Credit Crisis: Where Was The SEC?

02.06.08, 6:00 AM ET

Six years after the lessons of Enron and a decade after Long-Term Capital collapsed, regulators still can't seem to blunt the damage complex securities can have on financial markets. Why?

It's a fair question. Investment banks, mortgage brokers and ratings agencies are all being blamed for the subprime mortgage bubble and its sudden and stunning demise. But little has been said about the watchdogs at the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority, the regulators who oversee the activities of the banks. They have the power to stop fraud in the business of selling the complex credit derivatives, and they have jurisdiction over whether the complex securities sold by the banks met suitability requirements for the investors who bought them. Yet time and again, they've failed to do so.

Most notably, the SEC has the power to monitor whether the investment banks had adequate capital relative to their trading positions and balance sheets and the proper risk management systems to prevent catastrophic losses. More than $100 billion in write-downs later, several banks are scrounging for capital, and it's clear those risk management procedures weren't functioning very well, if at all.

One of the problems is the lack of clear information, outside the banks and trading floors, about the credit derivatives market. Collateralized debt obligations (CDO) and other structured finance products trade over-the-counter rather than on an exchange, at least in the United States. Many of them trade infrequently, meaning price information is limited.

Washington and Wall Street have been hesitant to clamp down on the over-the-counter market, the source of much profit-making. Last year, as the subprime market began its collapse, the President's Working Group, which includes the Treasury Department, the Federal Reserve, the SEC and the Commodities Futures Trading Commission, recommended against tighter oversight of the over-the-counter market, in the context of vetoing tighter regulation of hedge funds, saying the industry can self-police.

A counterparty risk group led by former New York Fed President Gerald Corrigan has also recommended industry "best practices" in lieu of tighter regulation of the derivatives trading market.

Leaving it up to Wall Street hasn't proven very effective, however. "The decision by the President's Working Group to recommend no detailed regulation of the over-the-counter market was wrong," says David Ruder, a former SEC chairman and now law professor at Northwestern University.

Regulators are taking a hard look at how banks structured, priced and sold mortgage-laden securities, but by the estimate of some it's too little and too late. "I don't think all the king's horses and all the king's men will put this together again," says Gary Aguirre, a former SEC lawyer.

There were warning signs.

In the summer of 2006, Jeff Kronthal, a senior executive in Merrill Lynch's (nyse: MER - news - people ) structured products group, was fired after reportedly balking at then-Chief Executive Stanley O'Neal's demands that the firm get more aggressive in its risk-taking with mortgage securities. Kronthal was hired back by new Chief Executive John Thain in December to advise on the firm's risk management.

He wasn't the only one to sound alarms about the housing bubble and the explosion of the credit derivatives market. "Many credible people were public about their dissatisfaction with the mortgage loan market," says Janet Tavakoli, a structured finance expert with her own Chicago consulting firm.

She blames the ratings agencies for flawed ratings methodologies. The Fed and the SEC, among other regulators, are just packs of economists and lawyers. "I do not expect lawyers to be rigorous in their analysis."

Regulators saw warning signs as early as 2005, but failed to pursue them. Bear Stearns (nyse: BSC - news - people ), in its first quarter 2005 financial disclosure, said it faced the threat of a civil enforcement action in connection with its pricing, valuation and analysis of $63 billion worth of CDOs. In the same filing, Bear Stearns said it was contacted by the New York State attorney general, then Eliot Spitzer, about $16 billion worth of CDOs it sold to an unnamed client.
The inquiries were brought up again in the August quarterly regulatory report and in the year-end 2005 filing, when Bear Stearns said it was "continuing to respond to subpoenas and other requests for information from regulatory and law enforcement officials."
But that's the last time Bear Stearns brought it up, suggesting the matter had been sidelined or dropped. Aguirre says it sounds fishy. "I find it troubling," he says.

Aguirre has his own beef with the SEC. He was fired in 2005 after aggressively pursuing an insider trading case against Pequot Capital, the powerful New York hedge fund. Aguirre, who says he was fired after trying to interview current Morgan Stanley (nyse: MS - news - people ) Chief Executive John Mack in the matter, says the agency is too close to the industry it covers to be effective as a watch dog. A spokesman for the SEC wouldn't comment for this story.

Others say it's just a matter of things spiraling out of control more quickly than anyone could imagine. "It's very late in the game to be pointing fingers," said Howard Pitkin, Commissioner of Banking in Connecticut. "We all need to sharpen our pencils as far as spotting these problems."
On Friday, Massachusetts securities regulators filed a civil fraud suit against Merrill Lynch over $14 million worth of collateralized debt obligations it sold to the town of Springfield. The state claims the CDOs were unsuitable and sold without the town's consent. (Merrill has acknowledged the latter and paid the town back in full for the investment, which is now practically worthless.)
Earlier last week, the Federal Bureau of Investigation disclosed it had opened criminal fraud probes into 14 companies over their mortgage securitization activities, which includes everything from originating loans to buying them, packaging them and selling them to investors. The FBI didn't identify the companies.

Connecticut and New York attorneys general have also opened investigations into how Wall Street structured and sold mortgage-laden securities.

Goldman Sachs (nyse: GS - news - people ), Morgan Stanley and Bear Stearns have disclosed in their recent regulatory filings that they have been questioned by multiple regulators about their activities involving subprime mortgage securities. In November, Merrill Lynch said the SEC had initiated an inquiry into its subprime mortgage portfolio. All the banks have said they are cooperating. Maybe they should shore up their risk management while they're at it.

Wachovia sells $3.5 billion in preferred shares

NEW YORK, Feb 6 - Wachovia Corp (WB.N: Quote, Profile, Research) said on Wednesday that it sold $3.5 billion of preferred shares as the bank looks to rebuild its capital position.
The preferred shares pay a dividend of 7.98 percent for 10 years, and then change to floating interest rates. The shares may be redeemed after 10 years.
Wachovia's Tier 1 capital ratio, a measure of capital strength, was 7.2 percent at Dec. 31. This issue would essentially raise that ratio to 7.9 percent. (Reporting by Dan Wilchins, editing by Gerald E. McCormick)

Home demand to drive Japan growth

Domestic demand will fuel economic growth in Japan in the next financial year, its government has said.

The economy is forecast to expand by 2% in the 12 months from April 2008, although the government warned that a US slowdown could jeopardise this.

However, government minister Hiroko Ota said that in the current financial year, Japan would see GDP growth of 1.3% - lower than previously forecast.

The Bank of Japan is this week expected to peg interest rates at 0.5%.
Lacklustre growth and lingering deflationary pressures in the world's second largest economy mean that the bank is expected to refrain from raising its key rate until the latter half of 2008, analysts say.

Mrs Ota said that while domestic demand would be playing a key role in boosting the nation's economy, growth in consumption would be limited because "wage increases will likely continue to be moderate".

She also warned that if the slowdown in the US - Japan's largest export market - continued then next year's growth "may be lower than the projection".

Higher crude oil prices could also have an impact, Mrs Ota said.

Investors enter 2008 in fog of uncertainty

By Jeremy Gaunt - Analysis
LONDON Will the U.S. economy fall into recession and spread its woes elsewhere? Will financial markets dry up in a cash drought brought on by the subprime debacle?

With such Rumsfeldian "known unknowns" as a backdrop, global investors are heading into 2008 with less certainty and less consensus about what to do with their money than has been the case for some half a decade.

Consider the case of Legal & General Investment Management and Morley Fund Management, two large British investors.

L&G is looking to 2008 to produce what it calls "sogflation" -- soggy growth with persistent inflation. The result: It expects cash to outperform equities. Accordingly, it is underweight equities and neutral to overweight bonds.

Not far away across central London, meanwhile, Morley is expecting economies to rebound after a recent slowdown and for central banks to contain the credit crisis. The result: It is overweight equities and underweight bonds.

"Although we recognize the risks ... we expect economies to pick up steam from here," said Morley senior economist John Ip.

Such divergence should not, perhaps, be surprising given the kind of volatile year financial markets have had in 2007. After rising steadily for most of the year, major equity markets began ebbing and flowing sharply in summer.

On a year-to-date basis, for example, MSCI's main world stock index .MIWD00000PUS was up nearly 13 percent in July, down 1.5 percent in August, up 16.5 percent in November and is heading into the last weeks of 2007 up around 7 percent.

Time names Putin "Person of the Year"

WASHINGTON Russian President Vladimir Putin was named Time magazine's "Person of the Year" for 2007 Wednesday for bringing his country "roaring back to the table of world power."
Putin, a former KGB official who was picked from obscurity in 1999 by then-president Boris Yeltsin, will appear on the cover of Time as the person the editors believe had the greatest impact on events this year, for better or worse.

"He's not a good guy, but he's done extraordinary things," said Time managing editor Richard Stengel, who announced Putin's selection on NBC's "Today Show."

"He's a new tsar of Russia and he's dangerous in the sense that he doesn't care about civil liberties; he doesn't care about free speech; he cares about stability. But stability is what Russia needed and that's why Russians adore him."

The choice came days after Putin announced a plan to hold onto power after his term ends. Putin said Monday that if his close ally, Dmitry Medvedev, wins next year's presidential vote, he would serve as Medvedev's prime minister.

The Russian president beat out several rivals for the Time distinction, including former U.S. Vice President Al Gore, British author J.K. Rowling, Chinese President Hu Jintao and U.S. Commander in Iraq Gen. David Petraeus.

Peres, Abbas sign industrial zone deal

resident Shimon Peres and Palestinian Authority President Mahmoud Abbas signed an agreement Tuesday paving the way for the establishment of two new industrial zones in the West Bank.

Peres, Gul and Abbas at the meeting of the Ankara Forum of Israeli, Palestinian and Turkish industrialists. Photo: GPO
The agreement was signed as part of a meeting of the Ankara Forum of Israeli, Palestinian and Turkish industrialists established two years ago to create economic opportunities in the Palestinian territories. The Forum is led by Turkish President Abdullah Gul.

"New markets will be accessible throughout the region and the world due to the establishment of the new zone," Gul said.

Abbas said the new industrial zones would be built near Jenin and in Trakumiya, located near Hebron.

Peres said the signing of the agreement Tuesday did not come to replace the planned Middle East conference in Annapolis, Maryland set for later this month, but was "in addition to it". He added that economic improvement was vital for achieving peace with the Palestinians. "This agreement is for Israel a win-win situation," Peres said.

Abbas concluded his remarks expressing hope that by this time next year, Peres, Gul and he himself would be sitting in a larger forum, signing a peace agreement between Israel and Palestinians.

At a joint news conference with Peres, Abbas said Israel will live in peace if it ends its occupation of Arab lands. "If peace comes and the occupation comes to an end, Israel will live in a sea of peace," he said.

The PA president added that his administration was preparing for the Annapolis conferece. "We are working with our full force to ensure that the meeting in Annapolis is a success," he said.
Later in the afternoon, Peres was slated to become the first Israeli president to speak before the legislature of a Muslim country. Abbas was also expected to address the Turkish Parliament.

Oil back above $96 after respite

Disruption to North Sea supplies has sent prices upwardsOil prices have rebounded above $96 in Asian trading as concerns about global supplies linger.

A barrel of US light crude was worth $96.46, up $1, having fallen to $95.46 on Thursday on pessimistic comments by Federal Reserve boss Ben Bernanke.

His forecast for slower economic growth may have meant weaker demand as firms reined in spending, analysts said.
But disruption to oil output in the North Sea from BP and ConocoPhillips rigs helped to support crude prices.

'Tight market'

Platforms pumping more than 200,000 barrels of oil a day in the North Sea were closed due to bad weather, exacerbating concerns about the availability of crude.

Prices hit a record high above $98 a barrel of Wednesday, leading many analysts to speculate that it was only a matter of time before the $100 mark was breached.

But prices then fell back sharply after US crude inventory figures showed a smaller than expected weekly fall.

Analysts still expect oil to break $100 a barrel
The weaker dollar has been driving up oil prices as investors have been using the commodity as an alternative to holding dollars.

"Markets have probably rethought how tight the market is and might be in the near term and that has caused an upward adjustment," David Moore, a commodity strategist at the Commonwealth Bank of Australia, said of Friday's price jump.

Oil prices have now risen by 60% this year but prices have still not reached a record high if inflation is taken into account.

Adjusting for inflation, US light crude's record peak of $101.70 came in 1980 against a backdrop of war between Iraq and Iran.

The dollar's current weakness has also seen prices of other commodities rise sharply, most notably gold, which is continuing near 27-year highs.