Among its several provisions, the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed by Pres. Barack Obama in July 2010, requires “municipal advisors” — who participate in the issuance of municipal securities, for example — to register with federal regulators for the first time. In the context of the law, municipal entities include “states, their political subdivisions such as cities, towns and counties, and their instrumentalities such as school districts or port authorities.”

In December, the Securities and Exchange Commission issued a proposed rule (PDF) excluding elected officials from the definition of “municipal advisor” — but specifically including appointed board members.

According to the proposed rule:

“The Commission does not believe that appointed members of a governing body of a municipal entity that are not elected ex officio members should be excluded from the definition of a “municipal advisor.” The Commission believes that this interpretation is appropriate because employees and elected members are accountable to the municipal entity for their actions. In addition, the Commission is concerned that appointed members, unlike elected officials and elected ex officio members, are not directly accountable for their performance to the citizens of the municipal entity.”

The proposal to make appointed board members register with the SEC and Municipal Securities Rulemaking Board has drawn comments from dozens of Texas entities — ranging from the Dallas/Fort Worth International Airport, to the City of Taylor, to university systems, to the Texas Attorney General — who all argue that the SEC should consider appointed board members as “municipal employees” rather than “municipal advisors,” exempting them from federal registration and regulation.

Despite the differences in size and scope of the entities, they all say that the proposed rule would dissuade citizens from volunteering to serve on the bevy of boards and commissions throughout the state. Registration with the SEC involves filling out a form (PDF) with contact information, municipal advisory activities and disciplinary information (such as felonies, financial regulatory violations or investment-related transgressions). Registration with the MSRB carries an initial $100 fee and annual fee of $500.

Texas AG Greg Abbott writes in a letter dated Feb. 22 (PDF):

“Citizen volunteers serve on approximately 400 Texas state boards, commissions,  authorities and committees. Collectively, they are critical to the governance of Texas. These citizen volunteers oversee great universities, public health and safety, criminal justice, historic preservation, parks and wildlife, environmental protection, public utilities, occupational licensing, and virtually every other aspect of Texas state government. These boards and commissions are a bastion of democracy, where over 3000 uncompensated citizen volunteers, selected from 25 million Texans for their skills for the job and their heart for the work, come to serve their State on a part time basis in the finest tradition of participatory government. There is no beltway mentality in Austin because these citizen volunteers bring Texas to the Capitol. Their hometown insights and experience guide Texas government. Texas government cannot run without the service of these citizen volunteers on its state boards and commissions. The SEC must not create a needless roadblock to their service.”

Multiplying $600 times 3,000 board members, Abbott estimates that the initial cost to Texas government — which typically reimburses board members for expenses — would run about $1.8 million.

Here are some of Abbott’s key statements and arguments, echoed by other entities as well:

“The SEC Should Issue Definitive Public Guidance on the Interim Rules.”

“The Proposed Rule Interferes with Traditional State Authority.”

“The Intrusion of the Proposed Interpretation into State Governance Is Breathtaking.”

“The Proposed Registration Requirements Could Cripple Texas State Boards.”

“Board Members Do Not Meet the Definition of Municipal Advisors.”

“If Necessary, the SEC Should Exercise Its Discretion to Exempt Board Members.”

“In Texas, Citizen Volunteers Are Held Directly and Publicly Accountable by Law for Honest and Ethical Conduct. Accordingly, There Is No Justification for the Many Burdens Resulting from the SEC’s Proposed Intrusion into State Governance.”

“The Proposed Rule Would Impose a Significant Financial Burden on States at a Time When They Can Least Afford It.”

“Texas’ Ability to Recruit Board Members Could Be Crippled If the Proposed Rule Is Adopted.”

“The Proposed Rules Will Interrupt State Government and Place Board Members Choosing Not to Register in an Untenable Position.”

“The SEC Should Adopt the Same Standard for Appointed Members as Elected Members.”

On Jan. 13, 2011, Jim Dunaway, city manager for the City of Taylor, wrote that the SEC should “distinguish between consultation and solicitation and policymaking.”

Dunaway writes:

“Board members, appointed or elected, perform the function of policymaking and approving certain decisions of their staff. A board’s function is to guide an organization in order to meets its constitutional and statutory objectives. Board members are not advisors or consultants in that they are responsible for making final decisions on behalf of the municipal entity. The duty of every board member to respective state constitutions and statutes does not discriminate based on employment or election. Each board member takes the same oath and, just as important, is subject to liability for fraud and subject to suit for malfeasance.

In contrast, advisors such as financial and swap advisors have minimal legal or ethical duties to the City of Taylor or the citizens of Taylor, Texas. Their objective is to receive compensation in return for providing a service. Even when compensation is not immediate or expressly sought, it is fair to conclude that they seek clients for the purpose of profit making and providing expert advice. Their services are critical to municipal governments, both large and small, yet their motivations and their relationship to the City of Taylor cannot be compared to a citizen volunteer who is an appointed board member.”

(Image by: Matt Mahurin)

The SEC warned:

[S]cam artists may target payout recipients with oil spill-related investment opportunities that promise high returns with little or no risk, or involve secretive or complex strategies. Members of religious or ethnic communities, professional organizations or other close-knit affinity groups could be likely targets for these scams because of the high level of trust that often exists within these groups and their tendency to share information with one another.

I called up the SEC late last week to see if they had identified any scams, and a spokesman told me he could not comment on whether there are any ongoing investigations into the issue. So I thought I’d turn to you, my readers.

If you have been the victim of an oil-spill-related scam or if you think you’ve been targeted by a scam artist, I’d like to hear your story. Email me: arestuccia@washingtonindependent.com.

Lawmakers say more work is needed to reform Wall Street. (Flickr: Pamhule)

Soon after Rep. Brad Miller (D-N.C.) came to Washington in 2002, a fellow member of the House Financial Services Committee told him to pick an arcane financial issue — any issue — and to make it his pet topic. Miller chose mortgage finance. He knew little about it. Banking lobbyists peppered him with data, but he had difficulty getting much information from independent sources.

[Economy1] “I was even reduced to reading blogs,” he quipped to a crowd of bankers, community organizers, financial reform experts, hedge fund managers and government aides at the Roosevelt Institute’s conference, “Financial Reform: Will It Work? How Will We Know?” on Monday. But Miller educated himself on the topic and became a leader in pushing for stronger regulation of mortgage products. By 2008, as the financial system collapsed, all of his colleagues in Congress had joined him in reading up on everything from liar loans to naked credit-default swaps.

That period of intense interest is over following the passage of financial regulatory reform legislation this summer, Miller and others said on Monday. But that does not mean that reform is done. In fact, because political attention has flowed from Wall Street to immigration, unemployment and myriad other topics, reform is imperiled. The regulatory law gave guidelines for fixing the financial sector, but the rule-writing process has fallen to dozens of agencies and government bureaucrats currently hammering out the details. That means the real work of reform is just beginning and the country is only incrementally closer to a safer financial system.

“It has become quite clear in recent years that the servant’s servant has become the master’s master,” argued Rob Johnson, a former hedge fund manager and current director at the Roosevelt Institute. Banks, he said, which should help companies merge, access credit and grow, instead ended up leeching off of them, piling on fees and unnecessary products. Ultimately, average Americans suffered. “We do not yet have a balance between society, the real economy and the financial sector.”

A few visiting investors noted that the sector has become more concentrated — due to a number of banks failing, and the others picking up their business — and therefore more dangerous. Each one of the systemically risky banks, like Goldman Sachs, has become more systemically important and therefore more likely to receive government backing if financial troubles re-emerge. (It will take years for Washington to put capital requirements and other safeguards in place.) Moreover, the long process of rule-writing allows banks ample time and opportunity to lobby bureaucrats working on legislation.

And that rule-writing is ongoing among dozens of agencies, including the Securities and Exchange Commission, the Federal Deposit Insurance Corporation, the Commodity Futures Trading Commission, the Treasury Department and the Federal Reserve. The government is also in the process of organizing and hiring workers for the new $500 million Consumer Financial Protection Bureau. And the massive legislation is drawing major lobbying interest. This campaign cycle, the American Bankers Association has pledged $13.6 million on lobbying and $2.1 million to campaigns, pushing for looser rules on banks. J.P. Morgan Chase alone has contributed nearly a million to campaigns this year.

So how will those interested in reform know if it is working in the meantime? The question posed to the gathering of 40 or so met with many answers. “[Reform] would be working if the banks were making a lot less money,” Miller argued. “The reality is for it to be successful it has to be a win-lose-win,” with markets and consumers winning, and banks losing. The Wall Street Journal reported yesterday that financial-sector corporate profits are near their all-time highs.

Sen. Jeff Merkley (D-Ore.) was more optimistic. He praised the reform process, citing the creation of the Consumer Financial Protection Bureau, derivatives reform and proprietary trading regulations as big wins. (Elizabeth Warren, the White House and Treasury advisor helping to build the new bureau, attended the conference but did not speak.)

Still, Merkley conceded, “There is more to do.” He noted that ratings agencies — which stamped triple-A ratings on hundreds of billions of dollars of worthless mortgage-backed products in the run-up to the recession — remained unfixed. (“They’re almost useless,” sighed Jerome Fons of Kroll Bond Ratings agency.)

Others pointed to problems with the derivatives clearinghouses, which might now be the new “too big to fail” institutions. (If banks post insufficient capital to cover their derivatives trades, and another credit crunch hits Wall Street, with investors pulling cash out, the government might be forced to bail them out to calm the markets.) Some criticized the new Treasury Department Office of Financial Research, tasked with understanding Wall Street’s new innovations. Dozens of such niche issues arose.

“There are the tools there to do this,” Mike Konczal, a Roosevelt fellow, said. “Now it’s an issue of political will. [The financial regulatory law] doesn’t presuppose that [reform] will happen. But it does have the tools to do it.”

He concluded: “Those tools sit there, and there’s going to be a lot of pressure not to use them.”

Congress is taking the issue up this week as well. Tomorrow, the same executives who met with the SEC today will appear at a hearing of the House Financial Services Capital Markets Subcommittee, called by Rep. Paul Kanjorski (D-Pa.). And last week, Sens. Ted Kaufman (D-Del.) and Mark Warner (D-Va.) asked the SEC and the Commodity Futures Trading Commission to investigate the market event in Sen. Chris Dodd’s (D-Conn.) financial regulatory reform bill.

Both the debt commission and Levin commission have released prepared remarks as well.

In today’s prepared testimony, Ben Bernanke argues that the government needs to fix its tax code and cut entitlements, or else face fiscal doom:

[The] federal budget appears set to remain on an unsustainable path….Unfortunately, we cannot grow our way out of this problem. No credible forecast suggests that future rates of growth of the U.S. economy will be sufficient to close these deficits without significant changes to our fiscal policies….

The commission will have the difficult job of weighing the economic, social, and other benefits of these [entitlement] programs and comparing the implications of cuts in these areas against other means of closing the fiscal gap. Choices regarding Medicare, Social Security, and other spending programs cannot be made in a vacuum but must be combined with decisions about how much revenue the government will raise and how it will raise it. No laws are more basic than the laws of arithmetic: For fiscal sustainability, whatever level of spending is chosen, revenues must be sufficient to sustain that spending in the long run.

And here are the Goldman testimonies. On the first panel are Daniel Sparks, former head of the mortgages department, Joshua Birnbaum, former managing director in structured products, Michael Swenson, managing director in structured products, and Fabrice Tourre, indicted in the Securities and Exchange Commission civil fraud case against Goldman Sachs and executive director in structured products. On the second panel are David Viniar, Goldman’s chief financial officer, and Craig Broderick, the chief risk officer. And on the third and final panel is Lloyd Blankfein, chief executive officer.

Tourre argues, “I deny — categorically — the SEC’s allegation. And I will defend myself in court against this false claim,” and goes on to detail that he made full disclosures about the structure of the mortgage-backed securities deal to the client who took the losing half of the bet.

And Blankfein’s testimony is largely conciliatory, though he says that Goldman has done nothing illegal or unethical with its mortgage products: “While we strongly disagree with the SEC’s complaint, I also recognize how such a complicated transaction may look to many people. To them, it is confirmation of how out of control they believe Wall Street has become, no matter how sophisticated the parties or what disclosures were made. We have to do a better job of striking the balance between what an informed client believes is important to his or her investing goals and what the public believes is overly complex and risky.”

My guess is that the public still won’t be hearing from Blankfein too often. The Financial Times reports that in his numerous calls to major clients, assuring them of the firm’s stability despite the SEC charge, he has argued the suit will “hurt America.”

Unlike Goldman’s participation in over-financializing the U.S. economy, stoking the mortgage crisis and shorting the housing market, leading to an $8 trillion loss in household wealth, the suit will hurt America. Right.

The lineup is full of heavy hitters, including Treasury Secretary Timothy Geithner, Fed Chairman Ben Bernanke, former Lehman Chief Executive Officer Dick Fuld and Securities and Exchange Commissioner Mary Schapiro. And several of the prepared testimonies are online in advance of the hearing. Most notably, Fuld’s. The former Lehman head makes some rather extraordinary claims.

First, he argues that Lehman was appropriately capitalized before its collapse: “The world still is being told that Lehman had a huge capital hole. It did not. … Using the Examiner’s analysis, as of August 31, 2008 Lehman therefore had a remaining equity base of at least $26 billion. That conclusion is totally inconsistent with the capital hole arguments that were used by many to undermine Lehman’s bid for support on that fateful weekend of September 12, 2008.” But then again, the examiner’s report does state: “The Examiner concludes that there is sufficient evidence to support a finding of undercapitalization of [Lehman Brothers] as of August 29, 2008.” I am not sure how Fuld squares that circle.

Fuld also argues that he had no knowledge of Repo 105: “Let me start by saying that I have absolutely no recollection whatsoever of hearing anything about Repo 105 transactions while I was CEO of Lehman. Nor do I have any recollection of seeing documents that related to Repo 105 transactions. The first time I recall ever hearing the term ‘Repo 105′ was a year after the bankruptcy filing, in connection with questions raised by the Examiner.” There is probably no way to know whether Fuld knew about Repo 105 or not — but regardless, it is now abundantly clear that he should have known.

He also argues that, in contravention of the Valukas finding, Repo 105 was acceptable accounting: “As I now understand it, because Lehman’s Repo 105 transactions met the FAS 140 requirements, that accounting rule mandated that those transactions be accounted for as a sale. That was exactly what I believe Lehman did. Lehman should not be criticized for complying with the applicable accounting standards.”

Valukas’ testimony is interesting as well. For one, he goes after Lehman’s regulators, including the SEC and the New York Fed: “We found that the SEC was aware of these excesses and simply acquiesced. With no regulator in place that required Lehman to adhere to its risk limits, … Lehman’s risk limits became meaningless.” He later says, “So the agencies were concerned. They gathered information. They monitored. But no agency regulated.”

Let’s say that you are buying a house in a foreign country where you do not know much about the real estate markets and therefore prices are fairly opaque to you. You decide to hire a real estate broker to help you find and buy a house and to act as a guide to the market. You know that real estate brokers sometimes represent the person selling a home as well as a person buying a home, but also know that your broker has a legal responsibility to act in your best interests and disclose as much about the house as possible. Ultimately, the broker makes money on the deal, but does not have a direct financial interest in the house.

So you meet with the broker, who shows you a plain apartment in a plain apartment building. You decide to go for it. He says he will hire an independent home inspector to appraise the home, to make sure it is sound and to help you determine your bid. The process moves forward, you buy the house and pay the broker his fee.

But just months later, you find out that the neighborhood is drug-addled and the apartment filled with leaks. You try to sell the apartment, but can only do so at a 90 percent loss. It turns out that the third-party independent home inspector had been hired by the seller; that the seller had made a bet with a bookie that the price of the house would go down; and that the broker knew it — he let them overvalue your house.

In this analogy, Goldman is the broker. Paulson is on the short side of the trade, and behind the home appraiser. The analogy is by no means perfect — collateralized debt obligations are more complicated than houses. But it goes to show that the issue here was that Goldman had a responsibility to disclose pertinent information to the buyer, and it did not.

The SEC alleges that Goldman Sachs structured and marketed a synthetic collateralized debt obligation (CDO) that hinged on the performance of subprime residential mortgage-backed securities (RMBS). Goldman Sachs failed to disclose to investors vital information about the CDO, in particular the role that a major hedge fund played in the portfolio selection process and the fact that the hedge fund had taken a short position against the CDO.

To simplify how the gambit worked: The hedge fund Paulson & Co. (no relation to former Treasury Secretary Henry Paulson) handpicked mortgage-backed securities that were doomed to stop performing, being backed with subprime mortgages, and Goldman packaged them into a kind of bond. Paulson bet against the bond, with Goldman acting as the broker; at the same time, Goldman sold the bond to other clients without disclosing that Paulson had engineered the bond to fail.

The SEC filing notes that those other clients lost $1 billion. Goldman had no direct stake in the success or failure of the CDO. It made money either way. Felix Salmon explains:

The scandal here is not that Goldman was short the subprime market at the same time as marketing the Abacus deal. The scandal is that Goldman sold the contents of Abacus as being handpicked by managers at ACA when in fact it was handpicked by Paulson; and that it told Abacus that Paulson had a long position in the deal when in fact he was entirely short.

Goldman Sachs has lost more than $10 billion in market capitalization today, in the wake of these revelations. Good. It can go long markets and it can go short markets. But it can’t lie to its clients. That’s well beyond the pale.

One of the reasons the markets must be so spooked about Goldman? This sort of deal seems to have been ubiquitous during the run-up to the housing crash. This is just one SEC filing. My guess is that more will be forthcoming.

To help explain the legal issues — particularly in light of the upcoming push for regulatory reform in Congress — I spoke with Jennifer S. Taub, a lecturer at the Isenberg School of Management at the University of Massachusetts, Amherst, and a member of the Economists’ Committee for Stable, Accountable, Fair and Efficient Financial Reform. She formerly worked as an associate general counsel at Fidelity and as assistant vice president for the Fidelity Fixed Income Funds.

I lightly condensed and edited the interview for clarity.

So, on Friday, the Journal reported that a number of major Wall Street investment banks, including Goldman Sachs and Bank of America, are routinely using repo transactions to lower their debt and leverage levels before making their quarterly reports. And I think everyone’s question is: Isn’t that fraud?

That is the question. Thus far, it seems that this is lawful. However, we just don’t have enough facts about what they were actually doing. The SEC is in the midst of an investigation into repurchase agreement-financing transactions at these firms, and we haven’t seen the SEC report yet. These investment banks say that they were not performing any Repo 105 transactions — the kind Lehman Brothers was performing — and that they recorded their repo transactions on their books properly. It seems clear what was going on in Repo 105 is criminally actionable, for example, under the Sarbanes-Oxley Act, which requires that periodic reports fairly represent in all material respects the company’s financial condition. And the question at Lehman is whether this was fair reporting.

Right — looking as an outsider with not much understanding of securities law, looking at Wall Street from Main Street, it seems that even if this wasn’t fraud, it should have been.

Yes, it definitely seems off, even if it was legally OK. I think you can take two paths looking at these transactions. You can say: Is this criminal or not? We can’t determine that yet, we just don’t have enough facts. But then you can say: Even if it is perfectly legal, it still seems that this is an issue because there is the question whether investors were being misled and whether this business model threatens the entire financial system.

These transactions involve very short-term borrowing to finance long-term, illiquid assets. Even Lloyd Blankfein, the head of Goldman Sachs, has described this maturity mismatch as very dangerous. This is especially the case, where prior to the crisis, the investment banks were using short-term, often overnight loans to finance up to 50 percent of the assets they held.

That is why I think that we should not focus exclusively on the question of whether or not this was illegal, but on the point of fact that it is dangerous, because of the magnifying effect of leverage. This was the problem during the financial crisis. If any one firm loaning to you starts to get nervous that you aren’t creditworthy, they pull their financing, all of a sudden, you can’t get loans, you have to sell assets, then everyone is doing the same — you have the same death spiral that seized the credit markets.

To me, in the interest of fairness and deterrence, securing convictions is important. However, I don’t want us to get distracted by what’s criminal and ignore whether what’s “perfectly legal”  makes us unstable.

And you’ve done some work describing how these repo transactions came to be a systemic risk problem — describing their dramatic growth around 2005, as possibly due to a change in the U.S. bankruptcy code. Could you explain that?

This is a hypothesis, and I need to dig deeper. But, my initial sense is that there is a connection between a recent change in the bankruptcy law and the growth of repo transactions.

Say that you are on the investment side of a repo transaction — you’re the cash-rich investor who is going to loan money overnight or for a week to an investment bank, who will give you Treasuries or other collateral. If you’re the investor, you want to make sure that if the other side can’t give you back the cash the next morning or next week, you can keep the collateral. Investors are also concerned that even if they hold onto that collateral, if the bank goes into bankruptcy, they might not be able to keep it.

When a company files for bankruptcy, something called the “automatic stay” comes into effect. The trustee (or the debtor-in-possession) stops all transactions. He can freeze almost anything. But, that isn’t actually true for everybody. If you’re a “secured creditor,” the freeze does not apply to you. In addition, the ability for the trustee to claw back your collateral is prevented. And one way to be a secured is to be in possession of collateral whether directly or through a custodian bank. That means that investors who loan through repo are in a better position than other kinds of unsecured lenders.

But if I loaned to you through repo — say I gave you $1 billion in cash, and you gave me $1.01 billion in collateral — I get to keep that collateral. If you’re a secured creditor you feel comfortable lending, even in really bad circumstances. And repo transactions are secured.

But it wasn’t always like that? Something changed to make repo a secure way to lend?

Right. Before 2005, where the bankruptcy code covered repurchase financing, it was only clear that some kinds of repos, backed by a limited list of collateral types, were secured. Only Treasuries, agencies, and a few other types were. If I were going to loan to you overnight, and you gave me Treasuries, then the bankruptcy code said, “Yes, you’re secured and if your business goes under, you get to keep it.”

In 2005, the code expanded to list a whole bunch of other types of collateral such as mortgage loans and interests in mortgage-related securities were. This encouraged the purchase of these assets, because financing through the repo market was more available. That meant, if I have a lot of money to park overnight, I’m willing to take not just Treasuries but these other riskier assets as well. I am exploring whether there is a connection between this legal change and the growth of repo transactions from approximately $4.9 trillion in 2004 to $7 trillion by the first quarter of 2009. That’s a preliminary take, though. And I need to dig deeper.