'I Think the SEC Was Distracted'

Outgoing Securities and Exchange Commissioner Paul Atkins talks about bailouts, hedge funds, and what he thinks the SEC should have been regulating.


The nickname "Dr. No" has been applied to more than former presidential candidate Ron Paul and a certain James Bond villain. In 2005 that's what Business Week called Paul Atkins, then halfway through his six-year stint on the Securities and Exchange Commission (SEC). This "fierce libertarian," the magazine warned in its headline, "is slowing some key reforms" of hedge funds.

Three years later hedge funds have imploded, toxic mortgage-backed securities have brought financial giants to their knees, the economy is officially in recession, and Washington is in the early stages of what is already the largest economic bailout in U.S. history. How does Atkins plead? Guilty—of focusing on market transparency via a clearinghouse to track over-the-counter trades, while previous SEC Chairman William Donaldson was busy joining forces with the board's two Democrats to pursue such distractions as forcing hedge funds to register as investment advisers. The SEC missed several crucial opportunities before the crisis hit, Atkins says, and partly as a result the federal government is throwing unprecedented amounts of money into the financial system. The commission, meanwhile, is being condemned as hopelessly, dangerously out of touch.

A graduate of Vanderbilt Law School, Atkins shuttled back and forth between corporate law and the government for most of his career, including a stint at the SEC from 1990 to 1994, serving on the staffs of former chairmen Richard Breeden and Arthur Levitt. His time on the commission board lasted from July 2002, when he was appointed to fill out the final months of Levitt's five-year term, to June 2008.

"I would describe myself as having faith in the free markets," he says. "To compare a few people in government making decisions based on limited information to millions and millions of people making decisions every second with their own hard-earned money, there's just no comparison there." Nonetheless, Atkins has supported federal intervention in managing a sale of the investment bank Bear Stearns and forestalling bankruptcies across the financial industry, on the grounds that the interconnectedness of global capital markets, combined with the complexity of securitized over-the-counter instruments, has created conditions in which the liquidation of companies such as Lehman Brothers can cause widespread bank runs and do lasting damage to the financial system.

Editor in Chief Matt Welch and Editor Nick Gillespie spoke with Atkins in early December about the ongoing economic crisis. A video from this conversation can be seen at here.

reason: Earlier this year, you were explaining why it was good for the government to get involved with the Bear Stearns renegotiation. Looking back right now, do you still agree with that assessment, and what do you think of the bailouts that have rolled out since then?

Paul Atkins: We've been through a lot, obviously, over the past year. As far as whether it's good or not to have gotten involved in the Bear Stearns thing the way it happened, leave that for the history books. But as far as not allowing Bear Stearns to go into a completely unstructured bankruptcy, I think that was the right motivation, because we saw with Lehman Brothers what exactly happened to the—

reason: So should Lehman Brothers have been bailed out or had a kind of government-brokered deal?

Atkins: Well, first of all, I don't think Bear Stearns was bailed out.

reason: Explain the distinction.

Atkins: Well, there the shareholders got pretty much wiped out.

Lehman Brothers basically just failed, went bankrupt, and, of course, that then triggered a lot of the things that a number of us had been afraid of. Which was the seizing up of the credit markets: A lot of hedge funds and other clients of Lehman Brothers suddenly found themselves frozen, mainly in U.K. courts, as far as trying to get access to their capital that was being held by Lehman Brothers.

reason: What is the simplest way of talking about the root of the economic crisis in the financial sector? And how bad is it?

Atkins: The nut of the crisis, I think, still is lack of confidence: lack of confidence in what financial institutions hold and what the value is of the assets that they hold. That then translated into other financing type of functions for normal corporations, the commercial paper market and things like that. So underlying all of this is investors wondering just what it is that people have. These instruments had gotten very complex. Once people started questioning those, then they started questioning other categories of financial assets, and so that's what created the underlying crisis of confidence.

reason: You were a big skeptic of hedge fund regulation, in particular, for the duration of your term. There's a critique saying that the SEC or someone should have mandated a clearinghouse, for example, for credit default swaps and mortgage-backed securities, just so we know what people hold. Do you think that's true in retrospect?

Atkins: Oh, yeah. In fact, I was one of the ones who was calling for just this sort of transparency with these particular types of securities, going back now two years or more.

Part of the problem was that with a lot of these types of instruments, you have a lot of trading of them. They're negotiable securities or contracts, basically,and so there are novations of these contracts, which means that you have two parties at the beginning who have agreed to do a swap or whatever it is and then one party decides to lay off that risk on somebody else who's interested in taking it up. And so as this goes through a chain of numerous novations, sometimes the original parties aren't quite sure who is the ultimate one on the other side.

reason: You were in favor of this clearinghouse regulation for a couple of years, but at the same time you were against the previous chairman's regulation approach toward hedge funds. What were you objecting to and what were you supporting?

Atkins: I think that's really the nub of the whole problem here. I think the problem was during the crucial time when these collateralized debt obligations and other types of instruments really built up, when you look at it, it's almost like a hockey stick. They had been rocking along for a while, and then suddenly there's a real market increase.

We were coming out of the post-9/11 recession, and that was right after the whole technology bubble burst. And so in about '03 and '04, things are starting to pick up, and new financial products are coming out—a lot of these collateralized debt obligations, collateralized mortgage obligations, those sorts of things. During this time, unfortunately, I think the SEC was distracted because of policy decisions that were made by the then-chairman—

reason: William Donaldson?

Atkins: Right. Looking at trying to force hedge funds to register as investment advisers. That rule was pushed through, but a court nullified that because it found that the SEC didn't have the jurisdiction to do it. Congress had spoken years before and said, no, you can't do it that way, and so there was a lot of effort spent by the staff to try to come up with that rule.

reason: What was the motivation for it?

Atkins: There was an attitude of, well, we didn't know who hedge funds were, and that there ought to be some sort of examination of them. My objection to that was we could work with other government agencies to find out if we need a census. The CFTC [Commodity Futures Trading Commission] and others had other sorts of registration of hedge funds. We could have teamed with the CFTC, the Treasury and the Fed and others, and my fear was that it was going to dilute the resources of the SEC to try to look at hedge funds where we hadn't really seen any problems before.

The people who invest in hedge funds are sophisticated investors; it's not retail investors like in mutual funds, so it sort of went against what the whole SEC's examination program was predicated on. And in fact, as we've seen, it's not been the hedge funds that were the problem here. In fact, the hedge funds were the ones who provided liquidity throughout a lot of this crisis. It was the registered entities that were really the most heavily regulated institutions, the banks and the brokerage houses, where a lot of the problems were.

reason: So what did the SEC do wrong? It was spending time trying to register hedge funds. What should it have been doing?

Atkins: Well, that was only one aspect. There was a series of rules pushed through on very divisive votes, 3-to-2 votes, because there was basically no cost-benefit analysis done as to how should you effectively spend your resources and whether there really is even a problem that would be solved by that. One was the hedge fund registration issue.

Second, there was a rule that said that every mutual fund in the country would have had to have a nonexecutive chairman of the board and a 75 percent independent board. Again, there was no correlation between the threat to investors and that particular governance rule. Again, huge distraction. The courts threw that rule out, not once but twice.

The third and worst I would say was a "national market system," so called, rule, which foisted on the securities trading markets and investment banks at that time a very costly re-do of their technology to the tune of well over $1 billion. The industry paid to try to develop a solution that was, I'd say, in search of a problem, to prevent what's called "trade-throughs" [trades at below-market rates] in the marketplace. The facts show that there really were no trade-throughs, so this was a very expensive fix to a nonexistent problem.

These were huge distractions and huge costs right at a time when a lot of these other instruments that turned out to be the ones that were going to blow up needed to be focused upon.

For example, when Amaranth, which was a $6 billion hedge fund, a relatively small hedge fund, blew up, I guess it was the summer of '06, it didn't really cause a big problem for the marketplace. But it took a number of weeks, with about 300 people from the two institutions that wound up buying the book and business of Amaranth, it took all those people that amount of time to just figure out what this hedge fund had as far as their investments were and what the valuation of it was. And that's because most of the investments were in what we call over-the-counter types of securities, and so they were not standardized. It took some doing to try to figure out what the value was.

So that was just an indication of what was going to happen later on with Bear Stearns and Lehman and everything else, because there was no type of standardized exchange trading of these collateralized debt obligations. And a lot of these were held, as we saw, not necessarily by hedge funds. It was really the regulated entities, the major institutions that caused the real crisis of confidence.

reason: Why wouldn't the market, this fierce disciplining force, create a system to certify trading activity and valuation?

Atkins: Well, there were outside parties—accountants, accounting firms, and, of course, the ratings agencies. Those were there to sort of give comfort to other parties, and the marketplace itself was starting to work on ways to try to have some sort of increased transparency with respect to these particular obligations. But the SEC has a statutory obligation to look at investment banks on a risk-management basis, to say, "What exactly do you think you're worth, and how do you think you're relating to the marketplace in general?" Those sorts of questions could have and probably should have been asked a little bit more forcefully.

Not that the SEC would have outlawed any particular type of product; I think that's a mistake, and unfortunately that's being talked about by some people on Capitol Hill. It's not the instrument itself that's bad; it's the way people either invested in them without knowing what the risks were or were not being clear on how to value them.

reason: The best way to arrive at a price is to let people fail. Yet we're now in a climate in which nothing shall fail ever again. Aren't you worried that we're creating the mother of all moral hazards?

Atkins: Oh, absolutely.

reason: What is too big to fail, or what's the sliding scale to say the government should intervene here but not here?

Atkins: Well, the trouble with Bear Stearns and Lehman and others was that they were so intertwined with some of these issues we're talking about that they're unstructured failures. With Lehman, it just was allowed to go bankrupt right away. That created such a jolt to the system because, again, you had clients and others who had assets there at the firm that were suddenly all frozen in bankruptcy proceedings. And that had a direct and predictable effect, I would argue, on the financial system.

reason: So anything of a certain size that had a lot of these opaque instruments is too big to fail?

Atkins: I would take issue with the whole argument "too big to fail." I mean, that's a banking term, where the banking supervisors have traditionally looked at major banks and have said, "Well, we can't allow them to fail and so we will step in and either do a workout by government intervention and government taking over the bank itself to run it, or to find some sort of buyer," or whatever. I think there were probably other ways that, especially in working with our counterparts abroad, where perhaps in the Lehman situation you could have had a smoother landing. The firm still would not have continued, but at least with respect to the customer assets, they would not have been just thrown into limbo, especially in the U.K. That's not necessarily the U.S. government's deal. It's more the British government's issue, but that was the thing that I think really precipitated the jolt to the system.

reason: Now, though, we're in a situation where no company is allowed to fail. In the financial sector, in the airline industry, in the auto industry, in mortgages, it creates a moral hazard in the sense that investors no longer have to worry about losing it all. How bad is that to the system down the road, and what should the government be doing instead?

Atkins: With respect to some of the other institutions, again, ultimately it's not necessarily the shareholders that come out ahead. Now if some are being artificially propped up, then I think that—

reason: How do you make a distinction between Goldman Sachs or Citigroup? Are they being "artificially propped up," or is it good to be throwing $25 billion of taxpayer money into preferred shares?

Atkins: Well, I mean, we have the whole TARP [Troubled Asset Relief Program] issue right now, where clearly the government's trying to come up with a reasonable solution. The problem is, looking forward to five years, 10 years from now, how all that will be unwound. And then, of course, the precedent that's being set. I think, you know, the real moral hazard issue is there. And so has this made things better through this intervention or not?

reason: What does your gut say? Is the Paulson plan a good thing or a bad thing?

Atkins: It's hard to put myself in their situation because I don't have all the facts that they do. I think I would have preferred the way they started out, with the idea that was proposed by the House Republicans back when the bailout was being debated, to either insure assets or, as the original plan was, to buy assets.

The problem with buying assets—as people quickly found out, and was my misgiving in the beginning—was how do you set the price of particular securities that are not being traded and where there is no market price and anything that you do is liable to influence the market? That's why I thought the insurance proposal was intriguing.

But to inject government capital, which is crowding out private capital, I think is in the long run not a good idea.

reason: A lot of people are saying we need a new New Deal. One of the things that FDR did was what he called "bold, persistent experimentation," which meant that you never knew as an investor or as a business owner or as a worker what was going to happen next. We seem to be in a phase where Paulson literally is having meltdowns on TV, where his plan keeps changing. And then there's a sense that when Obama comes in, there will be a new stimulus package, there will be a new bailout plan, etc. Is the uncertainty as bad as even a certain plan that is bad?

Atkins: A lot of commentators have talked about how the uncertainty is a problem, and I can certainly agree that that is one thing that makes it difficult for folks to plan. But on the other hand, you know, from the Treasury side, it's been a dynamic situation with a lot of things blowing up that they had not anticipated. Like when Lehman Brothers failed, Baltimore Gas & Electric had problems because Lehman Brothers had been one of their major trading partners for energy futures and things like that. Who would have thought that a utility, which is supposedly one of the most stable types of institutions, would fall into that? That sort of collateral thing, and then AIG falling, I think had people really scrambling.

reason: You were talking earlier about how the important thing is to maintain confidence in the system. Is the real root problem fiat currency, where you have to believe in the paper because there's nothing backing it?

Atkins: That's one thing that I think people will be debating intensively here over the next few years.

reason: What's keeping you up at night? What's the next horror right around the corner?

Atkins: Ultimately, frankly, it's what we're talking about: currency. I mean, the on-balance-sheet and off-balance-sheet obligations that the government is taking on are now really, really large. When you look historically at other countries where debt obligations have crept up to 40 percent, 50 percent or so of GDP, how the ratings agencies look at that and how investors look at that becomes a bit problematic.

reason: Is it conceivable that the U.S. would become like Argentina? Argentina in 1900 was something like the fourth largest economy in the world, and it has never been like that again. Could the U.S. actually go into that kind of national receivership?

Atkins: Well, let's hope not. I think we have a lot more going for us than Argentina did. But again, inflationary pressures have got to be a concern of everybody.

reason: Most of the financial crises that we've lived through usually come out at the end with a forcible spoon-feeding of medicine to a perhaps unwilling patient, whether it's Paul Volcker raising interest rates to ridiculous degrees to beat inflation in the late '70s and early '80s, or in Eastern Europe, which went through any number of austerity programs.

Is there any austerity today? Are we missing the austerity that's happening right now, or is it just the fact that we're suffering higher unemployment, more foreclosures? Is that the medicine that is going to get us through to the other side?

Atkins: The austerity right now is the huge deflation that we have in assets. If the housing bubbles burst and asset values are declining, there's plenty of austerity to go around, especially on the financial instrument side. But once we get through the deflationary thing, what's going to happen with all the pent-up money that's been put into the system? That's going to be a big issue.