We have all heard the new spin coming out of the John McCain camp and from those that blog and parrot those talking points. I refuse to name names (Jules Gordon) but blaming the CRA and the poor seems to be the new ticket for Republicans to shift responsibility for a disaster that happened on their watch.
There is no question that many lenders made bad loans, and that some of those bad loans may have been made in conjunction with CRA guidelines. The truth is that if that is all we were worried about here we would not be in the type of trouble we are in. Lets look at the role of leverage in bringing us to this point, and how a few bad practices were magnified immensly by the banking industry using that leverage.
Yesterday’s New York times examined the impact that lowering capital requirements for the major investment banks had on the current situation.
But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.
On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.
They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.
So Wall Street petitions the SEC to allow greater leverage in the system. This is done not to serve poor people but to allow the utilization of greater capital to make big bets in the marketplace, including the market for sub-prime securities. What do you think happened at the meeting? Well there was reportedly some dissent.
A lone dissenter — a software consultant and expert on risk management — weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington.
A Commissioner brought out an obvious question.
One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told — those with assets greater than $5 billion.
“We’ve said these are the big guys,” Mr. Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.”
Mr. Goldschmid, an authority on securities law from Columbia, was a behind-the-scenes adviser in 2002 to Senator Paul S. Sarbanes when he rewrote the nation’s corporate laws after a wave of accounting scandals. “Do we feel secure if there are these drops in capital we really will have investor protection?” Mr. Goldschmid asked. A senior staff member said the commission would hire the best minds, including people with strong quantitative skills to parse the banks’ balance sheets.
What about the other participants?
Annette L. Nazareth, the head of market regulation, reassured the commission that under the new rules, the companies for the first time could be restricted by the commission from excessively risky activity. She was later appointed a commissioner and served until January 2008.
“I’m very happy to support it,” said Commissioner Roel C. Campos, a former federal prosecutor and owner of a small radio broadcasting company from Houston, who then deadpanned: “And I keep my fingers crossed for the future.”
And so, without further ado, the Republican controlled Commission started us on the road to amplifying the bad practices in a large way. Now even a Republican SEC would seek some additional oversight after giving the store away on this matter. Lets look at what happened.
The 2004 decision for the first time gave the S.E.C. a window on the banks’ increasingly risky investments in mortgage-related securities.
But the agency never took true advantage of that part of the bargain. The supervisory program under Mr. Cox, who arrived at the agency a year later, was a low priority.
The commission assigned seven people to examine the parent companies — which last year controlled financial empires with combined assets of more than $4 trillion. Since March 2007, the office has not had a director. And as of last month, the office had not completed a single inspection since it was reshuffled by Mr. Cox more than a year and a half ago.
The few problems the examiners preliminarily uncovered about the riskiness of the firms’ investments and their increased reliance on debt — clear signs of trouble — were all but ignored.
The commission’s division of trading and markets “became aware of numerous potential red flags prior to Bear Stearns’s collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain” capital standards, said an inspector general’s report issued last Friday. But the division “did not take actions to limit these risk factors.”
Come on down Chris Cox, Republican Chair of the SEC and explain how poor folks robbed the system. Lets see. The SEC was assured that the FIVE HUGE INVESTMENT BANKS had computer models that mitigated the risk. Why have the SEC do their regulatory duty when the companies themselves could take that work on. What a uniquely Republican concept.
In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.
It must have been the Community Reinvestment Act that forced the SEC to outsource regulation to the companies they were supposed to be regulating. But the Republican SEC had ample reason to deregulate and allow capital requirements to go in the toilet. That reason? The companies asked! In asking, those companies complained of excessive government regulation and received the warm response they usually do from Republicans. Lets look at that a little more closely and see what qualifications the sole public dissenter had.
In letters to the commissioners, senior executives at the five investment banks complained about what they called unnecessary regulation and oversight by both American and European authorities. A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso, Ind., who said the computer models run by the firms — which the regulators would be relying on — could not anticipate moments of severe market turbulence.
“With the stroke of a pen, capital requirements are removed!” the consultant, Leonard D. Bole, wrote to the commission on Jan. 22, 2004. “Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?”
He said that similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.
Mr. Bole, who earned a master’s degree in business administration at the University of Chicago, helps write computer programs that financial institutions use to meet capital requirements.
He said in a recent interview that he was never called by anyone from the commission.
“I’m a little guy in the land of giants,” he said. “I thought that the reduction in capital was rather dramatic.”
How many of us knew that the SEC had an office of risk management? I know that I didn’t. Where was the SEC office of Risk Management during this past year. They were gone, dismantled by Republican Chair of the SEC Christopher Cox. Did I mention that Cox was appointed by President George Bush?
Mr. Cox dismantled a risk management office created by Mr. Donaldson that was assigned to watch for future problems. While other financial regulatory agencies criticized a blueprint by Mr. Paulson, the Treasury secretary, that proposed to reduce their stature — and that of the S.E.C. — Mr. Cox did not challenge the plan, leaving it to three former Democratic and Republican commission chairmen to complain that the blueprint would neuter the agency.
In the process, Mr. Cox has surrounded himself with conservative lawyers, economists and accountants who, before the market turmoil of recent months, had embraced a far more limited vision for the commission than many of his predecessors.
You will all be happy to know that Chairman Cox is now of the belief that this program did not work. Maybe it was all the horses galloping up the road while Chairman Cox struggles to close the barn door that brought this vision to him.
Last Friday, the commission formally ended the 2004 program, acknowledging that it had failed to anticipate the problems at Bear Stearns and the four other major investment banks.
“The last six months have made it abundantly clear that voluntary regulation does not work,” Mr. Cox said.
And just who is Chris Cox?
Christopher Cox had been a close ally of business groups in his 17 years as a House member from one of the most conservative districts in Southern California. Mr. Cox had led the effort to rewrite securities laws to make investor lawsuits harder to file. He also fought against accounting rules that would give less favorable treatment to executive stock options.
Under Mr. Cox, the commission responded to complaints by some businesses by making it more difficult for the enforcement staff to investigate and bring cases against companies. The commission has repeatedly reversed or reduced proposed settlements that companies had tentatively agreed upon. While the number of enforcement cases has risen, the number of cases involving significant players or large amounts of money has declined.
This post is already to long but lets be clear about something that everyone on the ground already understands regardless of the Republican nonsense that is out there about CRA. The loan originators and the banks and ultimately the big investment houses made a fortune writing sub-prime. In some instances mortgage brokers tried to write exotic instruments for those that did not need them to qualify because they made LARGER COMMISSIONS on them. Whatever bad mortgage underwriting was undertaken the investment houses ability to securitize those instruments and cut them up and sell them to investors, pension funds, retirement systems, and banks has brought us to this disaster. The idea that loan originators had to be dragged kicking and screaming into making sub-prime loans because of CRA is the biggest fraud yet perpertrated in this campaign of deceit. They took sub-prime and made it into a monster to drive larger commissions on the ground and huge profits on the back end for the underwriters of these securities. THE INVESTMENT HOUSES OF WALL STREET, not the poor or CRA, caused this disaster. And the Bush Administration took a walk on regulating those monsters, and in fact by allowing greater leverage brought an even bigger disaster down on the country. I do not excuse the failure to properly regulate Fannie Mae and Freddie Mac, and for those Democrats that voted against reform we should be equally harsh in denunciation. But the Republicans simply avoid answering the question of why, during five years of controlling both houses of Congress and the Presidency, they never pushed a reform bill through the House. I await the answer. Read the New York Times story here.
Bill Manzi.com 