Obama's bank regulation: Doomed to fail?

Administration lax on cleaning up AIG, Bear Stearns, and Lehman Brothers

That annoys the hell out of proven financial-crime fighter Bill Black. Athletic and red-bearded, Black looks more like a lumberjack than a scholar, criminologist, and bureaucrat who, in 2005, authored The Best Way to Rob a Bank Is to Own One, the definitive history of the S&L debacle. A legend among regulators, he faced down House Speaker Jim Wright and the "Keating Five" senators (including McCain), who fought tooth and nail to protect that corrupt industry, and he overcame stiff resistance from within the Reagan administration.

Black always has a big smile and a ready joke, but he burns with the intensity of an Old Testament prophet, especially against "control fraud," the lawlessness that emanates from the top of legitimate businesses and causes bigger financial losses, he has said, than all other forms of property crime combined. Corporations practice control frauds with crooked accounting and perverse compensation systems, using bonus formulas that lead executives to loot their companies rather than serve them.

Now an associate professor of law and economics at the University of Missouri at Kansas City, Black has continued the fight against fraud and for regulatory controls as a consultant to a gamut of agencies from the FBI to the World Bank.

In 2007, the Office of Federal Housing Enterprise Oversight hired him to investigate the problems at Fannie Mae. His 70-page report plainly outlined how Raines and his lieutenants used "fraudulent accounting" and "perverse incentives" and took "unsafe and unsound risks" that "collectively caused Fannie to violate the law and deceive its investors and regulators."

Almost two years before the financial crisis broke in late 2008, Black, the FBI, and others outlined the structural problems that would wreck the economy, but Washington did nothing and continued to exercise "regulatory forbearance."

Black vents particular ire at Tim Geithner, who, as New York Fed chair, fiddled while Wall Street imploded; Henry Paulson and Geithner again, who, as Treasury secretaries, refused to enforce a key banking law; and Alan Greenspan and Ben Bernanke, who, as Fed chairs, were supposed to regulate banks, especially the renegade mortgage units. The two Fed chairs closed their eyes to excess and continued to blow easy money into the bubble.

The key statute that Treasury flouted under Paulson and Geithner is the Prompt Corrective Action (PCA) law. Congress passed it in the wake of the S&L scandal in 1991, and the first President Bush signed it. It's probably the best, fairest, and clearest piece of financial legislation since the New Deal. Under the law, Federal Deposit Insurance Corporation (FDIC) examiners initially rate banks as "well capitalized," "adequately capitalized," "undercapitalized," "significantly undercapitalized," and "critically undercapitalized." The tags determine the examiners' actions, if any. Undercapitalized banks must build up their capital and get FDIC approval for acquisitions and opening new business lines. When a bank becomes significantly undercapitalized, a regulator can order serious sanctions, ranging from firing management to restricting stock sales and forcing divestitures. Critically undercapitalized banks must be placed in receivership, unless the FDIC determines that some other action like a merger or sale would better protect the depositors.

The PCA worked like a charm. During the entrepreneurial Reagan-Bush era, the banking system had become a mess. Often more than a hundred banks failed annually, as will happen this year (as has happened this year). After the PCA, banks cleaned up and failures became rare—only a handful per year and sometimes none.

But after the second Bush's election in 2000, the PCA began to wither from disuse, especially because of opposition from the megabanks and the laissez-faire policymakers. Toward the end of the Clinton administration, Washington caved in to the financial lobby and passed new laws that promoted risk. Congress repealed the Depression-era Glass-Steagall Act, which had drawn a sharp line between commercial banks and investment banks. Another new law immunized securitizers from lawsuits even if their products were rubbish. A third allowed the wildest form of derivatives—"naked" credit default swaps, which are side bets on CDOs that could be placed by investors who didn't even own the bonds. The old prudent conservative banking model gave way to the sleek megabank casino. The message from the Bush administration was clear: The PCA "ceased to be applied to the big boys," says Camden Fine, president of the Independent Community Bankers of America. With his square jaw and plainspokenness, Fine calls to mind Jimmy Stewart in It's a Wonderful Life. Like Stewart's George Bailey, Fine is a small-town banker, though now he is the sole lobbyist for about 5,000 member banks around the United States.

Fine says he can live with the PCA law and even endorses it, but he detests that it was no longer being used for the megabanks. "Greenspan—banks couldn't get too big for him," Fine says ruefully. He recalls a 2004 battle in which the Fed wanted to remove all capital-reserve requirements from the big banks. Fortunately, the FDIC won that scrum. Otherwise, the megabanks' behavior could have been even riskier and more devastating than what occurred. Eventually, it became clear that "nothing was happening to the big banks, and everyone knew they were sliding south," says Fine. Major banks like Wachovia, National City, Bank of America, and Citigroup became critically undercapitalized, but regulators did nothing.

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