Wag the Reg: SEC Timed its Suit Against Goldman Sachs to Hide Stanford Screwup

Here are two interrelated questions about the SEC: Why is the agency so crappy, and why is it getting stronger? And here are the answers: It's complicated, and anyone got a better idea?

The latest example of said crappiness surfaced yesterday when SEC Inspector General David Kotz all but admitted that the agency announced its April lawsuit against Goldman Sachs (GS) to divert attention from his office's report -- issued the same day -- blasting the securities watchdog for repeatedly failing to nab alleged fraudster R. Allen Stanford. Asked about the timing of the action against Goldman, Kotz said:

It would strain credulity to think it was coincidental. I can't give you a conclusion right now, but it was suspicious.

More enlightening was hearing Kotz explain why Stanford, accused of running an $8 billion Ponzi scheme, slipped through the net despite having been under investigation for more than a decade. Indeed, staff in the SEC's Fort Worth, Texas, bureau had repeatedly concluded the financier was dirty. They did nothing. The major reason, as Kotz told the Senate Banking Committee, is that the SEC discouraged taking on big cases:

We found that senior Fort Worth officials perceived that they were being judged on the numbers of cases they brought -- so-called "stats" -- and communicated to the Enforcement staff that novel or complex cases were disfavored. As a result, cases like Stanford, which were not considered "quick-hit" or "slam-dunk" cases, were not encouraged.

Yet the SEC seems to have elevated standard bureaucratic wariness to an operating principle. That same timidity is visible in the agency's bumbling investigation into Bernie Madoff and, earlier, its sluggish response to the "analystgate" scandal after the tech bubble burst. It also may explain why the agency and other federal enforcers seem so reluctant these days to prosecute bankers for their misdeeds during the financial crisis. As Sen. Edward Kaufman, D., Del., said during the testimony:

I know that the Justice Department, the FBI, and the SEC have all been working incredibly hard, reviewing countless transactions, interviewing myriad witnesses, poring over literally millions of pages of documents. And yet we have seen very little in the way of senior officer or boardroom-level prosecutions of the people on Wall Street who brought this country to the brink of financial ruin. Why is that?

Poor leadership. Former SEC Chairman Christopher Cox proved feckless in responding to the financial crisis, especially after Bear Stearns collapsed in 2008. But such problems go further back, with commissioners too often engaging in partisan in-fighting and previous chairmen focusing on protecting their institutional turf rather than enforcing the agency's mandate.

Regulatory capture. Cox admitted in 2008 that the agency's botched supervision of Wall Street worsened the financial crisis. The main problem was that investment bank holding companies could choose to be regulated -- or not, which on the other side of the housing crash seems laughable. For decades, the agency -- and the broader business community -- pushed the idea that corporations could regulate themselves. Also under the influence of this ideology, the agency let Wall Street lever up and gamble its way into penury.

Lagging the securities industry. The SEC has long struggled to keep up with changes in the securities market. From exotic financial instruments (think synthetic CDOs and credit insurance) and bogus risk management models (think Citigroup) to advances in technology (think "flash crash"), the agency has a history of falling behind the investment world. In a related problem, the SEC has been heavy on lawyers, but light on experts in financial markets. That makes it hard to fulfill its mission of keeping markets transparent and protecting investors.

Weakening state enforcement. Invoking so-called legal preemption, federal regulators over the years have increasingly hogged the authority to supervise the financial industry and have sought to marginalize state officials. Big mistake. Local regulators have played a vital role in monitoring financial firms and clamping down on a range of harmful financial practices, most recently the scandal over auction-rate securities.

All of this would be troubling enough even if the Dodd-Frank financial reform law didn't hand the SEC a raft of new powers. These include expanded authority to prosecute anyone violating securities law, offer monetary rewards to corporate "whistle blowers" and bar securities pros from working for regulated financial firms.

Yet despite its flaws, the SEC is today more important than ever. Dodd-Frank charges the agency with developing a range of rules aimed at solidifying the capital markets and shielding investors. But the challenge facing current SEC chief Mary Schapiro is Herculean. She must revamp securities regulation at the same time she revamps the agency's culture -- even as financial firms seek to curb reform and our political class enact their usual election-year drama. Good luck to her.

Related:

• House Beautiful: To Clean Up Wall Street, Banks Must Camp Out at Banks
• For Financial Watchdogs, Principle Counts More Than Discretion
• Sure Bet: How Wall Street is Dodging the Volcker Rule
• Financial Reform: Four Reasons Why Stricter Financial Regulation Isn't Enough
• Ex-SEC Boss Arthur Levitt Tells it Like it Ain't
• No Time: Feds Have Given Up Trying to Send Bankers to Jail