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A Short History of the Breathtaking Cluelessness of U.S. Financial Regulators

By Amanda Alix - Oct 5, 2014 at 1:31PM

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New revelations about government oversight of big banks shows a shocking lack of acumen regarding financial matters.

Though the unfolding scandal surrounding Goldman Sachs and regulators at the Federal Reserve Bank of New York sounds more like the plot for a Hollywood political thriller, the tapes that former FRBNY examiner Carmen Segarra furnished for the radio show This American Life and the progressive journalism site ProPublica prove that the episode was disturbingly real. 

Segarra was hired in 2011 as part of an effort to counter the atmosphere of extreme deference by federal regulators toward the banks under their purview, but she alleges she was dismissed for attempting that very task. She filed a wrongful termination suit against the FRBNY, alleging retaliation for refusing to change a report in which she claimed that Goldman had no policy in place to deal with conflicts of interest.

The meeting at which her supervisor pressured her to change her opinion regarding Goldman Sachs occurred shortly before she was fired, and was one of 46 hours of conversations that Segarra surreptitiously recorded during her short time at the FRBNY. The existence of the tapes came to light during the filing of court documents relevant to her case.

As cries for additional investigation of the incident -- and, possibly, the entire bank regulatory system -- mount, evidence abounds that this was no isolated event. The cozy relationship between banks and their regulators is nothing new, and the seemingly out-to-lunch attitude of federal regulators has been apparent since well before the financial crisis struck.

Here are some examples of how bad decision-making and apparent cluelessness on the part of federal regulators actually helped create the most serious economic meltdown in history.

2001: Recourse Rule amendment to Basel I
Ten years after implementing Basel I global bank capital regulations here in the U.S., regulators made a few changes to the basic precepts. Back in 1991, well-capitalized commercial banks were required to hold a 10% capital cushion against liabilities such as commercial loans. A mere 5% cushion was needed for mortgages, since the regulations were apparently an effort to prop up the mortgage market across the pond. In the U.S., mortgages backed by Fannie Mae and Freddie Mac required only 2% in capital backing.

The Recourse Rule of 2001 added asset-backed securities into the mix, bonds made up of auto loans, credit card debt, and mortgages. According to the rule, mortgage-backed securities backed by Fannie or Freddie -- or those rated AAA or AA by ratings agencies such as Fitch Ratings, Moody's, or Standard & Poor's -- would require a paltry 2% capital cushion. Loading up on mortgage-backed securities, therefore, could increase leverage exponentially if they were substituted for, say, commercial loans, that required a much heftier 10% capital backstop. Seven years later, fully 93% of mortgage-backed securities held by banks were rated AAA or AA.

2004: SEC Net Capital Rule change allows leverage to increase
When the Securities and Exchange Commission broadened the Net Capital Rules to include the parent companies of broker-dealers in its regulatory net, the change was trumpeted as an expansion of federal regulation over the financial industry. Unfortunately, the new rules had the exact opposite effect.

How could increased scrutiny of the holding company be a bad thing? What happened was this: Bringing firms like Lehman Brothers and Goldman Sachs under the SEC umbrella allowed those companies, like the broker-dealers, to use less stringent collateral backing during securities trading. Instead of the old backstops of cash, or U.S. Treasury bonds, dealers -- and now, brokerage firms -- could now use mortgage-backed securities as collateral.  

Of course, those mortgage-backed securities needed to have AAA and AA ratings, bestowed by the same ratings agencies that had characterized Enron's debt as top-rated within days of its epic failure.

2008: Treasury fails to grasp the significance of the growing crisis
In early 2014, transcripts of the 2008 Federal Reserve's Federal Open Market Committee meetings were released, showing a completely out-of-touch regulatory body that believed that the economy could weather the little blip that was the Lehman Brothers bankruptcy.

How could the premier regulator of all things financial be so utterly ignorant of the economic tailspin that was taking place right under its nose? It's hard to say, particularly after the tweaks regulatory agencies had made to the system to encourage mortgage-backed security production over the previous several years.

In 2012, this ingrained obliviousness enabled the now-famous London Whale fiasco, whereby 110 federal regulators embedded within JPMorgan Chase failed to prevent a trading loss of $6.2 billion. 

A history destined to repeat itself
Perhaps we shouldn't be surprised that a well-respected compliance professional like Segarra was ignored, harassed, and then terminated because she was too good at her job. Ironically, the job Segarra and other examiners like her were hired to do was remedy to the culture of chumminess between big banks and their regulators -- a climate which was seen as instrumental to the genesis of the banking crisis. 

As the ProPublica article notes, this toxic relationship was unmasked in a study commissioned by FRBNY President William Dudley. The excessive deference exhibited by regulators to the very institutions within their oversight was seen as a problem that needed to be solved as soon as possible.

Yet Segarra was dismissed within seven months of her hiring, after repeatedly being pressured to soften her stance regarding Goldman Sachs, which she saw as needing tighter regulation. Of course, years later, a congressional study on the financial crisis fingered Goldman as being particularly active in the marketing and selling of faulty investment products based on mortgage-backed securities.

Will the public airing of this financial crisis-era outrage truly change the regulatory climate? It doesn't seem likely, if this rebuttal by the FRBNY is any indication. As new information regarding the economic crisis continues to creep into public view, the most salient takeaway may be the awareness that the next meltdown may not be very far away.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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