Tuesday, October 2, 2012

Why Bother With Financial Regulation?

Going into the 2008 financial meltdown, Sarbanes-Oxley was firmly in place, and a public company's CEO and CFO had to individually attest to the existence and effectiveness of a system of internal controls.  Consultants and internal auditors were busy helping management prepare "heat maps" that showed areas of weakness and areas of critical concern. 

Having been through the process myself as a CFO, my staff and I took everything very seriously. When I had to put my signature over my Section 404 attestation, I always took a deep breath thinking about the gravity of the attestation.  Implementation of Section 404 is filled with jargon and buzzwords, some of which have been transmogrified from ISO and TQM. 

Now, as we layer Dodd-Frank and other legislation over Sarbanes, we will add expense, management time, and information overload to the burden of public company shareholders.  Will their investments be any less risky?  Will their ability to analyze the riskiness of their investments be enhanced?  Can a public company shareholder have more confidence that the interests of the management are aligned with theirs?  I hardly think so.

Recently, former Fannie Mae CEO Franklin Raines won a major victory in Federal court when he was awarded summary judgment dismissing a case brought by institutional investors against Fannie Mae, three former executives and the company's the audit firm.  The leading paragraph of  the conclusion reads,
"Sustaining claims for securities fraud requires a showing of scienter-either an intent to deceive or an extreme departure from the standard of ordinary care-for each individual or entity claimed to have committed such fraud. Put simply, the securities fraud laws are not a means for shareholders to recover for all losses, no matter how sizable or sudden. Upon review of all plaintiffs' evidence, this Court concludes that plaintiffs have failed to put forth sufficient evidence from which a reasonable jury could find that Raines had such an intent. A failure to understand, or even negligent behavior,is not the equivalent of the necessary intent to deceive or conscious disregard of obvious risks. Therefore, Raines is entitled to summary judgment on all claims against him"
The Office of Thrift Supervision ("OTS"), one of the several Federal regulators overseeing Fannie Mae comes across as less than competent.  Evidently, Fannie Mae's Controller warned the CEO about some portfolio quality and accounting issues, but the plaintiffs didn't definitively prove that the memo was delivered and that it was definitive.  The Controller and the CFO could still be on the hook, as I understand.

The statement about the securities fraud laws not being a means for loss recovery is a fair statement which underlines the fact that Federal regulations do not, at the end of the day, provide any kind of "insurance" against loss. 

Today, the CEO of IndyMac bank was similarly exonerated in a separate decision. IndyMac, which we have written about at length, was minimally a bank with lax oversight and management, and according to the decision, nothing more. Again, for the public investor, "caveat emptor."  It is the third largest bank failure of the financial crisis era, so far. The OTS figures prominently in one of the very technical reasons for the court decision.  The long-running record of incompetence of this agency led to its being folded, not dissolved, into the OCC.  Federal agencies never go away--they are absorbed and morph into something else. 

The final, almost laughable irony about IndyMac is the sale of the distressed portfolio to a solitary bidding group led by Steve Mnuchin, formerly of Goldman Sachs.  His partners include John Paulson, George Soros and Chris Flowers.  The group has parlayed this portfolio, along with others, into a new, growing and financially stable California bank, OneWest.

Layering more and more regulation on the financial services industry is a waste of money.  The existing labyrinth, if everyone did their jobs, could be than adequate to perform its limited objectives.  No system can reduce risk, guarantee returns, and insure against losses. Our current system is broken, however. Particularly with the legal strategies pursued by the SEC and others, it absolves the main actors of any meaningful accountability and leaves taxpayers holding our moth-eaten bag--again.  

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