Eliot Spitzer: How to Keep Financial Markets in Check

How to Ground The Street
The Former 'Enforcer' On the Best Way to Keep Financial Markets in Check.

By Eliot L. Spitzer
Sunday, November 16, 2008; B01


President-elect Barack Obama will soon face the extraordinary task of saving capitalism from its own excesses, much as Franklin D. Roosevelt had to do 76 years ago. Up until this point in the crisis, policymakers have appropriately applied the rules of triage -- Band-Aids and tourniquets, then radical surgery -- to keep the global financial system alive. Capital infusions, bailouts, mega-mergers, government guarantees of unimaginable proportions -- all have been sought and supported by officials and corporate chief executives who had until now opposed any government participation in the marketplace. But put aside for the moment the ideological cartwheel we have seen and look at the big picture: The rules of modern capitalism have been re-written before our eyes.

The new president's team must soon get to the root causes of the mistakes that have brought us to the economic precipice. Yes, we have all derided the explosion of leverage, the failure to regulate derivatives, the flood of subprime lending that was bound to default and the excesses of CEO compensation. But these are all mere manifestations of three deeper structural problems that require greater attention: misconceptions about what a "free market" really is, a continuing breakdown in corporate governance and an antiquated and incoherent federal financial regulatory framework.

First, we must confront head-on the pervasive misunderstanding of what constitutes a "free market." For long stretches of the past 30 years, too many Americans fell prey to the ideology that a free market requires nearly complete deregulation of banks and other financial institutions and a government with a hands-off approach to enforcement. "We can regulate ourselves," the mantra went.

Those of us who raised red flags about this were scoffed at for failing to understand or even believe in "the market." During my tenure as New York state attorney general, my colleagues and I sought to require investment banking analysts to provide their clients with unbiased recommendations, devoid of undisclosed and structural conflicts. But powerful voices with heavily vested interests accused us of meddling in the market.

When my office, along with the Department of Justice, warned that some of American International Group's reinsurance transactions were little more than efforts to create the false impression of extra capital on the company's balance sheet, we were jeered at for attacking one of the nation's great insurance companies, which surely knew how to balance risk and reward.

And when the attorneys general of all 50 states sought to investigate subprime lending, believing that some lending practices might be toxic, we were blocked by a coalition of the major banks and the Bush administration, which invoked a rarely used statute to preempt the states' ability to probe. The administration claimed that it had the situation under control and that our inquiry was unnecessary.

Time and again, whether at the state level, in Congress or at the Securities and Exchange Commission under Bill Donaldson, those who tried to enforce the basic principles that would allow the market to survive were told that the "invisible hand" of the market and self-regulation could handle the task alone.

The reality is that unregulated competition drives corporate behavior and risk-taking to unacceptable levels. This is simply one of the ways in which some market participants try to gain a competitive advantage. As one lawyer for a company charged with malfeasance stated in a meeting in my office (amazingly, this was intended as a winning defense): "You're right about our behavior, but we're not as bad as our competitors."

No major market problem has been resolved through self-regulation, because individual competitive behavior doesn't concern itself with the larger market. Individual actors care only about performing better than the next guy, doing whatever is permitted -- or will go undetected. Look at the major bubbles and market crises. Long-Term Capital Management, Enron, the subprime lending scandals: All are classic demonstrations of the bitter reality that greed, not self-discipline, rules where unfettered behavior is allowed.

Those who truly understand economics, as did Adam Smith, do not preach an absence of government participation. A market doesn't exist in a vacuum. Rather, a market is a product of laws, rules and enforcement. It needs transparency, capital requirements and fidelity to fiduciary duty. The alternative, as we are seeing, is anarchy.

One of the great advantages U.S. capital markets have enjoyed over the decades has been the view -- held worldwide -- that there was an underlying integrity to the representations market participants made, because the regulatory framework in which they were made was believed to provide genuine oversight. But as we all know, the laws requiring such integrity are meaningless without a government dedicated to enforcing them.

Second, our corporate governance system has failed. We need to reexamine each of the links in its chain. Boards of directors, compensation and audit committees, the trio of facilitators (lawyers, investment bankers and auditors) whose job it is to create the impression of legal compliance, and shareholders themselves -- all abdicated their responsibilities.

Institutional shareholders, in particular mutual funds, pension funds and endowments, must reengage in corporate governance. Over the past decade, arguably the sole challenge to corporate mismanagement and poor corporate strategies has come from private-equity firms or activist hedge funds. These firms were among the few shareholders or pools of capital willing to purchase and revamp encrusted corporate machines. So it shouldn't be surprising that the corporate world has taken a skeptical view of them -- especially short-selling hedge funds, which have often been a rare voice raising the alarm.

Boards of directors were also missing in action over the past decade; not only did they not provide answers, they all too often failed even to ask the appropriate questions. And the roles of compensation committees, of course, must be totally rethought. No longer can Garrison Keillor's brilliant observation about our kids -- that they are all above average -- apply to CEOs and propel failed leaders' paychecks through the roof. Today's momentary public oversight and outrage over executive compensation, while long overdue, is no substitute over the long term for firm standards set by compensation committees and boards of directors.

Finally, we need to completely overhaul the federal financial regulatory framework.

Let's leave aside the ideological hesitancy that has long hamstrung regulatory agencies. Today's balkanized regulatory framework for financial services no longer matches in any way the needs of a fully integrated global financial system. The divisions of the past -- commercial banking vs. investment banking vs. insurance vs. hedge funds vs. private equity -- have become distinctions without a difference. But these old boxes and formalities still determine how entities are viewed and regulated. It should surprise nobody that capital found the crevices in the regulatory framework. That is what capital is paid to do. But we failed to respond with a regulatory framework flexible enough to plug the leaks.

We do not need additional fragmented areas of federal regulation to handle hedge funds, sovereign wealth funds or derivatives. We need a unified approach that addresses the underlying issues: what kinds of leverage we wish to tolerate, how to measure risk, how much disclosure various trading products should provide. We cannot survive with the current system: the SEC, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Fed, the Office of Thrift Supervision and on and on. We must go from the Rube Goldberg structure we now have to a sleek iPod design that is cleaner, has better operating software and may even look good.

We began to try to craft such a unified model in New York, as did Treasury Secretary Henry M. Paulson Jr. in Washington last year. But it is urgent that we finish the job. Having flooded the market with cash and seen the government take a chunk of many of our largest financial institutions, we now need to craft the rules that will apply to all market participants.

Three overarching priorities should guide government actions in the new structure. First, we need better control of systemic risk. The currently splintered federal regulatory authority, the continued presence of off-balance-sheet transactions for financial entities (even post-Enron) and the failure to subject major players to any government oversight means that nobody can really understand the full risk facing the financial system.

Second, investors must be protected with adequate, accurate information. Firms must offer transparency both to individual investors and to government regulators.

And third, as Eric R. Dinallo, the superintendent of the New York State Insurance Department, has wisely pointed out, we will have to step back from the current environment in which government has become a guarantor of all major risk. The so-called moral hazard will serve to devalue risk in the market, and this too will have a debilitating long-term effect on capital flows. Only if private actors have to bear the real risks they incur will the market function properly. We are now perilously close to nationalizing risk.

As the rules of modern capitalism are rewritten over the next year, those who benefit from the enormous flow of cash being spread throughout the U.S. economy must be expected to compete within a system of rules that creates a true market -- based on sound, skilled regulation, vigorous corporate governance and transparency.

Although mistakes I made in my private life now prevent me from participating in these issues as I have in the past, I very much hope and expect that President Obama and his new administration will have the strength and wisdom to do again what FDR did.

Eliot L. Spitzer was governor of New York from 2007-08 and state attorney general from 1999-2006.

Eliot Spitzer:,Feb 2008: Bush-Cheney's war on consumers --US intervention to support predatory lending

Predatory Lenders' Partner in Crime
By Eliot Spitzer
The Washington Post
(reprinted at Truthout.org)

Thursday 14 February 2008
How the Bush Administration stopped the states from stepping in to help consumers.

Several years ago, state attorneys general and others involved in consumer protection began to notice a marked increase in a range of predatory lending practices by mortgage lenders. Some were misrepresenting the terms of loans, making loans without regard to consumers' ability to repay, making loans with deceptive "teaser" rates that later ballooned astronomically, packing loans with undisclosed charges and fees, or even paying illegal kickbacks. These and other practices, we noticed, were having a devastating effect on home buyers. In addition, the widespread nature of these practices, if left unchecked, threatened our financial markets.

Even though predatory lending was becoming a national problem, the Bush administration looked the other way and did nothing to protect American homeowners. In fact, the government chose instead to align itself with the banks that were victimizing consumers.

Predatory lending was widely understood to present a looming national crisis. This threat was so clear that as New York attorney general, I joined with colleagues in the other 49 states in attempting to fill the void left by the federal government. Individually, and together, state attorneys general of both parties brought litigation or entered into settlements with many subprime lenders that were engaged in predatory lending practices. Several state legislatures, including New York's, enacted laws aimed at curbing such practices.

What did the Bush administration do in response? Did it reverse course and decide to take action to halt this burgeoning scourge? As Americans are now painfully aware, with hundreds of thousands of homeowners facing foreclosure and our markets reeling, the answer is a resounding no.

Not only did the Bush administration do nothing to protect consumers, it embarked on an aggressive and unprecedented campaign to prevent states from protecting their residents from the very problems to which the federal government was turning a blind eye.

Let me explain: The administration accomplished this feat through an obscure federal agency called the Office of the Comptroller of the Currency (OCC). The OCC has been in existence since the Civil War. Its mission is to ensure the fiscal soundness of national banks. For 140 years, the OCC examined the books of national banks to make sure they were balanced, an important but uncontroversial function. But a few years ago, for the first time in its history, the OCC was used as a tool against consumers.

In 2003, during the height of the predatory lending crisis, the OCC invoked a clause from the 1863 National Bank Act to issue formal opinions preempting all state predatory lending laws, thereby rendering them inoperative. The OCC also promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks. The federal government's actions were so egregious and so unprecedented that all 50 state attorneys general, and all 50 state banking superintendents, actively fought the new rules.

But the unanimous opposition of the 50 states did not deter, or even slow, the Bush administration in its goal of protecting the banks. In fact, when my office opened an investigation of possible discrimination in mortgage lending by a number of banks, the OCC filed a federal lawsuit to stop the investigation.

Throughout our battles with the OCC and the banks, the mantra of the banks and their defenders was that efforts to curb predatory lending would deny access to credit to the very consumers the states were trying to protect. But the curbs we sought on predatory and unfair lending would have in no way jeopardized access to the legitimate credit market for appropriately priced loans. Instead, they would have stopped the scourge of predatory lending practices that have resulted in countless thousands of consumers losing their homes and put our economy in a precarious position.

When history tells the story of the subprime lending crisis and recounts its devastating effects on the lives of so many innocent homeowners, the Bush administration will not be judged favorably. The tale is still unfolding, but when the dust settles, it will be judged as a willing accomplice to the lenders who went to any lengths in their quest for profits. So willing, in fact, that it used the power of the federal government in an unprecedented assault on state legislatures, as well as on state attorneys general and anyone else on the side of consumers.

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The writer is governor of New York