The Project On Government Oversight (POGO) Blog

Brokerages Demand Greater Transparency from Self-Regulatory Organization

You don’t often hear about regulated entities calling on a regulator to be more open and transparent about its oversight activities. Yet that’s exactly what happened last week at the 2010 annual meeting of the Financial Industry Regulatory Authority (FINRA), a private self-regulatory organization that oversees more than 4,500 broker-dealers operating in the U.S.

Earlier this year, POGO sent a letter to Congress calling for greater oversight of FINRA and other self-regulatory organizations (SROs). We raised concerns about FINRA’s weak enforcement record leading up to the financial crisis, its failure to crack down on the Madoff and Stanford Ponzi schemes, the lack of disclosure on its private investments, its lavish executive compensation packages, its incestuous relationship with the securities industry it oversees, and more.

After we sent our letter, we heard from the heads of many firms that are regulated by FINRA. Nearly everyone was outraged by the compensation packages approved for FINRA’s executives (in 2008, a year in which the financial system nearly collapsed and FINRA lost $568 million in its investment portfolio, FINRA’s top 20 executives received nearly $30 million in salaries and bonuses). We also learned that a number of FINRA’s member firms had filed a lawsuit alleging that current and former FINRA executives—including SEC Chairman Mary Schapiro—made highly misleading statements about the regulatory merger that led to FINRA’s creation in 2007.

U.S. District Judge Jed Rakoff recently decided to dismiss the lawsuit against Schapiro and other officials. But that hasn’t stopped FINRA’s member firms from pushing for more transparency and accountability.

Lt. Col. Elton Johnson, Jr. is the president of Amerivet Securities, a small California-based brokerage firm that is regulated by FINRA. In anticipation of FINRA’s annual meeting, Johnson submitted seven proposals for opening up FINRA’s records and holding the organization accountable:

Morning Smoke: FINRA Under Pressure to Increase Transparency

FINRA faces calls to lift veil on finances, pay by Joseph Giannone [Reuters]

Do Feds Make Twice What Private Sector Workers Do? by Tom Shoop [FedBlog]

Implementation of Financial Overhaul Gets Off to Rocky Start by Michael Crittenden [The Wall Street Journal]

DOE revives secretarial advisory board by Frank Munger [Atomic City Underground]

Geithner takes first step in new consumer agency's creation by Stephen Losey [Federal Times]

Performance pay for most DoD intel employees to end in fiscal 2011 by Stephen Losey [Federal Times]

Republican Seeks Hearing on Fannie Mae Whistleblower by Claritza Jiménez [Center for Public Integrity]

Freedom of Information Act exemption for SEC stirs protests by Daniel Strauss [Politico]

House Committee Schedules Hearing on Michigan Oil Spill by Andrew Restuccia [The Washington Independent]

Questions for SEC Chairman Mary Schapiro as She Testifies Before the House

SEC Chairman Mary Schapiro is currently testifying before the House Financial Services Committee. We applaud the Committee for providing some much-needed oversight of the “present reforms and future challenges” facing the SEC.

Here are just a few questions we’d like to see the Committee ask Chairman Schapiro:

• Are you aware of the serious allegations of whistleblower retaliation at the SEC’s Ft. Worth office, as recently confirmed by the Inspector General? What steps has the agency taken to hold the Ft. Worth officials accountable for retaliating against their own employees, one of whom played an instrumental role in uncovering the Stanford Ponzi scheme?


• Given your experience as the former head of FINRA in the period leading up to the financial crisis, do you still believe that self-regulation is an appropriate model for overseeing the brokerage industry? Why, in your view, did FINRA fail to adequately regulate many of its larger firms that were at the heart of the financial crisis, including Bear Stearns, Lehman Brothers, and Merrill Lynch, and why did FINRA fail to detect the Madoff and Ponzi schemes? How do you justify the outrageous compensation paid to FINRA executives in 2008, a year in which the economy nearly collapsed and FINRA lost $568 million its own investment portfolio?


• What steps is the SEC taking in response to the recent report by the House Oversight Committee minority staff, which detailed several systemic problems that are hindering the SEC’s effectiveness, including outdated disclosure technology, a lack of collaboration between offices, and a lack of management and finance experts?


• Have you made any progress in acting on the hundreds of unimplemented recommendations from the SEC Inspector General? Why does the SEC routinely ignore the IG’s recommendations for disciplinary action in cases of serious misconduct?


• Do you believe that the revolving door has undermined any SEC investigations? Would you consider making your agency’s revolving door statements available to the public as a check against future revolving door abuses?


• How are you planning to allocate resources and staff time to handle the many responsibilities that have been tasked to the SEC in the Dodd-Frank Wall Street reform legislation, such as increased oversight of hedge funds and an expanded authority to oversee securities-based swaps—not to mention the countless studies buried in the bill?


• What specific steps has the SEC taken to improve its FOIA procedures in response to the IG’s finding that the SEC has one of the worst FOIA response rates in the government?


• Why has the SEC only awarded five whistleblower reward payments in the past two decades? What is the agency doing to prepare for its soon-to-be-enhanced authority to make reward payments to whistleblowers who provide the agency with tips, and how is the agency improving its procedures for protecting whistleblowers against retaliation?

 

Check out POGO’s Twitter feed for live updates from the hearing.

--Michael Smallberg

Can Regulators Be Trusted to Crack Down on Derivatives Abuses?

Earlier this week, the Chairs of the Senate Agriculture and Banking Committees reached an agreement on a proposal that could bring sweeping changes to the regulation of over-the-counter (OTC) derivatives. The Democratic leadership announced it will incorporate the joint proposal, which was negotiated by Senators Blanche Lincoln (D-AR) and Christopher Dodd (D-CT), into a substitute amendment for the main bill, which is set to be introduced on the Senate floor any second now. (POGO has obtained a copy of the substitute amendment, which can be viewed here; the section on derivatives begins on page 501).

But even before it’s officially introduced, the Lincoln-Dodd bill has already encountered some stiff opposition.

The controversy surrounding derivatives reform

Departing FINRA Executive to Join Other Former Enforcement Officials at Bingham McCutchen

The Wall Street Journal reports this morning that Susan Merrill, who announced last month that she is stepping down as head of enforcement at the Financial Industry Regulatory Authority (FINRA), has decided to join the New York office of Bingham McCutchen, where she will “lead Bingham's enforcement practice and advise clients on regulatory and securities enforcement matters.”

As we wrote last month, Merrill is leaving FINRA following a period in which the organization took a decidedly light approach to regulating the securities brokerage industry. In addition to missing the Madoff and Stanford Ponzi schemes, FINRA has also come under criticism in recent years for its overall decline in enforcement stats, for coming down heavily on its smaller member firms while ignoring the larger broker-dealers whose excessive risk-taking helped to fuel the financial meltdown, and for liquidating its $647 million portfolio in auction-rate securities without informing the investing public, among other things.

In our letter to Congress calling for increased oversight of FINRA and other self-regulatory organizations (SROs), we highlighted Merrill’s previous position at Davis Polk—where she represented broker-dealers, investment advisers, and other firms before the SEC and various self-regulators—to illustrate how FINRA is overly cozy with the industry it is tasked with regulating. The AmLaw Daily reports that Merrill was seriously considering an offer to return to Davis Polk before settling on Bingham.

The AmLaw Daily also points out that Merrill will be joining other former regulatory and enforcement officials at her new gig, including former SEC Chairman Christopher Cox, and former SEC enforcement official Herbert Janick, III, who, according to Merrill, played an influential role in convincing her to join the firm.

We would highlight Merrill’s move to Bingham as another example of the revolving door between government regulators and the financial services industry, but that might suggest that Merrill actually entered the government to begin with. While SROs such as FINRA have the authority to act like government regulators—and to enjoy absolute immunity from private damages suits—FINRA is technically a private entity, which explains how Merrill was able to make a tidy $1.4 million working for the organization in 2008.

No word yet on who will be replacing Merrill as the head of enforcement at FINRA, but as we wrote in our letter to Congress, POGO questions whether FINRA can ever be an effective regulator given its incestuous relationship with the securities industry.

-- Michael Smallberg

FINRA's Enforcement Chief to Step Down

The Wall Street Journal reports this morning that Susan Merrill, head of enforcement at the Financial Industry Regulatory Authority (FINRA), will be stepping down from her post, following a period in which FINRA’s lax enforcement of its large member broker-dealers and its failure to catch the Madoff and Stanford Ponzi schemes have raised serious questions about the organization’s regulatory effectiveness.

The Journal doesn’t hide the fact that Merrill’s enforcement track record was less than stellar, noting that “her division has brought fewer cases than its predecessors did,” and that “her departure leaves Finra looking for an enforcement chief who can bolster its reputation and bring more cases.”

Although there was a slight increase in FINRA’s enforcement stats in 2009 in terms of new disciplinary actions filed, firms expelled, fines levied, etc., the organization’s overall stats underwent significant declines under Merrill’s leadership. It was also during this time that FINRA failed to detect the high-profile Madoff and Stanford Ponzi schemes (Madoff’s broker-dealer operation was “by definition within...FINRA’s jurisdiction,” according to securities law scholar John Coffee). And as the Journal points out, in the run-up to the financial meltdown of 2008, FINRA tended to focus on filing cases against its smaller members, rather than supervising the larger brokerage firms whose excessive risk-taking helped to fuel the crisis.

FINRA’s 990 form shows that Merrill pocketed $1.4 million in 2008, a year in which the organization’s top 20 executives were paid nearly $30 million.

In an attempt to describe Merrill’s positive achievements, the Journal notes that she “helped to successfully merge the enforcement departments of the NASD [National Association of Securities Dealers] and NYSE [the regulatory arm of the New York Stock Exchange].” What the article doesn’t mention is that this “successful” merger, which led to FINRA’s creation in 2007, has come under much critical scrutiny, as several former NASD members filed a lawsuit alleging that the organization’s leadership—including current SEC Chairman Mary Schapiro—lied to members about the merger in order to secure their vote. Unfortunately, U.S. District Judge Jed Rakoff recently decided to dismiss the suit, arguing that self-regulatory organizations (SROs) such as FINRA are protected by absolute immunity.

The article also notes that Merrill brought several auction rate securities (ARS) cases against Wall Street firms during her tenure. But as Larry Doyle at Sense on Cents points out, this is a complete joke. Not only is the $4 million fine cited in the article a drop in the ocean compared to the $150 billion in frozen ARS investments, but FINRA also liquidated its own $647 million ARS investment in 2007 as the market was starting to collapse, without giving any warning to investors. But since FINRA is allowed to operate with almost zero transparency, the public still doesn’t have the full story about what Merrill and other executives knew about the collapse of the ARS market, among many other things.

In our letter to Congress last month calling for a critical examination of FINRA and other SROs, we highlighted Merrill’s previous employment at Davis Polk—a top law firm representing some of the largest financial firms in the world—as an example of how FINRA appears to be overly cozy with the industry it is supposed to be regulating.

Now that she’s leaving FINRA, there are certainly no rules prohibiting her from returning to Davis Polk or any other private sector firm. In fact, she would be in good company. Davis Polk’s website boasts that many of its “current and former lawyers have held prominent positions with the relevant law enforcement agencies and financial regulators, including the SEC, DOJ, Treasury, FDIC, OFAC and CFTC.” This list includes Linda Chatman Thomsen, who herself was the former Director of Enforcement at the SEC. (Last year, Thomsen was investigated by the SEC Office of Inspector General (OIG) for “improperly disclos[ing] non-public information to a senior executive of a large investment bank who was a former SEC Senior Official.” That “senior executive” was another former Director of Enforcement, Stephen Cutler, who left the SEC and ended up as General Counsel of JPMorgan, during which time he contacted Thomsen to seek assurances that his new employer would not be sued in the course of acquiring Bear Stearns, according to the OIG.) And another former head of NASD enforcement, Barry Goldsmith, is now a partner at Gibson Dunn, which also represents some of the world’s largest financial firms. Notice a trend here?

As the Senate debates overhauling the financial regulatory system, we hope they will take Merrill’s departure as an opportunity to scrutinize FINRA’s record, and to question whether self-regulators can really be trusted to protect the investing public.

-- Michael Smallberg

Photo: http://www.flickr.com/photos/lobstar/ / CC BY-NC-ND 2.0

Judge's Ruling Helps FINRA Keep Its Records Behind Closed Doors

As described in our latest podcast, POGO sent a letter to Congress last week calling for increased oversight of the Financial Industry Regulatory Authority (FINRA), a self-regulatory organization (SRO) that oversees thousands of securities broker-dealers, and is supposed to be looking out for the interests of the investing public. In our letter, we raised numerous concerns about FINRA’s cozy relationship with the industry it is tasked with regulating, its failure to protect investors from the Madoff Ponzi scheme, its outrageous executive compensation packages, and its lack of transparency, among other things.

One thing we didn’t mention is that current and former FINRA executives—including current SEC Chairman Mary Schapiro—have also been accused of making misleading statements regarding the merger that created the organization. FINRA was formed in 2007 through a consolidation of the National Association of Securities Dealers (NASD) and the regulatory arm of the New York Stock Exchange (NYSE). NASD members were supposed to receive a payment made possible by the cost savings resulting from the merger. But several former NASD members filed a lawsuit alleging that Schapiro and other executives misled members in order to secure their vote, telling them that the IRS had limited the payment amount to $35,000 per firm, when in fact the IRS didn’t issue its final determination until two months after the NASD members voted in favor of the merger. Meanwhile, the merger resulted in Schaprio getting a 57 percent pay raise.

Over the past few years, a number of journalists and news organizations have written to Judge Jed Rakoff, U.S. District Judge for the Southern District of New York, asking him to unseal materials that could potentially shed some light on the suspicious circumstances surrounding FINRA’s creation. Unfortunately, Judge Rakoff decided earlier this week to dismiss the lawsuit, ruling that “SROs and their officers are absolutely immune from private damages suits challenging official conduct performed within the scope of their regulatory functions.” A copy of Judge Rakoff’s ruling is available here.

 The plaintiffs are considering an appeal, but in the meantime, Judge Rakoff’s ruling highlights yet another problem with FINRA—as a commenter at Sense on Cents points out, it’s “interesting that FINRA has the benefit of a quasi governmental entity, i.e. immunity, but not the customary burden of a governmental entity—transparency.” This lack of transparency only adds to the perception that FINRA is more concerned with shielding the large broker-dealers and paying out lavish salaries to its executives than it is with protecting the investing public.

In the past week or two, we’ve received dozens of calls, emails, and faxes in response to our FINRA letter. Some said that we didn’t go far enough in criticizing FINRA’s shortcomings, and that we should be looking into other issues such as FINRA’s forced arbitration process, which generates handsome fees for the organization but often requires member firms to spend precious resources defending themselves against frivolous allegations. Others said that we unfairly criticized FINRA’s failure to regulate some of its larger member firms whose speculative investments fueled the financial crisis, since much of that activity took place outside of FINRA’s official jurisdiction. Some reminded us that the SEC’s track record of regulating the broker-dealers is hardly any better than FINRA’s, and that investors ultimately benefit from having more cops on the beat. Others argued that FINRA does nothing but give investors a false sense of security. And a number of commenters remarked that while there are inherent problems with the self-regulatory model, the perennial lack of funding at the SEC has resulted in an agency that is perpetually overworked and understaffed, and that the SRO model is a flawed but necessary solution.

If any blog readers have other suggestions or tips for our investigation into FINRA, please feel free to leave us a comment below.

-- Michael Smallberg

Photo: http://www.flickr.com/photos/photobunny_earl/ / CC BY-NC-ND 2.0

New Podcast: Examining FINRA and Other Self-Regulatory Organizations in the Financial Sector

POGO has posted a new podcast, in which Michael breaks down in plain English the problems we found with the Financial Industry Regulatory Authority (FINRA) and other self-regulatory organizations (SROs) in the financial sector.

Get on the POGO podcast trolley!

• Download / listen to the latest podcast.
• Subscribe to our podcast RSS feed.
• Subscribe to our podcasts via iTunes.
• POGO Podcast home page.

Image: http://www.flickr.com/photos/bigbadvoo/ / CC BY 2.0

See also:

• POGO Calls on Congress to Investigate Ineffective Financial Self-Regulators
• Judge's Ruling Helps FINRA Keep Its Records Behind Closed Doors
• FINRA's Enforcement Chief to Step Down

POGO Calls on Congress to Investigate Ineffective Financial Self-Regulators

There was plenty of blame to go around in the aftermath of the financial crisis, as evidenced by a series of well-publicized congressional hearings that examined the wrongdoings of investment bankers, credit rating agency executives, and Federal Reserve officials, among other culprits. But what about the Financial Industry Regulatory Authority (FINRA) and other self-regulatory organizations (SROs) that were supposed to be the front-line regulators and enforcers of the financial services industry? 

POGO believes that the failure of these self-regulators played a big role in the government’s inability to prevent the economic meltdown. That’s why we sent a letter to Congress today calling for increased oversight of SROs, and questioning whether an organization like FINRA can ever be trusted to protect the investing public given its incestuous ties to the industry it is tasked with regulating.

History of SROs and FINRA 

Most Americans probably haven’t heard of FINRA or SROs, but the concept of self-regulation is deeply embedded in our financial regulatory framework. Congress first recognized SROs in legislation passed in the wake of the stock market crash of 1929, when it became clear that stock exchanges and over-the-counter (OTC) securities dealers were failing to regulate widespread market manipulation. A 2004 Securities and Exchange Commission (SEC) concept release explained the reasoning behind Congress’s decision to formally recognize self-regulators as overseers of the securities industry:

In enacting these provisions, Congress concluded that self-regulation of both the exchange markets and the OTC market was a mutually beneficial balance between government and securities industry interests. Through establishment of self-regulation, the securities industry was supervised by an organization familiar with the nuances of securities industry operations. In addition, industry participants preferred the less invasive regulation by their peers to direct government regulation and the government benefited by being able to leverage its resources through its oversight of self-regulatory organizations.

Fast forward to 2007, when the SEC approved the creation of FINRA by combining two other self-regulatory entities: the National Association of Securities Dealers (NASD) and the regulation, enforcement, and arbitration functions of the New York Stock Exchange (NYSE). In its proposed rule change, NASD argued that “consolidation will...serve to enhance oversight of U.S. securities firms and help ensure investor protection,” and that the “investor ultimately would be better protected by a single, more efficient regulator.” 

Today, FINRA continues to highlight its commitment to “putting investors first,” and over the past year, the organization has been promoting itself through advertisements in The Washington Post, commercials on CNN, and “public interest” spots on National Public Radio. In fact, FINRA thinks it should be given the authority to regulate not just securities brokers, but investment advisers as well. In an attempt to justify this expanded authority, FINRA Chairman and CEO Richard Ketchum told Congress that FINRA has a “strong track record in our examination and enforcement oversight.” 

In our letter today, we argue that FINRA’s track record actually tells a very different story, one that is typical of financial self-regulators that have a cozy relationship with the industry they are supposed to be regulating. POGO believes that SROs, despite the power vested in them by the federal government, have effectively been asleep at the wheel during all of the major securities scandals dating back to the 1980s. 

Regulatory and Enforcement Failures 

FINRA’s recent failures are detailed in Amerivet Securities, Incorporated v. FINRA, a case that is currently pending before the D.C. Superior Court in which Amerivet, a California-based broker-dealer, is seeking to access some of FINRA’s books and records. As Amerivet’s complaint points out, FINRA failed to regulate many of the larger firms that were at the heart of the financial crisis, including Bear Stearns, Lehman Brothers, and Merrill Lynch. Even an internal review conducted by FINRA itself found that the organization missed several key opportunities to investigate the securities fraud by R. Allen Stanford. And while FINRA officials have denied any wrongdoing in the failure to detect Bernard Madoff’s Ponzi scheme, securities law scholar John Coffee testified before Congress that “Madoff’s brokerage business was by definition within...FINRA’s jurisdiction.” A recent investigation by The Wall Street Journal confirmed that FINRA and its predecessor NASD, under the leadership of current SEC Chairman Mary Schapiro, had a decidedly light touch when it came to regulation and enforcement, with significant declines in disciplinary fines assessed, individuals barred, and firms expelled during her time at the organization. 

It appears that FINRA also failed to warn the investing public about the risks associated with investing in auction rate securities (ARS). Many investors thought these were safe, cash-like investments that paid a higher yield than money market mutual funds or certificates of deposit. But in February 2008, the auctions for these securities failed, leaving investors stuck with tens of billions of dollars that are now frozen in the ARS market. Of course, FINRA neglected to inform investors when it liquidated its own $647 million ARS investment in 2007. In fact, NASD (FINRA's predecessor) knew well before then that ARS shouldn’t be treated like cash or cash equivalents, explaining in its 2003, 2004, and 2005 annual reports that it was classifying its own auction rate securities as available-for-sale investments. We think Congress should at least investigate the circumstances surrounding NASD’s liquidation of its ARS investment before deciding to grant FINRA any additional authority to “protect” investors. 

Outrageous Compensation Packages 

Despite these numerous regulatory and enforcement failures, FINRA’s board has approved outrageous compensation packages for the organization’s senior executives. Tax documents show that in 2008—a year in which FINRA also lost $568 million in its investment portfolio—the organization’s 20 senior executives received nearly $30 million in salaries and bonuses. Mary Schapiro alone received over $3 million, in addition to a lump-sum departing payment that was worth $7.2 million. FINRA’s decision to reward its senior leadership with seven-figure salaries and bonuses—at a time when many of its larger member firms were getting away with securities violations that brought our financial markets to the brink of collapse—ought to raise serious concerns about granting the organization any additional regulatory authority.

Conflicts of Interest 

Of course, we shouldn’t be surprised to learn that FINRA is a weak and ineffective regulator, given the incestuous relationship that often exists between SROs and the financial services industry. Throughout the years, NASD/FINRA’s senior leadership positions, board of governors, and committees have all been filled with current and former executives and board members from the securities industry, including some of the firms whose reckless behavior fueled the financial meltdown and drew investors into Ponzi schemes. For instance, the Amerivet lawsuit claims that “Bernard Madoff joined NASD’s Board of Governors in January 1984 and served as Vice Chairman while his Ponzi scheme was well underway.” There were also close connections between FINRA and Allen Stanford’s firm, which was later found to be running a Ponzi scheme.

Even after the financial crisis exposed the problem of regulators captured by industry, FINRA remains in bed with some of the very same firms it’s supposed to be regulating: for instance, Richard Ketchum served as former General Counsel for the Corporate and Investment Bank at Citigroup, Inc.; Robert Errico, FINRA’s Executive Vice President for Member Regulation, is a former Senior Vice President for Capitals Market Oversight at Charles Schwab & Co., and a former General Counsel for Schwab Capital Markets L.P.; and Susan Merrill, FINRA’s Executive Vice President and Chief of Enforcement, is a former partner at Davis Polk & Wardwell, which represents some of the largest financial institutions in the world. And on FINRA’s Board of Governors, many of the members who are supposed to represent the public’s interest have close ties to the securities industry. Given that SROs such as FINRA are supposed to be the front-line overseers for many financial products, POGO believes that the cozy relationships built into this system create a serious conflict of interest. 

A Good Deal for Taxpayers? 

Proponents of the self-regulatory model often claim it’s a good deal for taxpayers since SROs like FINRA are funded by their members. In explaining why FINRA should have more supervisory authority, Ketchum told Congress that “the increased manpower and enhanced investor protection would come at no cost to the taxpayer.” The problem is that FINRA’s member fees simply get passed on to investors in the form of transaction costs. And taxpayers still have to foot the bill for the SEC’s routine oversight of FINRA, which entails approving SRO rules, monitoring their activities, hearing internal appeals, and overseeing board activities. 

Time to Remove the Fox from the Henhouse 

POGO calls on Congress to thoroughly reexamine the government’s long-standing reliance on self-regulators to police the securities industry. Time and time again, FINRA and other SROs have made it abundantly clear that they are either unwilling or unable to protect the investing public from securities fraud and other market abuses. Our fragile economy is simply too important to be left in the hands of a weak regulator that is in bed with the very industry that brought our financial markets to the brink of collapse.

-- Michael Smallberg

Further reading: 

• POGO letter to Congress calling for increased oversight of financial self-regulators
• Not a TRACE of Transparency for Troubled Assets
• A Dozen Nonpartisan Good Government Fixes Congress Should Implement in 2010

Not a TRACE of Transparency for Troubled Assets

POGO sent a letter to Securities and Exchange Commission (SEC) Chairman Mary Schapiro on Friday raising concerns that a proposed rule for increasing price transparency in the market for troubled assets has been undermined by significant loopholes.  

POGO’s letter describes how the proposed rule, which was issued in October by the Financial Industry Regulatory Association (FINRA), contains provisions that will indefinitely delay transparency in these markets, and will prevent the dissemination of key information to the public. POGO believes that the inclusion of these loopholes reflects the pervasive influence of the securities industry, and exemplifies the kind of watered down rulemaking we’ve come to expect from FINRA and other industry-friendly self-regulatory organizations (SROs). 

FINRA’s proposed rule would require its members to submit information on transactions in certain types of troubled assets—such as mortgage- and asset-backed securities—to a centralized reporting system known as the Trade Reporting and Compliance Engine (TRACE). But if the SEC accepts the rule as it’s currently written, this information won’t have to be reported until the end of the day—as opposed to the usual 15-minute timeframe—and won’t have to be disseminated to the public. These restrictions could potentially have far-reaching consequences: according to one recent estimate, the total outstanding debt in mortgage-related and asset-backed securities is worth over $11 trillion—nearly one-third of all outstanding debt in the U.S. bond market.

As highlighted in an August report by the Congressional Oversight Panel, when the original credit risk assumptions for these assets came into question due to the rise in residential mortgage defaults, it led to a dramatic freeze in the markets for mortgage- and asset-backed securities, and as a result, the usual price-discovery mechanisms for these securities became frozen as well. Since the financial meltdown last fall, many of the government’s bailout programs have been aimed at strengthening the price-discovery mechanisms for troubled assets. 

The TRACE system could potentially have a huge impact on price transparency for mortgage- and asset-backed securities if the loopholes in FINRA’s proposed rule are removed. In fact, the TRACE reporting system has been improving transparency in other types of assets for nearly a decade. 

In 1998, under pressure from Congress and buy-side traders to improve price transparency, the SEC asked FINRA’s predecessor—the National Association of Securities Dealers (NASD)—to create a database for the reporting of transactions in the corporate bond market. In response to this mandate, NASD proposed a rule that led to the creation of TRACE, but the rule only required reporting on transactions in corporate bonds. The following types of securities were exempt from the reporting requirement: “debt issued by government-sponsored entities, mortgage- or asset-backed securities, collateralized mortgage obligations, and money market instruments.” 

In the aftermath of the financial crisis last fall, many experts highlighted the need for more transparency and price disclosure for the types of securities that were originally exempt from TRACE reporting. In its white paper on financial regulatory reform, the Treasury Department wrote that “the SEC and the Financial Industry Regulatory Authority (FINRA) should expand the Trade Reporting and Compliance Engine (TRACE), the standard electronic trade reporting database for corporate bonds, to include asset-backed securities.” 

But when it came time to write the rule, FINRA added loopholes that will undermine price transparency and prevent the public dissemination of key information about these securities. Under the current TRACE rules, FINRA members are required to report transactions to TRACE within 15 minutes of the transaction, and transaction information for most TRACE-eligible securities is immediately disseminated to the public. While FINRA’s proposed rule would bring mortgage- and asset-backed securities under the TRACE reporting system, it wouldn’t require reporting until the end of the day, and information on these transactions would not be disseminated to the public. Future dissemination would only be possible in limited circumstances pending an indefinite review by FINRA. 

Participants and institutional investors have told POGO that FINRA’s restrictions would completely undermine the purported intent of this rule, which is to increase price transparency for the troubled assets that fueled the financial meltdown. The restrictions are being supported by securities industry lobbying organizations like the Securities Industry and Financial Markets Association (SIFMA), which has been described by the Center for Responsive Politics as “one of the industry’s most vocal trade groups.” The securities industry wants to stop these transparency reforms since it makes money from the “bid-ask spread”—the difference in price between what the buyer and seller are offering. Less transparency means a higher bid-ask spread, which means more profit for the securities industry. 

In addition, SIFMA has enjoyed a particularly cozy relationship with FINRA. As Chairman Schapiro described it when she was CEO of FINRA, a white paper written by SIFMA’s predecessor “was one of the sparks that helped light the fuse” that ultimately led to FINRA’s creation. And one of FINRA’s Board members, Richard Brueckner, also serves on SIFMA’s Board. 

SIFMA argues that requirements for 15-minute reporting and public dissemination will “act to hamper a return to normal market conditions, thus acting counter to government's efforts to safeguard financial stability and restore the provision of credit and lending to the economy.” But at a 2007 conference, when a SIFMA executive was asked if he had any data to support this argument, he could only point to a survey which showed that 15 other institutional investors shared his view. On the other hand, a study conducted by Professor Kumar Venkataraman found that the effects of TRACE on the corporate bond market led to a dramatic decrease in trading costs. Professor Venkataraman also explained to the conference attendees that increased transparency gives investors a better tool for valuing securities, improves investor confidence, and can help give regulators early indications of fundamental credit problems. 

POGO is urging the SEC to amend FINRA’s rule so that transactions in asset- and mortgage-backed securities are reported to TRACE within the standard 15-minute timeframe, and information on these transactions is immediately disseminated to the public. There’s simply no reason to delay any longer in bringing these much-needed transparency reforms to the troubled assets market.

-- Michael Smallberg

Not Yet a Junkyard Dog But...

It's no secret to friends of POGO that we were not enamored of the appointment of Mary Schapiro to head the Securities and Exchange Commission (SEC).  We were afraid she had spent too much time working for toothless self-regulatory outfits like the National Association of Securities Dealers (NASD) and the Financial Industry Regulatory Authority (FINRA) to be able to reinvigorate the battered and limping SEC.

But a speech she delivered last Friday gives us hope.  She is making some very strong noises here.  Yes, of course, her actions ultimately will speak more loudly than any words.  But for now we are willing to admit we like what we hear.

For one thing, there was none of that magic-of-the-marketplace talk.  She promised: "A strong and reinvigorated SEC will be on the beat like never before to catch wrongdoers.  But there needs to be a new era of responsibility on Wall Street and throughout our markets to ensure that wrongs don't occur in the first place."

She said that the SEC would move with the sense of urgency demanded by investors who need the SEC to protect them: "Those who break the law and take advantage of investors need to know that they will face an unrelenting law enforcement agency in the SEC--an agency that will pursue them until the full force of the law is the sure, certain, and sole reward for their wrongdoing.  No one should be heard credibly to question whether enforcement is a priority at the SEC.  It is, and always will remain, a foundation of our mission."

Schapiro announced several steps to free Commission staff from rules imposed by her predecessor, Christopher Cox, that had slowed down SEC investigators and impeded their ability to jump quickly into investigations:

1) Ending the so-called "penalty pilot" program which had forced Enforcement staff to obtain special approval from the Commission in cases involving securities fraud where the staff is demanding monetary penalties.  Schapiro said the program had sent the "wrong message" to corporate wrongdoers by introducing major delays and demoralizing the staff.

2) Providing for more rapid approval of formal orders of investigation, without the necessity of a full review at a meeting of all five Commissioners.  This will enable the staff to issue subpoenas for witness testimony and document production without having to wait, sometimes weeks, for a full Commission meeting.

3) Discussing other ways to "reinvigorate the SEC's enforcement program, including improving the handling of tips and whistleblower complaints," something I hardly need say POGO very much applauds.

4) Formation of an Investor Advisory Committee so that the SEC will have early warning of issues of concern to investors.

Schapiro also announced a series of initiatives she wants to pursue "as priorities," including improving the quality of credit ratings by addressing inherent conflicts of interest; reducing systemic risk to investors by promoting and regulating centralized clearinghouses for credit default swaps; strengthening risk-based oversight of brokers and investment advisers; and improving the quality of audits and promoting safe and sound custody of customer assets.

It has also been announced that Linda Chatman Thomsen, the much-criticized head of Enforcement, is leaving that post.  We think it's good that Schapiro will have the chance to name a new chief to that all-important position.  We will be carefully watching to see whom she chooses, and whether she can achieve her goals, but we must admit, we're pleased with the sound of her bark.

-- Beverley Lumpkin

A Proponent of Self-Regulation Atop the SEC?

In December, President-elect Obama nominated Mary Schapiro, currently the head of the Financial Industry Regulatory Authority (FINRA), to be the next Chair of the Securities and Exchange Commission (SEC) (her confirmation hearing before the Senate Banking Committee is scheduled for this Thursday).  Schapiro has years of experience in securities regulation, and is widely regarded for her honesty and political independence.  However, we're concerned that Schapiro may not be the right person to confront the extraordinary challenges that await the incoming SEC Chair.

Consider what Obama said about the current state of our financial regulatory system when introducing Schapiro:

In the last few days, the alleged scandal at Madoff Investment Securities has reminded us yet again of how badly reform is needed when it comes to the rules and regulations that govern our markets.  Charities that invested in Madoff could end up losing savings on which millions depend--a massive fraud that was made possible in part because the regulators who were assigned to oversee Wall Street dropped the ball.  And if the financial crisis has taught us anything, it's that this failure of oversight and accountability doesn't just harm the individuals involved, it has the potential to devastate our entire economy. [emphasis added]

Based on her own testimony, where she described her role in regulating "every aspect of the brokerage business," it sure sounds like Schapiro is one of the regulators who "dropped the ball," although it is hard to know exactly who is at fault.  As a recent GAO report points out, the U.S. financial regulatory system is based on “a fragmented and complex arrangement of federal and state regulators,” which tends to result in a whole lot of finger pointing when things go wrong.

But regardless of who is to blame for our current economic mess, Schapiro has a troubling history of extolling the virtues of self-regulation.  In our view, the incoming SEC Chair must be prepared to question the orthodoxies on which the existing structure is based.

We'll be watching the hearing closely to see if the Banking Committee asks Schapiro any tough questions about the viability of the current regulatory system.

-- Michael Smallberg