Economic Reform is Overdue

More than a year after the cataclysmic collapse of Lehman Brothers just about everyone on Main and Wall Streets agrees that the Market Crisis of 2008 was the economic equivalent of 9/11. Like that tragic event, it galvanized legislators, commentators, and presidential candidates to promise a top-to-bottom overhaul of the financial services industry and its regulators. And it brought to mind the words of FDR: "We [have] to struggle with the old enemies of peace - business and financial monopoly, speculation, reckless banking, class antagonism, sectionalism, war profiteering."

Democrats and Republicans blamed the government's inability to oversee and curb Wall Street's greed but aside from spending hundreds of billions of dollars to prop up banks deemed "too big to fail," exactly what has Congress done to protect the American economy from its baser instincts in the future?

The answer is simple: Nothing.

Within a month of the inauguration, the Obama administration began laying out a framework for regulatory remediation. In July the Treasury Dept. released a white paper modestly titled, "Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation."

The lynchpin of this plan is the creation of the Financial Services Oversight Council - essentially an economic version of the Department of Homeland Security. The FSOC will include the Secretary of the Treasury, the Fed Chair, heads of all financial regulatory agencies, director of the proposed Consumer Financial Protection Agency and the National Bank Supervisor. Essentially, FSOC's mandate will be to insure Wall Street never goes into a uncontrollable freefall again, by identifying and remedying emerging risks in the financial marketplace and identifying and filling gaps in the regulation and oversight of the entire financial service industry.

The Obama reforms require any institution holding or investing other people's money to exercise prudence and restraint, and give government overseers the power and prerogative to insure this is being done in a timely fashion. The Fed will be tasked with designating financial and related entities thought to be "too big to fail" as Tier 1 Financial Holding Companies and subjecting this group to constant scrutiny and more stringent standards for capital and liquidity levels and risk management. All other financial firms will be subject to clearer and tighter standards, too, and financial phantasms, such as derivatives and credit default swaps will be registered and regulated along with hedge and venture capital funds.

Ambitious, to be sure, but no less necessary than increasing security measures after 9/11 - regardless of halting improvement in the economy while the Dow inches toward 10,000 because 25 years of investigating all types and magnitudes of get rich schemes has taught me that as soon as one artifice is detected or fails, another, more creative one pops up in its place. The exigency for reform becomes even more apparent in light of continuing revelations of enforcement missteps that contributed to the meltdown in the first place.

SEC Inspector General David Kotz has documented what the SEC didn't know before Bear Stearns imploded; what it wouldn't do to stop naked short sellers before and after Lehman's demise; and what it didn't do to stop Bernie Madoff from perpetrating the longest and largest Ponzi scheme in history.

The Bear Stearns report came first, just ten days after Lehman declared bankruptcy. SEC staff told Kotz they only ever reviewed quarterly filings, or Forms 17h, for six of the 146 broker-dealers required to file such reports under its Broker-Dealer Risk Assessment Program. Bear Stearns was one of those six, but the other 140 broker-dealers could have mailed in pages from the telephone book and been deemed in compliance with SEC regs.

In its defense, the SEC personnel argued it ignored the remaining 140 broker-dealers because the six firms it did review carried 43% of all investment accounts and 11% of the cash balances maintained by the universe of broker-dealers registered with FINRA. Kotz never explains if anything could have been done to detect Bear Stearns' diminishing capital and increasing investment risk before its March 2008 crisis, but he does point out that recommendations made to streamline the program in 2002 remained largely unimplemented in 2008.

This March, Kotz took on the regulation of naked short-selling. From January 2007 through June 2008, over 5000 naked short selling complaints were lodged with the SEC. Only 123 - 2.5% - of them were investigated and none resulted in any enforcement action. Had naked short sellers known these odds, Lehman wouldn't have been the only financial behemoth closing its doors after a rout of predatory trading, and we might find ourselves today in the midst of another Great Depression, and not just suffering from the 9.8% unemployment rate announced last week.

Capping this trifecta of mea culpas, Kotz recently reported on the SEC's almost incomprehensible inability to uncover Madoff's wrongdoing over the 16 years it investigated complaints about his investment advisory service and issued a list of post-Madoff reforms.

While Kotz concludes that neither criminal conduct nor malfeasance played any role in the SEC's inability to catch Madoff, the laundry list of red flags ignored or misinterpreted by SEC investigators reads like "Ponzi Schemes for Dummies" and the proffered reforms - prepare investigatory plans, insure these plans are followed, assign supervisor and staff experienced investigating similar charges -- are steps followed by every competent compliance and investigative professional in the industry. If the SEC wasn't following these basic steps, what were they doing?

America's growing loss of livelihood, while not as dramatic as the loss of life suffered on 9/11, is no less dangerous to our democratic way of life. One would hope Congress would have approached Wall Street reform with the same gusto they have brought to debating a public option in health care or the cap and trade on emissions. Now is the time to finally tackle the thorny issues that brought us to this point. If we don't act quickly, we risk the bottom falling out again.