MARKOPOLOS TESTIFIES

Harry Markopolos, the private investigator who tried to blow the whistle on Bernie Madoff, testified before Congress today and told the story of a Securities and Exchange Commission (SEC) that dropped the ball on its oversight functions.

Saying that the SEC had become "nonfunctional" because of agency officials who were "financially illiterate" Markolopos made it clear that the SEC's inability to do its job made the agency "harmful to our capital markets and harmful to our nation’s reputation as a financial leader."

Those are pretty tough words for an agency that was created by FDR to make sure that market players played by the rules and actually did what they said they were doing. The SEC is not supposed to fawn over and cover for industry.

But I especially liked the testimony of Markopolos because it supports what I say in in my book about the regulatory environment that has governed our nation's economy since the early 1980s ...

. . . In 1987 the Federal Reserve Board voted 3-2 to allow banks to handle a limited amount of underwriting for financial instruments like municipal bonds and mortgage backed securities. By allowing banking institutions to take on the risk of distributing these types of securities the Federal Reserve was effectively undermining one of the principal firewalls of the 1933 Glass-Steagall Act.

Specifically, one of the Acts goals was to keep commercial banks away from selling (underwriting) securities, or getting involved in investment banking. The thinking was that banks might get reckless and, because of their F.D.I.C. guarantee, force the federal government into a bailout situation. Before the collapse of 1929 commercial banks had done this by pushing faulty investment products, but with little concern for their client’s interests. Investors and bank depositors lost millions because, ultimately, the banks “overriding interest was promoting stocks of interest and benefit to the banks.”

The voting members of the Federal Reserve in 1987, however, had been convinced that this could not happen in the modern era. Then Citicorp vice-chairman, Thomas Theobald, argued that corporate misbehavior couldn’t occur like it did before 1933 because the economy had seen the emergence of: (1) a “very effective” Securities and Exchange Commission, (2) knowledgeable investors, and (3) “very sophisticated” rating agencies. Three members were convinced. Two were not.

One of the “nay” votes from the Fed Board came from Fed Chair, Paul Volcker. He believed if commercial banks were allowed to get back into underwriting securities (like mortgage backed securities) they would lower lending standards in an effort to gain lucrative fees from underwriting bonds, which would strengthen their securities market position and generate more profits. Still, without veto power Volcker’s nay vote didn’t matter. His argument lost the day.

Paul Volcker notwithstanding, the Fed board members who voted to allow commercial banks to underwrite securities failed to recognize the weakness in Theobald’s argument. The SEC could always be converted into a toothless tiger if its chair and staff were governed by ideology rather than the public interest. Greed can get the best of investors in an increasingly deregulated environment. Ratings agencies could be co-opted, and even consumed by market euphoria. A running with the market herd mentality could quickly swamp market players who, as John Kenneth Galbraith pointed out in A Short History of Financial Euphoria, are filled with fast-profits and a sense of their own genius because of what they see as their “novel” wealth generating skills.

With the walls between S&Ls, commercial banks, and investment banks crumbling in the 1980s, U.S. banks dove into lucrative mortgage and security instruments. Rather than learn from the intoxicating effects of previous periods of deregulation, speculation, and debt-driven growth, caution was thrown to the wind. The commercial banking sector slowly came to depend on mortgage backed assets as their primary earning’s tool, jumping from about 28 percent of bank earnings in 1985 to more than 60 percent in 2005 . . .

Worse, as I point out in my book, this lax oversight environment crept into all aspects of commerce in America, and led market players to assume that they could get away with playing fast and loose with the books. This helps explain Bernie Madoff. It will also help us understand the "mini-Madoff's" that seem to be crawling out of our financial floor boards.

I'll have more to say about this on Saturday's program.

- Mark