WASHINGTON — Though state regulators were swifter and more aggressive than their federal counterparts in responding to abuses that led to the 2008 collapse of the auction-rate securities market, they could have played a larger role in preventing the crisis if their authority had not been preempted by Congress, the head of a regulator group warned yesterday.
Testifying before the Financial Crisis Inquiry Commission during its second day of hearings on Capitol Hill, Denise Voigt Crawford, president of the North American Securities Administrators Association and the commissioner of the Texas Securities Board, took aim at a 1996 law.
She said the National Securities Markets Improvement Act, or NSMIA, has kept a large cadre of law enforcement agents — state securities regulators — off the beat. As a result, she said, the law was a significant factor in the heightened severity of the financial crisis.
For instance, Crawford told crisis commission members that prior to the law’s passage, all nationally recognized statistical rating organizations, or NRSROs, were registered with the Securities and Exchange Commission as investment advisers and subject to both state and federal oversight. But the passage of NSMIA bifurcated the oversight of advisers between the SEC and the states. When the SEC subsequently approved new rules that exempted NRSROs from investment adviser registration, they removed the rating agencies from review of any kind by the states.
“The naivete behind the view that markets are always self correcting now seems apparent,” Crawford said in written testimony. “But clearly, reliance by the investing public on federal securities regulators, self-regulatory organizations (SROs), and 'gatekeepers’ in the years preceding the crisis (and in its very midst) to detect and prevent even the most egregious of frauds and deceit was equally naive.”
The argument that credit rating agencies played a central role in the crisis, by giving unduly high ratings to tainted mortgage-related structured products, appeared to gain strong support from key members of the commission, which was created by legislation signed into law by President Obama. The panel is modeled in part on the Pecora Commission that investigated the events that led to the Great Depression.
Early in the five-hour hearing, chairman, Phil Angelides, a Democrat and former treasurer of California, said that rating agencies remain a problem because they do not face competition and their ratings benefit from “deference and status,” presumably a reference to their inclusion in numerous federal regulations.
“Isn’t the whole system broken?” he asked. “It was proved to be worthless, broken, and it remains so today.”
SEC chairman Mary Schapiro, who testified on a panel of federal officials, said that one key concern is that NRSROs are currently shielded by the securities laws from liability, unlike auditors and lawyers who can be sued when transactions go awry.
However, she said the SEC has issued a concept release asking market participants for comment on whether it should be easier to sue them, and stressed her belief that holding individuals and firms legally accountable for their actions — including through private rights of action — is a critical component of financial regulation and in instilling discipline in the financial system. Legislation pending in Congress would give private parties the right to sue rating agencies under certain circumstances.
Since the SEC was given authority to regulate the agencies by Congress in 2006, Schapiro said it has proposed no fewer than five sets of rule changes tied to NRSROs. And since she joined the SEC last year, it has approved two separate proposals aimed at boosting rating agency disclosure and curtailing conflicts of interest.
In addition to the concept release on NRSRO liability, Schapiro said the SEC is developing a system in which rating agencies will be required to release standardized, formatted information that will give investors “the ability to second guess” ratings.
Schapiro also touched on the need for additional resources for her agency, warning that even though the SEC is “traditionally independent” of the executive branch, unlike most other financial regulators it lacks an independent source of funding.
Because the commission’s budget is proposed by the president and set by Congress, “the SEC has been unable to maintain stable, sufficient long-term funding necessary to conduct long-term planning and lacks the flexibility to apply resources rapidly to developing areas of concern,” she said in written testimony. She added that funding is also unpredictable because the SEC rarely receives its annual appropriation at the beginning of a fiscal year and is often funded under a continuing appropriation.
Under financial regulatory reform legislation drafted late last year by the Senate Banking Committee, the SEC would be able to fund itself from fees levied on the firms it regulates. The commission expects to collect $1.5 billion in registration and transaction fees this fiscal year, compared to its budget of about $1.1 billion. During the later panel with state officials, Crawford criticized calls for additional SEC resources, saying regulators never have enough resources and staff simply need to learn to work in the most effective way.
Asked by Angelides how she would rate federal regulators — including the SEC — over the past decade, Crawford said, “D-minus.”
“The problem is they’ve missed the boat with the most dramatic threats to the investing public,” she said.
Turning to the SEC’s handling of the auction-rate security crash, Crawford faulted the commission for following state regulators by several weeks in reaching settlements with Wall Street firms that misled their clients about the safety and liquidity of the securities. Their slowness to respond reflects in part “regulatory capture,” in which the SEC staff is too close to the firms it was regulating, she said.
Douglas Holtz-Eakin, a Republican member of the commission, said the ARS collapse was “one of the really seminal moments” of the financial crisis, because of its “shocking” magnitude and duration. But, he asked, could regulators have done anything to prevent it from occurring?
Crawford did not directly answer the question, but said that a troubling trend that has not been widely discussed is the privatization of governmental functions like securities regulation. She pointed to the Financial Industry Regulatory Authority, a self-regulatory organization, for failing to supervise the firms under its oversight.
“FINRA is a private entity that is responsible for actually looking at broker-dealer operations,” she said. “However, for whatever reason, they failed to uncover these unsavory practices at all of the major Wall Street firms. Had they done better job, or if the SEC had assumed responsibility and accountability for looking at firms, perhaps they could have stemmed [the ARS collapse] early on.”