An Ounce of Prevention, SEC Edition

Zachary Goldfarb reports in today's Washington Post about the SEC's efforts to reform its enforcement image.  There are plenty of examples given that illustrate how far the SEC has to go, and I am not going to argue that enforcement shouldn't be better and that securities fraud is okay.

But lax enforcement was not the SEC's main contribution to the financial crisis.  The place where the SEC screwed up, and the revelation that should have shaken things up 18 months ago, was this event, reported by Stephen Labaton in The New York Times:

Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.

On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr.  Two years later, he left to become Treasury secretary.

The place to stop the damage was by limiting the extent to which the big investment banks could issue debt to leverage their bets on risky activities.  Enforcement is expensive.  Prevention is cheap by comparison.