On Dec. 14, Mary Schapiro will step down from her role as the chairwoman of the Securities and Exchange Commission. Barack Obama will shortly appoint a new leader to take her place, a leader who has a big task in rebuilding the credibility of an agency tasked with protecting the capital markets from fraud and ensuring transparency in the markets. I've asked Neil Barofsky, whose name has been floated by Simon Johnson in the New York Times as a possible chairman for the agency, what he would do to reform the Securities and Exchange Commission.
The stakes are high. In the 1930s, the SEC cleaned up a stock market that had gone out of control, rigged by insiders and ultimately wrecking the economy. During this most recent financial crisis, the SEC operated as Barofsky put it, as a "backwater.” SEC Chairman Chris Cox was known as a passive regulator who did not understand the markets. Whistle-blower Harry Markopoulos later embarrassed the SEC by revealing he had tried to tell them about Bernie Madoff's $20 billion-plus fraud for eight years, to no avail. Obama appointee Mary Schapiro has done marginally better, but the SEC has still been battered in the courts and in Congress. And Schapiro recently lost a high-profile fight to regulate money market funds, which were a key part of the highly vulnerable shadow banking system.
Most significantly, the SEC has no high-profile court wins against key players in the financial crisis. The SEC charged Goldman Sachs in 2010 with defrauding its customers in the mortgage-backed securities market, the centerpiece of the crisis. But it later settled with the company, not forcing Goldman to admit or deny wrongdoing. In fact, settling with corporations without forcing them to admit wrongdoing is policy at the SEC, under former Deutsche Bank executive turned SEC Chief of Enforcement Robert Khuzami. This policy is so ingrained that when Judge Jed Rakoff invalidated a settlement between the SEC and Citigroup on selling toxic mortgage bonds and ordered a trial, Khuzami fought bitterly to have the judge overruled.
Fortunately, this is something Barack Obama can fix in his second term. The banking system is now stable enough to withstand legal challenges, and there's a clear opening to change directions at the SEC. But what does the next SEC chair need to do to restore credibility to the agency?
Barofsky is uniquely positioned to comment on this, as a Democrat in public office who became one of the Treasury's most high-profile critics, who received significant support from Democratic and Republican critics of the bailouts. He was a staunch ally of Elizabeth Warren, but conservative bank analyst Chris Whalen also says Barofsky would be "an excellent choice" for SEC chair, and says he was one of the "few advocates for the public" during the bailouts. Liberal economist Jane D'Arista calls him "the obvious first pick" for the job. Barofsky has a background in prosecuting complex financial frauds, having done so as an assistant U.S. attorney in the Southern District of New York. He also has a clear policy profile as a foil for Tim Geithner during the bailouts, when he ran the Special Inspector General Office for the Troubled Asset Relief Program (or SIGTARP).
A big change he'd make is in the enforcement area. He says it's time to reexamine the policy of settling with corporations without forcing them to admit wrongdoing. He'd fight hard for more transparency within large financial institutions, and for reform of the money markets. Barofsky also believes that the next SEC chairman could make the Financial Stability Oversight Council, a council of regulators established by Dodd-Frank with the power to break up the banks, a real forum for action.
Would he take the SEC job, if offered? "I would do it in a heartbeat."
Simon Johnson floated your name in the New York Times for Securities and Exchange Commission chairman. Is that something you would do?
I'm not holding my breath for that type of appointment. It's not particularly likely given my likely standing with the Obama administration and my time at Treasury, but absolutely it's a job I'd be honored to do if I were asked to serve in that type of capacity. Public service is sort of in my blood and to be able to serve in that type of capacity and to have the ability to effect that type of positive change, I would do it in a heartbeat, presuming I had the support of the president and the commitment to put the necessary capital behind the agency.
How did the SEC perform in the crisis, during the crisis, before the crisis and afterward?
The SEC was in terrible, terrible shape in 2008 entering into the crisis. The sort of deregulatory mania that possessed so much of the federal regulators was really exemplified by the SEC, especially during the financial crisis. Looking into some of the work that we did at SIGTARP and some of the accounts of that time, when the financial crisis hit and some of the bailouts began, you would have thought that we would have had a prominent role and instead it acted as a backwater. I think it really was one of the low points for that agency.
Since the financial crisis, in some ways, it has performed well and in some ways there are real questions about its performance. You know, for instance, I think that its leadership and what it's done in areas like insider trading investigations have been very effective and very important in regulating that aspect of the market. On the other hand the SEC, along with the broader Department of Justice, hasn't brought the level of accountability and justice when it comes to those responsible for the financial crisis, and I think that's hanging over its head. Finally, I think in the area of meaningful regulatory reform it's sort of hard to determine where it is right now; it's still a work in progress. I would like to see it being more a leader for progressive reform of our financial system to protect against another crisis.
As an agency they didn't get something as simple as reform of the money market funds out of the box yet. And that's not to assign blame to [current SEC Chairwoman] Mary Schapiro as maybe it is to her co-commissioners. And this is such a blatant area of necessary reform and we haven't gotten there four years after the crisis. It's sort of an indication of one of those areas; it should have been one of those areas that so obviously needs reform and hasn't been done. It's disappointing. It's still a work in progress in areas like derivatives reform and other areas.
Let's wave a magic wand, and Neil Barofsky is appointed and confirmed to the SEC chairman position. What do you do to the SEC bureaucracy to achieve the goals you lay out for it, and what are those goals?
I think with the bureaucratic changes of any incoming commissioner you have to be a little cautious. The enforcement division just underwent a radical overhaul, and bringing in a subsequent radical overhaul is more than any subsequent agency can bear in such a short period of time, so I think from a bureaucratic perspective you need to work within this new system. And so, having an outsider's perspective gives you a fresh look and helps you see where you'd want to tweak it or improve it. But radical restructuring would be such a diversion of energy and resources and potentially morale crushing. [No one works at an agency that changes its entire bureaucratic structure every three or four years.]
But look, I know, to me, the biggest priorities of where we are today in 2012 and where I think the agency should focus on going forward is fundamental stuff, that's fairly obvious really. Transparency, being an agent for transparency in the markets. When you look at the big financial institutions ... this is a financial crisis that was caused in part by a lack of transparency, by a lack of understanding of what was going on under the hood of a lot of these institutions, their exposure to certain assets, particularly real estate. Part of what triggered those great runs on Bear Stearns, and then Lehman, and then AIG, was a sense of the unknown. And that's going to continue to trigger potential crisis. And at some point there are limits to transparency for legitimate business reasons. But I think overall our system can require a great deal more transparency without having major harm to these institutions, at least not in harmful ways that are relevant to the overall systemic stability.
I think the second area is on the enforcement side. I would want to have a real reexamination of the neither-admit-nor-deny settlement approach toward enforcement. And that goes to really a core question of the priorities of the agency and what it is they want to accomplish with their enforcement arm. One would assume that the neither-admit-nor-deny approach of settling cases, entering a settlement with financial penalties but not requiring the institution to acknowledge that it actually did something wrong -- and really they haven't gone after a lot of individuals for their role in these big financial problems in the big big banks -- um, that's going to likely generate higher cash value of settlements because they are more valuable to the institutions than ones in which they are acknowledging liability and therefore giving the basis for follow-on civil lawsuits from other entities. It is an approach where if your goal is to maximize returns for the agency and the victims in the form of restitution, it's probably the right approach.
If you come with a different approach, a different perspective, my perspective, an equally important if not more important goal is deterrence, and causing enough pain so that these types of behaviors don't continue -- so you don't have these serial settlements of neither admit nor deny.... And that's not to say it doesn't have any place -- it may have some place -- but it certainly feels like the overwhelming default is to do this. The reality is that for these institutions several hundred million dollars in penalties and fines is unlikely to change significantly their behavior as an effective deterrent, and it may be worth rolling the dice and trying some of these cases, and winning, and scaring them into doing settlements of admissions of liability to achieve a significant deterrent effect, so the ramifications are more significant than the bad behavior.
Goldman Sachs had that $500 million and change settlement on the CDOs with the SEC and no admission of wrongdoing, and that certainly seems to be the default approach. But the SEC would argue that they don't have the resources to go to trial with these institutions, that they are outgunned, and that they may very well lose. In fact, they do frequently lose. The ideal would be that you use very few resources and you win a case against a massive financial institution, but critics would argue with you that it's not a particularly realistic outcome.
And that's absolutely right. In a world of limited resources, going to trial in these cases, even if you win you might not get the same dollar value that you achieve in your settlement -- all completely true. The bottom line is if you're committing resources to trying big cases in a world of limited resources, that means there are other cases that you're not making. All these are very, very true statements and that's why I say we need a reexamination.
On the other hand, you know, what is the measure of the accomplishment of an agency that's supposed to protect the markets if it's not achieving the appropriate level of deterrence to keep this type of bad conduct from happening again? And that's why it's a delicate balance, but part of this requires having a realistic conversation with Congress, talking about the fact that approaching this to bring real accountability and real deterrence may end up costing more money, if they don't want other security fraudsters to go free. And that may be the most unrealistic thing in the world, in these days of budget negotiations and fiscal cliffs, but a relatively modest initial investment in the SEC could yield significant returns, not only in the form of money coming back to the agency but for systemic stability that led to the last crisis.
You've actually successfully prosecuted complex financial frauds.
Yeah, and look, I've gone into cases, where I thought I had rock-solid cases, walking into grand jury for an indictment, and I heard a defense argument or saw a defense presentation of something I didn't know, that made us walk away from the case. That's why I say it's really hard to judge and know for sure without hearing all of their arguments. But when I hear arguments like, Well, we can't afford to try these cases, it makes me question whether the line is being drawn in the right place. But look, it would require a real assessment of what the goals of the agency are and what the SEC is supposed to be doing and what it wants to accomplish. Like I said, there is absolutely a fair and rational basis for saying that maximizing your return to potential victims and to the agency is a legitimate purpose for the SEC to pursue as a primary mandate; it might be written into their policy. I would advocate for a reexamination of the roles and deterrents in systemic stability, on top of those other concerns. I just might draw the line in a slightly different place than it's been drawn.
Money markets are sort of the ground zero for the crisis and it seems like, well, you have a chairman like Mary Schapiro who wanted to reform the money markets and then she was outvoted by the other commissioners, one of whom was appointed as part of her own party. To what extent are the problems at the SEC structural and to what extent could one person actually make a difference in changing the agency to perform better?
That's a heavy question. It is a commission structure, it's going to be a commission structure, and ultimately a chairman doesn't get to decide who their co-commissioners are and from what industries they are drawn or where their sympathies are. But I think one of the important jobs of a commissioner -- and I think Schapiro has started this process -- is using all the tools in your toolkit to try to accomplish the type of reform that you think is necessary. So look, good for her for going to [the Financial Stability Oversight Council], although I wouldn't say their reaction out of the box and how long it has taken is necessarily the perfect way; at least, rather than just folding the tent on this issue, there is this push forward to do something. But look, I think compromise is essential and sometimes it's not.
There's sort of a bigger picture here... the idea of having a floating net asset value is absolutely an essential type of reform to avoid the next crisis, [and] you should go all in with every lever you can pull. Whether that's press, whether that's Congress, whether that's through FSOC, whether that's through making it a priority, whether it's seeking legislative suggestions as well as a regulatory fix, putting all the tools on the table if you think it's a make or break issue. That's certainly one of those areas.
But it's a broader definition of the role of chairman as well. The Financial Stability Oversight Council has been a tremendous disappointment to date. If I were to be chairman of the SEC, as a voting member of FSOC, one of the 10 voting members, there's opportunities for one individual to push that entity and that organization, which is so crucial to regulatory reform, to be more transparent, to be more proactive, to be more nimble, and to push harder and if necessary more publicly for the types of necessary reforms to protect the financial system, you know, behind the scenes and in front of the scenes if necessary.
Can you explain the problem with money markets, for those who don't know what the issue is?
At its very core, money markets are not insured deposits. They are investments that are subjected to risk, which means they can go up and they can go down in value. Essentially what has happened over the years is they have been transformed in large part because of the perception that the government will bail them out as being the equivalent of an insured deposit. And part of that comes with this rule that allows them to maintain what's called the net asset value of $1, which essentially means that they get to, despite whether or not the value of the assets in the fund go a little bit above a dollar or go below a dollar, they're being able to hold out to depositors in these funds as being $1, which means the depositors can redeem at $1. Which is again the equivalent of, if you go to Citibank and open a deposit account, your principal is being held at the value of the money you put in. So money market funds offer the same type of almost implicitly guaranteed returns, but the problem is that it is not an explicit guarantee, the government doesn't explicitly stand behind it, and if there are losses in one of these funds, and they are significant enough to affect the value of the fund, then investors will take a loss.
But what happens is it becomes this presumption of whatever you put in you're going to get out, plus the interest along the way; it becomes a fundamental part of the banking system. And because these funds are such a prolific source of funding for the big banks in the commercial paper markets and elsewhere ...
Three or four trillion dollars or something like that …
So, for example, when they have exposure and one of these institutions or big counter parties goes down, like, say, Lehman Brothers went down and its commercial paper went to zero, and these money market funds suffered significant losses, and that means the value of these funds will go below a dollar. And because of the way these things are structured and because of the need to maintain these net asset values at $1, if you as an investor in one of these things suspect that they may have to drop the price below a dollar because of significant losses, there's a huge incentive to get your money out first before the fund recognizes the drop in value, which creates these tremendous runs, which we saw in the financial crisis. As everyone tried to pull their money out in order to get that dollar value, before the values went below a certain threshold where they'd have to recognize those losses, that pulled huge amounts of liquidity out of the financial system, which only was restored after Treasury came out and guaranteed every money market fund. So that implicit guarantee from the government with the taxpayers standing behind it became explicit. So basically we did that for awhile but we haven't fixed any of the fundamental problems that go behind this process. And, again, the implicit guarantee of taxpayers standing behind remains to this day and that's going to set the stage for, if another large-scale loss of a counter-party in the commercial paper market would likely trigger yet another run, pulling so much more money out of the financial system again -- money that so much of the large financial institutions are dependent on for their daily obligations, which could yet again trigger a massive crisis.
So this is kind of ground zero, money market funds and tri-party repo and the shadow banking system, and frankly they haven't been fundamentally addressed or fixed since the financial crisis. And they're only getting bigger; when you look at tri-party repo it's only bigger and in some ways more dangerous than back in 2008. And meanwhile, we've done very little on money market funds and we've done almost nothing on the repo market. So these are areas that the Financial Stability Oversight Council and the SEC chairman, as a member of that and within their own jurisdiction, needs to be aggressive and move forward, if we want to protect the systems from another crisis.
I heard you talk about FSOC, which is a council of regulators set up in the Dodd-Frank financial regulation that is supposed to be the overall watchdog or systemic regulator. They have had meetings, and nobody really notices them because nothing significant really goes on. They made a few moves on money markets, but I haven't heard any comments on that particular piece of the law. What do you think can be done? I mean, it's 10 regulators who get together, chaired by the secretary of the Treasury. Why is that a useful body, what would you do with it?
Well, I think there's tremendous things that the stability council can do. In many ways it's the fundamental bedrock on which Dodd-Frank is built; it's this super-regulatory council that has the power and authority under its auspices to really do the functional equivalent of breaking up the biggest banks if they get too big, of taking extraordinary measures to protect the financial system, of compelling or forcing the kind of regulatory rules that need to be adopted. It has a huge amount of potential, but it's done precious little since it's been enacted. In part that's because of a lack of transparency; there's really not a lot of knowledge of what goes on behind closed doors. Part of their meetings are in the public, but the rest of them are done essentially in secret.
I was briefly on an inspector general oversight board that was supposed to provide some oversight of the council. They wouldn't allow the head of that oversight agency to even show up at the nonpublic portions of those meetings, making it not even subjected to the oversight Congress intended. So pushing for transparency always helps its related cousin, accountability, and so while there are always going to be areas of systematic regulation that by definition may have to be shielded from the public, this appears to be much more of a black box that may be being used to hide accountability, and in effect very little is being done. And, frankly, I think you have a secretary of the Treasury who runs this council, who is chairman of this council, who has not pushed for effective regulatory reform and the dramatic steps that are necessary, and that's sort of the current ideological place of the oversight council.
I can see you're really lobbying for the job.
Matt, let's be realistic. If I came out and said Tim Geithner was doing a terrific job it wouldn't help me get the job and it would be pretty obviously untrue. If the president wants to have someone who will serve the interests of the American people as they deserve to be on the SEC Commission, I would hope he wouldn't want someone who would just be a rubber stamp for whatever the Treasury secretary wants at any given moment.
You're one of the few people I've met in D.C. who a) talks like a normal person and b) is pretty honest about the people involved instead of speaking in platitudes to avoid criticizing powerful people. You're just sort of straight up saying, "this is what the Treasury secretary is interested in and this is what he's not interested in.” And you're pretty honest. There's a part of your book where in the hiring process your press secretary said, “I'm not going to lie for you,” and that to you was a big plus. And at SIGTARP overseeing the bailouts you were pretty straightforward with the press in a way that almost no one else is. But there's a reason that's a rarity in D.C. You were at a fairly high position in government, you've had multiple high positions in government -- how did you make that work? How did you avoid the standard D.C. game?
When I was at SIGTARP I put the job and the oath I took for office, and I know it sounds cheesy, above my personal advancement. And look, the way I did this job is a really, really terrible way to become chairman of the SEC, or moving up in the administration. I was told point blank that the way I carried out this job was going to significantly hinder my ability to move up in the administration and get a higher-ranking government job. But you know, I think a lot of people go to D.C. with the intention of taking a position and leveraging it higher and higher in order to get a higher ranking, an ever more powerful job, and therefore you have to sort of play the game if you want to advance by those set of rules. I didn't go to Washington with the intention of staying there and positioning myself for a higher-level position, I went there to do the job I was asked to do and supposed to do. So that was a bigger priority than my personal advancement. And so this is why it's fun to talk about this, but it's extremely unlikely that it's going to happen, precisely for that reason. I wouldn't suddenly become the SEC commissioner and hold my tongue because I saw something that was going the wrong way, especially if it's something that's tremendously important. That doesn't mean I wouldn't work within a commission structure, and, by definition, chairman …
Well, that's the thing, you had really good relationships with Republicans and Democrats.
If you speak the truth it's accepted that you don't have a hidden agenda, that you're not trying to serve personal interests, that there will be people in Washington who respond and react to that. Some because it's in their political interest to do so, some because they believe that they can trust you to do the right thing even if it's not always what they want you to do. So you know it's not that I couldn't work within a commission structure in terms of finding consensus, it's a, look, a lot has to do with the type of job you have. I was given a job at SIGTARP that was by definition not a consensus building job. It was a job where you try and find problems and mistakes and make recommendations to fix them. That was exactly what the job was, it required a bulldog approach. I would work within whatever system I had to make the most effective and positive change. But that doesn't mean you need to compromise on what you think is important, or to bullshit, frankly.
What about the flash crash and high frequency trading and some of the structure of the capital markets that Sen. Ted Kaufman pointed to that seemed to be problematic and are causing mistrust within the capital markets?
The SEC definitely has a role to play in high-frequency trading, and it's a very important role. I'm not going to pretend to be conversant on the issue, I don't have a deep grasp of the issue, it's just an area that I've spent a lot of time looking at. If I were actually being vetted for the position, in the real world, I'd get smart on it in a hurry. And Sen. Kaufman has been right about so many things, he'd be an excellent place to start as a source. It certainly does appear to be a portion of the market that has not been living up to all of its promises and propaganda that's put out by the industry and obviously it's an area that needs tight regulation. What specifically that regulation would be I'd have to look into a lot more before I start having a specific position.
What are the signs going forward that the SEC is performing well or performing poorly? And, actually, I would expand that to financial reform in general because the rules are being written for the next year or so.
A lot of it is going to depend on who the individuals are. You're going to have a new SEC chairman, most likely not going to be me [laughter], so the agency will take a lot of cues from the person who is selected and what their positions are and what role they've played so far, if any, inside of government. That person will then start populating the agency with their own picks, a new head of enforcement, etc. You can sort of take a little bit from that as to which direction they're going to be going for, of types of people and their background. Will it be folks who are from the industry, or part of the industry, and who are susceptible to arguments from the industry, or those who have a background that is more reform-minded and enforcement-minded? And with all of these things that's sort of what you see, is where they come out on these issues, which are so ferociously being lobbied by Wall Street, and whether they show an undue deference to these arguments, the same arguments that have been made for decades, to water down reform. Concerns about international competitiveness, and restricting credit markets, these sort of canards that are rolled out …
Actually, Department of Justice criminal division head Lanny Breuer said that when deciding whether to bring cases against corporations, one of the arguments large corporations would make was that there was a systematic risk in bringing the case. That made sense to them and they accepted those arguments from economists.
I saw that and, frankly, what Lanny said is sort of a very honest indication of the reality that faces the country now with "too big to fail" banks. In 2009, it really wasn't possible to indict one of the largest financial institutions for fraud because it really would bring down the entire financial system. And that's a problem that the Department of Justice can't solve; that's a problem the Financial Stability Oversight Council and the Treasury Department and the regulators have to solve first.
And that's underlying all of this. Now the SEC is in a different place, because an SEC case is not going to bring down an institution the way a criminal indictment would. It's a different set of standards.
Policymakers decided that was not a viable option in 2008 and invested huge amounts of treasure and energy to keep them alive. So I think it's an honest acknowledgment of what's very, very broken with our financial system and continues to be broken with our financial system. But again, from the SEC perspective I think that's a very different concern. And look, you have seen some big settlement cases, some big cases, with record settlements that have come out of the SEC, so you know I think that would be less of a concern on that side. But, look, you know ultimately it's something; you have the framework of Dodd-Frank, which can do good things around the edges, and you know, could with the right amount of political capital do dramatically good things. And you know the SEC has a small but very important role of carrying out Dodd-Frank within its four corners, and we'll see if they're going to be aggressive and fighting back against the endless loopholes and waivers and exceptions that seem to be being passed down on a daily basis from the Treasury Department, or whether it's going to be a go along, get along response that won't forestall the next crisis.
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