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Fixing the Regulatory System: Geithner and Schapiro Ignore the Need for Mutual Fund Reform

Fixing the Financial Regulatory System: Geithner and Schapiro Ignore the Need for Mutual Fund Reform  I waited for March 26, 2009, in great anticipation that we might see meaningful change in protecting investors. I pray that my retirement years are not stolen from me as they have been from those who we represent - those who trusted Charles Schwab, OppenheimerFunds, MassMutual and Madoff. However, March 26 came and went with little recognition of why and how this happened by those our new President entrusted to help steer these changes. Both Timothy Geithner (Secretary of Treasury) and Mary L. Schapiro (SEC Chair) testified today on improving our financial regulatory system. Geithner spoke to Barney Frank and his House Committee on Financial Services, and Schapiro spoke to Christopher Dodd's Senate Committee on Banking, Housing and Urban Affairs. Geithner's testimony can be found here, and Schapiro's here.

Before I start in on my criticism, let me say that I understand that both Geithner and Schapiro are long time industry/regulatory insiders. Change comes slow to those who have been part of the system and failed to step forward early. Certainly, it is better to talk about "failures" than to admit that they were asleep at the switch. It is better to talk in the abstract with little criticism that might incite a lynch mob.

Reading both testimonies, I am dumbfounded at how little attention is paid to the mutual fund industry that took investors' money and started pouring it into any asset available regardless of its objectives.

Geithner gives a strong statement recognizing the need for investor protection:

"[W]eaknesses in our consumer and investor protections harm individuals, undermine trust in our financial system, and can contribute to systemic crises that shake the very foundations of our financial system."

 Hear hear! Geithner then swiftly moves on to talk about mortgage lending, not investor protection. Try to sort out the following statement:

"Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-term profits over long-term return. We saw huge gains in increased access to credit for large parts of the American economy, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations they did not understand and could not sustain. The huge apparent returns to financial activity attracted fraud on a dramatic scale. Large amounts of leverage and risk were created both within and outside the regulated part of the financial system."

It's almost like the financial services industry wrote his words: "Tim, throw in words that make it look like 'things' caused us to commit fraud, and then put the blame on the 'many Americans with obligations they did not understand...'"

Let's pretend our mess was caused by poor consumers who did not know what they were buying, instead of the greed; greed of financiers who "created" packages of garbage loans, and dumped them on retirees for huge fees, profits and commissions. This slight of hand makes my blood boil.

Geithner completely leaves out the crimes of our mutual fund industry. Instead, he focuses on Money Market Funds that broke the buck. Big deal. This cost the American people a tad of what was lost in mutual funds by companies that sold "conservative," "stable" investments to retirees following the models that touted moving to bonds in your retirement years to preserve capital and earn income. The Reserves money market fund, when all is said and done, lost about three percent. Oppenheimer's Champion Income Fund lost 79 percent. Schwab's Ultra Short Term Bond Fund lost more than 50 percent.

Schapiro jumps on the fraud bandwagon too. She deplores penny stock frauds and insider selling, she touts the SEC's recent (mostly pre-Schapiro) enforcement activity, but she appears oblivious to reality, and the following statement is laughable:

"Our capital requirements go a long way to ensuring that customer funds entrusted with a broker-dealer are safe in the event the broker-dealer gets in financial trouble. Again, our focus is not to insulate broker-dealers from competition and the risks of failure, but to protect investors in the event that failures do occur. We conduct examinations of these firms to assess their compliance with laws and regulations. And when we find violations or deficiencies, we direct that corrective action be taken."

Think Bernie Madoff Investment Service (a broker dealer regulated by the SEC). Ahhhhh! Capital requirements? Protect? Examinations? Compliance? Of course note the disclaimer; "And WHEN we find..."

Schapiro does however have a solution for making sure Madoff's don't occur:

"I expect the staff to recommend that the Commission consider requiring a senior officer from each firm to attest to the sufficiency of the controls they have in place to protect client assets. The list of certifying firms would be publicly available on the SEC's Web site so that investors can check on their own financial intermediary. In addition, the name of any auditor of the firm would be listed, which would provide both investors and regulators with information to then evaluate the auditors."

"As part of this effort, I expect to come to you in the near term with a request for authority to compensate whistleblowers who bring us well-documented evidence of fraudulent activity."

 Ok. Let me get this straight...

  1. Madoff would be required to sign a certification - big help.
  2. The auditors name would be public - oh, this helped the Oppenheimer Tremont Rye fund investors who received audit reports from KPMG and Ernst & Young who believe that they are isolated from liability because they can rely on certifications by Madoff's audit or shoeshine man.
  3. The SEC could now pay whistleblowers who present "well documented evidence...because when Madoff's whistleblower Harry Markopolos came to the SEC for free the SEC could not believe that anyone would blow the whistle for free!

As for mutual funds: NADA, Nothing, Zip! Certainly, Schapiro recognizes the importance of mutual funds:

"Ultimately, capital comes from investors - people who invest directly in companies; people who invest in financial institutions that lend capital; people who invest in mutual funds and other pooled vehicles that in turn invest in America's businesses; people who buy municipal securities to help fund the operations of state and local governments; and people who look to the capital markets to save, put away money for their kids' education, and prepare for retirement. Markets that attract this capital are critical to America's economic future."

But Schaprio talks only about the past enforcement efforts and current regulations. As for future change, she talks only about money market funds. She apparently does not recognize that current regulations do not work for mutual funds.

The Courts have recently thrown out the private rights of action under the Investment Company  Act, which regulates the fund industry. Because of the structure of the funds, purported independent trustees ( who often sit on the boards of 10, 20 and even 40 funds offered by the same investment adviser), and trust agreements, even state law claims are impossible to bring. That leaves the paltry resources of the SEC to enforce those laws for an industry with more than $9 trillion in assets.

Mutual Funds are sold primairly over the phone or with glossy web pages and/or brochures containing smiley faces, impressive graphics and a sales pitch. To the extent that disclosures can be found, they  are impossible to read, dispursed in a staggering array of documents with indecipherable names, never actually delivered until after the purchase, and even then rarely. The funds' advisers retain near unlimited power to change their focus overnight...if it brings in more profits. The industry is driven by a need to do what it takes to attract capital, not the interests of the investor.

Neither Geithner nor Schapiro seem to recognize these issues, nor seem to care.

Dear, dear. The more things change the more they stay the same.

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