Crisis Poses Big Test for Markets' Regulator

By Carrie Johnson
Washington Post Staff Writer
Friday, September 19, 2008

The Securities and Exchange Commission is confronting its biggest test in nearly 75 years, when the agency was founded in response to a market crash that devastated ordinary investors.

SEC Chairman Christopher Cox and his counterparts who oversee stock markets often have operated on the sidelines during the current crisis, the worst fallout on Wall Street in at least a generation, leading critics to question how aggressively the agency is policing fraud and working to stabilize trading.

In the latest volley, presidential nominee Sen. John McCain yesterday decried the SEC chief, saying he "betrayed the public trust." The Arizona Republican told an audience that if he were president, he would fire Cox, who has served as the panel's chief since 2005 and before that logged 17 years in Congress, including a decade in the GOP leadership ranks of the U.S. House.

McCain's blistering comments drew a measured reply from Cox, whose performance has been scrutinized as some of the nation's largest financial institutions have succumbed to bankruptcy and fire sales in recent weeks.

"In this market crisis, the men and women of the SEC have responded valiantly as they always do," Cox said yesterday in a prepared statement. "[N]ow is not the time for those of us in the trenches to be distracted by the current election campaign. And it is precisely the wrong moment for a change in leadership that inevitably would disrupt the work of the SEC."

A bipartisan group of current and former agency officials say that calls for Cox's ouster on the grounds that he failed to anticipate and prevent a credit crisis are misplaced. The SEC did not serve as the primary overseer of the insurer American International Group or the mortgage-finance companies Fannie Mae and Freddie Mac, whose downfalls prompted severe unrest in the markets. In fact, the officials argue, the housing-fueled credit crisis has exposed systemic missteps by banking overseers, securities regulators, Congress and corporate executives -- all of whom underestimated the risks of leveraging and now are paying the price.

"It's not fair to blame all the problems of the current market on the SEC," Richard C. Breeden, a former chairman of the agency, said yesterday. "At the same time, it's fair to ask whether the SEC has done everything it could have done."

The roots of the current debacle, which has razed the landscape of investment banking and cost thousands of Wall Street jobs, date to the 1990s. In that decade, regulators took a hands-off approach to reviewing complex financial contracts known as derivatives, and lawmakers removed historic restrictions that barred banks from selling securities but did not change the regulatory structure, said former SEC chairman Harvey L. Pitt.

"Generally, the responsibility for what has happened was a decision that the markets can take care of themselves," said Irving Pollack, a Washington securities lawyer who worked for decades at the SEC. "On the derivatives and that other stuff, Treasury and the Federal Reserve going all the way back to Greenspan always resisted the regulatory approach."

Nearly a dozen alumni of the agency said they nonetheless are frustrated by the SEC's sluggish response to the credit crisis as it unfolded and by what they view as its leaders' initial reluctance to use the bully pulpit to reassure investors and issue warnings about fraud and manipulative stock sales, one of the issues McCain singled out yesterday in his broadside.

President Bush yesterday affirmed his support for Cox during a brief news conference at the White House.

Also yesterday, New York Attorney General Andrew M. Cuomo (D) entered the fray, citing federal regulators' "ineffective" oversight and arguing they had not moved swiftly enough to curb stock price manipulation. Cuomo has initiated his own investigation.

Former SEC officials and Democratic lawmakers this week criticized Cox for being "behind the curve" and for deferring to leaders at the Federal Reserve and the Treasury, which released a regulatory blueprint earlier this year that would have diminished the agency's authority. Sen. Jack Reed (D-R.I.) said yesterday that the SEC had "woefully underperformed" under Cox's reign but rejected calls for his ouster.

"There's been no one thinking rigorously or looking ahead at how things fit together," said former commissioner Harvey J. Goldschmid, now a law professor at Columbia University, who has exhorted the agency to devote more resources to risk assessment.

For his part, Cox yesterday stressed the steps he has taken: new rules that ban some short sales and require additional disclosure of hedge funds' trading positions, as well as information-sharing pacts with banking overseers. He recently called on Congress to give the agency more authority over credit-rating agencies, which frequently underestimated the risks of many debt products and contributed to the market downslide, and over holding companies that own investment banks.

Four years ago, securities watchdogs agreed to monitor risk and liquidity at five broker-dealers controlled by holding companies, making monthly visits to assess risk and ensure that investor assets were protected. The Fed led oversight of the holding companies themselves.

Today, only two of those banks remain standing, and one of them is negotiating a sale. Bear Stearns and Lehman Brothers collapsed, Merrill Lynch is to be absorbed by Bank of America, and Morgan Stanley is in talks to be acquired. Only Goldman Sachs remains relatively strong.

SEC officials said they had been urging investment banks all along to strengthen their balance sheets. Unlike other federal authorities, securities regulators do not have the power to influence interest rates, loosen borrowing capacity or set monetary policy. The five banks had a combined liquidity pool of $158 billion in February 2007. One year later, they had $232 billion, a 47 percent increase. In particular, Bear Stearns increased its liquidity from $5.5 billion to $17.4 billion in that time, the officials said.

"They sent people in to do it, but they didn't discover the terrible risk position the banks had," said former SEC chairman David Ruder. "Neither did the banking supervisors. Nobody figured it out. My opinion is that the SEC probably could have done a better job if they had more experience and more money. And even then, they would have needed to be smarter than the people they were regulating."

Joel Seligman, president of the University of Rochester and author of a history of the SEC, said, "There's a lot of fault to go around" among Washington regulators. "It's fair to say Cox is now in a storm that is probably the most serious since the 1930s. A lot of people have been finding their way. It is important that he is now at the table."

Special correspondent Heather Landy in New York contributed to this report.

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