The SEC and the Financial Crisis University of Wisconsin-Madison Center for World Affairs and the Global Economy March 25, 2009 _________________________________ Darian M. Ibrahim Assistant Professor of Law University of Wisconsin Law School

Overview Why talk about the Securities and Exchange Commission? – Untold Story Most Attention on Treasury Department/Federal Reserve Exception: John McCain: “Fire Christopher Cox!” – Important Story SEC Regulates Investment Banks Investment Banks key players in subprime securitizations and CDS/derivatives markets Plan of Attack – Examine SEC’s past, present, and future – Past and present will focus on SEC’s origins and purposes, culpability for current mess – Future will put SEC in context of broader U.S. financial regulatory structure

SEC’s Past Origins & Purposes Origins of SEC – Great Depression: Swindlers selling worthless stock – SEC: Administrative Agency created after Great Depression as part of FDR’s New Deal – Administers 1933 Securities Act (offerings of “securities”) & 1934 Exchange Act (ongoing obligations for public companies) – Disclosure philosophy (“Sunlight is best disinfectant”) Purposes of SEC – To protect investors by eliminating fraud – Eliminate fraud by requiring truthful disclosure, enforcing Is it Working? – U.S. has been global financial leader – Still some spectacular failings (Enron, WorldCom, Madoff)

SEC’s Present The Current Financial Crisis: Is the SEC to blame? Arguments that SEC is culpable – Oversight over Investment Banks (Big Five: Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, Morgan Stanley) – Investment Banks Way Overleveraged, SEC allowed it Prudence: D/E Ratio of 1 Pre-2004: “Hard” Net Capital Rules (D/E Ratio of 15) 2004: “Hard” Net Capital Rules (D/E Ratio of 15)  “Soft” Internal Risk Models (D/E Ratios of >30) Result: More Purchases of Toxic Assets & Less Ability to Cover Losses  Failures  Domino/Chain Reaction effect Arguments that SEC is not culpable – Designed to deal with fraud, not chain reactions (systemic risk)

SEC’s Future Will it Survive? Challenges from the Current Crisis – Focus going forward on systemic risk, not fraud – Wither the Investment Bank – Lehman Brothers – Bear Stearns  – Merrill Lynch  – Goldman Sachs  – Morgan Stanley  Challenges even before Current Crisis – Competitive Global Markets, SEC Regulation Too Costly – Treasury’s 3/08 Blueprint for Financial Regulatory Reform – “Twin Peaks” model of financial regulator (systemic risk oversight under Fed, all types of investor/consumer protection under new “business conduct” regulator) JPMorgan Chase (Fed) Bank of America (Fed) Bank Holding Company (Fed)

U.S. Financial Regulatory Structure Should we move to “Twin Peaks” or a Single Regulator? Current Structure: Separate Regulators by Industry – Securities/Futures: SEC, CFTC – Banking: Federal Reserve (OCC, FDIC, OTS) – Insurance: States – Swaps: (including credit default swaps): No One (Congress, 2000) Should U.S. Consolidate its Regulators? – Arguments For: Other Countries Doing It (UK single regulator, Australia twin peaks) Industries are Consolidating (e.g. Citigroup = Banking + Insurance) Economies of Scale/Efficiency Gains (adaptive capacity) – Arguments Against: Political Impediments Make Unrealistic Loss of Sector-Specific Expertise