Charles Gasparino: SEC Bungles Its New Powers

Last Updated Dec 18, 2009 4:40 PM EST

The Sellout by Charles Gasparino

"If anything goes wrong," said Harvey Goldschmid in his thick New York accent, "it's going to be an awfully big mess." It was April 2004, and Goldschmid, a commissioner at the Securities and Exchange Commission, had a knot in his stomach.

The commissioners were gathered in the basement hearing room of the agency’s headquarters to vote on an amendment to the so-called net capital rule, an obscure but important provision that governed how the investment banks set aside capital to cover potential losses on trades.

The event received little media attention. There were no cameras, no reporters waiting outside for interviews. But the changes were vast and potentially lethal.

In the past, investment banks had set a model for capital requirements for their assets: The less risky an asset, the less capital they had to set aside. But under the amendment the SEC was set to vote on, everything would change.

First, the big firms were now supposed to self-monitor their risk levels and report those risks to the SEC. But, most important, they could use any risk measurement tool they wanted, including VaR (Value at Risk), which could be incredibly misleading. Its risk measurements were based on historical trends, and every risk manager knows you can’t count on history to repeat itself forever.

The next major change was more daunting: All triple-A securities would be treated about the same. Firms now could hold just about the same amount of capital for a triple-A mortgage-backed bond as for ultrasafe Treasuries. Risk and leverage, made cheap by low interest rates from the Federal Reserve, was now made even cheaper by the SEC.

Despite his gut telling him otherwise, Goldschmid supported the measure, and the rule was adopted unanimously.

The SEC commissioners weren’t walking away empty-handed, or so they believed. Now, the SEC’s mandate covered the breadth of the Wall Street business model. SEC examiners would be able to delve into firms’ private-equity arms and hedge funds; firms could no longer hide positions in off-balance sheet corporations. The recent repeal of Glass-Steagall had made brokerage firms and commercial banks almost indistinguishable, making regulation even more important as commercial banks such as Citigroup adopted the risk-taking strategies of Wall Street firms.

This might have made the decision a good trade for the SEC if the commission had had the bodies and brains to carry out its new mandate.

Yet instead of enhanced oversight, the new capital rules were met with less regulation, not more. The SEC had no idea what it was doing, its ranks depleted by years of defections of longtime officials to higher-paying jobs on Wall Street. With that, the commission missed scandal after scandal, including a brewing $50 billion Ponzi scheme perpetuated by Bernard Madoff.

In retrospect, Goldschmid, now a law professor at Columbia University, concedes that his vote was a mistake, primarily because the SEC’s staff didn’t really know what to do with its new powers.

“We didn’t have a sophisticated enough staff,” he said. “The sad part is, we should have been getting that information on the risk they were taking, but we didn’t because we didn’t know what to ask for.”

Excerpt courtesy of HarperBusiness, an imprint of HarperCollins Publishers. The Sellout is available wherever books are sold.

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