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How Wall Street captured Washington’s effort to rein in banks

AS THEY WISH: Banks got much of what they wanted when the U.S. Securities and Exchange Commission cut some key disclosure requirements from new rules on asset-backed securities. REUTERS/Jonathan Ernst

Intense lobbying of regulators, many of them veterans of the industry themselves, helped ensure that practices the Dodd-Frank law was meant to stop would remain in place.

NEW YORK – In the aftermath of the 2008 financial crisis, Keith Higgins was certain: Banks weren’t to blame.

Higgins, a top attorney at prominent law firm Ropes & Gray LLP, was chairman of an American Bar Association committee on securities regulation. As such, he lobbied strenuously against a rule U.S. regulators were drafting that would require banks to disclose a lot more about asset-backed securities like those that had just torpedoed the economy.

In letters to the Securities and Exchange Commission, Higgins argued that divulging more details about the mortgages and other financial products that go into such securities would only confuse investors. And it was investors, with “insufficient understanding and … commitment” to their investments, who had been the real cause of the crisis, he argued in a July 2008 letter.

Then, in May 2013, as the SEC was still hashing out the rule, Higgins was tapped to lead the very 500-person SEC division that was writing it.

When the final version of Reg AB II came out last year, disclosure rules advocated by many within the agency had been stripped out. Of particular concern: Banks could continue to sell asset-backed securities to institutional investors on the private market with no new disclosure requirements.

Reg AB II was one of many rules Congress ordered up in the 2010 Dodd-Frank Wall Street Reform Act to fill regulatory holes in the market for asset-backed securities. An unprecedented expansion of this multitrillion-dollar market, in which banks repackage mortgages and other assets into complex securities and sell them to investors, lay at the heart of the financial crisis.

But as the evolution of Reg AB II suggests, banks and their advocates have managed to preserve many of the industry’s pre-crisis practices by focusing lobbying efforts on obscure corners of the regulatory world, far from the glare of congressional debate or public scrutiny. Many of these agencies are staffed by appointees from the industry they regulate and return to it when their stints are over.

“The banks have done an end run around all the disclosure efforts,” said Thomas Adams, a securitization lawyer at Paykin Krieg & Adams LLP.

Four of the six lawyers now in the leadership of the American Bar Association committee that Higgins chaired have worked for the SEC’s Division of Corporation Finance. And between 1993 and 2006, the proportion of financial services veterans on the Financial Accounting Standards Board (FASB) went from zero to 25 percent, according to a 2012 Harvard Business School study.

BIG LEAP: Keith Higgins was chair of an American Bar Association committee that had been lobbying the SEC to ease proposed dislcosure requirements in asset-backed securities when he was named to head the SEC division drafting those rules. REUTERS/Joshua Roberts

Higgins declined to comment.

SEC Chief of Staff Lona Nallengara said the selection of Higgins to run the division was a reflection of his status as “a respected securities practitioner with 30 years’ experience.”

Nallengara, who was acting director of the Division of Corporation Finance for seven months before Higgins took over, said the decision to remove disclosure requirements for private offerings from Reg AB II was made before Higgins arrived. “Keith had no influence on that decision,” he said.

Like the SEC when it was weighing rules on asset-backed securities, FASB, the private group that sets accounting standards for public companies, came under political pressure to tighten rules blamed for exacerbating the financial crisis. Critics said FASB had made it too easy for banks to stash mountains of securitized loans in off-balance-sheet vehicles based in the Cayman Islands, hiding their exposure to risks that eventually swamped them and the global economy.

Here, too, banks pushed back hard. And here, too, their protests reached sympathetic ears. Ultimately, FASB’s rules barely dented the size of banks’ off-book holdings.

The practical effect of these lobbying efforts has been obvious.

Thanks to the private-market loophole in the SEC’s Reg AB II, banks are selling a greater share of securitized debt than ever on private markets – largely off the radar of regulators and watchdogs.

Residential mortgage-backed securities tendered on the private market jumped to 78 percent of all new offerings last year from 46 percent in 2013 and just 10 percent in 2007, according to data obtained by Thomson Reuters. The privately sold share for commercial mortgage-backed securities jumped to 83 percent from 37 percent in 2013.

The markets for asset-backed securities today are a fraction of what they were in the run-up to the crisis. But they are showing strong signs of revival. What bothers some current and former regulators and industry watchers is that much of the regulatory framework that enabled the crisis remains in place.

“What’s playing out is exactly what we were worried about,” said Sheila Bair, former chairwoman of the Federal Deposit Insurance Corp. “Most everything is going into these private markets where regulations require little visibility of what’s happening.”

With their access to off-balance-sheet entities largely preserved, the banks continue to hold vast sums of securitized loans offshore and off their books. Together, JPMorgan Chase & Co, Bank of America Corp, Citigroup, Wells Fargo & Co, Goldman Sachs Group Inc and Morgan Stanley hold nearly $3.3 trillion of securitized loans in off-balance-sheet entities.

“I still think there is significantly more risk there than is being reflected on banks’ balance sheets,” Bair said.

It isn’t just the banks. As hedge funds and private equity funds have ramped up high-risk lending in recent years, their use of off-balance-sheet vehicles has ballooned. For example, KKR & Co LP’s reported exposure to loss from off-balance-sheet entities has risen tenfold since 2010. A KKR spokesperson said less than half of the firm’s off-balance-sheet entities are composed of corporate loans originated by KKR and securitized into collateralized loan obligations, but declined to provide numbers or other information.

Robert W. Stewart, a spokesman for the Financial Accounting Foundation (FAF), which oversees FASB, said the new rules “resulted in a dramatic increase” of the holdings financial firms and companies in other industries keep on their books. “These standards eliminated long-standing exceptions for securitizations, and that reduced the opportunity for work-arounds,” he said.


Even before the crisis, FASB struggled for years with how banks should account for off-balance-sheet entities and the assets held in them.

Every additional dollar in assets on a bank’s balance sheet requires holding more idle cash in capital reserves to cover those assets if they drop in value. The increase in reserves means less revenue and earning power and smaller employee bonuses.

Off-balance-sheet vehicles free banks to make more loans and build assets without having to add to capital reserves. These assets include all sorts of things: Treasury securities, home and commercial real estate mortgages, auto loans, even “junk” loans used to finance leveraged buyouts. Banks bundle the assets into securities, sell the securities to investors, and then park the assets in separately incorporated off-balance-sheet vehicles.

In theory, if one of these vehicles fails because the underlying assets sour – as, for example, when large numbers of homeowners default on their mortgages – the bank does not have to bail it out.

In practice, they often do – to preserve their reputations in a lucrative market, and because specific asset-backed securities often carry implicit or explicit guarantees that leave banks legally liable to make investors whole.

“Repeatedly, constantly, when the new off-balance-sheet entity got into financial difficulty, the bank bailed out the entity that they supposedly didn’t have any more connection with,” said Halsey Bullen, who was with FASB from 1983 to 2006, much of that time managing financial instruments projects.

STANDARDS-BEARER: Robert Herz resigned as chairman of the Financial Accounting Standards Board after years of advocating for tougher accounting rules for banks. REUTERS/Mike Theiler

“There was unending lobbying of the FASB” to let banks continue stashing loans off their balance sheets.

Don Young, former Financial Accounting Standards Board member, in 2008 congressional testimony

FASB sought to address the issue several times before the crisis – to no avail. It tightened rules on Special Purpose Entities, the off-balance-sheet vehicles that played a big role in the collapse of Enron Corp in 2001. But banks simply started using alternatives called Qualifying Special Purpose Entities (QSPEs).

Again, in 2005, as banks were stuffing huge amounts of securitized subprime mortgages into QSPEs, FASB Chairman Robert Herz began to push for change. Earlier in his career, Herz turned down a shot to be U.S. chief executive officer of accounting giant PriceWaterhouse Coopers, where he was a partner, rather than give up his campaign to remake accounting standards. Now, he wanted to toughen the rules and require banks to put more loans back on their balance sheets.

“Clearly there were lots of things that had been given off-balance-sheet treatment that should not have been designated as such,” said Herz. “All the big Wall Street firms were doing it.”

Herz was opposed, former FASB officials said, by former JP Morgan Vice President Leslie Seidman – a FASB member known to some of her critics as “Loophole Leslie” for her advocacy of bank-friendly accounting rules.  

Herz’s effort fizzled out. “I started to realize that some people on the board didn’t want to get anywhere,” said Don Young, a FASB board member at the time.

Seidman said she objected to the initial proposals because they would have made the rules more complex and created more exceptions.

Then, in 2008, the U.S. housing bubble burst, and with it, the market for mortgage-backed securities.

Citigroup announced that it was on the hook for more than $100 billion in loans it had placed in off-balance-sheet vehicles. All told, the biggest U.S. banks wound up bringing back onto their books more than $300 billion of guarantees for off-balance-sheet loans and bonds, according to a report by RiskMetrics Group Inc. The banks paid out billions more in lawsuits to investors demanding that they take responsibility for off-balance-sheet loans.

Under pressure from Congress, FASB again took up the issue. Banks bombarded the board with comment letters and tasked full-time staff to sway it as it started drafting new rules.

Force banks to report too much lending on their balance sheets, Citigroup, Bank of America and other banks argued, and credit available to ordinary Americans would shrink. Make them disclose too much information about what was going off-balance-sheet, and it would just confuse investors.

In September 2008, Young, the FASB member, told a congressional hearing: “There was unending lobbying of the FASB” to preserve banks’ right to continue stashing loans off their balance sheets.

Even so, FASB’s draft rules did away with QSPEs. That left something known as a Variable Interest Entity, which carried a tougher standard banks had to meet to secure off-balance-sheet treatment. But then, as the lobbying continued, FASB relaxed the rules for VIEs, essentially closing one loophole while opening another.

“The changes were all in the direction of watering it down,” said Marcus Stanley, director of Americans for Financial Reform, a consumer group in Washington, D.C.

There are concrete measures of the banks’ lobbying success. When FASB published the first draft of the rules in 2008, Citigroup warned in its annual report that it expected to increase its risk-weighted assets by $100 billion as a result of having to bring loans onto its books.

A year later, after FASB issued its final draft of the new rules, Citigroup brought just $24 billion in risk-weighted assets back onto its books. At the time, it had $557.5 billion in off-balance-sheet loans.

The new rules took effect on Jan. 1, 2010. The top six U.S. banks brought about $400 billion of loans back onto their books, a 2010 Deloitte Study found, a fraction of the $4 trillion of loans – mostly mortgages – those banks then held off their balance sheets.

That August, Herz walked out of a FASB meeting and resigned. He said at the time that he wanted to spend more time with his family. Several people close to him said FAF, the overseer of FASB, forced out Herz amid growing backlash against his tough stances on some accounting rules important to banks.

Stewart, the FAF spokesman, declined to comment on the circumstances surrounding Herz’s departure.

The six-person committee overseeing the selection process for Herz’s successor included a former chief investment officer of Swiss bank UBS AG; the managing partner of Brown Brothers Harriman & Co, one of the largest private banks in the U.S.; a former American Express vice president; and a lawyer from Brown & Associates, a law firm that caters to financial industry clients.

They chose Seidman, the first former bank executive – rather than auditor – to hold the top spot.

Bank stocks rose on the news.

Seidman’s term at FASB ended in 2013. She is now a director at ratings company Moody’s Corp and on the board of governors of the Financial Industry Regulatory Authority, Wall Street’s self-regulatory group.


A few months after FASB published the final version of its new accounting rules, the SEC released a draft of Reg AB II.

The rule represented regulators’ effort to address a big factor in the financial crisis: lack of information about the mortgages, leveraged loans and other securitized assets that banks had been stuffing into off-balance-sheet entities.

Banks argued that additional disclosures would saddle them with an unnecessary and costly burden that would cripple the securitization industry and dry up credit for millions of Americans.

Among other things, Dodd-Frank ordered the SEC to “adopt regulations … requiring each issuer of an asset-backed security to disclose, for each tranche or class of security, information regarding the assets backing that security.”

An early draft of the rule would have required, for example, that a seller of mortgage-backed securities provide “loan tape” to regulators and investors. That’s an industry term for a breakdown of all the mortgages in a security, including each borrower’s credit history, the loan-to-value ratio of each mortgage, and other measures of risk.

The first draft of the rule applied the stricter requirements to securities sold on both the public and the private markets. SEC rules have long distinguished between investments meant for ordinary mom-and-pop investors and those for wealthy, sophisticated institutional investors.

The mass-market investments are registered with the SEC and require extensive disclosure before they can be offered to the public. The private investments typically aren’t registered with the SEC, carry scant disclosure requirements and are sold to “accredited investors” considered savvy enough to know what they are buying.

That distinction fell apart during the financial crisis, when it became clear that supposedly sophisticated investors were holding vast stores of toxic mortgage-backed securities. “The disaster was way worse in unregistered private markets during the crisis,” said a senior industry regulator. “Not addressing that market did not seem to be addressing the crisis.”

SEC staff overwhelmingly supported the rule, according to people inside the agency. So, too, did two important SEC constituencies: investors, who believed the rule would make it easier to assess the quality of the securities, and ratings agencies, whose failure to accurately rate such securities landed them in hot water in 2008.

The banks, however, opposed the early draft. In dozens of comment letters to the SEC, they argued that the additional disclosures would saddle them with an unnecessary and costly burden that would cripple the securitization industry and in turn dry up credit for millions of Americans.

Banks were helped by a particularly vocal and effective advocate: the American Bar Association. The ABA’s Committee on the Federal Regulation of Securities – that’s the committee with four former SEC employees – wrote 94 comment letters to the SEC and other regulators after the crisis, making it one of the most prolific commenters on SEC rules. Nearly all of the comments parroted letters from banks and financial industry lobbyists.

Higgins, chair of the committee when the SEC started drafting Reg AB II, personally signed 46 of the letters. He also was one of Ropes & Gray’s top securities lawyers, advising clients such as Hasbro Inc and Reebok International Ltd.

Time and again, he argued that investors had only themselves to blame for their losses in the financial crisis. “These problems have been compounded in the structured finance markets not by insufficient information, but by insufficient understanding of the information that is already available to investors,” he wrote in one letter. “Rather than needing more information, these investors need both the commitment and the tools to analyze and distill the information that is already available.”

The ABA’s lobbying carried particular weight with the SEC because of the banks’ growing reliance on the courts to fight reforms they opposed. In the year that followed 2010 passage of Dodd-Frank, the SEC churned out an average of 5.5 new rule proposals a month, one of the fastest rule-making clips in SEC history. Rules governing swaps, whistleblowers, and reporting of executive compensation were among dozens of proposals the agency issued.

TOP WATCHDOG: SEC Chair Mary Jo White said the agency’s new disclosure rules on the asset-backed securities at the heart of the financial crisis ensure that investors “have full information.” REUTERS/Jose Luis Magana

Then, on July 22, 2011, the U.S. Circuit Court of Appeals in Washington, D.C., struck down an unrelated SEC rule mandated by Dodd-Frank that would have made it easier for shareholders to replace company directors. The court said SEC staff hadn’t done a sufficient cost-benefit analysis of the new rule.

The ruling, which was sharply critical of the SEC’s rule-making process, “intimidated the agency,” said Barbara Roper, director of investor protection for the Consumer Federation of America and a member of the SEC’s Investor Advisory Committee.

SEC rule-making ground to a halt. Since the court decision, the SEC has published less than one new draft rule a month.

In May 2013, one month after Mary Jo White was sworn in as SEC chairwoman, she tapped Higgins to be director of the agency’s Division of Corporation Finance, in charge of writing the rule he had lobbied against. Some inside the SEC were shocked.

Higgins was close to White’s husband, John White, a partner at Cravath, Swaine & Moore LLP who had himself chaired the SEC division when Higgins was head of the ABA committee, according to people who know both men.

John White and Mary Jo White declined to comment.

On August 27 last year, 52 months after the original draft proposal of Reg AB II was floated, the SEC adopted the final version. The 683-page rule detailed a raft of new disclosure requirements for asset-backed securities – but only for those registered with the SEC for general offer to the public. For the same securities sold on the private market, disclosure requirements remained scant.

SEC Chair White said the new rules would ensure that investors “have full information, the tools and the time to understand potential investments and the nature and extent of associated risks.”

In the end, 2014 saw a bigger share than ever of asset-backed securities being sold on private markets, with little disclosure or regulatory oversight.


Wall Street’s Way

Reporting by Charles Levinson

Web programming: Charlie Szymanski

Graphics: Christine Chan

Design: Troy Dunkley

Photo editor: Jim Bourg

Edited by John Blanton