Recently, the Fraud Enforcement and Recovery Act of 2009 (“Act”) was signed into law. That legislation generally broadens the coverage of current laws against financial crimes, including fraud affecting mortgages, securities and commodities, and authorizes additional funding for the Justice Department to hire fraud prosecutors and investigators. The Act also provides for the establishment of a “Financial Crisis Inquiry Commission” (“Commission”) in the legislative branch intended to investigate the causes of the existing financial and economic crisis in the United States.
The Commission is modeled, to some extent, on the 9/11 Commission and the Depression-era Pecora Commission, which held financial hearings in the 1930s. The Commission will be comprised of three (3) members appointed by each of the Senate majority leader and the Speaker of the House of Representatives and two (2) members appointed by each of the Senate and House minority leaders. The Act provides that members of the Commission should be prominent United States citizens with nationally recognized experience in areas such as banking, market regulation, tax, finances, economics, consumer protection and housing. No member of Congress or federal, state or local government employee may serve on the Commission.
The Commission will have a chairperson selected jointly by the Senate Majority Leader and the Speaker of the House and a vice chairperson chosen jointly by the Senate and House minority leaders. The chairperson and vice chairperson may not be from the same political party. The chairperson and vice chairperson are authorized to jointly appoint a Commission director and additional necessary staff.
The Act gives the Commission several general functions. The first is to investigate the causes of the financial and economic crisis. The Act designates certain specific possible causes that the Commission is to examine, including the following:
- fraud and abuse, specifically towards consumers in the mortgage sector;
- the federal and state financial regulators, particularly their enforcement of, or failure to enforce, statutory, regulatory or supervisory requirements;
- the global imbalance of savings, international capital flows and fiscal imbalances of various governments;
- monetary policy and the availability and terms of credit; accounting practices, including mark-to-market and fair value rules and treatment of off-balance sheet vehicles;
- tax treatment of financial products and investments;
- capital requirements and regulations on leverage and liquidity, including the capital structures of regulated and nonregulated financial entities;
- credit rating agencies, including the reliance on credit ratings by financial institutions and regulators and the use of credit ratings in securitization markets and financial regulation;
- lending practices and securitization, including the originate-to-distribute model for extending credit and transferring risk
- affiliations between insured depository institutions and securities, insurance and other nonbank companies;
- the concept that certain institutions are “too-big-to-fall” and its impact on market expectations;
- corporate governance, including the impact of conversions from partnerships to corporations;
- compensation structures and changes in compensation for employees of financial companies, as compared to compensation for others with similar skill sets in the labor market;
- the legal and regulatory structure of the United States housing market;
- derivatives and unregulated financial products and practices, including credit default swaps;
- financial institution reliance on numerical models, including risk models and credit ratings;
- the legal and regulatory structure governing financial institutions, including the extent to which the structure creates the opportunity for financial institutions to engage in regulatory arbitrage;
- the legal and regulatory structure governing investor and mortgagor protection;
- financial institutions and government-sponsored enterprises; and
- the quality of due diligence undertaken by financial institutions.
Another function given the Commission by the Act is to examine the reasons for each “major” financial institution failure, or major failure that was prevented by government assistance, from August 2007 through April 2009. The Commission will therefore be looking into specific cases, as well as the broader causes for the crisis.
A third function is to submit a report containing its findings to the President and Congress by December 15, 2010. The chairperson is also required to appear before the Senate Banking Committee and the House Financial Services Commissioner within 120 days of the date that the report is submitted.
A fourth function is to refer to the Attorney General of the United States and the attorneys general of any relevant states information regarding any person that the Commission finds may have violated the laws of the United States in connection with the financial and economic crisis.
The Act provides the Commission with authority to hold hearings and receive evidence. The Commission also has subpoena authority. In an effort to reduce politicization, a subpoena may only be issued if the chairman and vice chairman agree or a majority of the Commission, including at least one member appointed by the minority, approves. United States agencies and departments are directed to furnish information directly to the Commission upon request. However, President Obama’s signing statement indicated that the executive branch will construe that aspect of the Act as not abrogating any constitutional privilege, meaning that the President has reserved the right to assert that certain documents are protected by executive privilege.
Senate Banking Committee Chairperson Dodd and House Financial Services Commissioner Frank have indicated an intent to enact financial services regulatory restructuring legislation by the end of this year. The Obama Administration, likewise, has indicated that regulatory reform is a major priority. Inasmuch as the Commission’s report is not contemplated until almost the end of 2010, the Commission’s findings may not be rendered in time to benefit the process for the regulatory restructuring legislation, absent unexpected delay. That is not unusual; for example, the 9/11 Commission issued its report after the Patriot Act and Homeland Security Act had been adopted. Nevertheless, it is possible that interim reports and findings of the Commission, as with the 9/11 Commission, will have an impact on the restructuring legislation
Perhaps of particular note is the absence from the list of possible causes to be studied by the Commission is a specific reference to the actions and inactions of Congress and regulators as to government-sponsored entities (Fannie Mae, Freddie Mac, FHA) with respect to capital and mortgage underwriting standards. There is a reference to possible regulatory failures in imposing mortgage leverage limits on financial institutions, which is widely perceived as having been a cause of the crisis. Perhaps the Commission will suggest strengthened rules limiting mortgage leverage and risky mortgage terms.
Credit ratings agencies are listed for study. The Securities and Exchange Commission (“SEC”) has had regulatory oversight of them since June 2007 and it recently proposed new rules designed to promote more transparency. However, the Commission may look into whether any conflicts inherent in the issuer paying for the ratings requires the establishment of investor-owned credit ratings agencies, and other solutions.
The reference to the structure of regulation of financial institutions and regulatory arbitrage includes consideration of establishing a systemic stability regulator (SSR). Various proposals have already been made in Congress and by the Treasury Department for an overarching SSR, perhaps with rulemaking power over other agencies. It remains to be seen if the Federal Reserve Board will be the SSR or a new SSR agency will be created.
The references to the legal and regulatory structure for investor and mortgagor protection and fraud and abuse in the mortgage area, are important because the Treasury Department has indicated some interest in proposing a new cross-agency horizontal products regulator. Any such a proposal is likely to be opposed by individual agencies that would lose jurisdiction or be subject to supervision themselves by the cross-agency regulator.
The derivatives and unregulated products and practices cause is significant because, not only has legislation already been introduced, but the Treasury Department is making proposals in the area. Some proposals call for a mandatory exchange, others call for insurance and capital requirements, all call for more regulation. The Commission can contribute in this area toward elimination of regulatory gaps and reregulation of what is one of the biggest single markets in the world—derivatives. In addition, stronger regulation of the mortgage brokerage industry, largely responsible for writing many of the subprime and Alt-A mortgages, seems a possible outcome.
With respect to the accounting cause, such as mark-to-market accounting and off-balance sheet accounting, such matters have already been the subject of legislation and an SEC report at the end of 2008. The ultimate questions are whether the Commission will suggest that more assets be placed in the held to maturity account, resulting in less marking to market, and whether further limitations are placed on the ability to transfer assets off balance sheet without a capital requirement. Short selling is already the subject of new SEC rulemaking, such as restoration of the uptick rule in a revised form, but an issue remains as to whether the Commission will ask for complete outlawing of naked shorting and other techniques which allegedly produce great market volatility.
Executive compensation is always a topic of interest for Congressional inquiry, but recent statements by the Treasury Department move away from compensation caps and focus on perverse incentives resulting from bonus and other incentive compensation which does not have long term financial results as a requirement.
The Commission will have a big job to do identifying the causes, ranking them and suggesting reform. Many parties will likely have input, including the Treasury Department, Congress itself and the public. Hopefully, the Commission will not become politicized and can produce a report comparable in quality to the 1933 Pecora Commission and 2003 9/11 reports.