Chairman Cox — Forgotten but not Gone


New York – Tuesday’s blog discussed the major changes affecting the investment research industry. One of the points regarded the general lack of confidence in the investment management industry, which fell prey to the activities of Bernie Madoff, as well as suffered the largest run up in financial market risk in recent history.

One of the most stunning occurrences was that the rampant run up in profitability, leverage and risk at hedge funds and budge bracket firms was contemporaneous with a sharp reduction in oversight by the SEC.  This makes no sense from a risk management perspective. When your traders are excessively partying, it is time to look more closely at trading records. When traders are quiet and have very few absences, its time to look at the trading records.  When the party spreads across Wall Street, it is time for the Fed to take away the punch bowl and for the SEC to start reviewing firms more aggressively.

Yet, as the excesses on Wall Street ramped up over the past few years, the SEC virtually stopped doing reviews. As well, the securities fraud prosecutions by the SEC fell by 75% from 2002. Imagine what would happen if at the annual New Year’s Times Square party, The NYPD fielded only 25% of the police force it had fielded in the previous year.

The genesis of the situation that certainly contributed to the current global financial crisis began April 28, 2004 when the Donaldson SEC decided to allow the bulge bracket firms to measure their capital requirements against the investment bank holding company’s capital, rather than against the brokerage business.  This was a decision that released billions of dollars of capital reserves that could now be “productively employed” in pursuit of greater profits. The SEC’s decision was a compromise, in which the bulge bracket firms were able to leverage up significantly in exchange for the SEC having the ability to look at the books of the entire investment banking operation. The rule, that would become know as the “net capital rule” was covered under Item 3 of the April meeting agenda.

At the time, the net capital rule seemed to make sense because it allowed the SEC greater access to the books of these institutions. The SEC set up a 7 person supervisory group to examine the parent companies. Only muted warnings as to the increased debt being laded on balance sheets were heard from the supervisory group and these went largely unheeded. And since the group was reshuffled by Chairman Cox, there has not been one examination of any of the firms in over a year, despite the apparent need.

Of course, with a new Administration coming January 20th, we can add SEC restructuring to the list of major problems that will need to dealt with in the coming year. Mary Schapiro has been tapped to take the reigns at the SEC. She is currently the CEO of FINRA, a non-government securities industry regulator, and is an ex-SEC Commissioner.  As such, she is already fully aware of the existing regulatory environment and has solid working relationships within the industry.  Additionally, the calls by lawmakers to combine the SEC with the CFTC would be less onerous a task under Schapiro, because she is also a past Chairman of the CFTC.

Hopefully expanding the markets covered by the restructured oversight body and refocusing efforts to root out financial fraud perpetrators, monitor capital requirements, and provide greater guidance on current legislation, the SEC or its successor can find its footing and help to rebuild investor confidence in the financial markets in the near future.


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