"We have to start taking accounting fraud seriously. It is a crime. It is a felony. It is the "weapon of choice" among financial control frauds."

Yves Smith:

"Obama's Financial Reform Proposals: Less Than Meets the Eye

Team Obama has started to preview some of its financial reform proposals. And if the New York Times has represented it accurately, it falls far short of what is called for.

Consider the opening sentence of the article:

The Obama administration plans to move quickly to tighten the nation’s financial regulatory system.

If all the Obama administration intends to do is tinker around( MY FEAR AS WELL ) the margins of our existing framework, the US will make perilous little headway in cleaning up the financial system. In the Great Depression, the Securities Act of 1933 and the Securities and Exchange Act of 1934 were bold, root and branch reforms that proved to be remarkably effective and lasting.

That isn't to say we have to start from a blank sheet of paper, but the powers that be need to be willing to question and probe our existing institutional arrangements more deeply than they seem willing to.

Let's go through some relevant sections of the Times' story:

Officials say they will make wide-ranging changes, including stricter federal rules for hedge funds, credit rating agencies and mortgage brokers, and greater oversight of the complex financial instruments that contributed to the economic crisis....

A theme of that report [by an international committee headed by Paul Volcker], that many major companies and financial instruments now mostly unsupervised must be swept back under a larger regulatory umbrella, has been embraced as a guiding principle by the administration, officials said.

Yves here. So far, motherhood and apple pie circa 2009, but look at the particulars:

Officials said they want rules to eliminate conflicts of interest at credit rating agencies ...The core problem, they said, is that the agencies are paid by companies to help them structure financial instruments, which the agencies then grade....

Yves here. Notice the problem has been defined narrowly: rating agency conflicts. No consideration of rating agency competence( I WOULD SAY THAT THE NATURE OF RATING IS WHAT NEEDS TO BE STUDIED.) (they were unduly dependent on issuer input for some structured products), or the depth of the conflicts (even if you change the pay arrangements, rating agencies have long been a revolving door, with the best staff going to Wall Street. Even in a brave new world of lower financial firm pay, that pattern will still persist. And staff will therefore still have an incentive not to be as tough as they might need to be.

Back to the article:

The administration is also preparing to require that derivatives like credit default swaps, a type of insurance against loan defaults that were at the center of the financial meltdown last year, be traded through a central clearinghouse and possibly on one or more exchanges. That would make it significantly easier for regulators to supervise their use.

We have long been in favor of getting as many OTC products as possible traded on exchanges. But thee is a second issue with credit default swaps. The size of the market is so large relative to the size of the underlying volume of bonds that it has produced significant distortions in the pricing of bonds in new issues (there was a period last summer when the correlation models were blowing up, and one of the side effects was that AAA issuers were suddenly facing insanely high spreads if they financed due to the arbitrage the cash and derivative markets (see here and here for more detail). Similarly, the financial press too often last summer took up financial firm CEO claims that evil stock short sellers were driving down the prices of their stocks, when in fact, CDS were a better vehicle and the cognisenti argued were a far more likely culprit( GOOD JOB YVES ).

The justification for financial "innovation" is that it lowers the cost of financing, improves liquidity, and produces other benefits to the real economy. But there are numerous examples of CDS creating distortions to the detriment of the real economy. Thatt suggests that some thought should be given as to whether and how measures might be put in place to reduce the size of the CDS market (personally, I think the justifications for its existence are weak, but I see no willingness in the Obama crowd to make bold moves in this arena).( I OF COURSE BLAME PEOPLE )

Another reason to rein in the CDS market is that the scale of the risks involved may be too large even for an exchange. As we noted last fall:

The most valuable element of moving CDS to an exchange, as far as lowering systemic risk is concerned, is centralized clearing, since if anyone defaults, the counterparty is the exchange, not an individual firm. Thus regulators have been moving forward as quickly as possible to set up a central clearinghouse. In particular, the CME Group proposed acting as a clearlinghouse, which means that its members would absorb the losses if any counterparty failed. Some rival proposals suggested setting up a new clearinghouse, which is a much sounder design, but would take longer to implement.

However, some savvy and influential and savvy CME members are now objecting to the idea, arguing that the additional risk of CDS clearing on top of their existing CME obligations is more than the members can realistically support. Moreover, they contend that putting together CDS and futures under the same umbrella is too much risk in one venue, and will increase, not reduce systemic risk.

The article recites a host of rather conventional ideas that have been bandied about that Team Obama has latched on to, such as requiring hedge funds to register with the SEC. Bernie Madoff was registered; the SEC skipped his normal inspection and ignored a detailed letter by one Harry Markopolos ("The World's Largest Hedge Fund is a Fraud") that concluded that the Madoff funds were most likely a Ponzi scheme. So exactly what is this going to accomplish? Eliot Spitzer in an article at The Big Money tells us that the SEC is not serious about enforcement:

The traditional critiques of the SEC have been that it was underfunded and didn't have up-to-date laws needed to regulate sophisticated financial transactions in evolving markets. That's not accurate. The SEC is a gargantuan bureaucracy of 3,500 employees and a budget of $900 million—vast compared with the offices that actually did ferret out fraud in the marketplace. And the general investigative powers of the SEC are so broad that it needs no additional statutory power to delve into virtually any market activity that it suspects is improper, fraudulent, or deceptive. After each business scandal (Enron, Wall Street analysts, Madoff …), the SEC claims a need for more money and statutory power, yet those don't help. The SEC has all the money and people and laws it needs. For ideological reasons, it just didn't want to do its job, and on the rare occasions when it did, it didn't know how.

Now in theory, with a new SEC chief, the SEC might get a bit more aggressive, but even in the Clinton era, reform minded Ted Levitt was reined in by Congress that threatened to SEC budgets if it made life too hard for Wall Street (and Democrat Joe Lieberman was the biggest perp). So aside from some cosmetic moves, I doubt much will change here.
Now let us return to the Times article, which illustrates that the underlying problem:

Officials said that the proposals were aimed at the core regulatory problems and gaps that have been highlighted by the market crisis. They include lax government oversight of financial institutions and lenders, poor risk management efforts by banks and other financial companies, the creation of exotic financial instruments that were not adequately supported by their issuing companies, and risky and ill-considered borrowing habits of many homeowners whose homes are now worth significantly less than their mortgages.

In other words, this is a symptom oriented, patchwork approach( TRUE ). And it misses some of the underlying drivers: the opaqueness and complexity of many of the new instruments, texcessive leverage (oh wait, the powers that be think excessive leverage is the solution) and widespread accounting fraud.( TRUE. BUT, IN REALITY, ONLY SUPERVISION AIMED AT COMPREHENDING THESE INNOVATIONS WILL WORK. )

For instance, how could Lehman have collapsed with what turned out to be a hole in its balance sheet of in excess of $100 billion when its financial statements gave no clue of problems of that size? And as we noted at the time, its executives were claiming, forcefully, that everything was OK, the converse of what was actually the case (see here, here and here for examples).( THIS IS FRAUD )

Or consider the views of William Black (a bank regulator during the S&L crisis who went after Lincoln Savings, owned by the powerful Charles Keating. Black's efforts were thwarted but he was eventually vindicated) on Merrill:

Thain portrayed himself as a hero of capitalism and the embodiment of a successful CEO deserving of millions of dollars in bonus compensation because he "sold" Merrill to B of A -- minimizing the losses of Merrill's shareholders. There was, of course, criticism of the scale of these bonuses, but no fundamental rejection of his claim to be a hero.

The lack of rejection illustrates why we are in crisis. We need to be blunt. Thain transferred a loss that risk capital is supposed to bear to the taxpayers of the United States (not B of A). He was able to transfer that loss to the taxpayers because Merrill, under his leadership, engaged in monumental accounting fraud (which means it also engaged in securties fraud)( I AGREE ). We have to start taking accounting fraud seriously. It is a crime. It is a felony. It is the "weapon of choice" among financial control frauds. It causes staggering direct losses and indirectly, by eviscerating trust, it causes entire markets to shut down. This should not surprise economists. We make things crimes in large part because they produce material negative externalities. ( THIS IS MY POSITION )

So, Thain "was part of the problem." The fact that he could (A) lead such a massive fraud and (B) think that he should be rewarded with many billions of dollars for defrauding the citizens of the United States shows two key reasons why the crises keep getting worse( SPOT ON. ). Our most elite business leaders now embody traits we used to understand were loathsome. The fact that this is not obvious even to skilled, sceptical financial reporters shows how serious a problem we face.( I COULDN'T AGREE MORE )

Until we start talking addressing the root causes, these financial "reforms" will prove as effective as trying to treat gangrene with antibiotics. "( I AGREE )