March 20, 2009

The Systemic Dismantling of the System

Below are a dozen pearls of wisdom from former SEC Chief Accountant Lynn Turner:

I am taken aback when people like President Obama say our problem is we had an outdated regulatory system. I beg to disagree. It was a regulatory system that in the past two decades had not become out-of-date, but rather had been almost entirely dismantled by Congress and the various Administrations as they:

1. Passed Gramm-Leach-Bliley guaranteeing large financial supermarkets that can only be too big to fail, while prohibiting the SEC from being able to require regulation of investment bank holding companies. When legislation was passed saying one could put all these businesses under one roof, without a single word in the law requiring regulation of the inherent conflicts, it was sealed in stone that there would be huge institutions the government would HAVE to bail out if they failed. And this legislation was specifically passed to permit the merger of CitiBank and Travelers to form CitiGroup, now one of the largest institutions requiring a bailout.

2. Cutting budgets at CFTC and SEC year-after-year dismantling those agencies block-by-block. They sent these agencies to do a gunfight with an empty gun all too often.

3. As new products such as credit derivatives were created and introduced to the credit markets, Congress and the Administrations took action to ensure those products could not be regulated. Companies such as Enron and AIG used the law to avoid regulation of these products. And history now has another chapter on how these products became financial weapons of mass destruction.

4. As hedge and private equity funds grew exponentially in the past two decades, Congress again exempted them from any regulatory oversight, even as they took in increasing amounts of retail money.

5. The banking regulators became “Prudential Supervisors” and not regulators, as they allowed the banks to engage in unsound lending practices, notwithstanding the 1994 legislation giving the Fed the power to stop such destructive business practices. Congress passed legislation that even allowed the Federal Home Loan Banks to expand their lending and compete with one another for the same bank’s business, with significantly increased risk.

As a result, today they have balance sheets loaded up with lousy mortgage securities and loans to the like of Citi, WaMU, Countrywide and Wachovia. It use to be they were simply in the business of making loans to local community and regional banks. And when Congress passed this legislation, they also allowed the compensation for the executives of these banks, whose business is guaranteed in the same manner as Freddie and Fannie were, to jump significantly.

6. Congress failed to provide authority, tools and resources for OFHEO, the regulator of Fannie and Freddie, blocking attempts to provide for effective oversight and regulation. These agencies watched as their assets and guarantees grew to trillions of dollars without effective oversight, while the government backed them up with the guarantee of taxpayer dollars. These agencies were allowed to grow their balance sheets unchecked, and with insufficient capital in light of the risks they were taking on and imposing on the taxpayer.

7. The credit rating agencies were granted exemption from accountability by the investing public it turns out they were misleading as well as by the securities regulators. Yet it was mandated that their ratings be used. To this day, the SEC must judge the work of these credit rating agencies by the policies and procedures the rating agencies themselves decide are sufficient, even if the rating results in a bad rating. That is quite simply still the law today.

8. Congress interceded to block attempts to bring greater transparency to financial reporting of equity compensation that grew to hundreds of millions of dollars in some cases, as the use of stock options became a drug many executives and their boards became addicted to.

9. The courts and Congress stepped in to prevent investors from getting justice through legitimate legal actions. It ultimately led to the Supreme Court of this land ruling it was legal and quite fine for people to assist others in the commission of a securities fraud – in essence drive the get away car – and there would be no justice or legal course of action for those who had been their victims.

10. Shareholders were stripped of their rights, as we saw the SEC first in 1992, and then again in 2007, denying them the right to have the same access as the management who work for them, to the proxy of the companies they owned. While Congress was well aware of compensation abuses, they failed to pass legislation that would have reined in such abuses. While two to three years ago, the House passed such legislation, it went no where in the Senate.

11. We now have Congress stepping in to put undue pressure to undo transparent accounting practices. The FASB has become most accommodating as the new rules they are proposing, with only a two week comment period, will effectively become a moratorium on fair value accounting for banks.

They will no longer have to report the effect of their bad investment decisions in their income statements – much like suspended disbelief occurs at the movies. We are now going back to accounting that the GAO in 1991, in a report titled “Failed Banks,” said raised the cost to taxpayers of the S&L bailout.

12. And finally, people were put in charge of the key agencies who did not believe in regulation. Inspector General reports on the OTS, OCC and SEC cite serious lapses in regulation. From Greenspan at the Fed who failed to act on the 1994 Hoepa legislation, to Dugan and Hawke at the OCC who opposed state regulators attempts to rein in predatory lending practices, to the SEC’s Chris Cox, these were all regulators who publicly opposed regulation and engaged in the dismantling of the regulatory system we once had.

It wasn’t that we didn’t have an effective system as much as it was the system we had was dismantled during the past two decades. And now tens of millions of Americans are paying for this with their jobs, the loss of their retirement, having to work for many more years when they have grown old, and kids having to leave college, no longer able to afford it. It is no wonder the public is so outraged by what they see going on with Congress and at companies such as AIG.

More on Notorious A.I.G. – and B.A.D. Congress

Rightfully so, many of the folks I know have as equal disdain for the House of Representatives as for AIG itself, due to the silly Рand potentially harmful Рlegislation which passed yesterday that imposes a huge tax on bonuses to anyone earning over $250,000, who happens to work for a TARP company that received $5 billion or more in funds. Those same people also show disdain for the Treasury’s bait and switch, wherein some companies were forced to accept TARP money. The processes of the bailout from start to finish so far have been the stuff of comedy (except unfortunately this is all reality).

Even though I believe changes in the way senior executives get paid need to happen, I don’t think that Congress should be dictating them. As I’ve said before, until boards want change, they will find a way around any artificial restrictions. And those work-arounds typically end up being more excessive than the pay arrangements that would have originally been implemented.

My blog about AIG a few days ago resulted in a record level of member correspondence. Here are just a few from the many I received:

1. This letter from a former AIG Financial Product unit executive has been in the hands of Congress since October. After the fact, it is clear that AIG mispriced the risk on the credit default swaps – they took in a lot less premium than they should have, given the scope of risk. I don’t know if the board has gone back and determined if the mispricing was error, or done deliberately to make a commission-generating and bonus-generating product more attractive. I would want to know that before paying out any bonuses, particularly in light of the red flag raised in that letter.

2. Congress will do something stupid and penalize AIG – which is realizing penalizing taxpayers given that we own the thing – rather than just try to get the money back from the rouges.

3. No first-year corporate lawyer would ever let her or his client invest billions in a company without doing, apparently, ANY DUE DILIGENCE.

4. As I read the news stories, these severance agreements have been in place for a very long time, perhaps before the first government advance.

5. The recipients are not to blame. Whoever approved these agreements is to blame, if, and only if, their actions are not protected by the business judgment rule (as things existed at the time; not with the benefit of 20-20 hindsight). I’ve seen nothing to indicate that to be the case (see the recent Citigroup case).

6. Be very careful, my friend, whatever the government concocts to punish these recipients, they can also do to you. Trust me, my friend, you really do not want to start meandering down that path.

7. I think the board could only be justified in paying bonuses to those employees whose services directly related to the winddown, and presumably those bonuses were only earned in the last few months so its hard to see how they got to be 165mm; anything else smacks of gross negligence. Further, the bonuses clearly didn’t need to be at the same rate as they were before the meltdown – are there that many jobs available to these employees.

Finally, it seem likely that at least some of these employees violated fiduciary or other duties to the corporation – so the only bonus should be that “if you get the corporation successfully out of the mess you got it into, the corporation won’t sue you for breach of those duties”. In this environment, how successful do you think a claim for a bonus would be when matched up against a counterclaim by the corporation?

8. It’s obviously a very complicated legal issue totally swamped by the idiocy of the players. You certainly can’t blame the public for being outraged.

9. With all the layoffs, there is plenty of talent available (and having created the mess, its hard to see that the talent that AIG has is all that talented or irreplaceable).

10. People must be held accountable for their actions, and inactions – in this case, the directors. A few lawsuits will bring a new sense of vitality to them, and given the failures revealed by the recent past, I don’t think the argument that current boards are irreplaceable and no one will serve is sufficient – certainly a better balance needs to be struck.

– Broc Romanek