Investors must take responsibility: former SEC Chair

There’s a lot of blame to go around for the troubles caused by the U.S. sub-prime mortgage market, but among the biggest culprits are investors themselves, says the former chair of the U.S. Securities and Exchange Commission.

At the Dialogue with the OSC held recently in Toronto, Arthur Levitt, the longest-serving chair in SEC history, told a packed house that the sub-prime crisis is as serious as any other financial crisis in living memory.

“In terms of market meltdowns and the degree of pain inflicted on the financial system, the sub-prime mortgage crisis has the potential to rival just about anything in recent financial history, including the post-Enron downturn of a few years ago,” he said.

During his tenure at the SEC, which ended in 2001, Levitt earned a reputation as a protector of the individual investor, but he believes investors do have to bear some of the blame for recent events. He argues they didn’t orchestrate the sub-prime crisis, but they did buy into a “deification of debt.”

“None of this takes place in a vacuum. A prospering society gave way to gluttony of debt. New businesses developed, pandering to unsophisticated appetites for the good life. A ‘starter’ home became a mansion; a 60% mortgage became ‘no-money-down’ borrowing,” Levitt said. “Incentives created by banks and intermediaries were as obscene and addictive as narcotics, while radio, TV and newspapers, lured by this new source of ad revenue, flooded the community with ‘pie in the sky’ inducements to borrow.”

Investor ambivalence may have fuelled the crisis, but Levitt believes that if the proper gate-keeping measures had been in place, the crisis might not have been as severe as it is. He places particular blame on credit rating agencies, which, he said, had a vested interest in not conducting appropriate due diligence on financial instruments that contained significant exposure to sub-prime mortgage assets.

“Now investors are relying on credit ratings to make informed investment decisions, but the credit rating firms are paid not by investors but by the companies they rate,” he said. “And as complex, structured debt products have increased in popularity, the relationship between rater and issuer became even closer, and the line between independent rater and paid advisor became blurred.”

Evidence of this collusion can be observed in the downgrading that has taken place since the sub-prime meltdown began. Levitt said 97% of the sub-prime security assets that have a rating of A or lower have been downgraded from their original assessments.

Earlier this year, the SEC implemented the Credit Rating Reform Act of 2006, which requires credit rating agencies to have policies and procedures in place to manage conflicts. Levitt said credit rating oversight can be further improved by allocating more resources to the SEC to monitor credit ratings agencies and by giving audit committees the direct responsibility for determining credit agency compensation.

Levitt also noted that even if the credit ratings were appropriate, many corporate holders of structured investment products with sub-prime exposure, like mortgage-backed securities and collaterized debt obligations, didn’t appropriately disclose they held these assets on their balance sheet.

“In examining what happened, one has to ask: why didn’t investors see what was happening? The answer is that these risky mortgage-backed products were held in structured investment vehicles [SIVs] that were not reported on the companies’ balance sheets. If it sounds familiar, it should, because these SIVs are just like the infamous Special Purpose Entities of Enron that also hid the real financial health of that company,” he said.

Levitt concedes regulators can do only so much, noting rule-makers are never as fast at adapting to market conditions as those who break the rules. Ultimately, the best measure of protection will come from a more informed investor.

“I hope the sub-prime meltdown serves as a reminder to investors that they need to take more responsibility for evaluating the products they invest in. And this is especially true for complex structured financial instruments,” he said. “We cannot protect people against their own foolishness.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com