Wall Street and the Financial Crisis: Anatomy of a Financial Collapse


E. Market Oversight

U.S. financial regulators failed to stop financial firms from engaging in high risk, conflict-ridden activities. Those regulatory failures arose, in part, from the fragmented nature of U.S. financial oversight as well as statutory barriers to regulating high risk financial products.

Oversight of Lenders. At the end of 2005, the United States had about 8,800 federally insured banks and thrifts, |73| plus about 8,700 federally insured credit unions, many of which were in the business of issuing home loans. |74| On the federal level, these financial institutions were overseen by five agencies: the Federal Reserve which oversaw state-chartered banks that were part of the federal reserve system as well as foreign banks and others; the Office of the Comptroller of the Currency (OCC) which oversaw banks with national charters; the Office of Thrift Supervision (OTS) which oversaw federally-chartered thrifts; the National Credit Union Administration which oversaw federal credit unions; and the Federal Deposit Insurance Corporation (FDIC) which oversaw financial institutions that have federal deposit insurance (hereinafter referred to as "federal bank regulators"). |75| In addition, state banking regulators oversaw the state-chartered institutions and at times took action to require federally-chartered financial institutions to comply with certain state laws.

The primary responsibility of the federal bank regulators was to ensure the safety and soundness of the financial institutions they oversaw. One key mechanism they used to carry out that responsibility was to conduct examinations on a periodic basis of the financial institutions within their jurisdiction and provide the results in an annual Report of Examination ("ROE") given to the Board of Directors at each entity. The largest U.S. financial institutions typically operated under a "continuous exam" program, which required federal bank examiners to conduct a series of specialized examinations during the year with the results from all of those examinations included in the annual ROE.

Federal examination activities were typically led by an Examiner in Charge and were organized around a rating system called CAMELS that was used by all federal bank regulators. The CAMELS rating system evaluated a financial institution's: (C) capital adequacy, (A) asset quality, (M) management, (E) earnings, (L) liquidity, and (S) sensitivity to market risk. CAMELS ratings are on a scale of 1 to 5, in which 1 signifies a safe and secure bank with no cause for supervisory concern, 3 signifies an institution with supervisory concerns in one or more areas, and 5 signifies an unsafe and unsound bank with severe supervisory concerns. In the annual ROE, regulators typically provided a financial institution with a rating for each CAMELS component, as well as an overall composite rating on its safety and soundness.

In addition, the FDIC conducted its own examinations of financial institutions with federal deposit insurance. The FDIC reviews relied heavily on the examination findings and ROEs developed by the primary regulator of the financial institution, but the FDIC assigned its own CAMELS ratings to each institution. In addition, for institutions with assets of $10 billion or more, the FDIC established a Large Insured Depository Institutions ("LIDI") Program to assess and report on emerging risks that may pose a threat to the federal Deposit Insurance Fund. Under this program, the FDIC performed an ongoing analysis of emerging risks within each insured institution and assigned a quarterly risk rating, using a scale of A to E, with A being the best rating and E the worst.

If a regulator became concerned about the safety or soundness of a financial institution, it had a wide range of informal and formal enforcement actions that could be used to require operational changes. Informal actions included requiring the financial institution to issue a safety and soundness plan, memorandum of understanding, Board resolution, or commitment letter pledging to take specific corrective actions by a certain date, or issuing a supervisory letter to the financial institution listing specific "matters requiring attention." These informal enforcement actions are generally not made public and are not enforceable in court. Formal enforcement actions included a regulator's issuing a public memorandum of understanding, consent order, or cease and desist order requiring the financial institution to stop an unsafe practice or take an affirmative action to correct identified problems; imposing a civil monetary penalty; suspending or removing personnel from the financial institution; or referring misconduct for criminal prosecution.

A wide range of large and small banks and thrifts were active in the mortgage market. Banks like Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo originated, purchased, and securitized billions of dollars in home loans each year. Thrifts, whose charters typically required them to hold 65% of their assets in mortgage related assets, also originated, purchased, sold, and securitized billions of dollars in home loans, including such major lenders as Countrywide Financial Corporation, IndyMac Bank, and Washington Mutual Bank. Some of these banks and thrifts also had affiliates, such as Long Beach Mortgage Corporation, which specialized in issuing subprime mortgages. Still more lenders operated outside of the regulated banking system, including New Century Financial Corporation and Fremont Loan & Investment, which used such corporate vehicles as industrial loan companies, real estate investment trusts, or publicly traded corporations to carry out their businesses. In addition, the mortgage market was populated with tens of thousands of mortgage brokers that were paid fees for their loans or for bringing qualified borrowers to a lender to execute a home loan. |76|

Oversight of Securities Firms. Another group of financial institutions active in the mortgage market were securities firms, including investment banks, broker-dealers, and investment advisors. These security firms did not originate home loans, but typically helped design, underwrite, market, or trade securities linked to residential mortgages, including the RMBS and CDO securities that were at the heart of the financial crisis. Key firms included Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and the asset management arms of large banks, including Citigroup, Deutsche Bank, and JPMorgan Chase. Some of these firms also had affiliates which specialized in securitizing subprime mortgages.

Securities firms were overseen on the federal level by the Securities and Exchange Commission (SEC) whose mission is to "protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation." |77| The SEC oversees the "key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds," primarily for the purpose of "promoting the disclosure of important market related information, maintaining fair dealing, and protecting against fraud." |78|

The securities firms central to the financial crisis were subject to a variety of SEC regulations in their roles as broker-dealers, investment advisors, market makers, underwriters, and placement agents. Most were also subject to oversight by state securities regulators. |79| The securities firms were required to submit a variety of public filings with the SEC about their operations and in connection with the issuance of new securities. The SEC's Office of Compliance Inspections and Examinations (OCIE) conducted inspections of broker-dealers, among others, to understand industry practices, encourage compliance, evaluate risk management, and detect violations of the securities laws. In addition, under the voluntary Consolidated Supervised Entities program, the SEC's Division of Trading and Markets monitored the investment activities of the largest broker-dealers, including Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, Citigroup, and JP Morgan Chase, evaluating their capital levels, use of leverage, and risk management. |80|

Like bank regulators, if the SEC became concerned about a particular securities firm, it could choose from a range of informal and formal enforcement actions. Informal actions could include issuing a "deficiency letter" identifying problems and requiring the securities firm to take corrective action by a certain date. Formal enforcement actions, undertaken by the SEC's Division of Enforcement, could include civil proceedings before an administrative law judge; a civil complaint filed in federal district court; civil fines; an order to suspend or remove personnel from a firm or bar them from the brokerage industry; or a referral for criminal prosecution. Common securities violations included selling unregistered securities, misrepresenting information about a security, unfair dealing, price manipulation, and insider trading. |81|

Statutory and Regulatory Barriers. Federal and state financial regulators responsible for oversight of banks, securities firms, and other financial institutions in the years leading to the financial crisis operated under a number of statutory and regulatory constraints.

One key constraint was the sweeping statutory prohibition on the federal regulation of any type of swap, including credit default swaps. This prohibition took effect in 2000, with enactment of the Commodity Futures Modernization Act (CFMA). |82| The key statutory section explicitly prohibited federal regulators from requiring the registration of swaps as securities; issuing or enforcing any regulations or orders related to swaps; or imposing any recordkeeping requirements for swaps. |83| In addition, the law explicitly prohibited regulation of any "‘interest rate swap,' including a rate floor, rate cap, rate collar, cross-currency rate swap, basis swap, currency swap, equity index swap, equity swap, debt index swap, debt swap, credit spread, credit default swap, credit swap, weather swap, or commodity swap." |84| These prohibitions meant that federal regulators could not even ask U.S. financial institutions to report on their swaps trades or holdings, much less regulate swap dealers or examine how swaps were affecting the mortgage market or other U.S. financial markets.

As a result, the multi-trillion-dollar U.S. swaps markets operated with virtually no disclosure requirements, no restrictions, and no oversight by any federal agency, including the market for credit default swaps which played a prominent role in the financial crisis. On September 23, 2008, in a hearing before the Senate Committee on Banking, Housing, and Urban Affairs, then SEC Chairman Christopher Cox testified that, as a result of the statutory prohibition, the credit default swap market "is completely lacking in transparency," "is regulated by no one," and "is ripe for fraud and manipulation." |85| In a September 26, 2008 press release, he discussed regulatory gaps impeding his agency and again raised the issue of swaps: "Unfortunately, as I reported to Congress this week, a massive hole remains: the approximately $60 trillion credit default swap market, which is regulated by no agency of government. Neither the SEC nor any regulator has authority even to require minimum disclosure." |86| In 2010, the Dodd-Frank Act removed the CFMA prohibition on regulating swaps. |87|

A second significant obstacle for financial regulators was the patchwork of federal and state laws and regulations applicable to high risk mortgages and mortgage brokers. Federal bank regulators took until October 2006, to provide guidance to federal banks on acceptable lending practices related to high risk home loans. |88| Even then, the regulators issued voluntary guidance whose standards were not enforceable in court and failed to address such key issues as the acceptability of stated income loans. |89| In addition, while Congress had authorized the Federal Reserve, in 1994, to issue regulations to prohibit deceptive or abusive mortgage practices – regulations that could have applied across the board to all types of lenders and mortgage brokers – the Federal Reserve failed to issue any until July 2008, after the financial crisis had already hit. |90|

A third problem, exclusive to state regulators, was a 2005 regulation issued by the OCC to prohibit states from enforcing state consumer protection laws against national banks. |91| After the New York State Attorney General issued subpoenas to several national banks to enforce New York's fair lending laws, a legal battle ensued. In 2009, the Supreme Court invalidated the OCC regulation, and held that states were allowed to enforce state consumer protection laws against national banks. |92| During the intervening four years, however, state regulators had been effectively unable to enforce state laws prohibiting abusive mortgage practices against federallychartered banks and thrifts.

Systemic Risk. While bank and securities regulators focused on the safety and soundness of individual financial institutions, no regulator was charged with identifying, preventing, or managing risks that threatened the safety and soundness of the overall U.S. financial system. In the area of high risk mortgage lending, for example, bank regulators allowed banks to issue high risk mortgages as long as it was profitable and the banks quickly sold the high risk loans to get them off their books. Securities regulators allowed investment banks to underwrite, buy, and sell mortgage backed securities relying on high risk mortgages, as long as the securities received high ratings from the credit rating agencies and so were deemed "safe" investments. No regulatory agency focused on what would happen when poor quality mortgages were allowed to saturate U.S. financial markets and contaminate RMBS and CDO securities with high risk loans. In addition, none of the regulators focused on the impact derivatives like credit default swaps might have in exacerbating risk exposures, since they were barred by federal law from regulating or even gathering data about these financial instruments.


73. See FDIC Quarterly Banking Profile, 1 (Fourth Quarter 2005) (showing that, as of 12/31/2005, the United States had 8,832 federal and state chartered insured banks and thrifts). [Back]

74. See 1/3/2011 chart, "Insurance Fund Ten-Year Trends," supplied by the National Credit Union Administration (showing that, as of 12/31/2005, the United States had 8,695 federal and state credit unions). [Back]

75. The Dodd-Frank Act has since abolished one of these agencies, the Office of Thrift Supervision, and assigned its duties to the OCC. See Chapter IV. [Back]

76. 1/2009 "Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System," prepared by the Government Accountability Office, Report No. GAO-09-216, at 26-27. [Back]

77. See SEC website, "About the SEC: What We Do," www.sec.gov. [Back]

78. Id. [Back]

79. Some firms active in the U.S. securities and mortgage markets, such as hedge funds, operated without meaningful federal oversight by taking advantage of exemptions in the Investment Company Act of 1940. [Back]

80. See 9/2008 "SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program," report prepared by Office of the SEC Inspector General, Report No. 446-A. [Back]

81. See SEC website, "About the SEC: What We Do," www.sec.gov. [Back]

82. CFMA was included as a title of H.R. 4577, the Consolidated Appropriations Act of 2001, P.L.106-554. [Back]

83. CFMA, § 302, creating a new section 2A of the Securities Act of 1933. [Back]

84. CFMA, § 301, creating a new section 206A of the Gramm-Leach-Bliley Act. [Back]

85. Statement of SEC Chairman Christopher Cox, "Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions," before the U.S. Senate Committee on Banking, Housing and Urban Affairs, S.Hrg. 110-1012 (9/23/2008). [Back]

86. 9/26/2008 SEC press release, "Chairman Cox Announces End of Consolidated Supervised Entities Program," http://www.sec.gov/news/press/2008/2008-230.htm. [Back]

87. Title VII of the Dodd-Frank Act. [Back]

88. 10/4/2006 "Interagency Guidance on Nontraditional Mortgage Product Risks," (NTM Guidance), 71 Fed. Reg. 192 at 58609. [Back]

89. For more information, see Chapter IV. [Back]

90. Congress authorized the Federal Reserve to issue the regulations in Section 151 of the Home Ownership and Equity Protection Act of 1994 (HOEPA), P.L. 103-325. The Federal Reserve did not issue any regulations under HOEPA, however, until July 2008, when it amended Regulation Z. The new rules primarily strengthened consumer protections for "higher priced loans," which included many types of subprime loans. See "New Regulation Z Rules Enhance Protections for Mortgage Borrowers," Consumer Compliance Outlook (Fourth Quarter 2008) (Among other requirements, the rules prohibited lenders "from making loans based on collateral without regard to [the borrower's] repayment ability," required lenders to "verify income and obligations," and imposed "more stringent restrictions on prepayment penalties." The rules also required lenders to "establish escrow accounts for taxes and mortgage related insurance for first-lien loans." In addition, the rules "prohibit[ed] coercion of appraisers, define[d] inappropriate practices for loan servicers, and require[d] early truth in lending disclosures for most mortgages."). [Back]

91. 12 CFR § 7.4000. [Back]

92. Cuomo v. Clearing House Association, Case No. 08-453, 129 S.Ct. 2710 (2009). [Back]

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D. Investment Banks F. Government Sponsored Enterprises

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