By Oxford Analytica - 09/18/07 07:46 PM EDT
The collapse of the equity market bubble in the early 2000s, and the corporate bankruptcies it triggered, led federal and state prosecutors, and the enforcement division of the Securities and Exchange Commission (SEC), to initiate several significant legal actions. These were targeted at corporate officers, outside advisers (including an indictment and conviction of the accounting firm Arthur Andersen) and investment banks.
Regulators have begun investigations into the causes of the sub-prime market collapse. Such complex investigations are typically time-consuming, and would not yet be expected to have run their course; therefore, it is not surprising that legal actions against individuals or firms have yet to be announced.
Nonetheless, several significant political and legal differences that have occurred since the earlier equity market collapse suggest that enforcement actions will be more narrowly targeted, and will focus on individuals rather than firms.
Most significantly, there is widespread market sentiment that the sub-prime crisis is far from over. Further significant revelations, and subsequent adjustments, are expected. Until these occur, markets will remain skittish:
• Standard deal terms. Market participants have yet to agree on what deal terms should now be standard in current market conditions. Significantly, the private equity firm Kohlberg, Kravis, Roberts (KKR) agreed to include a maintenance covenant as a deal term in the First Data Corporation loan sale that is being brought to market this week. The $5 billion transaction is being offered at a 4 percent discount. Yet even if this transaction succeeds, credit market weakness will leave banks holding about $19 billion in obligations related to this leveraged buyout on their own balance sheets. Market participants are watching this offering closely to see whether it will break the impasse that has this summer stalled most syndication of private equity deals. It is unclear whether this deal will pave the way for subsequent financings, or instead reveal the extent of market weakness.
• Quarterly results expected. Investment banks are due to report quarterly results this week. These will be closely watched for indications of continued weakness, or lurking uncertainties, related to current credit market turmoil.
Although legal factors only are supposed to guide the decisions of federal and state legal officers, these officials are not oblivious to wider economic and political trends. Until the market stabilizes, no significant prosecutions or enforcement actions should be expected.
Diffused regulatory authority
Since the United States lacks a unitary financial market regulator, several regulators are currently investigating sub-prime market issues. The first regulatory priority has been ensuring market liquidity and efficient functioning. However, as markets stabilize, enforcement issues will increase in importance:
• Investment banks. The SEC is monitoring the strains that the sub-prime crisis is imposing on the balance sheets of the five investment banks it supervises on a consolidated basis (Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley), according to testimony by Erik Sirri, the SEC’s director of market regulation, before the House Financial Services Committee on Sept. 5. These include the potential need to unwind off-balance sheet structures, such as conduits or structured investment vehicles (SIV), and the funding requirements for various leveraged lending commitments, where firms have agreed to fund acquisitions or restructurings. The structure of off-balance sheet vehicles protects the firm in the case of the structure’s collapse, but firms may still believe that reputational considerations force them to bail out such investments. It is unclear whether these investigations will provoke a regulatory response. In addition, the SEC is monitoring valuation processes, particularly the challenges of marking positions to market in illiquid circumstances.
Further and separately, Sirri stressed that the SEC remains committed to bringing enforcement actions for securities laws violations, including but not limited to fraud.
• Uneven mortgage underwriting standards. Various federal and state regulators police mortgage lending, resulting in a lack of uniformity and consistency in mortgage underwriting standards. The current turmoil has focused congressional attention on reforming such standards. If enforcement actions are necessary, these may involve some state legal officers, or a cooperative federal/state effort.
Justice Department disarray
Controversy over the firing of various U.S. attorneys — the senior Justice Department prosecutors in the regions in which they operate — has led to the resignation of Attorney General Alberto Gonzales, and severely damaged agency morale. Until a new attorney general is selected, and some new managerial control is imposed, it is unlikely that federal prosecutors will launch any major civil or criminal actions arising from the collapse in the sub-prime mortgage sector.
Corporate prosecutorial guidelines
In January 2003, Deputy Attorney General Larry Thompson set forth a series of nine guidelines for prosecutors to weigh in determining whether or not to indict a corporation. Once federal prosecutors decide to indict a corporation — regardless of the merit or scope of the underlying charges — it is very difficult for that entity to continue to conduct its business as a going concern. Under pressure from a then-Republican Congress, in December 2006, Thompson’s successor, Paul McNulty, outlined new guidelines. These weakened the Thompson standard and gave greater weight to senior Washington-based Justice Department officials to override prosecutorial discretion in certain circumstances.
The replacement of the Thompson guidelines by the weaker McNulty standard suggests that even if prosecutions are initiated against sub-prime mortgage abuses, the scope of prosecutions will be narrowly targeted, and aimed at miscreant individuals rather than firms.
Role of Spitzer
Former New York state Attorney General Eliot Spitzer played a major role in shaping the enforcement agenda in the wake of the collapse of the equity market bubble, especially with respect to what led to the landmark settlement by investment banking firms over research-based conflicts of interest. This settlement forced major changes in the way investment banks provide research analysis and included payments of more than $1.4 billion.
Since January, Spitzer has served as governor of New York. The new state attorney general, Andrew Cuomo, is focused on more populist political issues, and less on financial-sector transgressions. Although the sub-prime crisis has a populist dimension, Cuomo has shown little inclination toward pursuing complex financial investigations. Concern over Spitzer is no longer a factor accelerating the timing or expanding the scope of federal enforcement decisions.
Democrats are driving the regulatory agenda for addressing sub-prime lending problems. Despite this emphasis, Congress does not set enforcement priorities for federal agencies; this is an executive branch prerogative.
Oxford Analytica is an international consulting firm providing strategic analysis on world events for business and government leaders. See www.oxan.com.