The Smoking Gun

New York City -- Stuff happens, but in dissecting financial disasters, more often than not, it turns out that some singular event--usually regulatory--not mere chance, opened the gates to abuse.  In the S&L fiasco in the 1980s, one such event was the success by lobbyists in winning a rule change that allowed them to take unlimited brokered deposits, ie deposits not from you and me opening accounts, but through financial markets. From that point on, many banks bid for deposits with little thought of the interest rate, lent the money without oversight and, when markets turned downward, a disaster ultimately occured.

This time around, while there is still a sense that our current crisis just happened, the New York Times reports today that, once again, it was not an accident.  As revealed in the article, in 2004, in an obscure meeting held in the basement of the SEC building, Commissioners voted to approve a proposal by lobbyists of Wall Street's biggest firms, led by Goldman Sachs, to change the rules to allow the firms to increase their rates of leverage on equity up to 33 to 1. As long as their returns were greater than the cost of borrowing, this allowed them to juice their returns.  However, one or two bad investments at this leverage--for example in sub-prime loans--had the ability to go diastrously awry, wiping out the firm's entire equity.  This, in essence, is what has happened to the entire financial industry. It turns out there is a smoking gun in this crisis, a rule change secured by lobbyists--that had disastrous effects.

The Times goes on to report that in exchange for the unprecedented leverage, the firms promised to monitor their risk and the SEC set up an office to monitor risk as well.  Unfortunately, the office never became functional.  A software consultant and MBA who designed software used by banks to monitor risk was the lone dissenter in a letter to the SEC.  However, his letter and advice were ignored and the rule was approved unanimously.

Had the SEC followed through on the oversight it was supposed to perform, the consequences might not have been so dire.  But dergulation combined with abdication of all responsibility by the regulator, the SEC, provided fatal.  And we are now seeing the consequences.