The SEC Fiddled While Rome Burned (Part 3 of 3)
Botching the Bernie Madoff Ponzi swindle and thus failing to prevent tens of billions in losses was pretty bad press for the SEC. But the more one looks into the agency’s conduct in the Bush years, the more missteps become apparent.
Take Allied Capital, a D.C.-based finance firm that makes loans to small to mid-size concerns, whose stock is plummeting, having recently defaulted on a credit facility and suffered a $1 billion loss in 2008 ($578.8 million of which came in the 4th quarter), compared to earnings of $153.3 million the year before. Allied’s problems were foreseeable. Allegations that the company engaged in illusory accounting practices began dripping into the SEC almost a decade ago.
It took five years for the SEC to begin an investigation. When it did finally investigate, the SEC didn’t like what it saw. In an action filed in June 2007 against Allied, the SEC found numerous violations in connection with false valuations of illiquid assets.
But in the subsequent settlement, Allied admitted no wrongdoing and paid no money.
As with Madoff, there was a tipster in the case of Allied Capital. But with Allied, the SEC did not ignore the tipster. Instead it threatened to sue him.
In his book, “Fooling Some of the People All of the Time,” David Einhorn, who manages a New York hedge fund, tells a harrowing tale of how he tried to convince the SEC to investigate Allied. The plot begins when Einhorn told investors at a May 2002 charity event that betting against Allied was something to consider. After conducting a thorough investigation of the company, Einhorn had concluded that Allied Capital was likely overvaluing its troubled assets.
Allied had a different view of the matter. It believed a number of hedge funds, including Einhorn’s Greenlight Capital, were disseminating false information to drive Allied’s stocks down and then cash in on their short positions. Allied went on the offensive, waging war on Einhorn, even allegedly impersonating his wife to access Einhorn’s telephone records in efforts, according to Einhorn, to “root out relationships and silence critics.” A number of Allied’s critics had experienced similar irregularities in their phone records.
But when Einhorn sent the SEC an analysis of Allied’s misleading numbers and super aggressive accounting practices in 2002, the agency provided no response. Rather, the agency began an investigation of Einhorn for allegedly manipulating Allied’s stock. The investigation turned up nothing, but the SEC lawyer who interrogated Einhorn, Mark K. Braswell, later left the agency to become a registered lobbyist for — you guessed it — Allied Capital.
The Rope To Hang Themselves
But it was in 2004, under the leadership of then-Chairman William Donaldson, that the SEC made its most far-reaching mistake, essentially giving the country’s five largest investment banks the ropes to hang themselves (and the rest of the economy) with.
In 2002, the European Union was threatening to regulate the European affiliates of the big U.S. investment banking interests, by imposing stricter capital requirements. In response, those firms begged Europe for the opportunity to work with the SEC to alleviate the concerns. As reported by Time magazine, “It is a measure of the industry’s comfort level with the SEC that investment banks, when faced with the demand that they open their books, lobbied for the commission to conduct the oversight.”
The arrangement ultimately reached between the mega-banks and the SEC went something like this: The banks would agree to open up their holding company’s books for the SEC’s “voluntary” supervision, in exchange for which the SEC agreed not to extend to the holding companies the debt limits the Commission had once imposed on bank-owned brokerages. Whereas otherwise applicable net-capital rules required the firms to keep their debt-to- net capital ratios below 12-1 (i.e., for every $12 dollars in debt they had to have at least $1 in net assets), the SEC agreed to permit the banks to have ratios of 40-1! This freed up the billions held by the banks in reserve as a cushion against losses, to invest in mortgage-backed securities and other risky derivatives.
The matter was formally considered on April 28, 2004, in a meeting that lasted less than an hour. Commissioner Harvey J. Goldschmid, a securities law expert from Columbia who advised Sen. Paul Sarbanes in rewriting some of the nation’s corporate laws after the accounting scandals in 2002, was uneasy. “Do we feel secure if there are these drops in capital we really will have investor protection?” Mr. Goldschmid asked. A senior staff member stated in response that the commission would enlist the best and the brightest, including people with strong quantitative skills to examine the banks’ balance sheets. One of the major concerns was that if the maximum leveraging occurred, and if the firm’s asset values declined even modestly, creditors’ security would be drastically weakened and could cause a widespread rush on the bank.
“We’ve said these are the big guys,” Mr. Goldschmid said referencing the reassurances by staff members that the new rules would only apply to banks with $5 billion or more in assets. “But that means if anything goes wrong, it’s going to be an awfully big mess.” Laughter ensued. In fact, there was a surprising amount of laughter and good cheer on that March day.
Ultimately, the new rule was unanimously approved. But while the investment banks agreed to open up the books of their parent companies for the SEC, the agency did not supervise the program to the extent intended, and never otherwise took advantage of the increased transparency. Furthermore, the agency relied on the banks’ own computer models in ascertaining the risk of investments, rather than conducting an independent analysis.
When Christopher Cox arrived at the agency a year later, supervision of the subject banks was made a low priority. SEC examiners did, however, take note of an astronomical rise in the leveraging, with Merrill coming close to the maximum debt load allowed under the program. Most experts agree there were plenty of red flags prior to Bear Stearns’ collapse, but the SEC did nothing.
SEC Commissioner Harvey Goldschmid now maintains that Chairman Cox should have “gone in and pounded on the table and said, ‘Look, there are all these red flags. Why are you still leveraged? We want you to have more capital.’ There’s never been a time when those firms were not going to respond to demands by the SEC chairman.” According to Goldschmid, Cox “was the primary regulator. He should’ve been there earlier to try to avoid these things from happening.”
“We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing,” said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law. “Letting the firms police themselves made sense to me because I didn’t think the S.E.C. had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We’ve all learned a terrible lesson,” he added.
There was, however, one lone voice of dissent way back in 2004. On January 22, 2004, Leonard D. Bole, a consultant from Indiana, wrote a two page letter to Commission warning that allowing the banks to lever up so much would be a huge mistake. “With the stroke of a pen, capital requirements are removed!” Bole wrote. “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?” Bole observed that computer models of risk assessment did not protect Long-Term Capital Management, the hedge fund that collapsed in 1998, nor the companies involved in the market plunge of October 1987. Needless to say, Bole’s letter was not seriously considered, and likely was promptly tossed in the trash.
While there are many causes of the financial crisis, there is consensus that but for the SEC’s 2004 rule change, the crisis would not be as severe as it is, because Bear Stearns, Lehman Brothers and Merrill Lynch would have had thicker cushions. “They constructed a mechanism that simply didn’t work,” said former SEC official Lee Pickard on September 18. “The SEC modification in 2004 is the primary reason for all of the losses that have occurred.”
So why didn’t Cox do anything when the red flags became apparent? Cox says the SEC chairman “typically does not” micromanage the CEOs of those firms. But other observers say it’s because Cox was, for all intents and purposes, vacant. “They never heard from him. They never saw him,” says another ex-commissioner. “He was never a factor. Even when things got bad, it took a long time before he got on the phone to find out from these firms what their exposures were and what they were doing about it.”
The Vacancy of Christopher Cox
The appointment of Cox as chairman of the SEC in 2005 marked the beginning of a exceptionally lax era of regulating the financial industry and a tendency toward a policy of letting large financial institutions regulate themselves. The dockets show that under Cox’s leadership the SEC steered away from bringing cases against large Wall Street firms, focusing instead on what many lawyers call “petty fraud” cases, small Ponzi schemes and the like.
Under Cox’s new rules, members of the enforcement staff no longer had authority to resolve cases or negotiate fines and penalties. Rather, it was politically appointed Commissioners, three Repubs and two Dems, who would do that. But they rarely did. (And for a sustained period during the Bush Administration, Bush failed to fill the two Democrat seats, leaving the three Republican “groupthink tank” to make the decisions.) With their newly-donned authority, the Commissioners would endlessly delay approval of cases against large firms, while quickly approving the bite-size cases involving penny stocks and other small investors.
Subsequently, penalties decreased precipitously from $1.5 billion in 2005 to $507 million in 2007. A January 2008 analysis by the law firm Morgan Lewis found that S.E.C. penalties have dropped by a “staggering degree” and that “the numbers suggest a philosophical shift by the Cox commission in what constitutes an appropriate penalty.”
The number of employees working in the enforcement division also declined almost 10% under Cox to 1,124 in 2008. Cox also instituted serious cutbacks in the risk-assessment office, whose duties including analyzing current market conditions and financials with an eye toward preventing problems in the future, and relaxed rules regarding short-selling, including the “naked short-selling” that many believe contributed to the fall of Bear Stearns and Lehman, among others. A report by Syracuse University shows that SEC agency investigations that led to Justice Department prosecutions for securities fraud dropped from 69 in 2000 to just 9 in 2007, a decline of 87 percent.
Meanwhile, AIG was selling hundreds of billions in credit default swaps, totally unregulated, without any requirement that it’s reserve base be adjusted to account for its huge potential swap liabilities. Of course, as we now know, the executives at AIG didn’t consider the swaps liabilities at all, but rather riskless assets.
Some of the cases pursued by the SEC during this period seemed designed to create the appearance that the agency was being vigilant in the post-Enron world, but upon closer examination the cases themselves lacked much substantive punch. For example, the SEC made as lot of hay about stock options backdating, a common practice from the the dot-com boom in which the grant date of stock option is backdated so that at the time of the grant the strike price is “in the money” (i.e., below market value). That’s not in itself illegal. What is illegal, technically speaking, is failure to expense the option to account for its depressed value. Gregory Reyes, former CEO of Brocade Communications, was convicted for backdating in a symbolic trial and faces jail time, despite the fact that Brocade restated its earnings to account for the added expenses and Reyes did not personally benefit from the practice, at least not in any direct way. One is hard-pressed to identify any real “victim” in backdating. To this day, however, the agency continues to pursue these cases.
Although Cox vehemently defends his tenure, there is no question that he deliberately cut back on enforcement activity while acting as Chairman. The business community felt “that [Former SEC chairman William] Donaldson was too tough on corporate America and Wall Street,” says a former enforcement official. “Cox was brought in to chill it out.”
A New Era?
Barack Obama has chosen Mary Schapiro to lead the SEC out of its sad state of disrepute. Since taking office Shapiro, a former SEC commissioner and former head of the Financial Industry Regulatory Authority (FINRA), has been waging a campaign to ramp up enforcement and reverse some of the Cox-era rules. She has already repealed the rule requiring the staff members to obtain commissioner approval before resolving cases. Shapiro also intends to reform the manner in which the SEC deals with tips and whistle blowers. To get things started with a bang, Shapiro has brought a juicy new case against the flamboyant billionaire R. Allen Stanford and three of his companies, charging $8 billion in investment fraud.
While there are many issues on Shapiro’s plate, here are a few things she might want to consider:
First, end “naked short selling” and revive the uptick rule, which requires an uptick in share prices before investors can short a stock.
Second, advocate for the continuation of current mark-to-market valuation rules. Many commentators suggest suspending these rules because they force firms to value assets at the price those assets would fetch in the market today which, for most of the so-called “toxic assets,” is zero or less. This, say the commentators, is bogging the market down. Allowing banks more latitude within which to value these assets, however, would probably lead to inflated valuations and therefore could prolong economic recovery. The current regime will inflict more pain in the short term, but will serve to ensure that when a recovery begins, it’s real.
Third, hire armies of financial geniuses, forensic accountants and any other experts that are needed to ensure that agency officials truly understand an increasingly complicated financial world.
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