All the Devils Are Here [151]
Where were the regulators as this buildup of risk was taking place? They were nowhere to be found. Just as the banking regulators had averted their eyes from the predatory lending on Main Street, so did they now ignore the ferocious accumulation of risk, much of it tied to subprime mortgages, on Wall Street.
No regulator had the authority—or the ability—to systematically look across institutions and identify potential system-wide problems. That role just didn’t exist in America’s regulatory scheme. The Fed, for one, had little insight into the packaging and endless repackaging of mortgages. In part, this was because the Gramm-Leach-Bliley Act prevented it from conducting detailed examinations of the nonbank subsidiaries of the big banks. In other words, even though it was responsible for regulating the big bank holding companies, it had to rely on the SEC to oversee, for example, a bank’s trading operation.
In any case, the Fed wasn’t all that eager to look too deeply. Like all the regulators, the Fed believed that the risk was off the banks’ books and distributed into the all-knowing market. The attitude was: “Not our role to tell the market what it should and should not buy,” in the words of a former Fed official. This was true even after Alan Greenspan retired in early 2006 and was replaced by Princeton economist Ben Bernanke.
The Fed also had enormous—and unwarranted—faith in bank management. A GAO report would later find that all the regulators “acknowledged that they had relied heavily on management representation of risks.” In 2006, the Fed had conducted reviews of stress-testing practices at “several large, complex banking institutions,” according to the GAO. It found that none tested for scenarios that would render them insolvent and that senior managers “questioned the need for additional stress testing, particularly for worst-case scenarios that they thought were implausible.” From 2005 through the summer of 2007, the Fed issued internal reports called “Large Financial Institutions’ Perspectives on Risk.” The report for the second half of 2006, issued in April 2007, stated, “There are no substantial issues of supervisory concern for these large financial institutions” and that “Asset quality across the systemically important institutions remains strong.”
In at least one notable case, regulators reached for responsibilities that they weren’t capable of handling. It took place in 2004 and involved the Securities and Exchange Commission, whose chairman at the time was William Donaldson.
Historically, the SEC oversaw everything that had to do with the buying and selling of stocks. The five big American investment banks—Bear Stearns, Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman Brothers—all came under the regulatory purview of the SEC. But they had all formed holding companies and had affiliates engaged in all kinds of activities—such as derivatives trading—that had nothing to do with selling stocks. Astonishingly, no government agency regulated the holding companies.
In 2002, the European Union ruled that these holding companies had to be supervised by a U.S. regulator, or the EU would do the job itself for the subsidiaries that fell under their jurisdiction. This was not something the American investment banks wanted to have happen, so they asked the SEC to set up a program called Consolidated Supervised Entities, or CSE. It created a voluntary supervisory regime, thus getting around the SEC’s lack of statutory authority to regulate the holding companies.
It would become part of the lore of the financial crisis that the CSE somehow abolished a previously held limit of 12 to 1 leverage at the broker-dealer level and allowed the banks to use their internal models to determine the capital they should hold. But the first part