A ‘Flawed’ SEC Program [A Retrospective “April Fools” Analysis]

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SEC Failed to Rein in Investment Banks [April Fool’s Day – 2015]

By Ben Protess, ProPublica – October 1, 2008 5:01 pm EDT

Editor’s Note: This investigative report was first published almost seven ago. And so, we ask you to consider – on this April Fool’s Day 2016 – how [if] things have changed since then?  

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Flag MOney

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The Securities and Exchange Commission [SEC] last week abolished the special regulatory program that it applied to Wall Street’s largest investment banks. Known as the “consolidated supervised entities” program, it relaxed the minimum capital requirements for firms that submitted to the commission’s oversight, and thus, in the view of some experts, helped create the current global financial crisis.

But, the SEC’s decision to ax the program currently affects no one, since three of the five firms that voluntarily joined the program previously collapsed and the other two reorganized.

The Decision – 18 Months Ago

The decision came last Friday, one day after the commission’s inspector general released a report [1] (PDF) detailing the program’s failed oversight of Bear Stearns before the firm collapsed in March. The commission’s chairman, Christopher Cox, a longtime opponent of industry regulation, said in a statement [2] that the report “validates and echoes the concerns” he had about the program, which had been voluntary for the five Wall Street titans since 2004.

The report found that the SEC division that oversees trading and markets was “not fulfilling its obligations. “These reports are another indictment of failed leadership,” said Sen. Charles Grassley (R-Iowa) who requested the inspector general’s investigation.

The SEC program, approved by the commission in 2004 under Cox’s predecessor, William Donaldson, allowed investment banks to increase their amount of leveraged debt. But, there was a tradeoff: Banks that participated allowed their broker-dealer operations and holding companies to be subject to SEC oversight. Previous to 2004, the SEC only had authority to oversee the banks’ broker dealers.

Longstanding SEC rules required the broker dealers to limit their debt-to-net-capital ratio and issue an early warning if they began to approach the limit. The limit was about 15-to-1, according to the inspector general report, meaning that for every $15 of debt, the banks were required to have $1 of equity.

But the 2004 “consolidated supervised entities” program revoked these limits. The new program also eliminated the requirement that firms keep a certain amount of capital as a cushion in case an asset defaults.

Bear Sterns

As a result, the oversight program created the conditions that helped cause the collapse of Bear Stearns. Bear had a gross debt ratio of about 33-to-1 prior to its demise, the inspector general found. The inspector general also found that Bear was fully compliant with the programs’ requirements when it collapsed, which raised “serious questions about whether the capital requirement amounts were adequate,” the report said.

The report quoted Lee Pickard, a former SEC official who helped write the original debt-limit requirements in 1975 and now argues the 2004 program is largely to blame for the current Wall Street crisis.

“The SEC gave up the very protections that caused these firms to go under,” Pickard said in an interview with ProPublica. “The SEC in 2004 thought it gained something in oversight, but in turn it gave up too much public protection. You don’t bargain in a way that causes you to give up serious protections.”

Pickard, now a senior partner at a Washington, D.C.-based law firm, estimated that prior to the 2004 program most firms never exceeded an 8-to-1 debt-to-net capital ratio.

The previous program “had an excellent track record in preserving the securities markets’ financial integrity and protecting customer assets,” Pickard wrote [3] in American Banker this August. The new program required “substantial SEC resources for complex oversight, which apparently are not always available.”

Asked if he believes the 2004 program was a direct cause of the current crisis, Pickard told ProPublica, “I’m afraid I do.”

The New York Times reported Saturday that the SEC created the program after “heavy lobbying” for the plan from the investment banks. The banks favored the SEC as their regulator, the Times reported, because that let them avoid regulation of their fast-growing European operations by the European Union, which has been threatening to impose its own rules since 2002.

SEC Spokesman

A SEC spokesman declined to comment for this article, referring inquires to Chairman Cox’s statement. In the statement, Cox admitted the program “was fundamentally flawed from the beginning.” But Cox, a former Republican congressman from California, offered mild support for the program as recently as July when he testified before the House Committee on Financial Services. The program, among other oversight efforts, Cox said, had “gone far to adapt the existing regulatory structure to today’s exigencies.” He added that legislative improvements were necessary as well, and has since told Congress that the program failed.

More Questions

So why did the commission not end the program sooner? Some say that the program’s flaws only recently became apparent. “As late as 2005, the program seemed to make a lot of sense,” said Charles Morris, a former banker who predicted the current financial crisis in his book written last year, The Trillion Dollar Meltdown [4]. The SEC “didn’t know it didn’t work until we had this stress.”

And leverage does not always spell trouble. In a strong economy, leverage can also be attractive because it can increase the profitability of banks through lending.

In his recent statement, Cox said the inspector general’s findings reflect a deeper problem: “the lack of specific legal authority for the SEC or any other agency to act as the regulator of these large investment bank holding companies.”

Secretary of the Treasury Henry Paulson has called for a refining of the regulatory structure to reflect the global and interconnected nature of today’s financial system. In any case, the program’s failure can be seen in the disappearance of the participating banks: Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and Goldman Sachs.

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April

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Assessment

Merrill Lynch’s leverage ratio was possibly as high as 40-to-1 this year and Lehman Brothers faced a ratio of about 30-to-1, according to Bloomberg [5].

The Fed and Treasury Department forced Bear Stearns into a merger with JPMorgan Chase in March. And the last two months, Lehman Brothers went bankrupt and sold their core U.S. business to British bank Barclays PLC, and Merrill Lynch was acquired by Bank of America. Morgan Stanley and Goldman Sachs, the two remaining large independent investment banks, changed their corporate structures to become bank holding companies, which are regulated by the Federal Reserve.

As these banks have folded or reorganized over the last several months, the Federal Reserve has largely assumed the SEC’s oversight responsibilities, though the commission will still have the power to regulate broker dealers.

Original Essay: http://www.propublica.org/article/flawed-sec-program-failed-to-rein-in-investment-banks-101

Conclusion

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10 Responses

  1. Proposed SEC Public Advocate is Debated in 2010

    Did you know that a new proposal to hire an investors’ advocate at the Securities and Exchange Commission begs the question: What [who] is the SEC advocating for now, if not the interests of investors?

    http://www.fa-mag.com/fa-news/5379-proposed-sec-public-advocate-debated.html

    Answer: For no one … but the industry itself.

    Duke

    Like

  2. On Goldman Sachs

    The Federal government has accused Goldman Sachs & Co. of defrauding investors by failing to disclose conflicts of interest in mortgages it sold as the housing market was faltering.

    The SEC just announced civil fraud charges against the Wall Street powerhouse and one of its vice presidents. The agency alleges Goldman failed to disclose that one of its clients helped create — and then bet against — subprime mortgage securities that Goldman sold to investors.

    http://www.msnbc.msn.com/id/36597290/ns/business-us_business/?GT1=43001

    Yep, just keep trusting the wire-houses, BDs, SEC, auditors and investment bankers.
    You’ll do just fine!

    The Cynical Doctor

    Like

  3. More [Sadly] on Broker Integrity or the Lack Thereof

    Cynic, did you know that a former Merrill Lynch broker accused of stealing a $780,000 signing bonus highlights how little brokerages and other investment firms may know about certain job candidates they’re recruiting.

    http://www.fa-mag.com/fa-news/5438-alleged-bonus-theft-shows-firms-hiring-soft-spot.html

    Always perform your own due-diligence before hiring anyone to invest your money. Trust no one – and paddle your own canoe.

    Ann Miller; RN, MHA
    [Executive-Director]

    Like

  4. I agree with this really interesting investigative post. And, readers are invited to visit us at Open Congress for related political and governmental material.

    Krissy
    http://www.OpenCongress.org

    Like

  5. SEC Staff Surfed Porn as Economy Fell

    Employees spent hours surfing adult websites on government-issued computers, a watchdog says in this report

    http://www.msnbc.msn.com/id/36725550/ns/business-stocks_and_economy

    Dr. Marcinko is correct about trusting no one with your money. Guys – we are now officially on our own.

    Chip

    Like

  6. SEC Inspections To Focus On Risk

    Hi Chip

    Did you know that the new director of the SEC’s Office of Compliance Inspections and Examinations says the agency has ushered in a “new day and a new regulatory approach.”

    http://r20.rs6.net/tn.jsp?et=1103328685424&s=60746&e=0019itJL16NCNzEw4jSlkpHy55IznmlDnMhPEeoymbOT1jA0RmxLoLeFwwNXSJKccU9J8CQI2a2Zd57LZGO5PLXsBTeLGbueglor52urchsSj99l—DX8_zigvfV0cS8zGWkIVQ6ljQA7Q3KOfgdoTatXXhnXMol_ClhNWtpIm6cM=

    Yada … yada … yada … What do you think?

    Sally

    Like

  7. [SEC and] Workers Gone Wild

    Did you know that last week the House of Representatives voted to block online pornography from all government PCs, following reports that regulators were spending work time surfing porn sites even as they failed to prevent major catastrophes?

    In the SEC, for example, employees were spending hours at a time ogling X-rated material as the stock market melted down.

    http://www.newsweek.com/photo/2010/05/28/bad-work-behavior.html?Gt1=43002

    Now, do you think that anyone at all is afraid of governmental watchdogs and regulators?

    Jane

    Like

  8. SEC eyes brokerage banking products to enforce money-laundering rules

    Securities and Exchange Commission examiners will scrutinize brokerages selling traditional banking products to enforce rules against money laundering, Kevin Goodman, an SEC director who oversees brokerage exams, said at a recent industry conference.

    The intent is to stop those who believe a brokerage firm’s banking services are more lax in compliance with money-laundering regulations.

    Jane

    Like

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