The SEC’s budget is the topic of hot debate, with SEC Chair Mary Schapiro begging Congress not to make further cuts to the agency that is charged with policing our securities laws. It is distressing to contemplate that this is even up for discussion at a time when investors are still climbing out of the rubble of a market collapse that was the culmination a massive fraud perpetrated on the public by some of the very people the SEC is supposed to regulate.
The fraud in question was Wall Street’s sale to investors of over a trillion dollars of securities which were “backed” by subprime mortgages that were doomed to fail. Pretty much by definition, subprime loans were made to people who were not likely to be able to afford to repay them. As Warren Buffett has said, if you loan money to people who can’t pay you back, bad things will happen.
Here’s the short version of how the fraud worked: Lenders promiscuously gave mortgages to people who suffered low credit scores and had minimal or no equity in the property they were buying. Many of these subprime borrowers were assured by lenders that they could represent whatever income they wanted on their loan applications because the lender would not verify the stated income. The lenders weren’t concerned about whether the subprime loans could actually be repaid because they never intended to keep them on their books. Instead, the lenders sold the loans to Wall Street firms which pooled thousands of loans and re-issued them as bonds with impressive names like collateralized debt obligations (CDOs). The next step was for the rating agencies like Moody’s and Standard & Poor’s to bless these CDOs with high credit ratings. Why would they bless pools of junky subprime mortgages with coveted AAA ratings? Because the same people who created and sold the CDOs paid the agencies for the ratings! Wall Street then earned huge fees by selling these CDOs to pension plans and other investors who had no idea how risky they really were and were naïve enough to think that the credit ratings actually meant something.
Things began to fall apart in the world of CDOs when the housing bubble burst in 2006-2007. Subprime borrowers simply couldn’t repay or refinance their loans. Houses went into foreclosure and home prices dropped. Mortgage lenders filed for bankruptcy. CDOs and other subprime based securities became all but worthless, and the economy almost ground to a halt.
There are many people to blame for the sub-prime crisis. Certainly the lenders who gave loans to people who didn’t deserve them, and deftly avoided the risk of default by selling those loans to others, bear much of the blame. Just as certainly, the investment houses that repackaged trash loans and the rating agencies who gave them their seals of approval, bear responsibility. And goodness knows, brokerage firms that sold subprime-tainted bonds to individual and institutional investors like pension funds are worthy of condemnation and even prosecution.
Many have asked where was the SEC when all of this mischief was afoot? Part of the answer is that it was fighting for its life against people who preached the gospel that any government regulation is the enemy of economic growth. The agenda of these folks was to starve the “beast” (meaning government) so that it couldn’t do its job and then use that failure as an excuse to cut back even further on regulations and on funding for those who enforce regulation. In fact, from 2005 to 2007, a period of huge growth in the market in general and the fraudulent subprime market specifically, the SEC’s budget was frozen or reduced, forcing a 10% reduction in its workforce.
The SEC has asked Congress to set its budget for 2012 at $1.4 billion. That is not really that much considering that the SEC has responsibility for reviewing the financial filings of over 10,000 companies, as well as regulating approximately 35,000 entities, including 11,800 investment advisers, 7,500 mutual funds, and more than 5,000 broker-dealers with over 160,000 branch offices. For a sense of proportion, compare the $1.4 billion SEC budget request to the 2010 marketing expenditures by Bank of America ($2 billion) and Citigroup ($1.6 billion). Sadly however, powerful members of the House of Representatives have recently proposed cutting the SEC’s budget by as much as 30%. Any claim that this is a necessary measure in light of the national deficit is completely refuted by the fact that securities registration and transaction fees charged on Wall Street firms by the SEC actually exceed the amount the agency spends each year. That’s right, the SEC is a net money-maker for the government.
The impact of cuts in the SEC budget is not hard to predict. If you take cops off the street, crime increases. It doesn’t matter whether the crime is in the streets or in the suites. Although additional funding to the SEC will not end securities fraud, you can be certain that less money will facilitate more fraud.