Category: Securities Regulation


GW Fin Reg Conference Nov. 6

As financial regulation reform reaches its apogee, we at GWU are delighted to host a roundtable on Friday Nov. 6 at the Law School (2000 H Street, NW, Washington, DC).   An outline of the Program, co-sponsored by the Institute for Law and Economic Policy, follows, along with how to register.  Note that participation of some panelists is subject to the legislative calendar. Read More


Smart or Not So Smart Money; The Limits on Derivatives and Regulating Them

The New York Times op-ed by Calvin Trillin, Wall Street Smarts, has a parable-like quality with the two characters meeting and exchanging wisdom. The lesson offered by the wiseman: “The financial system nearly collapsed,” he said, “because smart guys had started working on Wall Street.” The piece goes on to explain why that is a good explanation. It seems that the not-so-smart sat at the top of the heap and ran the companies: “Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.” There is also an claim about what is enough and what is greed in this tale. I leave it to others to debate or verify these ideas (our own Mr. Cunningham has been a favorite for me on these issues). Now, a paper by some folks at Princeton may show that not even the smart guys knew what they were doing.

As Andrew Appel explores in his post Intractability of Financial Derivatives, the computer science world’s Intractability Theory may better explain the derivative world than other theories. (the theory is used for DRM, cryptography, and more). The paper is Computational Complexity and Information Asymmetry in Financial Products (pdf) by Sanjeev Arora, Boaz Barak, Markus Brunnermeier, and Rong Ge.

For those who are interested in the topic and/or understand the math and theory behind the risk shifting involved in this area, check out Andrew’s post. He does a great job explaining how the paper applies to a CDO (collateralized debt obligation). If you need a little more to understand why this paper and its ideas are important, consider Andrew’s take away

In principle, an alert buyer can detect tampering even if he doesn’t know which asset classes are the lemons: he simply examines all 1000 CDOs and looks for a suspicious overrepresentation of some of the asset classes in some of the CDOs. What Arora et al. show is that is an NP-complete problem (“densest subgraph”). This problem is believed to be computationally intractable; thus, even the most alert buyer can’t have enough computational power to do the analysis.

Arora et al. show it’s even worse than that: even after the buyer has lost a lot of money (because enough mortgages defaulted to devalue his “senior tranche”), he can’t prove that that tampering occurred: he can’t prove that the distribution of lemons wasn’t random. This makes it hard to get recourse in court; it also makes it hard to regulate CDOs.

UPDATE: It appears from the comments to Andrew’s post that CDO and derivatives are not precisely the same thing. In addition, the comments explore the limits of the study. It is a good discussion.

ALSO check out the FAQ for the paper. It addresses many issues that the initiated may want to probe.


Bernie Madoff and the Unfortunate Consequences of Celebrity Bias

744040_jesterCelebrity is intoxicating.  We have long been willing to play the fool to the rich and powerful, even if that means turning a blind eye to signs of trickery.  In the late 1980s, a 37-year-old con artist convinced Duke University administrators and students that he hailed from the wealthy Rothschild family of France despite the fact that he spoke no French, drove a run-down car, and offered clipped out magazine articles to show his family’s homes. During a two-year charade, the imposter borrowed (stole) thousands of dollars from Duke and joined a fraternity. (I was an Duke undergraduate at the time, but alas did not know him).  More recently, Christopher Chichester tricked many into believing that he was a Rockefeller despite his gauche manners and outrageous claims (e.g, that he owned “the key to Rockefeller Center”).  As Clark Rockefeller, he gained admission to exclusive clubs and married a partner at McKinsey Consulting.  Only after Mr. Chichester kidnapped his daughter from his ex-wife did the police discover his true identity and connection to unsolved murders.120px-Bernie_Madoff_Cropped

Perhaps such celebrity bias had some role in the SEC’s bungling of the Bernie Madoff fiasco.  On Thursday, the S.E.C.’s Inspector General’s Report explored why the agency missed so many “red flags” about Madoff since 1992.  The report discussed missed leads, bureaucratic snafus, and investigators’ inexperience.  Investigators were far too believing because they were simply awed by him.  One investigator described Madoff as “a wonderful storyteller” and a “captivating speaker.”  As with the faux Rockefeller and Rothschild incidents, Madoff’s ruse worked for so long despite the clues of foul play perhaps because investigators and investors could not shake their sense of Madoff as a rich, powerful, and trusted financial guru.  Madoff’s celebrity reputation anchored their thinking, permitting Madoff to get away with his scheme for far longer than it should have.  As Madoff’s victims’ stories attest, celebrity bias had profoundly destructive consequences.

StockXchange Image; Wikimedia Commons Image


“A great vampire squid wrapped around the face of humanity”

That’s how Matt Taibbi describes Goldman Sachs in the opening paragraph of his 12-page Rolling Stone article (which, as far as I can tell, is available online only here, in moderately annoying scanned form). From there, Taibbi picks up steam. For instance, we learn that:

The bank’s unprecedented reach and power have enabled it to turn all of America into one giant pump-and-dump scam, manipulating whole economic sectors for years at a time, moving the dice game as this or that market collapses, and all the time gorging itself on the unseen costs that are breaking families everywhere — high gas prices, rising consumer credit rates, half-eaten pension funds, mass layoffs, future taxes to pay off bailouts. All that money that you’re losing, it’s going somewhere, and in both a literal and a figurative sense, Goldman Sachs is where its going.


Is this just another crackpot conspiracy theory? (Paging Mr. Stein, Mr. Ben Stein.) Nay — Taibbi has give us proof of Goldman’s nefari-iety. It goes more or less along these lines: 1. Goldman survived the Great Depression. 2. Goldman made some savvy bets in the past ten years. 3. Goldman pays really big bonuses. Read More


Washington Backwards on Fin Reg

money-in-dcIf Treasury Secretary Timothy Geithher has his way, two big mistakes appear to be forthcoming from the Obama Administration on financial regulation, born of an atmosphere in which any kind of reform seems possible. A quick quiz illuminates:

1.  Suppose someone you put in charge of overseeing banks did a terrible job supervising them while someone you put in charge of mutual funds did a reasonably good job supervising them. If banks failed while mutual funds prospered, would you (a) increase the power of the bank supervisor and decrease that of the fund supervisor or (b) correct the failings of the bank supervisor and reward and maintain the fund supervisor? The correct answer is (b) but the Administration is about to propose (a), by stripping the Securities and Exchange Commission of power and expanding the Federal Reserve’s power.

2.  Suppose a system-wide financial crisis spread across the land that gave you an opportunity to revise the prevailing oversight system of relevant financial institutions. Would you (a) authorize a formal investigation of the source of problems to identify tailored solutions and follow up with legislative corrections or (b) begin with legislative overhauls followed by a formal investigation? The correct answers is (a) but the government is choosing (b). The House and Senate have approved legislation now heading to the President’s desk for signature to start the investigation, while simultaneously writing legislation to be enacted long before investigation is complete.

The case to expand the Fed’s powers will be made under the fashionable heading of the need to have a single super-senior risk regulator able to oversee all institutions posing systemic risk. Participants should not be misled. In effect, what appears to be happening is the banking industry exercising its considerable influence to regain market share it has lost to the mutual fund industry in recent decades. Read More


Hello Ms. Schapiro

SEC Seal.gifThe Senate on Thursday confirmed President Barack Obama’s nomination of Mary Schapiro as Chair of the Securities and Exchange Commission. In Ms. Schapiro’s written answers to questions posed by Senator Carl Levin, she indicates a refreshingly sharp break with many policies of her predecessor, Chris Cox.

Differences appear on numerous particular subjects. These reflect a general orientation to re-dedicate the agency to its primary mission of investor protection. Examples from Ms. Schapiro’s letter follow (with full text available here from Investment News):

1. Corporate Governance. Ms. Schapiro favors (a) rules letting shareholders (at least significant, long-time holders) nominate candidates for corporate boards of directors; and (b) rules allowing shareholders to express advisory opinions and votes on executive compensation .

2. International Accounting. Ms. Schapiro, unlike Mr. Cox: (a) does not believe that the International Accounting Standards Board meets US legal criteria and is not prepared to delegate authority to it; and (b) believes that US authorities must oversee foreign auditing firms auditing financial statements of companies with securities listed in the US.

3. Internal Controls. Ms. Schapiro, unlike Mr. Cox, would enforce laws requiring internal controls as to small and large public companies alike.

4. Accounting. Ms. Schapiro also believes in: (a) maintaining the independence of the US accounting standard setter, the Financial Accounting Standards Board; (b) cracking down against abuses of off-balance sheet accounting; and (c) continuing the requirement that stock options be accounted for as compensation expense.

5. Regulatory Scope. Ms. Schapiro favors: (a) regulating hedge funds; (b) strengthening capital requirements for securities brokers; and (c) strengthening regulation of rating agencies.

So far so great.


Good Bye Mr. Cox

SEC Seal.gifYesterday was Christopher Cox’s last day of a 3.5 year term as Chair of the Securities and Exchange Commission, the United States federal agency charged with investor protection. Investors may be tempted to feel some relief. He leaves the agency weakened and its staff demoralized. But he also leaves its continued existence in doubt, given its manifest failures and contributions to the global financial crisis. It may be undiplomatic to say, but it is possible that his tenure was among the worst in the agency’s history.

Despite the agency’s primary mission of investor protection, Mr. Cox mostly ignored or subordinated that mission in preference to elevating other goals, such as promoting capital formation and engagement with technology and globalization. Headline dramas illustrating these problems include how, during Mr. Cox’s tenure, the SEC:

• failed to interdict Bernard Madoff’s Ponzi scheme despite warnings, costing investors billions, with Mr. Cox later saying he was “deeply troubled” that he didn’t catch it;

• failed in its oversight of the investment banking industry, which led to its extinction, costing investors hundreds of billions more (with multiplied costs for the rest of the economy and probably permanently impairing the economy of New York City, the country’s center of investment capital), with Mr. Cox later describing the SEC’s oversight program as a total failure;

• reduced enforcement intensity for securities law violations (measured by year-to-year reductions in fines and restitution of about 2/3), with uncertain but probably significant future costs for investors from reduced deterrence; and

• reversed major parts of the 2002 Sarbanes-Oxley Act’s implementation concerning corporate internal controls, the costs and fallout from which will not be known for months or years when accounting scandals emerge as a result of the increased opportunities for fraud, although the costs may again run to billions of dollars.

In addition, as Chair of the SEC, Mr. Cox concentrated considerable personal and institutional resources on two subjects that subordinated investor interests to pursue projects that Mr. Cox believed in for some other reasons. In particular, Mr. Cox and the SEC Staff at his direction:

• spent thousands of hours and enormous other resources pushing an ill-advised campaign to eliminate US accounting standards in favor of global ones, although this was fortunately delayed in the final months of his term in response to investor and academic criticism; and

spent considerable resources promoting policies to let non-US enterprises access US capital markets, without any US regulatory oversight or legal enforcement, so long as they are overseen at home by authorities deemed comparable, also an idea that luckily has gained little traction and may die on the vine.

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Congrats to Mary Schapiro, SEC Chair Nominee

Mary Schapiro.jpgUS President-elect Barack Obama announced his intention to nominate Mary Schapiro as Chair of the Securities and Exchange Commission. We at GW Law School, from which Ms. Schaprio graduated in 1980, are delighted. We wish her well in what promises to be a very difficult period for the SEC. Already, questions arise about the orientation Ms. Schapiro will bring, raised sharply in Susan Antilla’s Bloomberg column today. From the Obama transition team web site is the following biography of Ms. Schapiro.

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Times Softens SEC Bashing

SEC Seal.gifOn Monday, I posted my opinion that people should be cautious in rushing to rebuke the Securities and Exchange Commission for any failures leading to the Madoff Ponzi scheme. Also on Monday, the New York Times engaged in such a rush. In today’s paper, the Times softens that stance. These views may have some bearing on whether the SEC survives, is dismantled or reconstituted in coming financial regulation reform.

My post said charges against the SEC for failure in the Madoff case should be looked into but that it was equally likely that the charges would prove incorrect. Above all, I opined that talk of SEC blame for the Ponzi scheme risks distracting from manifestly pressing matters of systemic significance arising in the general financial crisis.

In Monday’s Times Stephen Labaton painted a very unflattering piece on the SEC, emphasizing its alleged failures to interdict the Madoff scam, and quoting Chris Cox, current SEC Chair, as acknowleding some fault. The story, which ran on page B6 and spanned 876 words, called the Madoff episode the “latest black eye” for the SEC. It also mentioned the SEC’s failure to anticipate the problems at Bear Stearns, and cited SEC inspector general reports on “several major botched investigations” (although without noting that those reports have been contested by other SEC officials).

The Monday story also reported on other rumor-based and word of mouth complaints about morale among SEC staff, even assertions of a “hollowing out” of the agency under Bush administration directives.

In today’s paper, Mr. Labaton offers a different view.

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Required versus Probable Reform and the Madoff Distraction

dollar sign.jpgThe press, politicians and reformers are devoting extraordinary attention to a Ponzi scheme whose only peculiarities are scale and duration. Compared to ongoing global financial devastation, this is trivial. Yet this attention may lead politicians to distract focus from their role in the deeper problems that matter far more.

Recriminations against the Securities and Exchange Commission arise from allegations it has made (complaint here) that Mr. Madoff operated a large-scale Ponzi scheme involving tens of billions of dollars over perhaps decades and bilking scores of sophisticated parties. SEC critics include prominent securities law professors Jim Cox (Duke) (SEC may “have a hell of a lot to answer for”) and Joel Seligman (Rochester) (“a debacle for the SEC”).

Critics express concern that the SEC may have failed to investigate investor tips (see Wall Street Journal story here); failed to regulate sufficiently Madoff’s investment advisory services or fund vehicles; or failed to enforce existing regulations. Calls are for both investigation and greater regulation, many pinning hope on the incoming Obama administration to institute such searching and effect requisite change.

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