US Financial Regulation and Arbitrage

There is no doubt that we have had a major world wide financial collapse drastically affecting many innocent people in terms of livelihood and life long savings. It is fair to say that if the regulators had done their job, the country would have not had the hard landing that was experienced in 2008. The 2010 Financial Reform Bill kicked the can down to the Regulators for implementation and the bankers still have influence. This article takes a look at who the regulators were and how they did or did not do their job. The Obama people in the regulator domain are identified along with examples of Bush regulator failures.  Hopefully this will give insight into what is being done to preclude another crisis

The financial industry has a gaggle of regulators, each with its politically protected turf.

From Wikopedia: Financial regulation is a form of regulation or supervision, which subjects financial institutions to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial system.

Regulation is an unnecessarily a complex subject. It is important to understand that in some cases financial entities can choose their regulator. Some regulators were much more lenient and in many cases banks switched to them, hence the term Regulatory Arbitrage.  The following are the major Federal regulators: FED, SEC, OCC, OTS, FDIC, CFTC and FINRA described below. Except for the FED, most of these organizations have direct or indirect ties to the Treasury organization.

FED – Federal Reserve System

From Wikopedia: Its duties today, according to official Federal Reserve documentation, are to conduct the nation’s monetary policy, supervise and regulate banking institutions, maintain the stability of the financial system and provide financial services to depository institutions, the U.S. government, and foreign official institutions.Current chairman is  Ben Bernanke, the former chairman was Alan Greenspan. Much more on Mr Greenspan later.

SEC – Securities and Exchange Commission

From Wikopedia: It holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation’s stock and options exchanges, and other electronic securities markets in the United States. Mary Schapiro is the current Chair. Predesessors were; Christopher Cox – 2005-2009, William H. Donaldson – 2003-2005, Harvey Pitt – 2001-03

OCC – Office of Comptroller of the Currency

From Wikopedia: US federal agency established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States. Current Acting Chairman is John Walsh. Previous Chairman were John C. Dugan – (2005 – 2010) John D. Hawke, Jr. – (1998–2004)

OTS – Office of Thrift Supervision ( recently folded into OCC)

From Wikopedia: United States federal agency under the Department of the Treasury. It was created in 1989 as a renamed version of another federal agency (that was faulted for its role in the Savings and loan crisis). Like other US federal bank regulators, it is paid by the banks it regulates. The OTS was initially seen as an aggressive regulator, but was later lax. Declining revenues and staff led the OTS to market itself to companies as a lax regulator in order to get revenue.

FDIC – Federal Deposit Insurance Corporation

From Wikopedia: United States government corporation created by the Glass-Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. The FDIC insures deposits at 7,895 institutions. The FDIC also examines and supervises certain financial institutions for safety and soundness, performs certain consumer-protection functions, and manages banks in receiverships (failed banks).

Sheila Bair is the current chairman of the FDIC and is viewed as a serious regulator with the right incentives for all concerned.

CFTC – Commodity Futures Trading Commission

From Wikopedia: The stated mission of the CFTC is to protect market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and option markets.

CFTC is considered to be the primary regulator for Credit Default Swaps in the Dodd Frank regulation scheme.

FINRA – Financial Industry Regulatory Authority

From Wikopedia: In the United States, the Financial Industry Regulatory Authority, Inc., or FINRA, is a private corporation that acts as a self-regulatory organization (SRO). FINRA is the successor to the National Association of Securities Dealers, Inc. (NASD). Though sometimes mistaken for a government agency, it is a non-governmental organization that performs financial regulation of member brokerage firms and exchange markets.

Previously run by Mary Shapiro, FINRA has been critisized as being a ineffective regulator. Most notable was their (and SEC)  allowing Bernie Madow to continue for 10 years to operate despite being warned by a whistle blower. When testifying before congress, the whistle blower (Harry Markopolos) said SEC was incompetent, FINRA was corrupt.

It must be said that Financial Regulation in the United States is done by committee of political bureauocrats. It is important to be aware of the fact that many of them are funded by fee’s assessed to the agencies they regulate. So opportunity for Regulatory Capture and Regulatory Arbitrage is prevalent in these agencies. The clear example is Office of Thrift Supervision bowing to their clients. The opposite example is that of Sheila Bair who tries to do the right thing for her clients despite critisizm.

Obama Appointee’s – a mixed record on financial reform

Ben Bernanke (FED) was inhereted from Bush, but later reappointed by Obama. Bernanke was a reluctant enforcer against the subprime fraud totally ignored by Greenspan. His actions were to little to late. Thereafter his actions in handling the crisis were mixed. The FED purchasing of failed bank toxic assets and putting them into Maiden Lane I,II and III are still a result to be determined. Quantitative Easing is probably good from a theoretical perspective, but effectiveness is still a open question. Bernanke will probably will be judged in the long run in terms of what he does to clean up the financial mess.

Tim Geitner Treasury Secretary. He certainly was in the middle of the financial crisis with Paulson and Bernanke. How ever the record will show that not only did he have dificulty in reconizing the need to pay nanny taxes, he was right in the middle of the Citi group crisis. Geitner was head of the New York Fed and had direct responsibility for regulating the failed Citigroup. This is documented in the Propublica article: How Citigroup Unraveled Under Geithner’s Watch

Mary Shapiro SEC also has a mixed record, She was head of FINRA in the era of Bernie Madow. It is argued that FINRA was the primary responsible regulater in that story along with SEC. In a congressional testimony, the whistle blower Hary Markopolos said SEC (under Chris Cox) was incompetent, FINRA (under Schapiro) was corrupt. So far Schapiro seems to be moving in the right direction, agonizingly slow, Still suspect she is a mole for the financial community.

Gary Gensler (CFTC) was part of the cabal that attacked Brooksley Born on Derivatives Regulation.

Initially, he came out as a reformer documented in the NYT article: Goldman Deal-Maker Now Advocates Regulation However the record is showing at his reform zeal is open to question. He is not meeting congressional deadlines. That might be because his commissioners are a problem in regulation reform.  (See article Time to Dismiss the CFTC Chairman and His Commissioners.)

Financial Regulation failures

The Greenspan Era

The Alan Greenspan tenure is recognized as being a major catalyst to the Financial Failure. His low interest policies to stimulate the economy created the real estate bubble. He was clearly empowered by the 1994 Home Ownership and Equity Protection Act (HOEPA) to reign in the sub prime lending abuses. He was constantly advised by consumer advocate groups about sub prime problems, only to be ignored by Greenspan. In 1994 the FBI issued a warning about rampant real estate fraud.

Greenspan’s economic analysis was dominated by Ayn Rand who advocated free and open markets. In post 2008 testimony Greenspan acknowledged his decisions to be a major error. As Brooksley Born told him in FCIC testimony he failed at regulation.

Regulators Cutting Red Tape

In a article “The Dilbert Strategy”, Paul Krugman outlines the Bush Regulator Strategy of cutting red tape. This is substantiated by the famous picture of the regulators with a chain saw and pruning shears cutting up regulations. Economics of Contempt saved the picture provided here. The record culminating in the 2008 Financial Failure speaks for itself. It was reported that senior management had to be consulted before actions were taken on the banks, Senior management was in a cut red tape mode, often resulting in favorable decisions for the banks and not support of the ground Regulators. That had a very definite cooling effect on effective regulation.

OCC Preemption of State Prosecution of Fraud

OCC prohibited States from prosecuting real estate fraud. From Wikopeida Preemption of State Banking Regulation

“In 2003, the OCC proposed regulations to preempt virtually all state banking and financial services laws for national banks and their diverse range of non-bank, corporate operating subsidiaries. Despite opposition from the National Conference of State Legislatures, the OCC’s regulations went into effect. In Watters v. Wachovia Bank, N.A. in 2007 the United States Supreme Court validated the preemption of state regulations by the OCC, ruling that the OCC, not the states, has the authority to subject national banks to “general supervision” and “oversight”:

…State regulators cannot interfere with the business of banking by subjecting national banks or their OCC-licensed operating subsidiaries to multiple audits and surveillance under rival oversight regimes

In Cuomo v. Clearing House Association, L. L. C., the Court clarified its decision in Watters, stating that federal banking regulations did not pre-empt the ability of states to enforce their own fair-lending laws, as “‘general supervision and control’ and ‘oversight’ are worlds apart from law enforcement,” and therefore states retain law enforcement powers but have restricted “visitory” powers over national banks.

The Cuomo case was decided June 29, 2009. Hence by design, it was the policy of OCC  to stymie state prosecution of real estate fraud committed by the unregulated loan originators (Country Wide, Ameriquest et al). In turn, the Federal prosecutors only brought only 35 cases to the courts. In a de facto sense it was the policy of the United States government to condone fraud

Financial Arbitrage

Financial Arbitrage is the process of a bank selecting a regulator more favorable to one’s needs. It is important to understand that Regulation is funded primarily from assessments to its member banks being regulated. So, low cost for ineffective regulation becomes a attractive option for unscrupulous bank operators. OTS was the poster child of ineffective regulation. Even though OTS is being absorbed into OCC, it is instructive to observe some of the shenanigans that went on in the OTS organization.

Each time a bank fails, the FDIC Inspector General issues a Material Report on the bank, citing the reasons for failure. The Material Report is a forensic audit and tends to pull no punches in terms of assigning responsibility.

Note- I have been having trouble with links to Treasury. If the below links do not work, Google “Treasury IG “ and enter “OIG-09-032” or “EVAL-1-002” and scroll down to get the article. The articles provide a lot of forensic detail, however summaries are very good.

From the IndyMac IG report OIG-09-032 – Results in Brief

“The primary causes of IndyMac’s failure were largely associated with its business strategy of originating and securitizing Alt-A loans on a large scale.

.IndyMac’s aggressive growth strategy, use of Alt-A and other nontraditional loan products, insufficient underwriting, credit concentrations in residential real estate in the California and Florida markets, and heavy reliance on costly funds borrowed from the Federal Home Loan Bank (FHLB) and from brokered deposits, led to its demise when the mortgage market declined in 2007.  IndyMac often made loans without verification of the borrower’s income or assets, and to borrowers with poor credit histories. Appraisals obtained by IndyMac on underlying collateral were often questionable as well. As an Alt-A lender, IndyMac’s business model was to offer loan products to fit the borrower’s needs, using an  extensive array of risky option-adjustable-rate-mortgages (option ARMs), subprime loans, 80/20 loans, and other nontraditional products. Ultimately, loans were made to many borrowers who simply could not afford to make their payments.

…

We found that OTS identified numerous problems and risks, including the quantity and poor quality of nontraditional mortgage products.

…

OTS examiners reported Matters Requiring Board Attention (MRBA) to the thrift, but did not ensure that the thrift took the necessary corrective actions. OTS also did not always report all problems found by the examiners, which were evident in the work papers but not in the Reports of Examination (ROE). OTS relied on the cooperation of IndyMac management to obtain needed improvements. However, IndyMac had a long history of not sufficiently addressing OTS examiner findings. OTS did not issue any enforcement action, either informal or formal, until June 2008.

In short, earlier enforcement action was warranted.”

OTS closed IndyMac July 2008.  Further from the report

“It is important to note that IndyMac did not even appear on OTS’s problem thrift list provided to our office including the June 2008 list provided to us less than a month before the thrift was closed”.

The only conclusion one can draw from this report is that the on ground auditors raised flags and Bank / OTS management ignored the warnings.

EVIDENCE OF RED TAPE CUTTING.

From the IG report on Washington Mutual Bank EVAL-10-002 Results in Brief

“WaMu failed primarily because of management’s pursuit of a high-risk lending strategy that included liberal underwriting standards and inadequate risk controls. WaMu’s  high-risk strategy, combined with the housing and mortgage market collapse in mid-2007, left WaMu with loan losses, borrowing capacity limitations, and a falling stock price. In September 2008, depositors withdrew significant funds after high-profile failures of other financial  institutions and rumors of WaMu’s problems. WaMu was unable to raise capital to keep pace with depositor withdrawals, prompting OTS to close the institution on September 25, 2008.”

The on site Regulators repeatedly recommended corrective action informally but Wamu management was non responsive. Later in the report the IG said

“We concluded that OTS should have lowered WaMu’s composite CAMELS rating sooner and taken stronger enforcement action sooner to force WaMu’s management to correct the problems identified by OTS. Specifically, given WaMu management’s persistent lack of progress in correcting OTS-identified weaknesses, we believe OTS should have followed its own policies and taken formal enforcement action rather than informal action.”

In short WaMu’s management ignored OTS and continued on their merry way of high profit insolvent banking. OTS did not take sufficient corrective action to insure Safety and Soundness

Further in the report, it was identified that OTS fought FDIC access to the books to protect its insurance fund. Finally FDIC was granted access, however because of interagency red tape the FDIC corrective actions were not issued

Where are we today

The Financial Reform package has been passed by Congress and implementation is in the hands of the regulators who have a sorry history of job performance. It remains to be seen how the Obama team makes Reform happen. The incentives of greed are very powerful.