How Things on Wall Street Got so Bad

The NY Times did this great analysis on how everything went out of control. Sure in the past, many Democrats voted for relaxed regulation, but they were typically spineless for not standing up to the steamroller in front of them. They went along and believed the public sentiment called for deregulation. Like the Republicans say, “If you repeat something enough….

“We have a good deal of comfort about the capital cushions at these firms at the moment.” — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.
Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. A brief meeting on April 28, 2004 … five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow…to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments. A lone dissenter weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.

With that, the five big independent investment firms were unleashed. In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to essentially outsource the job of monitoring risk to the banks themselves.

Drive to Deregulate
The commission’s decision effectively to outsource its oversight to the firms themselves fit squarely in the broader Washington culture of the last eight years under President Bush.
A similar closeness to industry and laissez-faire philosophy has driven a push for deregulation throughout the government, from the Consumer Product Safety Commission and the Environmental Protection Agency to worker safety and transportation agencies. “It’s a fair criticism of the Bush administration that regulators have relied on many voluntary regulatory programs,” said Roderick M. Hills, a Republican who was chairman of the S.E.C. under President Gerald R. Ford. “The problem with such voluntary programs is that, as we’ve seen throughout history, they often don’t work.”

The 2004 decision also reflected a faith that Wall Street’s financial interests coincided with Washington’s regulatory interests.

“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 (and no relationship to Christopher Cox). “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.

Consultant, Leonard D. Bole, wrote to the commission on Jan. 22, 2004. He said that similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.

A once-proud agency with a rich history at the intersection of Washington and Wall Street, the Securities and Exchange Commission was created during the Great Depression as part of the broader effort to restore confidence to battered investors. It was led in its formative years by heavyweight New Dealers, including James Landis and William O. Douglas. When President Franklin D. Roosevelt was asked in 1934 why he appointed Joseph P. Kennedy, a spectacularly successful stock speculator, as the agency’s first chairman, Roosevelt replied: “Set a thief to catch a thief.”

Christopher Cox had led the effort to rewrite securities laws to make investor lawsuits harder to file. He also fought against accounting rules that would give less favorable treatment to executive stock options.

Under Mr. Cox, the commission responded to complaints by some businesses by making it more difficult for the enforcement staff to investigate and bring cases against companies. Mr. Cox dismantled a risk management office created by Mr. Donaldson that was assigned to watch for future problems.

Last Friday, the commission formally ended the 2004 program, acknowledging that it had failed to anticipate the problems at Bear Stearns and the four other major investment banks.
“The last six months have made it abundantly clear that voluntary regulation does not work,” Mr. Cox said. Mr. Cox has said that the 2004 program was flawed from its inception. But former officials as well as the inspector general’s report have suggested that a major reason for its failure was Mr. Cox’s use of it.

He said “Implementing a purely voluntary program was very difficult because the commission’s regulations shouldn’t be suggestions,” he said. “The fact these companies could withdraw from voluntary supervision at their discretion diminished the mandate of the program and weakened its effectiveness. Experience has shown that the S.E.C. could not bootstrap itself into authority it didn’t have.”