Financial Regulators Missed the ARS Market, But That’s Par for the Course

I can’t help but note the irony of David Brown, executive director of the New York State Dormitory Authority, lambasting Wall Street for allowing the collapse of the auction rate securities market.

“As a whole, this is not the finest hour of the investment-banking community,” the Wall Street Journal quoted Mr. Brown as saying. Auction dealers “are refusing to make a market in the securities, saying publicly the product is dead and everyone has to get out of it,” then recommending debt restructurings “where they will earn yet another investment banking fee.”

I applaud Mr. Brown for sounding his criticisms, as I already have voiced the same concerns. But let’s be honest here: As a whole, this also isn’t the finest hour for regulators and some former prosecutors, including Eliot Spitzer, who served as New York’s attorney general before being elected governor.

Mr. Brown was a deputy attorney general under Mr. Spitzer. He was the person who spearheaded a probe of mutual fund trading abuses that ultimately resulted in some $3 billion in fines. There’s no questions that is a severe penalty, but regulators gave a pass to the executives ultimately responsible for the wrongdoing. To Mr. Spitzer’s credit, he at least took some action to punish the mutual fund industry for its improper market timing trading; the practice was well known and reported in 1997 by then Wall Street Journal reporter Charlie Gasparino (no link available), who quoted SEC officials as saying they would investigate the matter. The agency did nothing until Mr. Spitzer stepped in.

But imposing fines on Wall Street firms has hardly proven to be a deterrent for Wall Street, particularly since most of the penalties are puny to begin with. The SEC in 2006 charged 15 Wall Street firms with wrongdoing relating to auction rate securities and let them off with a $13 million fine, which didn’t even constitute a wrist slap. So no one should be surprised that some of the wrongdoing continued. Wall Street executives regard regulatory and prosecutorial fines as simply the cost of doing business.

Wall Street cannot be reformed until regulators and prosecutors begin taking legal action against the top executives at the major firms. Most, if not all, the top Wall Street executives knew about market timing and it’s highly unlikely there weren’t aware of the wrongdoing taking place in the auction securities market. Federal prosecutors have done an impressive job garnering convictions of CEOs and other top executives at companies involved in wrongdoing; if Mr. Brown laments Wall Street’s ways, his criticisms should also be directed at the SEC and Mr. Spitzer.