interview
The Old Guard Wants New Blood
Former SEC Chairmen Weigh In on the Financial Crisis
Back Bearings: Levitt
On October 16, 2008, Arthur Levitt testified before a Senate banking committee that the foundation for the current financial crisis could be found in at least two decades of “a deregulatory approach to the explosive growth and expansion of America’s major financial institutions.” The former chairman of the Securities and Exchange Commission (1993–2001), Levitt has served as a senior advisor at New York’s Carlyle Group since May 2001.
He reminded Congressional leaders that in 2004 the SEC adopted new rules allowing for so-called CSEs (consolidated supervised entity). From then on, the largest well-capitalized investment bank holding companies and their affiliated broker–dealers could voluntarily accept CSE status and adopt a models-based method of calculating net capital requirements. That allowed major Wall Street firms to reduce the amount of capital they had to set aside by as much as 20% to 30%, according to some estimates. In return, firms agreed to broad SEC supervision and to the imposition of reporting and record-keeping requirements.
But the new entitlement did not work as advertised. In Levitt’s testimony, he recalled a September 25, 2008, report from the SEC’s Inspector General that revealed regulators’ failure to act on a multitude of red flags raised by Bear Stearns’s accumulation of unacceptable risk.
Moreover, Levitt told Congress, the SEC failed to enforce its own precepts. The growing markets and increasingly complex products should have sparked more transparency, but the agency tolerated opacity. “As an overheated market needed a strong referee to rein in dangerously risky behavior, the Commission too often remained on the sidelines,” he testified.
Levitt alleged that the lack of oversight, coupled with a “regulatory system that failed to adapt to important, dynamic, and potentially lethal new financial instruments,” created the perfect storm. He added that many investment banks were able to mask their failing financial health because of the lack of transparency about Wall Street’s risky investments, off-balance-sheet holdings such as structured investment vehicles, and credit derivatives like credit default swaps.
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Arthur Levitt: |
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In November 2008, Levitt spoke with the Investment Professional and elaborated on his testimony before Congress. He still remains focused on the SEC’s failure to regulate, arguing that the enormous amount of risk exported around the world was a direct consequence of “a series of steps that, in the midst of a deregulated and permissive environment, allowed uncontrolled and reckless leverage and the creation of poorly understood products.”
Back Bearings: Pitt
Harvey Pitt agrees with Levitt’s assessment of the role of deregulation in the current crisis. The former SEC chairman from 2001 to 2003, and the current CEO of Washington, DC, global consulting firm Kalorama Partners, LLC, Pitt hones in on a definite lack of both internal and external transparency, noting that prior to the meltdown, new financial markets were developing and financial products were being created, but transparency was nowhere near appropriate levels.
“The securitization of mortgages was a testament to American ingenuity,” Pitt says. But that creativity made it difficult to determine how leveraged and exposed firms really were.
He cites the fact that a major brokerage firm reported within a very short period of time losses of three different and increasing amounts of money. Pitt calls those discrepancies proof that the firm “didn’t have a clue” as to the true value of the securities. Most firms whose assets are being substantively written down will either decide to cut back on that particular business or to get out entirely. But Pitt explains that, in this example, not being able to gauge the real loss made such a determination nearly impossible.
“Nobody asked why that amount was changing,” he says. Not only was external transparency lacking, but there was no internal visibility either. “You can’t have a market without a constant and steady flow of accurate information,” he cautions. That lack of pinpoint accuracy caused frustration and panic, and exacerbated investors’ fear of the unknown.
Adding to the opacity issue was a general failure of the regulatory system and the regulations themselves, he continues. From the 1970s onward, the financial services industry has seen massive, explosive growth. However, while Congress kept expanding the turf of financial services companies, the regulatory structure did not keep pace, Pitt observes.
Take, for example, the Gramm–Leach–Bliley Act of November 1999, which repealed Glass–Steagall and removed the walls that had been purposefully erected between banking operations and broker–dealer securities operations. Pitt believes that Gramm–Leach–Bliley was a good initiative, but that Congress made a deliberate decision to leave the current patchwork system of regulation intact, rather than updating it for modern markets. “By doing that, we sowed a lot of seeds for the current difficulties. We have a system where products and services are regulated by what they were born as—not by what they are doing now.”
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Harvey Pitt: |
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Pitt notes that Congress’s decision left a growing financial services industry with inefficient regulation by overlapping agencies. Indeed, some pockets lack regulation altogether. “That failure to give regulators a clear mandate and tools with which to achieve specific goals will mean we will be paying quite a price for a long time to come,” he says.
In addition to opacity and weak regulation, Pitt identifies a third trigger for the financial crisis. The huge overexpansion of the credit market, which began in 1987, contributed to a sudden and unexpectedly massive contraction and caused a dramatic change in credit policies. “That created an enormous turbulence in our system that people weren’t prepared for,” he says.
better never than late
In late September 2008, the US Treasury rolled out a $700 billion rescue package aimed at steadying the markets, acquiring frozen assets from the balance sheets of Wall Street’s ailing firms, and encouraging the credit market to flow freely once again. After two revisions, Congress begrudgingly blessed the plan. But there was no consensus on Wall Street as to whether the Emergency Economic Stabilization Act of 2008 was a permanent resolution or a finger in the dyke.
“The federal rescue plan was neither a long-term solution nor a short-term Band- Aid,” Pitt says bluntly. “There was a perceived need at the time to do something to shore up confidence and return credit markets to a sense of normalcy.” But the legislation took way too long to gain passage, rendering useless any short-term advantages it could have brought. “This package was sold to the American public as a cure for our troubles, but it was not a cure—just a shortterm confidence booster,” argues Pitt.
Levitt takes a somewhat different view. “Henry Paulson did a heroic job in the midst of a tsunami. He’s proactive and flexible, and has admitted when something didn’t work.” As for the rescue plan itself, Levitt concedes that although “parts of it will be constructive, parts of it have not worked as intended.”
One of Pitt’s major concerns with regard to the Treasury plan centers on the possibility of allowing banks to waive fair-value pricing mandates for securities stuck in limbo. The concept of buying troubled assets makes sense, he says, but the Treasury would only have worsened matters by buying assets at below book value.
Levitt, too, is a strong proponent of fair-value accounting. In his address to Congress, he urged lawmakers not only to maintain fair-value accounting, but to actively advance its use. If financial institutions had been using fair-value accounting to mark their books, they would have seen their problems coming straight at them many months earlier, “and we could have avoided the current crisis,” he stated in his testimony.
assenting voices
Levitt and Pitt concur that our current regulatory system is not only antiquated, but outright broken, and is in dire need of a major overhaul.
“I’m recommending there be a private sector task force rather than doing this through the Treasury, which has its hands full,” Pitt says. He believes that a private sector task force, assembled to consider what changes need to be made, will bring fresh ideas to the restructuring process.
Levitt supports that view, asserting that a new, stronger agency with “robust law enforcement powers” must be free of White House influence. He is also a strong proponent of fusing the SEC with the CFTC (Commodity Futures Trading Commission) and having one regulatory body presiding.
This past March the SEC and the CFTC stopped short of formally merging, as some had recommended. Instead they forged a mutual cooperation agreement allowing the two regulatory bodies to work more closely in the oversight and regulation of derivatives securities products. But Levitt is a staunch advocate of a single regulator governing securities and derivatives markets.
“I think it’s important to create a new, combined agency; I think it’s necessary and I think it is going to happen,” he asserts.
He told Congress that under a new framework regulators should be empowered to govern hedge funds and to establish regulations and transparency rules for credit derivatives. He also spoke in favor of enhancing regulatory powers over both investment banks and credit rating agencies.
Pitt identifies two elements critical to any such reconfiguration of the regulatory framework. First, “we absolutely need the ability to collect data on a regular, timely basis on everyone who operates in our capital markets. Without that data markets cannot function.”
Secondly, the government must be given the flexibility to actually deal with problems, rather than simply abolishing certain financial innovations. “A lot of people want to castigate certain products, many of which have perfectly legitimate benefits if used properly.” Instead of putting an end to product creation and innovation, there should be a consensus on how to give the government the tools to enable it to respond to a crisis and the accountability to enable it to solve difficulties as they emerge, he says.
Levitt again coincides in his view. Much-maligned “credit default swaps themselves are not bad; in fact, they serve an important purpose as hedges for bondholders,” he told Congressional leaders. The turmoil has stemmed, in his opinion, from the absence of counterparty risk disclosures and other important information on this market.
Lori Pizzani is an independent journalist in Brewster, New York.
