30376-hlp_5-2 Sheet No. 5 Side A 09/07/2011 15:01:13 fo- describes at xviii-xix (2011), EPORT R The Truth About Regulation About Truth The NQUIRY * I Federal Funding and the Institu- RISIS C NTRODUCTION INANCIAL I Brooksley Brooksley Born , F N ’ ]. The FCIC was created by section 5 of the Fraud Enforcement OMM presents an empirical analysis of the application of 1 C of the Financial Crisis EPORT NQUIRY The Big Squeeze: The Communications Crisis in America I FCIC R describes the critical need for safety regulations provided by sev- http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full. RISIS . C Foreword: Foreword: Deregulation: A Major Cause IN My recent service as a member of the Financial Crisis Inquiry Commis- As the report recently issued by the FCIC documents, decades of der- I am delighted to introduce this Harvard Law and Policy Review Sym- F 1 * Brooksley Born was a Commissioner on the Financial Crisis Inquiry Commission from available at pdf [hereinafter challenges in federal oversight of medical research in an era where funding and other aspects of the research are changing. sion (“FCIC”) brought home to me how important it is for us to reexamine the role of business regulation. We are now experiencing the of tragic results thirty years of deregulatory pressures in the financial sector.quite rightly concluded The that FCIC failures in financial regulation and supervision along with failures of corporate governance and risk management at major financial firms were prime causes of the financial crisis engulfing this coun- try in 2007 and 2008. cuses on increasing concentration in the communications industry, sulting the re- reduction in Business as Usual? competition, Analyzing the and Development of Environmental Standing its Doctrine Since implications 1976 for standing the rules in public. environmental cases, with environmental some advocacy groups. encouraging results Finally, for tional Evolution of Federal Regulation of Biomedical Research and Recovery Act of 2009 and was directed “to examine the causes, domestic the and global, current of financial and economic crisis in the United 123 States.”Stat. 1617, 1625 (2009).Pub. L. No. It 111-21, issued §the FCIC Report 5(a), on January 27, 2011. egulation and failure to regulate newly emerging financial and products led to markets, a financial system that was extremely fragile firms, and vulner- posium on Regulation and Institutional Reform. explore The the articles importance in of this government regulation issue of business in the health protecting and welfare of the American people. in America eral federal agencies devoted to protection of consumers, workers, and environment. the \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 1 25-AUG-11 10:47 mid-2009 until February 2011. She is a retired partner of Arnold & Porter LLP and served as Chair of the Commodity Futures Trading agency for futures and options, Commission, from 1996 to 1999. the federal In that role she independent warned about the dangers regulatory of unregulated derivatives. 30376-hlp_5-2 Sheet No. 5 Side A 09/07/2011 15:01:13 A 09/07/2011 Sheet No. 5 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 5 Side B 09/07/2011 15:01:13 As 5 championed these — 54; Alan Greenspan, Chairman, Bd. of Governors of – a laissez-faire economist 6 — Fannie Mae and Freddie Mac, government-spon- 4 2 note 1, at 27; Ben Bernanke, Chairman, Bd. of Governors of the note 1, at 55. note 1, at 53 supra supra supra , , , 42. 3 – EPORT EPORT EPORT R R R at 41 at 42; Armando Falcon, Jr., Written Testimony before the FCIC 5 (Apr. 9, 2010). The FCIC found that the financial sector devoted enormous resources to resources enormous devoted sector financial the that found FCIC The The FCIC found that these vulnerabilities in our financial system were [P]rospective [P]rospective subprime losses were clearly not their large own to enough account for on the magnitude of the crisis. government’s the . in gaps with together . vulnerabilities, system’s the . Rather, crisis-response toolkit, were the principal explanations of why the crisis was so severe broader economy. and had such devastating effects on the FCIC FCIC FCIC Id. Id. 2 3 4 5 6 whether government regulation.” intervention strengthens or weakens private beliefs during his nineteen years in office. With support from large financial services firms, their trade associations, and like-minded economists, he was able to persuade a number of policy makers in several successive presiden- tial administrations, members of Congress, and federal financial regulators to support deregulatory efforts on the false assumption that would self-regulation be sufficient to protect the financial system and our economy against excesses in the market. As he argued in 1997, “[I]t is critically important to recognize that no market is ever truly unregulated. The self-interest of mar- ket participants generates private market regulation. Thus, the real question is not whether a market should be regulated. Rather, the real question is sored entities with a public mission to support the mortgage market, exem- plify the political power financial services firms From used 1999 to to 2008, resist they regulation. spent $164 million on lobbying efforts, employees and their and PACs made $15 million in campaign contributions. Fed. Reserve Sys., Written Statement before the FCIC 2 (Sept. 2, 2010). Fannie and Freddie political machine resisted any meaningful regulation us- ing highly improper tactics.” stated by Armando Falcon, Jr., who headed their federal regulator, “[T]he its effort to convince federal policy makers of the need for deregulation. In the decade leading up to the financial crisis, the sector spent $2.7 billion on federal lobbying efforts, and individuals (“PACs”) related to and the sector made more than political $1 billion in federal election action committees campaign contributions. the direct result of a growing belief in the self-regulating nature of financial markets and the ability of financial firms to police themselves. Former Fed Chairman Alan Greenspan 232able to a full-blown crisis when the U.S. housing bubble collapsed. Federal Reserve Board (“Fed”) Chairman Ben Bernanke told the FCIC, Harvard Law & Policy Review [Vol. 5 \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 2 25-AUG-11 10:47 the Fed. Reserve Sys., Government Regulation and Derivative Contracts, Remarks at nancial Markets the Conference of the Federal Reserve Bank of Atlanta Fi- (Feb. 21, 1997) (transcript available at http://www.federalreserve.gov/boarddocs/speeches/1997/19970221.htm). 30376-hlp_5-2 Sheet No. 5 Side B 09/07/2011 15:01:13 B 09/07/2011 Sheet No. 5 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 6 Side A 09/07/2011 15:01:13 7 we would remain vulnerable to the 8 note 1, at 354; Interview by the FCIC with Ben Bernanke, Chair- supra , EPORT R Foreword: Foreword: Deregulation: A Major Cause of the Financial Crisis 233 Beyond that, however, the FCIC investigation revealed that financial As a member of the FCIC, I voted in favor of adopting and issuing its During the late 1990s, as chair of the U.S. Commodity Futures Trading As a result of these pressures, significant regulatory gaps developed in FCIC Pub. L. No. 111-203, 124 Stat. 1376 (2010). 7 8 man, Bd. of Governors of the Fed. Reserve Sys., 24 (Nov. 17, 2009). supervision, among other areas. Described in more detail below are some of the deregulatory actions that the FCIC found contributed significantly to the financial crisis. Without comprehensive financial regulatory reform such as that contained in the Wall (“Dodd-Frank Act”) Street enacted Reform last year, and Consumer Protection Act Commission (“CFTC”), I participated in the debate described in Section III below about whether the over-the-counter derivatives market should be reg- ulated. The CFTC was concerned that the rapidly growing and opaque mar- ket posed dangers to market participants and the financial system as a whole and asked whether a regulatory scheme similar to that and options imposed markets would significantly reduce those dangers.on futures Deregulatory as came it investigation FCIC’s the during and debate, the in prevailed forces no surprise to me as evidence demonstrated that excesses in the deregulated over-the-counter derivatives market played a crisis. major role in the financial deregulation was not limited to the derivatives market, but has been perva- sive, extending to mortgage lending, securities regulation, and institutional report, which is a comprehensive causes. history The report of is based the on an financial nineteen extensive days investigation, of crisis which public hearings, included and interviews with more its than 700 witnesses and review of millions of pages of documents. I commend the report to the reader. It fully supports the FCIC’s conclusions about the that devastating inadequate role regulation played in causing the financial crisis and the re- sulting economic crisis we are still suffering today. dangers of widespread regulatory inadequacy. housing bubble to turn into a major financial crisis. As Fed Bernanke Chairman told Ben the FCIC, “As a scholar of the Great Depression, I believe honestly that September and October of 2008 was the worst financial crisis in global history, including the Great Depression.” 2011] the financial system including the lightly regulated shadow banking system that grew to rival the traditional banking system in size and importance and the enormous market in deregulated over-the-counter derivatives. A number of investment banks grew to be of oversight. systemic importance Institutional without supervision adequate of large bank holding companies, com- mercial banks, and thrifts was gradually weakened, allowing them to engage in riskier activities. Mortgage lending standards deteriorated, and securitiza- tion of mortgage-related assets burgeoned These with developments created little the regulatory conditions that scrutiny. caused the collapse of the \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 3 25-AUG-11 10:47 30376-hlp_5-2 Sheet No. 6 Side A 09/07/2011 15:01:13 A 09/07/2011 Sheet No. 6 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 6 Side B 09/07/2011 15:01:13 , 97 EGULATE R 13 12 09. – EFUSAL TO TANDARDS R S ’ In addition, lenders made many S 96, 108 9 – xxiv. 158, 108 Stat. 2160, 2190 (1994). – – OARD ENDING B L ESERVE note 1, at 20, 93 Nonetheless, the Fed refused to take action effec- R 11 ORTGAGE note 1, at 96; Interview by the FCIC with Scott Alvarez, General note 1, at xvii, xxiii supra M , supra EDERAL supra , , EPORT F R First Public Hearing of the Financial Crisis Inquiry Commission, Day Two Day Commission, Inquiry Crisis Financial the of Hearing Public First HE EPORT EPORT R FCIC at xvii; Pub. L. No. 103-325, §§ 151 79; at The Fed was well aware of the widespread abuses in mortgage lend- I. T 10 Id. See Id. FCIC R Stemming the volume of risky mortgages might well have prevented The FCIC found that there was an explosion in risky mortgage lending I think nipping this in the bud in 2000 and 2001 with some strong consumer rules applying across the can they sure make to income customer’s a document to got board you’ve that just simply said repay the loan, you’ve got to make sure the income is sufficient to pay the loans when the interest rate resets, just that simple . rules . like . could have done a lot to stop this. Sheila Bair, the current chairman of the Federal Deposit Insurance Cor- The FCIC found that the Fed had the statutory authority to regulate the FCIC 9 10 11 12 13 the housing bubble that triggered the financial crisis or at least mitigated its tive to maintain high lending standards. accompanied accompanied by a significant deterioration in mortgage lending standards in the years leading up to the financial crisis, with many mortgage lenders ig- noring borrowers’ ability to repay their loans. held loans for Because the duration of lenders the mortgages, but no instead sold them longer to mort- gage securitizers, they passed on the risks of the loans and had little incen- fied before the FCIC that such regulation would have made a difference: tively to regulate this irresponsible lending. poration and an Assistant Secretary of the Treasury from 2001 to 2002, testi- predatory loans designed to impose high interest payments increasing or the yield other on terms the loans. to address predatory issued by all lenders nationwide and terms of mortgages lending practices under the Home Ownership and Equity Protection Act of 1994. ing practices, having received reports from lenders, consumer advocates, and its own staff about the increase in risky underwriting standards. mortgage lending and the falling identified problem . . . . We were in the reactive mode because that’s the what mind-set was of the ‘90s and the early 2000s.” Despite her efforts and those of Fed refused governor to Edward strengthen Gramlich, its regulations the to Fed stop the predatory plained lending.by the Fed’s General As Counsel, ex- Scott Alvarez, it failed to do cause so be- of its deregulatory attitude: “The regulation; the market should take care of policing, unless there already is an mind-set was there should be no 234 Harvard Law & Policy Review [Vol. 5 \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 4 25-AUG-11 10:47 (2010) (statement of Sheila Bair, Chairman, Fed. Deposit Ins. Corp.). Counsel, Bd. Of Governors of the Fed. Reserve Sys., 15 (Mar. 23, 2010). 30376-hlp_5-2 Sheet No. 6 Side B 09/07/2011 15:01:13 B 09/07/2011 Sheet No. 6 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 7 Side A 09/07/2011 15:01:13 NFORCE E This mortgage This 16 Hearing on “Too Big AILURE TO 19 The FCIC found that , 27 (2010). F 14 S ’ ECURITIZERS note 7, at 74; S supra OMMISSION C ORTGAGE M 17 XCHANGE E “[F]irms securitizing mortgages failed to perform note 1, at xvii. note 1, at 3; Bernanke, 18 69. ISCLOSURE BY supra supra – , , D 15 170, 187. – EPORT EPORT ECURITIES AND at xxiii-xxiv. S at 129. at xxii, 165 at 187. at 169 HE Foreword: Foreword: Deregulation: A Major Cause of the Financial Crisis 235 Shelf registration permitted securitizers to file an initial prospectus FCIC R FCIC R Id. See id. Id. Id. Id. The FCIC found that in a number of instances the securitizing firms The Securities and Exchange Commission (“SEC”), which had the re- The FCIC found that many of these risky mortgages were securitized securities were institutions creating and selling these The large financial 20 14 15 16 17 18 19 20 II. T sold the securities to investors without full and adequate quality disclosure of of the the loans. sponsibility to ensure that adequate disclosures were made to investors, con- ducted little or no review of the disclosures on mortgage-related because securities of reliance on “shelf registration” tion. and exemptions from registra- and sold to investors around the world.$4 trillion Indeed, of between mortgage-backed securities 2003 and and $700 2007, billion of lated collateralized mortgage-re- debt obligations (“CDOs”) were issued. transferring the risks of the underlying poor quality mortgages to their pur- chasers. Those investors were lulled into a false sense of security because of the high credit ratings of the securities and the availability of credit default swap protection from large institutions such as International insurance giant Group American (“AIG”). these When securities were the downgraded and housing lost much of bubble their value. burst, many of securitization fueled the demand for risky mortgages and contributed signifi- cantly to the housing bubble. this inaction was a “prime example” financial crisis. of regulatory failure to prevent the adequate due diligence on the mortgages they purchased and at times know- ingly waived compliance with underwriting standards. were not Potential fully informed investors or were misled about the poor quality of the mort- gages contained in some mortgage-related securities.” quent issuance. Shelley Parratt, the SEC’s deputy director of disclosure, ad- mitted, “The elephant in the room is that we didn’t review the prospectus for mortgage-backed securities and then to file supplements for each subse- 2011] effects. Current Fed Chairman Ben Bernanke told the FCIC that the failure to regulate the mortgage market during the severe failure housing of the boom Fed in “was this particular the episode.” most \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 5 25-AUG-11 10:47 to Fail: Expectations and Impact of Extraordinary Government Intervention and The Role of Systemic Risk in the Financial Crisis” before the FCIC, Day Two 30376-hlp_5-2 Sheet No. 7 Side A 09/07/2011 15:01:13 A 09/07/2011 Sheet No. 7 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 7 Side B 09/07/2011 15:01:13 , EEDED to be 24 N CTIONS : A In addition, in 27 ERIVATIVES 22 D ERIVATIVES D OUNTER 25 -C INANCIAL THE , F In response to these events, the U.S. - 26 FFICE VER Hearing on H.R. 4062, the “Financial Derivatives O O , GGD-94-133 (1994). 28 YSTEM CCOUNTING S note 1, at 46. note 1, at 47; note 1, at 47; Over-the-Counter Derivatives Concept Release, 63 . A EN supra supra supra , , , 29 Mortgage-related CDOs were generally exempt from all re- EREGULATION OF INANCIAL xxv. 21 – U.S. G F 47. – EPORT EPORT EPORT R R R This deregulation of an enormous financial market was knowingly III. D at 187. at xxiv at 46 at 47; at 169. 23 Id. Id. Commodity Exchange Act of 1974, Pub. L. No. 93-463, 88 Stat. FCIC 1389 (1974). Id. Id. FCIC FCIC Id. The CFTC effort was immediately condemned by Alan Greenspan and Soon thereafter, a number of scandals and large losses occurred involv- The FCIC concluded that over-the-counter (“OTC”) derivatives con- Until the early 1990s, most derivatives were required by statute ROTECT THE 22 23 24 25 26 27 28 29 21 P 1998 while I was chair of the CFTC, it considered whether more regulation of the market was needed. traded on exchanges and were overseen comprehensive by regulatory the regime. CFTC, However, which in enforced 1993, under a the ship chairman- of laissez-faire economist Wendy Gramm, the CFTC exempted certain non-fungible derivatives traded by sophisticated parties from exchange trad- ing and most other regulatory requirements. other federal financial regulators, who proposed a Congressional moratorium Congressional a proposed who regulators, financial federal other on the CFTC’s regulation of OTC derivatives. In testimony moratorium, Alan urging Greenspan such said, “[A]side a from safety and soundness reg- ulation of derivatives dealers under the banking and securities laws, regula- tion of derivatives transactions that are privately negotiated by professionals is unnecessary.” tributed significantly to the financial crisis and that the market’s deregulation market’s the that and crisis financial the to significantly tributed by statute in 2000 “was a key turning point in the march toward the financial crisis.” ing these exempted OTC derivatives. TO General Accounting Office conducted an investigation and issued a pointing report out serious systemic risks posed by this market. Fed. Reg. 26,114 (May 12, 1998). 236supplements.” Harvard Law & Policy Review [Vol. 5 \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 6 25-AUG-11 10:47 gistration gistration because they were not treated as public offerings. Not only did the SEC fail to review the disclosures to investors concerning these securities, but state regulators had been preempted from doing so. undertaken at the urging of large financial services firms and their regulators despite widely available information about the dire risks it posed. Supervisory Improvement Act of 1998” Before the 105th Cong. (1998) (written testimony of H. Alan Greenspan, Chairman, Bd. of Governors of Comm. the on Banking and Fin. Fed. Reserve Sys.). Servs. 30376-hlp_5-2 Sheet No. 7 Side B 09/07/2011 15:01:13 B 09/07/2011 Sheet No. 7 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 8 Side A 09/07/2011 15:01:13 30 35 48. – In December 2000, on the recommendation 31 34 note 1, at 48; Pub. L. No. 106-554, appx. E, 114 Stat. 2763, 192. note 1, at 47 note 1, at 48. – supra supra supra , , , The FCIC found that this enormous unregulated market 33 EPORT EPORT EPORT R R at xxiv. at xxiv-xxv, 190 Foreword: Foreword: Deregulation: A Major Cause of the Financial Crisis 237 32 FCIC Omnibus Consolidated and Emergency Supplemental Appropriations Act, Pub. L. No. FCIC R FCIC Id. Id. Id. In addition, CDSs were used to create synthetic CDOs, which were not After this deregulation, the OTC derivatives market experienced explo- The FCIC concluded that OTC derivatives played several major roles in Despite this clear example of the dangers posed by the deregulated Two months after this testimony, in September 1998, the systemic dan- 36 30 31 32 33 34 35 36 of federal financial regulators, Congress adopted Modernization Act, the deregulating the OTC derivatives market Commodity by eliminating Futures CFTC jurisdiction over it and preempting state laws on gaming and bucket shops. bets. the financial crisis. Credit default swaps (“CDS”) are OTC derivatives con- tracts in which one party agrees to pay the other party in case of a default on an obligation such as a mortgage-related security.party makes a In series exchange, of premium-like the payments. other Investors in lated securities purchased mortgage-re- CDSs from large OTC derivatives dealers such as AIG in order to protect themselves from default on the securities.FCIC The found that the reassurance provided to investors by these CDSs fueled mort- gage securitization and the housing bubble. actual mortgage assets at all but rather were merely bets on mortgage securi- ties. These bets significantly amplified the losses from housing bubble, multiplying the the amount riding on particular mortgage secur- collapse of the ities. Goldman Sachs alone created and sold more than $70 billion of such weeks later in October 1998. sive growth, expanding more than sevenfold in the seven and leading a up to half June years 2008, when it reached its peak at tional $672.6 amount. trillion in no- OTC derivatives market, Congress passed the CFTC moratorium a few 2011] gers of OTC derivatives were vividly demonstrated by the threatened default of Long Term Capital Management (“LTCM”) on $1.25 trillion in notional amount of OTC derivatives that it $5 billion in capital. had that concluded York New of Bank Reserve Federal The managed to acquire on a failure by LTCM would endanger the financial system and masterminded a less than rescue by fourteen of LTCM’s OTC derivatives counterparties. \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 7 25-AUG-11 10:47 105-277, § 760, 112 Stat. 2681-1, 2681-35 (1998) was characterized by “uncontrolled leverage; lack of transparency, capital, and collateral requirements; speculation; interconnections among firms; and concentrations of risk.” 2763A-35 (2000). 30376-hlp_5-2 Sheet No. 8 Side A 09/07/2011 15:01:13 A 09/07/2011 Sheet No. 8 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 8 Side B 09/07/2011 15:01:13 39 Because 38 of all types 37 UPERVISION unseen and unknown S — NSTITUTIONAL I added to uncertainty and escalated panic, help- A. Investment Banks AILURES OF — F ROFOUND 54. – IV. P at xxv, 352. at xxv (emphasis added). at xviii. at 150 Under the program the country’s five largest investment banks, . at 151. 40 Id. Id. Id. Id. Id The FCIC found that federal supervisors of bank holding companies In addition to the role of CDSs in the financial crisis, the FCIC con- The SEC had previously regulated the investment banks’ securities bro- Perhaps the most egregious supervisory failure was the SEC’s Consoli- AIG’s AIG’s near failure because of its issuance of $79 billion of CDSs on 41 37 38 39 40 41 ing to precipitate government assistance to those institutions.” in this unregulated market cluded that “the existence of millions of derivatives between systemically important financial contracts institutions and investment banks failed in soundness their of mission a to number preserve of the systemically safety important and financial institutions. tion. The CSE program was essentially and the soundness” SEC’s or prudential first institutional foray supervision, and into the “safety FCIC found that it had neither the expertise nor the resources necessary to perform that role. Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear and Brothers, Lehman Lynch, Merrill Stanley, Morgan Sachs, Goldman Stearns, voluntarily submitted themselves to prudential supervision by SEC. the ker-dealer operations and in doing so focused primarily on investor protec- These institutions either failed or would have failed but for government as- sistance during the financial crisis. dated Supervised Entity (“CSE”) program, which was established in 2004. April OTC derivatives contracts created interconnections between firms through counterparty credit exposures, the failure of one large financial firm had the potential of spreading losses and failures throughout the financial system. 238 risky mortgage securities was one of the precipitating causes of the financial crisis. AIG had failed to set aside capital reserves or hedge its exposure on these OTC derivatives because it erroneously believed it would never have to pay out on them. When AIG Harvard was Law & unable Policy collateral to Reviewon meet these its CDSs, obligations the to government post had to rescue it, ultimately com- mitting more than $180 billion because would trigger losses of cascading through concerns the financial that system. AIG’s collapse [Vol. 5 \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 8 25-AUG-11 10:47 30376-hlp_5-2 Sheet No. 8 Side B 09/07/2011 15:01:13 B 09/07/2011 Sheet No. 8 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 9 Side A 09/07/2011 15:01:13 47 Concern about this capital 44 The large U.S. investment banks with 42 46 note 1, at 153. supra , 51. 52. 53. – – – 45 EPORT 43 at 150 at 151, 154. at 151 at 152 at 154; Press Release, SEC, Chairman Cox Announces End of Consolidated Super- Foreword: Foreword: Deregulation: A Major Cause of the Financial Crisis 239 Id. Id. Id. Id. Id. FCIC R The supervised investment banks were brought to the brink of failure Within four and a half years of the SEC’s adoption of the CSE program, CSE the of adoption SEC’s the of years half a and four Within The FCIC found that the CSE program had a number of weaknesses. Because the SEC had no statutory authority to impose supervision on The primary incentive for participation in the CSE program was a 2002 42 43 44 45 46 47 by high leverage, insufficient liquidity, large exposures loans to and risky mortgage-related mortgage securities, and an undue reliance on short-term all of the five investment banks supervised under the CSE program had dis- appeared in the financial Stearns crisis: and Merrill Lehman Lynch had Brothers stances by been large bank was holding acquired companies, and Goldman bankrupt, under Sachs and Morgan Bear emergency Stanley circum- had saved themselves by converting to bank holding companies su- Reserve.Federal the by pervised In terminating the program, then Chairman of the SEC Christopher Cox flawed concluded from the that beginning.” it had been “fundamentally The program’s staff was so limited that, unlike banking supervisors, it was unable to place on-site examiners at the investment banks, follow and up it on failed findings to of deficiencies by requiring changes in operations. investment banks, it developed a program that allowed the five investment banks to submit to supervision voluntarily. As an inducement for the invest- ment banks to do so, the SEC bank decided to use a to different and permit less rigorous method a of calculating its supervised securities investment subsidiary’s net capital based on value-at-risk models created by The the SEC firm. believed that this change would allow an forty percent in estimated the subsidiary’s capital charges. reduction of worldwide worldwide operations suddenly needed to find a consolidated supervisor to oversee their operations. Rather than submit themselves to the rigor of con- solidated supervision by the Federal Reserve System, which oversees bank holding companies, they requested that the SEC establish the CSE program, presumably on the assumption supervisor. that the SEC would be a more lenient rule change was expressed during the SEC meeting at which the CSE gram pro- was adopted. Commissioner Harvey goes Goldschmid wrong it’s going to be an said, awfully big mess. “If Do anything we feel secure if these drops in capital and protection?” other things [occur] we really will have investor 2011] directive of the European Union that consolidated supervision of holding companies and their financial subsidiaries was a prerequisite for them to con- tinue to do business in Europe. \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 9 25-AUG-11 10:47 vised Entities Program (Sept. 26, 2008) (on file with the Harvard Law School Library). 30376-hlp_5-2 Sheet No. 9 Side A 09/07/2011 15:01:13 A 09/07/2011 Sheet No. 9 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 9 Side B 09/07/2011 15:01:13 , at Bear 49 . 446-A O TEARNS AND S . N EP EAR B , R For example, Bear 48 ROGRAM P VERSIGHT OF O S NTITY E ., SEC’ ., EN G xx. UPERVISED thirty-eight thirty-eight to one. Despite that, former – S — NSPECTOR I B. Banking Supervisors 50 note 1, at xix note 1, at 283. note 1, at xviii. ONSOLIDATED FFICE OF C supra supra supra , , , THE : SEC O First Public Hearing of the Financial Crisis Inquiry Commission, Day Two 53 EPORT EPORT EPORT R 54 If indeed that was the view, the SEC had abandoned its role as NTITIES 52 at 230, 291. at 288; Christopher Cox, Former Chairman of the U.S. Sec. and Exchange Comm’n, at 283; at 154; E The FCIC was told that the SEC failed to do so because of an attitude Id. Id. FCIC Id. FCIC R Id. FCIC R Federal banking supervision, though somewhat more effective than the For example, the Office of the Comptroller of the Currency (“OCC”) The SEC had power under the CSE program to demand that the invest- 51 48 49 50 51 52 53 54 x (2008). – ELATED SEC Chairman Christopher Cox testified that he believed that Bear Stearns “had a capital cushion well above before what its is required” collapse in and March 2008 emergency just acquisition by J. P. Morgan. on the part of senior staff in the CSE program that “the SEC’s job was not to tell the banks how to run their assets.” companies but to protect their customers’ SEC’s CSE program, failed to rein in country’s largest the bank risky holding companies, activities including Bank of of some America and of Citigroup. the As the FCIC concluded, “In case after case after case, regulators continued to rate the institutions they oversaw as safe and sound even in the face of mounting collapse.” troubles, often downgrading them just before and the Federal Reserve Bank of New York their did not downgrade Citigroup to “less than satisfactory status” until April 2008, several months after announced it in had November 2007 that it had prime mortgage-related exposure holdings and would take an $8 to $11 to billion loss on $55 billion of sub- Inspector General reported that the CSE program had failed to require Bear Stearns to reduce its high leverage and its large position in mortgage securi- ties. ment banks act more prudently, but it failed to do so. For example, the SEC Stearns Stearns had enormous leverage R 240 borrowing in the commercial paper and repo markets. Harvard Law Stearns & Policy was Review also relying heavily on short-term 2007, borrowing. it At was the end borrowing of $11.8 $70 billion in equity. billion in the overnight repo market with [Vol. 5 \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 10 25-AUG-11 10:47 Written Testimony Before the FCIC 6 (May 5, 2010). prudential institutional supervisor and merely reverted protecting to the its investor. traditional Schapiro, role As of stated the by supervision.” current CSE SEC Chair “was Mary not successful in providing prudential 39 (2010) (statement of Mary Schapiro, Chairman, U.S. Sec. and Exchange Comm’n). ix 30376-hlp_5-2 Sheet No. 9 Side B 09/07/2011 15:01:13 B 09/07/2011 Sheet No. 9 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 10 Side A 09/07/2011 15:01:13 The 62 Timothy , 210 (2010) 56 which restricted 59 In explaining the bank super- 61 55. – 35. – 57 note 1, at 52 note 1, at 54; Rich Spillenkothen, Notes on the Performance of note 1, at 34 note 1, at 171; Interview by the FCIC with Eugene Ludwig, Prom- supra By 1998, many of the restrictions of the Glass-Steagall 04. supra http://fcic.law.stanford.edu/documents/view/1237. supra , supra – 60 , , , EPORT EPORT EPORT EPORT R R R 58 Hearing on “The Shadow Banking System” before the FCIC, Day Two available at at 260, 302 at 303. ; The OCC had become aware of Citigroup’s enormous exposure to Foreword: Foreword: Deregulation: A Major Cause of the Financial Crisis 241 55 Id. Id. Id. FCIC R Banking Act of 1933, Pub. L. No. 73-66, 48 Stat. 162 FCIC (1933). Financial Services Modernization Act of 1999, Pub. L. No. 106-102, 113 Stat. 1338 FCIC This weakening of bank supervision was in part a result of a long-term These failures in banking supervision were another result of the prevail- 56 57 58 59 60 61 62 55 gress to allow them to enter into new activities. Banking supervisors issued rules permitting banks or their nonbank subsidiaries to ingly risky activities, engage including securities activities in and over-the-counter de- increas- rivatives trading. banks’ participation in securities markets. As competition from banks investment banks, they pressed their experienced supervisors and Con- growing Geithner, Geithner, then President of the Federal Reserve Bank of New York and now Secretary of the Treasury, testified, “I do institution with the not authority we had to think help contain the risks we that ultimately did enough as an emerged in that institution.” (statement of Timothy F. Geithner, Secretary, U.S. Dep’t of the Treasury). ing deregulatory mindset at the Fed and other banking supervisors. As Rich- ard Spillenkothen, a former director of the Fed’s Banking Supervision and Regulation Division, explained, “Supervisors understood that forceful proactive and supervision, especially weaknesses early were reflected in intervention poor financial performance, might before be viewed as management i) overly-intrusive, burdensome, and constraint heavy-handed; on ii) credit an availability; or undesirable iii) inconsistent posture.” with the Fed’s public increase in permissible activities for banks that banking supervisors had al- lowed as exceptions to the Glass-Steagall Act of 1933, visors’ support for this action, Eugene Ludwig, Comptroller of the Currency from 1993 to 1998, said they had an “historic vision, historic approach, that a lighter hand at regulation was the appropriate way to regulate.” subprime subprime mortgages through liquidity CDOs puts in 2005, but and did not recognize super-senior the great risks tranches it posed to tion. of the institu- The Federal Reserve Bank Citigroup’s of New risk York seemed management to be and unaware of internal control problems. 2011] them. \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 11 25-AUG-11 10:47 (1999); FCIC Act had been effectively eroded, and Citicorp announced a planned merger with Travelers Insurance, which would have violated the Act. In response, Congress enacted the Gramm-Leach-Bliley Act of 1999, repealing most of the remaining constraints of Glass-Steagall. ontory Fin. Group (Sept. 2, 2010). Prudential Supervision in the Years Preceding the Financial Banking Supervision Crisis and Regulation at the by Federal Reserve Board (1991 a to 2006), at 28, Former May Director of 31, 2010, 30376-hlp_5-2 Sheet No. 10 Side A 09/07/2011 15:01:13 A 09/07/2011 Sheet No. 10 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 10 Side B 09/07/2011 15:01:13 in 67 Not only did 66 Alan Greenspan 63 there’s no way.” That weak supervision permit- — 65 64 74; Briefing Paper, Countrywide Financial Corpo- – ONCLUSION C note 1, at xviii. note 1, at 352. note 1, at 173 , May 1, 1994, at 382. . supra supra supra , , , ULL B EPORT EPORT EPORT R R The current structure provides banks with a method . . . of ESERVE at 54; Alan Greenspan, Chairman, Bd. of Governors of the Fed. Reserve Sys., State- at 351; Interview by the FCIC with John Reich (May 4, 2010). . R FCIC R Id. FCIC FCIC Id. arbitrary position or excessively rigid posture of any one regulator. The pressure of a potential loss of institutions has inhibited exces- sive regulation and acted as a countervailing force to the bias of a regulatory agency to overregulate. shifting their regulator, an effective test that provides a limit on the The causative role of deregulation and inadequate regulation in the fi- The FCIC found that Countrywide Financial Corporation chose the Of- The FCIC also found that the ability of banks to choose among banking OTS had also undertaken to act as the consolidated supervisor of AIG ED 63 64 65 66 67 F OTS fail to recognize the risks inherent in AIG’s issuance of mortgage-re- lated CDSs that led to its near collapse, but OTS did not adequately under- stand the operations of this enormous enterprise. As been John the Reich, director who of OTS, had told the FCIC, “[A]n organization like OTS can- not supervise AIG, GE, Merrill Lynch, and entities that have worldwide of- fices. . . . [I]t’s like a gnat on an elephant strongly supported this ability of a bank to choose touted among it supervisors as and a mechanism to diminish regulation: and its subsidiaries, and the FCIC found supervise an that institution “it the lacked size the and capability complexity to of AIG.” ted Countrywide Financial to issue an enormous volume of risky loans that brought it to the brink of failure prior to its acquisition by Bank of America in 2008. field central to the American economy and the welfare of the American peo- ple. Rebuilding a regulatory scheme designed for modern financial markets nancial crisis demonstrates the fallacies of reliance on self-regulation in a fice of Thrift Supervision (“OTS”) to be its regulator in December 2006 in part because its “regulation of holding companies is not as intrusive as that of the Federal Reserve. . . . The OTS generally is considered a less sophisti- cated regulator than the Federal Reserve.” 242 Gramm-Leach-Bliley Act left some banks as vulnerable to the the housing bubble as investment banks, and a number collapse of large bank holding of companies were brought to the brink of failure during the financial crisis. supervisors “became a race to the weakest Harvard supervisor.” Law & Policy Review [Vol. 5 \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 12 25-AUG-11 10:47 ment before the Senate Committee on Banking, Housing and Urban Affairs (Mar. 2, 1994), 80 ration, Meeting With Office of Thrift Supervision (July 13, Law 2006) School (on Library). file with the Harvard 30376-hlp_5-2 Sheet No. 10 Side B 09/07/2011 15:01:13 B 09/07/2011 Sheet No. 10 Side 30376-hlp_5-2 30376-hlp_5-2 Sheet No. 11 Side A 09/07/2011 15:01:13 69 5641). – (March 29, COM FT. , is an important first step in doing so. 68 Dodd-Frank Fails to Meet the Test of our Times Foreword: Foreword: Deregulation: A Major Cause of the Financial Crisis 243 Pub. L. No. 111-203, 124 Stat. 1376 (2010) (to be codified at 12 U.S.C. §§ 5301 Alan Greenspan, 68 69 2011), http://www.ft.com/cms/s/0/14662fd8-5a28-11e0-86d3-00144feab49a.html#axzz1K10k 5vOd (on file with the Harvard Law School library). However, However, it is imperative that those provisions should be fully implemented through new agency regulations and proponents of self-regulation have launched a campaign against implementa- rigorously enforced. The long-time tion of a number of critically important provisions using the same old argu- ments of unnecessary regulatory publicly burdens. warned against implementation Indeed, of Alan some provisions Greenspan of has the Act. 2011] is the challenge the country now faces. The enactment of tory financial reforms regula- in the Dodd-Frank Act That campaign must be resisted. learned from If the financial the crisis, we country’s will all policymakers be doomed have to repeat not it. \\jciprod01\productn\H\HLP\5-2\HLP210.txt unknown Seq: 13 25-AUG-11 10:47 30376-hlp_5-2 Sheet No. 11 Side A 09/07/2011 15:01:13 A 09/07/2011 Sheet No. 11 Side 30376-hlp_5-2