Regulatory Paralysis and the Financial Crisis

The Congressional post-mortem of the 2008 financial crisis has focused primarily on the handful of rogue banks, in particular Lehman Brothers and Goldman Sachs, whose actions helped precipitate the meltdown. This serves the convenient purpose of deflecting attention away from the network of government and government-anointed personnel that could have stopped their misdeeds before they infected the entire global financial system. Still, the investigations currently underway have provided a rare glimpse at the elite club of cronies who run the financial system from behind closed doors. All its members are culpable in the financial meltdown of 2008.

To be sure, the banks conned their clients in a manner befitting a mafia family. But the government institutions that were empowered to police them were all too happy to look the other way until the deals went sour — en masse.

This includes many of the same members of Congress now spewing vitriol at bankers’ shady business practices while TV cameras roll — but who happily accepted corporate dollars when campaigning for election. Sen. Carl Levin, chairman of the Senate’s Permanent Subcommittee on Investigations now raking Goldman managers over the coals, also has had his hands in the corporate till. According to the Center for Responsive Politics, the top 5 donors to the Michigan senator’s re-election campaigns between 2005 and 2010 do not include Goldman — but do include Ford, General Motors and Cerberus Capital Management, which took control of Chrysler in 2007 and then propelled it into bankruptcy in 2009.

In hindsight, Levin’s current outrage at Goldman appears disingenuous at best. Along with most Democrats, Levin voted for the Republican-sponsored Financial Services Modernization Act of 1999, signed into law by Bill Clinton. This piece of legislation nullified the Glass-Steagall Act of 1933 — the New Deal legislation requiring the separation of investment and commercial banks — and single-handedly enabled banks to run the unaccountable “shadow banking system” at the center of the 2008 financial crisis.

Even three decades of deregulation legislation did not entirely remove Wall St. oversight, however. Between them, the Security and Exchange Commission (S.E.C.), the Treasury Department, and the Federal Reserve surely could have taken action against these bankers’ game of Russian roulette while the good times were still rolling. After all, as soon as Wall St. entered its downward spiral, these same agencies banded together with lightning speed to save their banking brethren — swiftly gaining congressional approval for the government bailout on October 3, 2008.

Anton R. Valukas, a court-appointed examiner investigating how Lehman Brothers cooked the books to hide its enormous debt, clearly found the S.E.C. negligent in its duties. “I saw nothing in my investigation to suggest that the S.E.C. asked even the most fundamental questions that might have uncovered this practice early on, before Lehman escalated it to a $50 billion issue,” Valukas stated in written testimony released by the House Financial Services Committee.

Yet, when questioned about their collective inaction in the events leading up to Lehman’s bankruptcy on September 5, 2008, those with the power to have stopped the firm’s escapades engaged in an elaborate game of buck passing.

The S.E.C.’s then-chairman Christopher Cox claimed it lacked the authority to take action. Cox “told Mr. Valukas that he believed that the agency’s jurisdiction ‘was limited to Lehman’s broker-dealer subsidiary and that it was not the regulator of Lehman itself,’” wrote the New York Times.

Chairman Ben Bernanke admitted to Valukas that in March 2008 the Federal Reserve assigned two examiners to keep track of Lehman, but claimed they “had no authority to regulate Lehman’s disclosures, capital, risk management, or other business activities.”

The Obama administration has been even more sweeping in its defense of regulatory paralysis in the face of widespread wrongdoing, arguing that no one had the authority to take action. Larry Summers, director of the Obama’s National Economic Council, recently claimed on PBS Newshour, “Regulators didn’t have authority in a comprehensive way to monitor the derivatives market.”


When the S.E.C. charged Goldman Sachs with fraud last month, no one was more shocked by this sudden change of heart than the accused executives themselves. Until then, the Goldman brass enjoyed an especially cordial relationship with government regulatory agencies. Goldman executives transition regularly to employment at the Treasury Department – as did Treasury Secretaries Robert Rubin under Clinton and Henry Paulson under G.W. Bush. The crossover has continued under Obama: Goldman lobbyist Mark Patterson left his high-powered job last year to serve as chief of staff to Treasury Secretary Timothy Geithner.

The Treasury Department collaborated with Goldman probably more than any other Wall St. firm during the 2008 financial collapse. Upon taking office in June 2006, Paulson had ruled out any official contact with Goldman to avoid a conflict of interest with his former employer, but less than 15 months later, he requested and received an “ethics waiver” voiding that pledge. That was on September 17, 2008, just one day after the government agreed to lend AIG $85 billion to pay off its substantial debts to Goldman and other big banks.

Goldman was the largest recipient of the payoff. According to the New York Times, during the week of the AIG bailout Paulson spoke to Goldman CEO Lloyd Blankfein “two dozen times, the calendars show, far more frequently than Mr. Paulson did with other Wall Street executives.”

At the end of that tumultuous week, the Federal Reserve rushed through emergency requests by Goldman and Morgan Stanley to change their status from investment banks to traditional bank holding companies–with the flick of a pen bypassing the legal five-day antitrust waiting period. The deal was struck over a single weekend, and Goldman and Morgan Stanley emerged on Monday morning as entirely new entities – a signal from the Fed that it would not allow these two firms to fail. Interestingly, their new status switched their holding companies from S.E.C. to Federal Reserve oversight.

The S.E.C. was not simply asleep at the wheel while the financial system careened toward disaster. In 2004, it had designed a special program, known as the “consolidated supervised entities” program, which enabled the reckless borrowing that later caused the banking crisis. The special program was created, according to the New York Times, “after heavy lobbying for the plan from all five big investment banks. At the time, Mr. Paulson was the head of Goldman Sachs. He left two years later to become the Treasury Secretary.”

The same five investment banks — Goldman and Morgan Stanley, Bear Stearns, Lehman and Merrill Lynch — immediately “volunteered” to enroll in the new S.E.C. program that was created at their behest.

Through this special program, the S.E.C. allowed these Wall St. giants to vastly increase their amount of leveraged debt. S.E.C. rules had long required banks to hold roughly $1 of equity for every $15 of debt, or a 15-1 debt-to-net-capital ratio. The new program lifted these limits. As Ben Protess reported at, “Merrill Lynch’s leverage ratio was possibly as high as 40-to-1 [in 2008] and Lehman Brothers faced a ratio of about 30-to-1, according to Bloomberg.”

In return for this cash cow, the banking behemoths agreed to allow the S.E.C. to regulate their holding companies. But this also was at the banks’ request. Voluntarily submitting to S.E.C. oversight would allow their overseas operations to avoid European Union regulators. They preferred the S.E.C. for reasons that later became obvious: Their backslapping pals at the S.E.C. provided virtually no regulatory oversight.

The S.E.C. failed to shut down this disastrous program even as the system began to convulse in March 2008, at the time of Bear Sterns’ collapse and subsequent fire sale to JP Morgan Chase – months before Lehman Brothers filed for bankruptcy and Merrill Lynch was acquired by Bank of America. By the time the S.E.C. dissolved the program on September 26, 2008, none of the five investment banks remained as such, although their trail of poison was still working its way through the global financial system.


In the meantime, the top three credit rating agencies, Moody’s, Standard & Poor’s and Fitch, also played a key role in inflating — and then bursting — the housing bubble. One day they were handing out AAA ratings to subprime mortgage securities like cocktails at happy hour. Then suddenly the party was over. On the eve of the housing crisis in 2007, all three ratings agencies began simultaneously downgrading AAA-rated mortgage securities to junk. By the end of 2007, fully 91 percent of AAA-rated mortgage securities had been downgraded to junk status, as investors realized that their securities were fast becoming worthless.

In theory, “independent” credit rating agencies attach AAA-ratings to only the safest securities, based on objective criteria. In reality, these top three rating agencies make up an oligopoly, created and sustained by the S.E.C. since 1975.

In that year, the S.E.C. elevated a small number of credit ratings agencies to the coveted status of “Nationally Recognized Statistical Rating Organization” (NRSRO) that it empowered to assess the safety of securities, even though the NRSRO was made up of a group of corporations that were entirely unregulated. In this public-private partnership, even the S.E.C. had no authority over their conduct until the crisis was well underway in 2008.

By the 1990s, a series of mergers had left only three NRSROs: Moody’s, Standard & Poor’s and Fitch. Facing criticism, the S.E.C. granted a handful of other credit agencies NRSRO status beginning in 2003, but these three top agencies continued to dominate the market. As the Wall Street Journal complained in April 2009, “To this day, the Fed will only accept assets as collateral if they carry high ratings from S&P, Moody’s and Fitch.”

In the process, the ratings agencies’ traditional means of compensation switched from investors who paid for their services to the corporations whose securities they were charged with rating. This created a scenario of cutthroat competition among the three dominant credit rating agencies for market share from the corporations paying them. As might be expected, they became much less concerned with the integrity of their ratings than the goodwill of their banker clients.

A May 2006 message from a UBS banker to a Standard & Poor’s employee plainly threatened to take its business to competitors: “Heard you guys are revising your residential mbs rating methodology – getting very punitive… heard your ratings could be 5 notches back of mo[o]dys equivalent. gonoa (sic) kill your resi biz. may force us to do moodyfitch only cdos!”
If their clients were willing to blackmail and bully their way to AAA ratings, the ratings agencies were well aware of their role in the charade. As one Standard & Poor’s internal email read, “Ratings agencies continue to create an even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”

Rating agency employees who refused to accommodate to the wishes of their banker clients were swiftly moved to other accounts. Richard Michalek, a former managing director in Moody’s structured products derivatives group, testified before the Senate that, because he was unwilling cater to their wishes, managers told him he was “not welcome on deals” involving certain banks – including Goldman Sachs Group Inc., UBS AG and Merrill Lynch & Co.

Moody’s managing director Yuri Yoshizawa testified that they quietly moved analysts to other accounts because “we felt that our analysts were being abused.”


With mid-term elections looming large, the Democratic Party needs desperately to shore up its voting base. This can only be accomplished if its first year of Congressional inaction is followed by tough talk raising the specter of some action, however meager. Although congressional Republicans were prepared to play their familiar obstructionist role, bent on preserving every iota of corporate privilege in the name of fighting “big government,” they were forced to abandon their plans. So great is the public’s support for government action against Wall St. that no politician dares to openly stand in the way.

Unfortunately, the Democrats’ financial regulation bill now being hotly debated in Congress is far from the “sweeping overhaul” described by most mainstream journalists. In truth, it is aimed at preventing significant reform. At minimum, a regulatory overhaul would reinstate the provisions of the 1933 Glass-Steagall Act, requiring the separation of investment and commercial banks. In addition, no overhaul can be effective unless it dismantles the system by which rating agencies get paid by the corporations whose securities they are rating, rather than the investors they are ostensibly serving.

Perhaps more importantly, no politician has suggested so far that Corporate America be barred from policing itself. The line between banks and their overseers has become so blurred because watchdog agencies actively recruit from big banks and vice versa, in a revolving door of golfing partners.

But this practice continues. As the Wall St. Journal recently reported, “Securities and Exchange Commission enforcement chief Robert Khuzami oversaw a group of lawyers at his old firm, Deutsche Bank AG, that was closely involved in developing collateralized debt obligations, the same product in the agency’s fraud lawsuit against Goldman Sachs Group Inc., according to people familiar with the matter.” No worries, however, the Journal article continues: “Because of Mr. Khuzami’s old job and his financial interest in the company, he has recused himself from any matters related to Deutsche Bank.”

The 2008 financial crisis exposed the degree to which foxes have been guarding the chicken coop. And there doesn’t appear to be any end in sight. Until there is an independent and accountable agency regulating the regulators, Congress is merely rearranging the deck chairs on the Titanic until it hits the next iceberg.

SHARON SMITH is the author of Women and Socialism and Subterranean Fire: a History of Working-Class Radicalism in the United States. She can be reached at:




SHARON SMITH is the author of Women and Socialism and Subterranean Fire: a History of Working-Class Radicalism in the United States. She can be reached at: