In support of the Securities & Exchange Dismission

An investor visiting Washington, DC and chancing upon the handsome building at 100 F Street would discover on its façade, in the government’s restrained lettering, that its occupant was the “Security and Exchange Commission.” And were he to doubt its legitimacy for any reason, underneath its name the building bore the Great Seal of the United States complete with eagle, arrows, and olive branch.

Widening his gaze, the visitor could not help but be impressed by the building itself. Rising some seven stories from the street and extending well down the block, it would give every indication of fulfilling what must have been the architect’s intention to express solidity, trustworthiness, and power within a context of pleasing proportions and tasteful design.

Were he possessed of x-ray vision, our visitor would gain further confidence that the dignity and sense of purpose conveyed by the building’s exterior extended into its interior.  There he would observe a 3,800-strong, veritable army of people working in  well-lighted, safety-conscious offices and, presumably, all properly compensated ($200,000+ average salary) thanks to their proven competency and union affiliation.  More importantly, from the investor’s standpoint, was that each of these people was working to advance the agency’s objective as promulgated in its mission statement’s opening paragraph:

“The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”

Presented with this formidable assemblage of flesh and stone standing ready to defend him in time of need, our visitor would have every reason to feel reassured as to his financial future well being.  Were I present on the occasion of the investor’s visit, I would feel obligated to caution him that appearances could be deceiving, and when it came to governmental matters, often are.  To d rive the point home, I would add this historical footnote.  To wit:

During the financial crisis of 2007-2009, the SEC did absolutely nothing to protect you and your fellow investors from Wall Street’s unforgiving machinations.  You would have fared no worse had the imposing edifice before you mysteriously sunk below ground and its site rededicated as a public park.  Indeed, you, as a taxpayer, would have benefited from a reduction in federal expenditures of $913 million per year-the agency’s budget.

This outright contradiction to what his own eyes had clearly observed would no doubt elicit demands from the investor  that I defend my seemingly outrageous defamatory statement.  So there would be nothing for me to do but invite him to join me for a glass of beer at the nearest bar and take up SEC’s violation of its noble mission statements one by one.

FIRST MISSION: PROTECTING INVESTORS

The very first words out of the SEC’s mouth, as it were, declare its inviolable duty to protect investors.  So much for good intentions.  The fact is the self-declared “investor’s advocate” was, for all practical purposes, asleep at the switch during the period in question.

Take the case of Brion Randall.  According to the Wall Street Journal, “Prosecutors alleged he bilked 30 investors out of an estimated $6 million from 2004 through 2009.  They alleged Mr. Randall told investors he was putting their money in an Alliance Bernstein fund that didn’t exist and showed them fake account statements.”  Thus Randall was able to keep on defrauding people despite the fact that in 2002 the Journal ran a front-page article pointing to an earlier set of claims against him in the dot-com era.  Aside from pinning a “crook wanted” poster on SEC’s bulletin board, it is hard to see what more could have been done to stir the agency into action.

In defense of the SEC regarding the$6 million Randall affair, perhaps it is unfair to expect it to detect every trifling sum lifted from investor pocket books.  However, that defense is harder to maintain regarding the $380 million that went missing after passing into the hands of the crooked Marc Dreier.   Yale and Harvard educated, Mr. Dreier was the founder and principal of Dreier L.L.P., a Park Avenue law firm that grew to a 600 employee outfit with offices in five cities.  Taking advantage of his prestigious position, the smooth-talking, elegantly-tailored lawyer was able to bilk a number of Manhattan hedge funds and fashion houses into buying fake promissory notes, presumably issued by a reputable real estate firm, the proceeds of which he simply pocketed.  If nothing else, Dreier’s rapidly expanding law practice and ostentatious life style-three luxurious residences, a 121 foot yacht, and a 30 million dollar art collection-should have come to the attention of someone among SEC’s financial vigilantes.  But these did no more to awaken the agency’s suspicions than did the several rumors of Dreier’s shenanigans filtering into their offices.

But even in the Dreier case, the SEC has an excuse of sorts.  The injured parties were deep-pocketed firms that presumably could withstand their losses and were not, in any case, the inexperienced investors who were supposedly the primary beneficiaries of SEC’s protective shield.  When we come to the Allen Stanford imbroglio, however, SEC has no such excuses.  In this case we are talking real money-give or take, 8 billion-and real people-estimated at fifty thousand-victimized not only by Stanford but, in a very real sense, by SEC itself.  My authority for this rather startling accusation? A 151 page report by none other than the agency’s own inspector general.  It seems that Stanford’s operation was investigated by the SEC in 1997, 1998, 2002, and 2004 at the behest of worried investors, a number of SEC’s own examiners, the Texas State Securities Board, and US Customs.  But in each case suspicions pointing to a Ponzi scheme were squashed by the agency’s own enforcement group, in particular, its head, Spencer Barasch (who, after leaving the agency, performed legal work for, yes indeed, Allen Stanford.)  The tragic aspect of this affair is that SEC had much of the information it needed to indict Standford back in 1997 and, had it acted then, the damage done to the investing public would have been but a fraction of what it actually suffered.  As an ironical twist to the episode, some investors interpreted SEC’s aborted investigations as proof of Stanford’s legitimacy and invested more heavily than before.

The uncontested title of king of the Ponzi schemers belongs, of course, to Bernard Madoff whose $65 billion fraud over a sixteen-year period fleeced thousands of investors including universities, charities, hospitals, foundations, and, of course, wealthy individuals.  But that was by no means Madoff’s only accomplishment.  Equally impressive to my mind was his knack of goading SEC’s incompetence to hitherto unsurpassed levels.  Short of painting the word “guilty” in red letters across his imposing forehead I don’t know what more he could have done to advertise his nefarious undertakings.  Beginning in 1992 the agency received six substantive complaints against Madoff that triggered three investigations and two examinations none of which did anything whatsoever to impede the man’s operations.  Harry Markopolos, an independent financial fraud investigator, practically made it his career to nail Madoff.  According to CNN Money, Markopolos “sent detailed memos, listing dozens of red flags, laying out a road map of instructions for SEC investigators to follow, even listing contacts and phone numbers of Wall Street experts whom he said would confirm his findings. But Markopolos’ whistle-blowing got nowhere.”  It is said that at certain junctures even Madoff himself was amazed that his scheme had not been uncovered.  As a wry footnote to the affair, there was one tangible result of all this investigative activity: the SEC awarded a performance citation to an enforcement staff attorney for her “ability to understand and analyze the complex issues of the Madoff investigation.”

I cannot leave this discussion without acknowledging that in each of these cases the SEC did finally take action.  To the best of my knowledge, every one of the bad guys mentioned is, at the time of this writing, in jail.  But aside from providing impoverished victims a degree of satisfaction, such after-the-fact justice did nothing to compensate them for their financial losses.  The fact remains that the SEC sat on its well-padded behind for year after year while people were being swindled out of their money before it deigned to take action.  SEC’s bold declaration of purpose rightfully deserves to be heralded as “mission unaccomplished.”

SECOND MISSION: FACILITATE MARKETS

Protecting investors is not the SEC’s only declared responsibility.  Recall that the agency’s second mission is to “maintain fair, orderly, and efficient markets”-certainly an important objective on a par with its first.  Unhappily, during the period being discussed, the agency’s failure to accomplish this mission was likewise on a par with its first.  The market action alone tells much of the story.  On October 1, 2007 the Dow Jones Industrial Average stood at 14,067.  Some seventeen months later, by March 2, 2009, the DJIA had declined to 6,627, a drop of over fifty per cent.  A ruthlessly efficient market, perhaps, but hardly the fair and orderly one contemplated by the SEC.

The Great Recession, as it came to be called, cannot reasonably be ascribed to a single cause or a single entity.  But one guiding hand, so to speak, can be identified.  It was none other than our own government.  Consider the following, briefly summarized, succession of interdependent steps:

Step one: The government assiduously crafted an environment conducive to individual home ownership that was believed to be socially beneficial and politically advantageous.  Contributing to this environment were unnaturally low interest rates, an easy money policy, and an outrageously liberal legal system that allowed scofflaws to walk away from their mortgage obligations scot free.

Step two: Taking advantage of the situation, overzealous, often dishonest, mortgage brokers, in collusion with naïve and/or likewise dishonest home buyers, originated a flood of unsound mortgages.

Step three: With no reason to be overly concerned as to the mortgages’ true worth, the banks bundled them into securities that were then passed on, like hot potatoes, into the welcoming, largely unquestioning, arms of Fannie Mae and Freddie Mac.  These two government-sponsored enterprises (GSE’s) had been set up to facilitate mortgage financing at the lowest possible interest charges and with the fewest barriers to home ownership.  And, sure enough, they undertook these assignments with single-minded enthusiasm undeterred by such considerations as the attendant risks or costs.  As fast as the securitized mortgages came in their front door, the GSE’s shoveled them out the back onto the open market.

Step four: Once in the inventive hands of investment-bank and hedge-fund quants, the bundled mortgages were repackaged into still-larger multi-million dollar collateralized debt obligations (CDO’s) portions of which were awarded triple-A status by the three obliging, government accredited, rating agencies.  Again, at each step up the ladder, risk assessment was made secondary to the profit-making opportunities afforded by these huge financial instruments.

Step five: As discussed below, the SEC either stood by or actually contributed to the loosening of the money supply that enabled the players in the financial institutions to juggle more and more trades, collect more and more fees, and enjoy ever greater bonuses for their not-over-strenuous paper shuffling.

Step six: Given the massive sums involved, the purchasers of the CDO’s­­-insurance companies, local governments, pension funds, and the like-understandably sought to insure their value by entering into credit default swaps with presumably strong counter parties.

Step seven:  As more and more layers of such derivatives piled onto the already shaky financial structure, many trillions of dollars now rode on nothing more tangible than the presumed viability of the participants, none of whom, as it turned out, had anything like the capital required to engage in such a high stakes game.

Step eight: Unbeknownst to but a few, the Wall Street giants had put themselves at the mercy of overextended salaried home owners hanging on to their household budgets by their fingernails.  Then, somewhere in the United States, the unthinkable happened.  John Doe lost his job at the local supermarket, and, finding that he could no longer make his house payments, loaded his belongings into his pickup, gathered his family, turned his house keys over to his bank, and drove away unaware that he had just begun The Great Recession.

The purpose in enumerating these steps is to point out that had the SEC exercised its influence to thwart any one of them, the ascent into riskier and riskier realms would have been interrupted and the final plunge averted.  The commission would, no doubt,  argue that such criticism is based on twenty-twenty hindsight.  Who could have been prescient enough t0 detect the danger before the actual blowup?  Well, the fact is, a number of people actually did.  Unfortunately, none were employed by the SEC.  A small group of short sellers and hedge fund managers clearly perceived what would happen, placed their bets accordingly, and made billions of dollars in the process.  The inability of anyone on SEC’s staff to grasp the situation is all the more embarrassing given the fact that the short sellers were novices in the mortgage industry and had only a fraction of SEC’s resources available to them.  What they did have, and apparently what the SEC lacked, was common sense and the initiative to leave their desks long enough to find out what was happening in the field.

THIRD MISSION: FACILITATE CAPITAL FORMATION

The painful fact is that the SEC failed in its third mission even more spectacularly than it failed its first two.  Far from facilitating the formation of capital during the Great Recession, it significantly contributed to its destruction.  How could this be?  In a word, “leverage.”  In a series of fateful rulings the government provided the means for the banks to dangerously extend themselves in search for ever higher profitability.  First, in 2004, eager to increase their participation in the lucrative flow of mortgages, major investment banks successfully persuaded the SEC to reduce their percentage of reserve capital.  Second, the government ruled that the banks’ holdings of the GSE’s AA and AAA mortgage bonds could be considered equivalent to cash in the calculation of their capital requirements.  It was to the banks’ benefit, therefore, to stuff their vaults with these interest-bearing notes backed by the good faith of the US, use them to borrow at near zero percent interest, and put the borrowed capital to work earning more money.  Third, the banks were allowed to carry financials on their books at face value as opposed to their more deserved market value.  Fourth, the SECs supervision was lax.  It did not look into off-balance sheet transactions, allowed encumbered collateral to be treated as liquid, and turned a blind eye toward the bank’s “repos”-the practice of concealing substantial chunks of indebtedness at the end of each quarter in order to dress up their financial statements.  And, fifth, perhaps most egregious of all, government’s regulators allowed the banks to police their own risk management, for all practical purposes,           ‘ even when it was abundantly clear the firms were beginning to get into trouble-a relationship notoriously known as “regulatory capture.”

As a result of these accommodative policies, banks and other financial institutions extended themselves further and further.  At the end, Bear Stearns, for example, was in hock for $33 for every one dollar of net capital it had on hand as equity.  The motivation of bank executives to engage in such risky behavior is not hard to discern.  As lending increased, fees multiplied, profits soared, and bonuses liberalized.  From 2002 to 2010, one of these top dogs, Lloyd Blankfein, Chairman and CEO of Goldman Sachs, received $111.6 million in salary and cash bonuses.

When the entire fragile financial structure collapsed, one overleveraged firm after another ran into trouble meeting its obligations and, understandably, grew wary of the ability of its fellow institutions to meet theirs.  Losses escalated, major financial institutions either went bankrupt or were taken over at fire sale prices, interbank transactions commanded much higher costs, the derivative market was thrown in disarray, and credit froze.  Six trillion dollars of housing wealth and even more in stock wealth disappeared.  Eventually, the federal government was forced to massively intervene to hold things together.  Emergency measures included the Troubled Asset Relief Program designed to throw banks a life saver; an $862 billion stimulus package; and requiring the Federal Reserve to adopt the role of guarantor for vast amounts of commercial paper of dubious worth.

As noted above, throughout this sorry episode SEC either acted unhelpfully or simply retreated to the sidelines.  What is certain is that it certainly did not facilitate the formation of capital.  And, true to form, it did not spring into action until a full year after the crash when it launched fifty different investigations into the financial industry to figure out what happened and to look for some bad guys to blame.

AFTERTHOUGHTS:

The question naturally arises, what were the agency’s stalwart defenders of the fair market doing during the lead up to the crash?  Where were the Divisions of Investment  Management; Trading and Markets; Risk, Strategy, and Financial Innovation; and, most critical of all, Enforcement?

We can account for the inaction of 33 members of its staff.  By the agency’s own admission, they were too fixated on their computer screens alternative viewing to be distracted by financial matters.  But what of the 3,770 or so other members not so engaged?  It would seem that an administration lax enough to tolerate the voyeurism  of 33 people would positively welcome the countless more normal ways employees invent to avoid working: the two-hour lunch breaks, multiple sick days, shopping on company time, socializing around the water cooler, and so on.  And when they did spend time at their desks, how much of it was spent on internal housekeeping, preparing self-congratulatory performance reports, plumping for an increase in the next appropriation from Congress, feuding with other federal agencies, internal politicking, and other bureaucratic enterprises?  For that matter, were managers focused on the public interest or landing a job with the financial firms they were supposedly regulating?  One can’t help but wonder about a governmental culture that enabled three heads of SEC in recent years to enjoy a threefold boost in income when they left the agency, skipped through the revolving door,  and hunkered down with the opposition.  More recently, Ms. Elizabeth King, formerly SEC’s associate director for market supervision, was hired by Getco LLC, a Chicago-based high-frequency trading firm, at, one would assume, an increase in salary commensurate with her new responsibilities.

One would think that having utterly failed to live up to its own mission statement at a time when its involvement was sorely needed, the “three strikes you’re out” rule would have been called on the SEC.  But we are talking government, not baseball.  The financial reform bill moving through Congress is expected to pass and to be signed by the President who has expressed satisfaction in its provisions.  As a major player in the government’s plans, the SEC has not been ignored in the measure.  No, indeed.  Its authority is being expanded along with its appropriation-an indication, obviously, of Congress’s confidence in its competence.  A snide insinuation in this connection has circulated claiming that the SEC’s increase in funding will be partially devoted to replacing its present monitors with larger units outfitted with 3-D projection.  Having seen no facts to back up this allegation, I can only conclude that it is entirely apocryphal-an invention of some embittered detractor.

Personally, I would prefer that the funding for the SEC e used to transform its building at 100 F Street into one that would serve a more useful public service.  More specifically, I suggest that its present occupants be asked to leave, manikins installed in their place, and the building then reopened in its new incarnation: The Museum of Legislative Failure.  As I imagine it, a faint blue haze would permeate its spaces to remind visitors, upon entering, of the prevailing ennui.  Through the haze, the visitors would see row upon row of desks occupied by bored, bureaucratic hacks alternating with row upon row of stuffed file cabinets in which the fruits of their industry were stored, for the most part never to be seen again.  Another crowd-pleasing attraction would be colorful, informative panels illustrating the tangle of ill-advised, often conflicting, politically-motivated, accumulation of congressional measures under which these workers labored.  Thousands of empty cubicles and offices would emphasize the vast wastage of time and money committed on these premises.  And tactfully edited computer terminal displays would at least hint that not all of the workers’ time was consumed by financial matters.

Just before leaving the museum, visitors would be led into a large hall dominated by a floor-to-ceiling wall map of Washington DC on which the government’s other major horror stories would be located and numbered.  (The Wall Street Journal article posted in this issue of the quarterly tells of 115 separate regulatory agencies involved in financial services) A display screen and, below it, a panel of buttons corresponding to each of the sites, would make it possible for visitors to inform themselves of the offending agency’s identity, its own regulatory foibles and its cost to the taxpayer.

REGULATION ON POSTCAPIA

Faithful readers of this blog may wonder how regulatory matters are handled on Postcapia, a utopian planet I am known to visit from time to time.  My guess is, however, they already know enough of this planet’s ethos to have deduced the answer for themselves.  In any case, for old and new readers alike, let me set the matter straight.  On Postcapia the government has turned the job over to nonpartisan system engineers-impartial people who know how to analyze problems holistically and institute workable solutions.  Other professionals-even lawyers on rare occasions­-are called in for their expertise when needed.

Actually, the word “regulation” is seldom heard among these engineers; when addressing situations in need of control, they talk exclusively of feedback mechanisms.  The word “feedback” is often used rather loosely on earth, but on Postcapia it is always defined as a mathematically-rigorous circulatory system that constantly monitors the flow of a particular dataset, compares those data with present standards, and, when deviations are observed, automatically initiates action to bring the data back into compliance.

The virtues of Postcapia’s feedback mechanisms compared to our regulations are many : they operate in real time (not after the fact); they apply their remedies incrementally (not disruptively); they focus on outcomes (as opposed to intrusive, often outdated, diktats); and, since their solutions are applied automatically, their action is timely and effective (not delayed while the problem worsens and perhaps gets out of hand)  This is not to say that every feedback installation on Postcapia succeeds.  On the other hand, they are all equipped with a self-destruct capability that is triggered were they to run out of bounds.

During my short visit, I couldn’t possibly learn about all of the applications of feedback mechanisms that the Postcapians relied upon, but, to give the reader some idea of their prevalence, I did jot down a few that were pointed out to me.

• Controling inflation
• Providing shock absorbers to cushion stock market fluctuations
• Limiting the buildup of derivatives
• Determining interest rates
• Stabilizing currency exchange rates
• Smoothing out residential and commercial construction activity
• Management of the money supply
• Ensure proper credit flows to both large and small organizations
• Allocating resources for research and development
• Monitoring bank liquidity

Even this abbreviated list gives some inkling of the possibilities that could arise were we to emulate Postcapia’s enlightened approach.  This may seem a farfetched notion, but sooner or later, the government will have to come to grips with the twenty-first century and, keeping in mind SEC’s history, our regulatory policies might be a good place to start.