoing the usual committee hearings and preliminary votes, was immediately attached as a rider to an 11,000-page appropriations bill. It passed and was signed into law by President Bill Clinton six days later. Few lawmakers had likely perused the rider carefully, if they even knew it was there. And at any rate, Enron had given to the campaigns of over 200 legislators."

[Carl]

The link to the PDF from nefi.com was mangled in the post above. Click this instead
http://www.nefi.com/pdfs/NEFI_Press_Release_Enron_Loophole_Update.pdf