Emphases mine. Great reporting from the NYT. The meat of the article is in the middle, I've pulled that forward here.
The Reckoning - Agency’s ’04 Rule Let Banks Pile Up New Debt - Series - NYTimes.comI recall McCain got a hard time for saying Cox should be fired. What, people said, could Cox have had to do with a banking crisis?
October 3, 2008
By STEPHEN LABATON
... 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. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.
On that bright spring afternoon, the 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 up to the parent company, enabling it 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.
The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary...
One commissioner, Harvey J. Goldschmid, questioned the staff...
... “Do we feel secure if there are these drops in capital we really will have investor protection?” Mr. Goldschmid asked. A senior staff member said the commission would hire the best minds, including people with strong quantitative skills to parse the banks’ balance sheets...
... The proceeding was sparsely attended. None of the major media outlets, including The New York Times, covered it.
After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The Times, the chairman, William H. Donaldson, a veteran Wall Street executive, called for a vote. It was unanimous. 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 rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.
Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measurement of how much the firm was borrowing compared to its total assets — rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly....
... The supervisory program under Mr. Cox, who arrived at the agency a year later, was a low priority....
The commission assigned seven people to examine the parent companies — which last year controlled financial empires with combined assets of more than $4 trillion. Since March 2007, the office has not had a director. And as of last month, the office had not completed a single inspection since it was reshuffled by Mr. Cox more than a year and a half ago.
The few problems the examiners preliminarily uncovered about the riskiness of the firms’ investments and their increased reliance on debt — clear signs of trouble — were all but ignored....
... 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.
... A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso, Ind., who said the computer models run by the firms — which the regulators would be relying on — could not anticipate moments of severe market turbulence.
“With the stroke of a pen, capital requirements are removed!” the consultant, Leonard D. Bole, wrote to the commission on Jan. 22, 2004. “Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?”
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..
The commission’s most public role in policing Wall Street is its enforcement efforts. But critics say that in recent years it has failed to deter market problems....
... Christopher Cox had been a close ally of business groups in his 17 years as a House member from one of the most conservative districts in Southern California. Mr. 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. The commission has repeatedly reversed or reduced proposed settlements that companies had tentatively agreed upon. While the number of enforcement cases has risen, the number of cases involving significant players or large amounts of money has declined.
Mr. Cox dismantled a risk management office created by Mr. Donaldson that was assigned to watch for future problems. While other financial regulatory agencies criticized a blueprint by Mr. Paulson, the Treasury secretary, that proposed to reduce their stature — and that of the S.E.C. — Mr. Cox did not challenge the plan, leaving it to three former Democratic and Republican commission chairmen to complain that the blueprint would neuter the agency.
In the process, Mr. Cox has surrounded himself with conservative lawyers, economists and accountants who, before the market turmoil of recent months, had embraced a far more limited vision for the commission than many of his predecessors...
... “The last six months have made it abundantly clear that voluntary regulation does not work,” Mr. Cox said.
The decision to shutter the program came after Mr. Cox was blamed by Senator John McCain, the Republican presidential candidate, for the crisis. Mr. McCain has demanded Mr. Cox’s resignation.
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.
“In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the S.E.C. didn’t oversee well enough,” Mr. Goldschmid said in an interview. He and Mr. Donaldson left the commission in 2005...
I hate go give McCain credit for anything, but I might make an exception here. He may have had some inside knowledge.
I like that Mr Labaton connects the "market is wise and good" irrationality of the SEC to the neutering of the FDA and product safety agency.
In the end, it's Bush and the GOP. Again.
PS. If you Google on Leonard D. Bole you'll find his published comments. Maybe he'll appear on Oprah.
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