In the financial industry, deregulation has been a disaster. So has regulation. Damned if you do, damned if you don’t. In the past decade, the big Wall Street banks have concocted one highly complex swindle after another to conceal their own liabilities and those of their clients, including companies, cities, and countries. But the regulators have stood by and let it happen — even stating in writing that extremely dubious financial instruments were okay.
Feckless regulation and reckless banking have gone hand in hand.
Early this month, the New York Times ran an op-ed by four law professors telling how Wall Street has bullied its regulators. The Enron debacle of 2001 had revealed how the big banks created complex products whose only purpose was to help companies transform their debt into capital or revenue — rather like changing feces into chocolate ice cream. Shareholders of shaky companies and citizens of debt-besotted cities and countries have been completely bamboozled by phony maneuvers that have been going on for years.
“Complexity was what made it possible to hide debt, avoid capital requirements, and evade taxes,” said the Times. I have said for years that “contrived complexity is the essence of white-collar fraud,” and Wall Street derivatives cooked up by MIT mathematics Ph.D.s are a classic example of the genre.
The various bank regulators, including the Federal Reserve, felt they had to react to the public uproar over Enron. In 2004, they issued a milquetoast statement on complex instruments. But the pronouncement said these products should not be used to evade the law and financial institutions should be sure that buyers of the instruments understood them.
The banks howled. The regulators caved. In 2006, the weak-kneed regulators came out with another explanatory paper, “Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities” (italics mine). Get this: the regulators defined “complex structured finance” transactions as those that “lack economic or business purpose” and are “designed or used primarily for questionable accounting, regulatory or tax objectives.” Asked the professors in the Times, “How does one propose ‘sound practices’ for practices that are inherently unsound?” Good question.
The professors stated their own opinion: “Products having no economic purpose except to achieve questionable accounting” or products that customers will use to “issue materially misleading financial statements” should be prohibited. That’s a no-brainer. Illegalities should be illegal. But the regulators didn’t ban them. It was like a preacher singing the praises of sin.
No wonder the banks went loco creating products that led to fraud. It was hardly surprising that the banks’ irresponsible product creation, gambling, and piling up of debt almost pushed the world’s economy off the cliff — and still might.
American taxpayers rescued the crooked financial institutions, which then used the money partly to hire lobbyists to thwart reform. I asked San Diego financial experts about our banking dilemma: laissez-faire doesn’t work, but neither does regulation. What can we do? “Banks should be broken up so no bank is ever too big to fail again,” says Carlsbad money manager E. James Welsh. The most complex instruments — derivatives — “should be standardized and traded through a central clearing house.” Regulators would referee the process.
Del Mar’s Arthur Lipper III, who belongs to a longtime powerful Wall Street family, says whistle-blowers should be rewarded as fraud penalties are increased. “It is only in creating whistle-blowing rewards and severe penalties for those involved in breaching regulations that regulatory enforcement can be timely and successful,” says Lipper. “Once identified, the guilty parties and abettors — including involved law and accounting firms — should be dealt with harshly.”
Agrees San Diegan Gary Aguirre, former investigator for the Securities and Exchange Commission, “Call anybody in the SEC and ask what’s the best way to deter violations of securities laws, and 90 percent will say, ‘Put them [violators] in jail.’”
In 1999, Congress passed the Gramm-Leach-Bliley Act, which repealed parts of the Glass-Steagall Act of 1933. Glass-Steagall had mandated the separation of investment and commercial banks. The 1999 act allowed the various Wall Street firms — investment banks, securities firms, and insurance companies — to consolidate. Gramm-Leach-Bliley gave big banks “a pass to the gaming tables some call the financial markets,” says Aguirre, who is now in a pitched battle with his former employer, the Securities and Exchange Commission. While at the agency, Aguirre had wanted to interview one of Wall Street’s biggest big shots; top-level bureaucrats at the agency blocked the move and fired Aguirre. Congressional investigators and the agency’s own internal inspector general said Aguirre was right to press for the interview and his firing was unjust. But the agency is still fighting his claim before the Merit Systems Protection Board.
Both Aguirre and Lipper point to the so-called revolving door: lawyers at the regulatory agencies protect crooks, then go to work for $2 million a year for Wall Street law firms or brokerage houses. “As long as it is the Wall Street law and investment banking firms which are the likely future employers of many employees of regulating agencies, it is unlikely there is going to be stringent enforcement,” says Lipper. The Wall Street law firms completely control the Securities and Exchange Commission, says Aguirre. On Friday the agency made damaging charges against powerhouse Goldman Sachs; to establish credibility, the agency must not back down.
Welsh points out that as the housing bubble inflated, mortgage originators packaged and sold the loans to Wall Street, which then securitized them and peddled them to investors. So lenders had no incentive to make sure the borrower could pay off the mortgage. “Go back to the old lending standards, which required buyers to allocate no more than 33 percent of their income for a mortgage payment,” says Welsh. And once again, mortgage originators must verify borrowers’ income — no more liar loans. Mortgage originators should be forced to hold 5 percent of the mortgage “and be first to absorb any loss.” And rating agencies, which gave AAA ratings to securitized mortgages that were a bunch of junk “should be paid by the buyers, not the issuers.” It’s amazing that this blatant conflict of interest has gone on so long.
James Hamilton, economics professor at the University of California San Diego, says it’s a myth that all the financial woes were caused by deregulation. He says the Federal Reserve did not have significant regulatory authority over investment banks like Lehman Brothers. A major villain was the so-called shadow banking system in which nonbanks (hedge funds, for example) make loans without regulatory supervision.
Regulators didn’t move on the shadow banking system. “Failing to develop new regulatory structures for the new financial arrangements proved to be a terrible policy error,” says Hamilton. “But rather than blame it on a laissez-faire philosophy, it is more constructive to recognize it for what it is — the difficulty in continually adapting the regulatory structure to a changing world.”
Either way, the regulators screwed up. The bankers went bonkers, and the rest of us rushed into bunkers.
But will anything be done? “The odds of any of these changes becoming reality is near 0 percent,” says Welsh. “Both political parties are owned by powerful lobbies” — and Wall Street’s lobbies are among the most potent.