Panel probing causes of 2008 banking crash is told better regulation could have prevented problems. Bankers show little contrition

by Nick Paraskeva

Top bankers are claiming that some of the blame for America's biggest financial crisis since the Great Cepression rests with the regulatory system. Giving testimony at the first hearing of the bipartisan Commission looking into the causes of the 2008 banking debacle, heads of some of the country's biggest banks suggested that better regulation could have helped prevent the crisis. And, they argued against regulatory over-reaction.

“We should resist a (regulatory) response that is solely designed around protecting us from the 100-year storm,” Goldman Sachs chief executive Lloyd Blankfein told the US Financial Crisis Inquiry Commission (FCIC), during its first day of hearings, as GRR went to press.

He told the Commission that there is more than enough blame for the crisis to go around, but added: “We would do the process of meaningful reform a disservice if we allowed factors or areas that have had far less of a direct impact on the events of the last two years to detract from a focus on the underlying reasons.”

Blankfein, whose bank famously, and profitably, survived this particular storm, was one of a number of bank chief executives to appear before the Commission at its first day of hearings. Others were JP Morgan’s Jamie Dimon, Morgan Stanley’s John Mack, and Bank of America’s Brian Moynihan. All were grilled by the 10-member Commission set up under legislation passed last year to inquire into the crisis and its consequences. The FCIC’s membership comprises Republican and Democratic politicians as well as financial experts and business people. It’s scheduled to produce its findings by mid-December.

“Storms were acts of God and these were acts of men and women,” FCIC chairman Phil Angelides interjected after Blankfein pursued his 100-year storm analogy with references to the impact of hurricanes on risk-pricing.

Without apologising for their roles in the crisis, the CEOs acknowledged that their firms were too highly leveraged, and took on too much risk that they did not properly manage. They also took the opportunity to highlight inadequate regulation. Morgan Stanley’s Mack said the “crisis has made it clear that regulators simply didn’t have the visibility, tools or authority to protect the stability of the financial system.” While “complexity of markets and products has exploded in recent years, regulation and oversight have not kept pace.”

“Stronger regulation may have been able to prevent some of the problems,” said JP Morgan’s Dimon. While not blaming regulators, and accepting management responsibility, it was important to improve the system. “The current regulatory system is poorly organized with overlapping responsibilities, and many regulators did not have the statutory resolution authority needed to address the failure of global financial companies.” While no firm should be too big to fail, “the solution is not to cap the size of financial firms” and he instead backed a new resolution authority under the aegis of the Federal Deposit Insurance Corporation (FDIC), the federal agency that insures customer deposits at America’s banks.

But for all the sound and fury of its first hearing, the Commission’s efforts are expected to have little impact on regulatory reform. Individual testimony may well shed light on some of the minutiae of the crisis, but analysts think it unlikely that it will have much influence on the regulatory reform packages now working their way through Congress, although leading politicians initially opposed the FCIC’s creation because they believed it could interfere with their efforts at reform. What’s revealed may have more influence on voter perceptions – 2010 is a Congressional mid-term election year – as public anger reignites at the sight of bankers saved by the taxpayer once again rewarding themselves with spectacular bonuses and rewards.

The first hearing in mid January went straight into the role played in the crisis by the largest Wall Street firms and their top management. It set the tone and direction for a series of hearings in 2010, which “hopefully, can help rebuild the American people’s belief in a financial system” said chairman Angelides, a former California state treasurer.

Alongside reform moves

In addition to chief executives, testimony was given by the US Attorney-general and federal and state regulators with whom the FCIC will work. Their investigation will run alongside the separate Congressional efforts at finalising regulatory reform legislation. While major FCIC findings could influence the reforms, they are already at an advanced stage. Furthermore, President Barack Obama and congressional leaders have said they plan to complete the reforms before the FCIC issues its final report in December.

Congress appointed the bi-partisan Commission in July 2009. Its priority is to “examine the causes, domestic and global, of the current financial and economic crisis in the US”, said a spokesman for the Commission. It will also examine major financial institutions that failed or received government support, and a wide number of specific causes (see box, page 12) such as sub-prime mortgage lending, the role of derivatives and executive pay. Many of these issues were raised at the wide-ranging first hearing.

Angelides asked Blankfein about conflicts of interest at Goldman in relation to sales of sub-prime securities on which the firm then took a short position. Blankfein defended the firm’s actions as being integral to its role of market-maker in which it was not a fiduciary player, but dealt as principal with professional investors. Unconvinced, Angelides retorted “it sounds to me like selling a car with faulty brakes, and then buying an insurance policy on the buyer of those cars.”

Commissioner Heather Murren asked Blankfein about whether regulators had ever asked him to take a discount below 100 cents on the dollar on the firm’s open contracts with American International Group (AIG), the insurance-based financial services conglomerate that had to be bailed out by the taxpayer after its disastrous foray into complex financial products. Blankfein said he had not been asked personally. However, one of the firm’s staff had subsequently notified him that they were asked this by regulators, and replied they could not answer without discussing further within the firm. However, this issue was not raised again by regulators during the AIG rescue, and it was never directed to him

“We will deliver a report to Congress on December 15, 2010. We expect a series of hearings but the number of hearings will be determined by the course of our investigation,” an FCIC spokesman said.

The FCIC is required to file its final report with findings and conclusions to Congress and the President by the December mandate. The report will be commercially distributed and is expected to be of great public interest, on a scale similar to the shown in the report on the 9/11 terror attacks on the US in 2001.

However, it is the 1930s that are drawing the greatest number of comparisons for the FCIC. “The fact is that late in 1929, people were throwing themselves out of windows on Wall Street. This year, they’re lining up for bonuses. There has been no serious self-examination on Wall Street of what has occurred and what should be in the future,” Angelides said recently at a conference in Washington D.C.

Historical comparison

“Like the Pecora Commission, the FCIC has a responsibility to the American people to deliver a report on what caused the collapse of our financial system,” said a Commission spokesman. “However, whether it will have a similar level of “influence” would be a matter of opinion.” The 1930s Pecora Commission, headed by Ferdinand Pecora, a counsel to the Senate banking committee, was widely credited with influencing a number of key Depression-era regulatory reforms such as the Glass-Steagall Act separating investment and commercial banking.

FCIC vice chairman Bill Thomas recalls being told by Wall Street insiders “the music was playing and if I had not played along, I would be out of a job because there were people who were making money on paper”. He therefore believes that “somebody had to hold them responsible”. “You would like to think to a certain extent there were certain morals and mores that bankers would follow. But obviously the Fed relied on self-regulation to a certain extent. People could not help themselves.”

“The findings of this Commission can help the President, Congress, market participants, and the public reach the best judgments about how to fix our financial system”, said Angelides at the initial hearing. Thomas predicted few reforms will be in place before their December deadline. “You can be very cynical and say that the reporting date in the legislation is December 15, 2010, right after the election, so Congress can say it’s waiting for the Commission to give up the specifics if it can’t get anything done.”

“The Commission has the full support of Congress and regulators”, said a Commission spokesman, and the panel has already met the Administration, US Treasury Secretary Timothy Geithner and Securities and Exchange Commission (SEC) chairman Mary Schapiro. While Angelides compares the FCIC to an iceberg, with most of its work unseen, the hearing comes after what appeared to be a slow start. After being named in June 2009, the Commission held its inaugural meetings in September at which the Commissioners made prepared statements. The FCIC web-site only became operational the day before the January hearing.

The Commission’s 10-members are chairman Angelides, vice chairman Thomas and commissioners Brooksley Born, Byron Georgiou, Robert Graham, Keith Hennessey, Doug Holtz-Eakin, Heather Murren, John W. Thompson, and Peter Wallison. While there is much talk of a bi-partisan approach among the six Democrats and four Republicans, sharp party differences during the parallel discussions of the financial reform bill, will likely test this goal.

Angelides, who has a background in investor protection and market reforms, said that the Commission’s “role is to be a pursuer of the truth. If we commit ourselves to pursuing the facts and uncovering whatever is underneath whatever rock, we will do Americans a great service. And hopefully avoid this kind of thing happening again in the foreseeable future.”

The FCIC has an $8 million budget, enough to hire 50 investigators which is “probably less than any of the investment banks will spend dealing with this investigation,” Angelides said. The Commission will also have subpoena powers, the right to require financial institutions and others to testify by force of law. “If we need the information and can’t get it voluntarily, we’ll get it by subpoena.”

Vice Chairman Thomas encouraged whistleblowers and individuals with relevant information to come forward to the Commission on a confidential basis and invited people to suggest questions to ask. At the same time the SEC, which regulates US stock markets, announced major new initiatives to encourage individuals and companies to cooperate with investigations and to establish a new unit to collect tips and complaints. SEC chairman Schapiro is scheduled to testify to the Commission, as is FDIC chairman Sheila Bair.

The Commission’s investigative staff illustrates where it may focus its attention. Thomas Greene, the executive director, worked for over twenty years in the California Attorney General’s office. He chaired the Multi-State Antitrust Task Force for the National Association of Attorneys General, which coordinated the investigation and prosecution of major antitrust cases such as Microsoft. Martin Biegelman appointed assistant director, was chair of the board of advisors for the Economic Crime Institute of Utica College. He has 37 years of experience in fraud, corruption, and security investigation, including as federal law enforcement professional and took a leave of absence from Microsoft while serving on the Commission.

“The 9/11 Commission conducted over 1,200 interviews, reviewed over 2.5 million pages of documents, and held 12 days of public hearings. We should be similarly thorough” said Angelides. Even if the Commission doesn’t directly pursue wrongdoing by banks, some in the industry are concerned that the paper-trail it leaves behind will turn out to be a boon to plaintiffs’ lawyers.

FCIC Functions and areas of inquiry

The FCIC was charged by legislation to examine the causes of the current financial crisis, the collapse of each major financial institution that failed or was rescued by authorities, and the role of:

• Fraud and abuse in the financial sector, including consumer mortgages;

• Federal and State financial regulators, including failure to enforce rules;

• Global imbalance of savings, capital, and fiscal imbalances of governments;

• Monetary policy and the availability and terms of credit;

• Accounting practices, including fair value and off-balance sheet items;

• Tax treatment of financial products and investments;

• Capital requirements on leverage and liquidity, including unregulated entities;

• Credit rating agencies, including, reliance on ratings and use securitisation markets;

• Lending practices and securitisation, including the originate-to-distribute model;

• Affiliations between insured banks and securities, insurance, and other non-banks;

• Concept that certain firms are `too-big-to-fail’ and impact on market expectations;

• Corporate governance, including conversions from partnerships to corporations;

• Compensation structures;

• Compensation for financial industry, compared to others with similar skill sets;

• Regulatory structure of the US housing market;

• Derivatives and unregulated products, including credit default swaps;

• Short-selling;

• Reliance on numerical models, including risk models and credit ratings;

• Regulatory structure of financial institutions, and opportunity for regulatory arbitrage;

• Regulatory structure of investor and mortgagor protection;

• Government-sponsored enterprises;

• Quality of due diligence undertaken by financial institutions.

Nick Paraskeva is principal of Reg-Room LLC, and produces reports on financial industry regulatory for Global Risk Regulator.

nparaskeva@nyc.rr.com