[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
AUCTION RATE SECURITIES MARKET:
A REVIEW OF PROBLEMS AND
POTENTIAL RESOLUTIONS
=======================================================================
HEARING
BEFORE THE
COMMITTEE ON FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
__________
SEPTEMBER 18, 2008
__________
Printed for the use of the Committee on Financial Services
Serial No. 110-140
U.S. GOVERNMENT PRINTING OFFICE
45-624 PDF WASHINGTON : 2008
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HOUSE COMMITTEE ON FINANCIAL SERVICES
BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania SPENCER BACHUS, Alabama
MAXINE WATERS, California DEBORAH PRYCE, Ohio
CAROLYN B. MALONEY, New York MICHAEL N. CASTLE, Delaware
LUIS V. GUTIERREZ, Illinois PETER T. KING, New York
NYDIA M. VELAZQUEZ, New York EDWARD R. ROYCE, California
MELVIN L. WATT, North Carolina FRANK D. LUCAS, Oklahoma
GARY L. ACKERMAN, New York RON PAUL, Texas
BRAD SHERMAN, California STEVEN C. LaTOURETTE, Ohio
GREGORY W. MEEKS, New York DONALD A. MANZULLO, Illinois
DENNIS MOORE, Kansas WALTER B. JONES, Jr., North
MICHAEL E. CAPUANO, Massachusetts Carolina
RUBEN HINOJOSA, Texas JUDY BIGGERT, Illinois
WM. LACY CLAY, Missouri CHRISTOPHER SHAYS, Connecticut
CAROLYN McCARTHY, New York GARY G. MILLER, California
JOE BACA, California SHELLEY MOORE CAPITO, West
STEPHEN F. LYNCH, Massachusetts Virginia
BRAD MILLER, North Carolina TOM FEENEY, Florida
DAVID SCOTT, Georgia JEB HENSARLING, Texas
AL GREEN, Texas SCOTT GARRETT, New Jersey
EMANUEL CLEAVER, Missouri GINNY BROWN-WAITE, Florida
MELISSA L. BEAN, Illinois J. GRESHAM BARRETT, South Carolina
GWEN MOORE, Wisconsin, JIM GERLACH, Pennsylvania
LINCOLN DAVIS, Tennessee STEVAN PEARCE, New Mexico
PAUL W. HODES, New Hampshire RANDY NEUGEBAUER, Texas
KEITH ELLISON, Minnesota TOM PRICE, Georgia
RON KLEIN, Florida GEOFF DAVIS, Kentucky
TIM MAHONEY, Florida PATRICK T. McHENRY, North Carolina
CHARLES WILSON, Ohio JOHN CAMPBELL, California
ED PERLMUTTER, Colorado ADAM PUTNAM, Florida
CHRISTOPHER S. MURPHY, Connecticut MICHELE BACHMANN, Minnesota
JOE DONNELLY, Indiana PETER J. ROSKAM, Illinois
BILL FOSTER, Illinois KENNY MARCHANT, Texas
ANDRE CARSON, Indiana THADDEUS G. McCOTTER, Michigan
JACKIE SPEIER, California KEVIN McCARTHY, California
DON CAZAYOUX, Louisiana DEAN HELLER, Nevada
TRAVIS CHILDERS, Mississippi
Jeanne M. Roslanowick, Staff Director and Chief Counsel
C O N T E N T S
----------
Page
Hearing held on:
September 18, 2008........................................... 1
Appendix:
September 18, 2008........................................... 59
WITNESSES
Thursday, September 18, 2008
Adams, William IV, Executive Vice President, Nuveen Investments.. 52
Coakley, Hon. Martha, Attorney General, Commonwealth of
Massachusetts.................................................. 16
Galvin, Hon. William Francis, Secretary of State and Chief
Securities Regulator, The Commonwealth of Massachusetts........ 13
Merrill, Susan, Executive Vice President and Chief of
Enforcement, Financial Industry Regulatory Authority........... 11
Norwood, Leslie, Managing Director and Associate General Counsel,
Securities Industry and Financial Markets Association.......... 46
Payne, Tara, Vice President for Corporate Communications, New
Hampshire Higher Education Loan Corporation.................... 48
Preston, James, President and Chief Executive Officer,
Pennsylvania Higher Education Assistance Agency................ 54
Sherr, Roger, Vice President, Sherr Development Corporation...... 50
Thomsen, Linda, Director, Division of Enforcement, U.S.
Securities and Exchange Commission............................. 9
APPENDIX
Prepared statements:
Adams, William IV............................................ 60
Coakley, Hon. Martha......................................... 80
Galvin, Hon. William Francis................................. 85
Merrill, Susan............................................... 97
Norwood, Leslie.............................................. 107
Payne, Tara.................................................. 123
Preston, James............................................... 129
Sherr, Roger................................................. 134
Thomsen, Linda............................................... 137
Additional Material Submitted for the Record
Frank, Hon. Barney:
Written statement of the North American Securities
Administrators Association................................. 148
Written statement of Professor Frank J. Parker............... 153
Written statement of the Municipal Securities Rulemaking
Board...................................................... 157
Written statement of the Regional Bond Dealers Association... 178
Kanjorski, Hon. Paul:
Responses to questions submitted to James Preston............ 189
Miller, Hon. Gary:
Letter to Hon. Melvin Watt from HUD, dated September 12, 2008 191
Perlmutter, Hon. Ed:
CRS Report for Congress, Auction-Rate Securities, dated
September 17, 2008......................................... 192
AUCTION RATE SECURITIES MARKET:
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Washington, DC 20402-0001
A REVIEW OF PROBLEMS AND
POTENTIAL RESOLUTIONS
----------
Thursday, September 18, 2008
U.S. House of Representatives,
Committee on Financial Services,
Washington, D.C.
The committee met, pursuant to notice, at 10 a.m., in room
2128, Rayburn House Office Building, Hon. Barney Frank
[chairman of the committee] presiding.
Members present: Representatives Frank, Maloney, Watt,
Sherman, Hinojosa, Lynch, Scott, Green, Cleaver, Davis of
Tennessee, Hodes, Klein, Perlmutter, Carson, Speier; Bachus,
Royce, Jones, Shays, Capito, Neugebauer, and Campbell.
Also present: Representative Shea-Porter.
The Chairman. The hearing will come to order. I apologize
for being a little late. Can we get the door closed back there?
This is a very important hearing and I want to say I am
very appreciative for the hard work of a number of people,
including my two Massachusetts colleagues who are here, and the
people from the regulatory field, but also people from the
industry. We sometimes have a hearing to lament the bad state
of affairs. Obviously, this is a situation where there have
been problems.
We rarely have hearings of self-congratulation, but I am
pleased to note that the situation today regarding this looks a
lot better than it did when we called the hearing; and, I am
very appreciative of the efforts of a lot of people, as I said,
including those who are here, who in leadership and industry
responded. But it is still important for us to go ahead,
because we have been focused, understandably as a Congress, in
the Executive Branch and in the private sector on the important
questions of systemic stability.
No one thinks this country is falling apart, but we are
undergoing a degree of stress now that is having negative
consequences far beyond what we would like to see, and trying
to cope with them and trying to put in place rules going
forward that diminish the likelihood of a recurrence have been
very important. There is a danger here, and I don't impute it
to any one individual, but it is a danger for all of us. As you
focus on systemic stability, investor protection can slip,
partly because it is just not at the top of everybody's agenda,
partly because there are in some cases conflicts. To the extent
that you have institutions that have been weakened, it is a
question of what compensation they give is going to be raised
in some people's minds.
Going forward, it is easier to make sure we do not allow
these conflicts to arise, but I do believe that with regard to
auction rate securities, there was a danger several months ago
that investor protection was falling between the cracks, not
outrunning the line decision to do it, but because other things
were crowding it out, and because of some potential conflict in
people's minds.
I think through the efforts of a lot of people, and I think
this committee was a part of it by frankly announcing the
hearings and our staff working together to talk to people that
we have helped elevate investor protection to where it should
be.
There are a couple of issues about it, but with regard to
investor protection, one thing in particular stands out in my
mind that has changed some of what opinion had been; and, that
is, we had previously taken a view, for instance with regard to
hedge funds, that we had to protect the unsophisticated
investor, but that for sophisticated investors, the principle
of caveat emptor could prevail. We had a million-dollar cut-off
of hedge funds, but the people who have been victimized in this
include some very sophisticated investors, individual and
institutional.
I think what it shows is we are in a world today where the
complexity and opacity of financial instruments is such that
you cannot say, oh well, if you have more than a million
dollars you are on your own. I think this makes it clear that
it's not enough to simply say, okay we'll just let everybody do
what they want, and we just won't let you into it. We need to
have the kind of regulatory system that among other things
provide some safeguards, because as I said, some of the most
sophisticated entities and investors have been involved in this
and that means we have to broaden it. So I appreciate the
participation of the witnesses.
Our hearing is in part to figure out what has gone wrong.
It is in part to encourage compensation, and I think we have
made a lot of progress there and we will hear about that. I
mean, what went wrong? How can we sort of compensate or see
urged that people be compensated? Finally, and most importantly
from this committee, what do we want to do going forward,
because we will be adopting a set of regulatory rules going
forward. What do we do to diminish the likelihood of this
happening again?
Now, that being the statement, I do want to make one other
announcement not related to this hearing, and it has to do with
what the role of the committee will be going forward. There is
clearly a lot of interest in what has been going on with regard
to the interventions that have come from the Executive Branch
and the case of Fannie Mae and Freddie Mac authorized by us,
and the cases of Bear Stearns and AIG done by the Executive
Branch or the Federal Reserve. And I have had some requests
about what are we going to do to look into it. This committee
has a busy agenda.
There is an overlap. I have had a meeting with Chairman
Waxman of the Government Reform Committee; and, essentially, we
have a kind of division of labor. That committee will be
holding hearings under its jurisdiction, which is equal to us,
as our friend from Connecticut, a very senior member of that
committee knows. And it's always important to work out, I
think, without friction, the authorizing committee and the
oversight section; and, what we have agreed to is that this
committee will continue to function on the policy issues, in
particular on what going forward we ought to put in place to
make these things less likely.
The oversight committee, under its oversight function, will
be looking into what happened, what didn't happen, and what
should have happened. They will be looking at the actions of
the private sector and the actions of the regulators.
Obviously, those are not exclusively watertight compartments
but that's where we are. So the thrust of the hearings into
what happened and whether we are right or wrong are going to be
going on the oversight committee.
We will be talking about what is going to happen, moving
forward. There is continuous contact, we hope will go on
between the staffs from both parties and both sets of
committees; and I knew there was some interest in that and
that's where we are.
With that, I will now call on the ranking member to make
his opening statement.
Mr. Bachus. Thank you, Mr. Chairman, for holding this
hearing; and before I address auction rate securities, let me
just say to Director Thomsen that I appreciate the action of
the SEC yesterday. I think legitimate short-selling plays an
important role in our capital markets, but what we have seen in
the last year is abusive, naked selling.
I think it has weakened a lot of our financial institutions
that probably would have survived had it not been for those
abusive practices, because as short-sellers often acting in
concert with each other, systematically singled out one
institution and drove down their stock, it undermined the
confidence of the public and the customers of those
institutions in the institutions.
It impaired their ability to raise capital or to finance
their debt and I think in many cases institutions fail; and,
although it was not the root cause, the root cause of what we
were facing today is years of over leveraging, risk-taking,
over-extension of credit, failure of our rating agencies to
properly regulate; and, in many cases, because of our outdated
financial systems and inability in certain cases to regulate,
or a patchwork or regulation where really no one was
overseeing, for instance, the investment bank. But I will say
that I believe with the action yesterday and the first action
was taken it was limited to 19, I think, financial companies.
I expressed at that time my concern that the short-sellers
when that happened, went to some of the smaller, more mid-size
banks and began concentrating on some of your smaller
institutions; and, I think that what was needed then and what
you have done yesterday was a blanket order. I have compared
these packs of short-sellers to jackals, which have actually
attacked financial institutions and brought them to their
knees, and I think it has definitely worsened what we are going
through today.
In a conversation a year ago, Secretary Paulson told me
that it was going to be almost impossible to avoid a painful
deleveraging, because the chickens were coming home to roost--
many, many, because of failure to regulate--many, because the
Congress didn't address problems which we had known existed,
and that is across all Administrations and failure to modernize
our system.
But for whatever reason the industry, in many cases,
resisted attempts to regulate. And they resisted very harshly.
I was attacked across-the-board by the financial services
industry when I proposed a subprime bill 3 years ago; and they
went out and told the public. They told my colleagues that
there was absolutely no problem in subprime lending and trying
to regulate and impose some standards was going to make things
worse.
And a year-and-a-half ago, Chairman Frank and I referred to
what we considered some dire straights that we were in and we
were both criticized by our colleagues as exaggerating the
situation they were in.
The Chairman. More of your colleagues than mine.
Mr. Bachus. What?
The Chairman. I think it came more from your colleagues
than mine.
Mr. Bachus. There are quite a few.
And another thing that the Congress didn't do at that time,
there were things for instance that the chairman and I agreed
on, but some of our colleagues wanted more. Some wanted less.
And they would not agree to compromise; so we could not get
anything done. And often, that is the situation. You always
have folks who say they want to go further, people who say they
don't want to do anything at all; and, what fails to happen is
anything and that certainly happened. I think had it been left
to he and I, we would have had a subprime lending bill 3 years
ago. It wouldn't have been all that people have.
I'm going to submit my remarks on auction rate securities
as a matter for the record. Let me simply say with the auction
rate securities, many of them were sold as being very liquid to
investors. Cities, counties, they could get in, they could get
out. It was a wonderful way to finance debt and it would always
be liquid. Suddenly in February and March, they found that
these assets were totally illiquid. It was almost like a roach
motel, a financial roach motel. They could get in but they
couldn't get out.
It was a nightmare for our cities and counties and our
States, and I am glad, because of some of the efforts of people
in our first panel and others, and our announcement with Mr.
Kanjorski that we were holding a hearing and an investigation,
that a lot of that appears to be resolving itself, but as we
deal with the stability of our financial markets, a large
component of that is going to be the auction rate securities
market, and I do believe that is one area where we are making
real progress, and it is beginning to resolve itself. I think
that will have positive implications for the economy.
Thank you, Mr. Chairman.
The Chairman. Before we get to the Orkin men and women on
the panel, are there any other opening statements? I think the
gentlewoman from New York has one?
Mrs. Maloney. First of all, I want to thank the chairman
for his leadership, not only on this issue today, but this has
really been the most troubling time that I have ever seen on
this committee. And I would say the markets have not seen such
a turmoil in our country and I would say worldwide since the
Great Depression. I strongly believe we should be looking like
an RTC-like mechanism to take care of this crisis now.
We cannot continue to approach it in a piecemeal way. We
need a comprehensive approach. I would like to be associated
with my colleague, the ranking member, and the chairman of the
committee particularly on the naked shorts. Many people have
called me and they believed that their company would be there,
their jobs would be there, if this abusive practice had been
stopped earlier, so I applaud the SEC's action and I feel that
we should have a hearing and look in more to these naked
shorts.
With regards to the auction rate securities market, we all
have been following the situation since the market for these
securities froze back in February. At its height, $160 billion
worth of auction rate securities were issued by State and local
governments, charities, and colleges and universities of all
credit qualities and sizes. But, in February, everything just
stopped. Since this time, everyone has been asking how these
securities which were being marketed as something safe and as
liquid and cash could have frozen all at once leaving $64
billion worth of securities locked up.
I have had constituents who have come to me, and they said
they took out these securities. They said they could get their
hands on it. It was as good as cash. They still cannot get
their money back. Over the summer, we have seen settlements
with the New York State and Massachusetts State attorneys
general which would require banks to pay fines and buy back
much of the $64 billion in frozen securities.
While I applaud this effort, I still have concerns about
the cost that the States, municipalities, and other public
entities who were the issuers of these auction rate securities
have been forced to incur; and, their liability, of course,
then becomes a taxpayer liability. In a recent speech by former
SEC Chairman Arthur Levitt, he made the following point about
these issues, and I request unanimous consent to put his
entire--and he really points to the need of more transparency--
and I quote from him as we try to unravel what happened.
What becomes clear is that too many issuers were left in
the dark. Many had no independent advisors; and those that did
not hire advisors often found themselves receiving advice from
parties that were conflicted since these advisors also worked
as a banker in the auction securities market. He also reminds
us that problems in this market have been known about for at
least 4 years as a result of an SEC investigation into the
broader market in 2004 and 2008, and that a lawsuit by the
Massachusetts Secretary of State revealed that going back to
2006, nearly 85 percent of the auction would have failed or
produced different results without the single brokers'
intervention.
At this hearing, I am particularly interested in learning
exactly what happened and why it happened, and learning why
exactly this market froze simultaneously in February, despite
this market having problems and not functioning properly for
many years. And why were these large penalty rates required for
most issuers, but not required of the closed-end fund issuers
or most structured bond issuers, though the securities were
sold by the same underwriters to the same investors? So these
are some of the questions to which I hope to hear answers
today.
Again, I thank the chairman for having the hearing.
The Chairman. The gentleman from Texas is recognized for 3
minutes.
Mr. Neugebauer. I thank the chairman and I would ask that I
could just revise and extend my remarks.
The Chairman. All members will have general leave to put
anything in the record they want.
Mr. Neugebauer. I thank the chairman for having this
hearing today because auction rate securities have played an
important part of our market; and, particularly, I want to
address my remarks primarily to the student loan program,
because what has happened over the last year is one we passed
legislation here where we reduced the amount of Federal subsidy
to help some of the student loan securities be securitized in
finance.
And, at the same time, one of the major financing vehicles
for student loans was affected by the fact that auction rate
securities, and so I think what we are saying, and I applaud
the chairman, I think this committee does need to focus on
those things that we can do to get the markets back acting in a
normal way again, because the sooner we can do that the better
for all of the players. Unfortunately, some of the actions by
some of the players that were not good actions, poor decisions
were made as affected the entire market place; and our auction
rate securities have played an important part for cities and
particularly for entities that are financing student loans.
We have been hearing from our bank friends all during the
spring and summer their concerns about, because some of their
traditional sources to be able to go with their student loans
had basically dried up, because many of these entities, one of
those in my district, has quit making student loans or quit
purchasing student loans from banks until they can work through
this, because quite honestly, right now, with the cost of
financing or providing other financing vehicles for some of
these loans just doesn't make economic sense for them.
So I think as we hear from the panel today, one of the
things that we need to hear is the way you think. I'm not a big
market interventionist from the Federal Government. Maybe the
best thing for us is to get out of the way and let the markets
start functioning again. But, certainly, the sooner that they
function, we start functioning more appropriately, obviously,
the better for students and cities and other entities that have
used these securities. You know, because one of the issues was
that there are a lot of these entities.
There wasn't the creditworthiness necessarily of those
issues. It's just that once that pendulum started swinging
there was a competence factor that spread throughout the
market, and basically froze all of those auctions. And so
raising the cost of financing for many of those entities,
obviously providing some liquidity issues for people who
thought that you could just get your money out of those at any
time, and I think one of the underlying questions is you look
into your crystal ball here.
Do you see auction rate securities back in the market place
again?
With that, I yield back my time.
The Chairman. I thank the gentleman.
The gentleman from Georgia for 3 minutes.
Mr. Scott. Thank you very much, Mr. Chairman.
I'll be very brief. I hear a lot of discussion on the other
side about getting out of the way and letting the markets take
care of themselves. We have learned that is absolutely the
wrong thing for us to do. If anything, we need to get in the
way, and, we need to get in the way very quickly, because this
is not just a problem in the United States anymore.
This is a world-wide problem, and our prestige as a
financial leader of the free world is at stake, the two
underlining issues that we need to address very quickly is a
decline in value of the dollar at home and abroad especially.
But the other fact of the matter is where do you think we are
getting this money? Where do you think we are going to get the
money to bail out AIG, Bear Stearns, Fannie Mae, and Freddie
Mac? It is not just being pulled off a tree.
We are borrowing this money. Our debt is going out of the
ceiling; and, where are we borrowing it from? Foreign nations
and foreign governments at a rate that is really crippling the
future of our financial stability in the world. So, Mr.
Chairman, I just wanted to add my 2 cents to that, because this
is a very urgent issue, and we need to get in the way very
quickly and we need to find the appropriate vehicle to
intervene, much like the ROTC that the chairman has talked
about. As we responded to the savings and loan crisis of 1984,
I believe, so this is a very serious issue. The one before us
with the auction rate securities is especially, and I want us
to deal with more detail as we get into this discussion today
about the risk, the risk that is involved with the ARS market.
We need to understand that. We need to know not only what
is being done, but what can be done in the near future to
address this collapse. Could more have been done to assess, to
anticipate and further have prevented the auction rate mess?
Were investment firms and broker-dealers well aware that
the ARS market bubble was about to burst? There's a lot of
culpability here--the nature of the recent settlements--the
role of the auction manager. There's a lot we have to get in
with this, but this is part of this bigger picture, and I think
the climate in Washington needs to get very serious and get in
the way and save our economy and the prestige of the United
States as being the financial leader of the free world.
Thank you, Mr. Chairman.
The Chairman. The gentleman from Connecticut is recognized
for 3 minutes.
Mr. Shays. Thank you, Mr. Chairman.
I first want to say that I think you are recognized by
almost all the members here as being one of the smartest and
the most effective. But I think the one are that you are not
recognized, and I want to pay particular salute to it is that
you have taken this issue, as you do so many others. Instead of
trying to make it a political issue, have tried to say we have
a huge issue; how do we come together. You have done a
remarkable job, I think, of trying to get this committee to
understand these problems and work together for the good of the
country. And I just want to first thank you for that.
The Chairman. Thank you.
Mr. Shays. Secondly, I want to say that the smaller Federal
family education loan providers, the FFELP providers, have
utilized the auction rate securities market to raise capital to
originate new loans. And so when this market froze, certain
FFELP providers were unable to obviously access capital.
On July 9th, I wrote to you and our ranking member, Mr.
Bachus--I also appreciate the team that you have become--and
said, let's have a hearing on this. So first, I want to thank
you for doing this, for having this hearing. There's a lot
about this process that I need to understand better. But what I
do understand is that we have seen 19 of the top 100 lenders
leave the Federal family education loan program entirely. And
these totals include 14 nonprofit State loan agencies.
I am told that three State loan agencies--Pennsylvania
Higher Education Systems, the Massachusetts Education Finance
Authority, and the Michigan Higher Education Student Loan
Authority--suspended all FFELP originations. So every type of
lender has been affected, 14 State loan agencies, 56 banks, 14
credit unions, four nonprofit lenders, three school lenders,
schools with 45 coming soon, and 34 non-loan banks.
This is a very serious problem. One of our strengths as a
country is that we have the best educated, best trained
workforce. Our strength has still been particularly in higher
education; and I remember when the government was almost shut
down, the Clinton Administration and the Republican Majority in
Congress. And I think I heard more from parents concerned their
kids were not going to get their student loans and the programs
would start to shut down.
And it was interesting the number who were focused just on
that issue. If we don't resolve this issue, we are going to
hear from a lot of people and rightfully so.
I yield back.
The Chairman. I thank the gentleman. I thank him for his
very gracious words, and the subject with the cooperation of
most of the members of the committee that we have been able to
do this, I would now put into the record under the general leaf
a very thoughtful essay from Professor Frank Parker, who is a
professor of real estate development at the Carroll School of
Management, which is in the congressional district I represent,
Boston College, and the State legislative district, the
Secretary of the Commonwealth used to represent and lives near,
but it's a very thoughtful article.
And then, also, a written statement from the North American
Securities Administrators Association; and, let me just say as
we begin the testimony, we have had debates here from time to
time over whether or not there should be a pre-emption at the
Federal level of the role that the States play in securities
law. And anyone who wanted some evidence that it would be a
mistake to wipe out the State role or substantially diminish it
can look at the history of this issue, because it has been at
the State level that we have seen from my own State of
Massachusetts, from New York and elsewhere, a degree of
intervention, I believe, the State of Missouri, our colleague's
sister from the State of Missouri, Ms. Conahan, that in a
number of States it has been the State securities officials and
law enforcement officials who have taken the lead.
So I am pleased to put that statement in the record and
they are entitled to say this is a strong affirmation of the
need for that role.
We will now begin with our panel, and will first hear from
Linda Thomsen, the Director of the Division of Enforcement at
the U.S. Securities and Exchange Commission.
Ms. Thomsen.
STATEMENT OF LINDA THOMSEN, DIRECTOR, DIVISION OF ENFORCEMENT,
U.S. SECURITIES AND EXCHANGE COMMISSION
Ms. Thomsen. Good morning, Chairman Frank, Ranking Member
Bachus, and members of the committee.
I am Linda Thompson, the Director of the Division of
Enforcement at the Securities and Exchange Commission. Thank
you for the opportunity to testify today about the Commission's
efforts in response to the freezing of the auction rate
securities market in mid-February 2008.
I have submitted my written testimony and asked that it be
made a part of the record. I would like to start with the very
big picture, and that is this: Thanks to the collective efforts
of Federal, State, and SRO law enforcement and securities
regulators, thousands and thousands of investors have billions
and billions of dollars of liquidity restored to them in very
short order. This relief is virtually unprecedented in type,
magnitude, and timing. And due to these collective efforts,
investors in auction rate securities at a number of firms,
including retail customers, small businesses and charitable
organizations will have the opportunity to receive quickly 100
percent of the dollar investments.
Customers who accept these offers will receive all of the
interest payments or dividends they are due and will be given
the opportunity to sell their auction rate securities without a
loss. Since the auction rate securities market seized up in
mid-February 2008, the need to restore liquidity for investors
has been of paramount importance to the SEC and to our fellow
regulators.
Through the Division of Enforcement, settlements in
principle, with UBS, Citigroup, Wachovia, and Merrill Lynch,
over $40 billion in liquidity will be made available to tens of
thousands of customers. Auction rate securities were first
developed in 1984, and as of 2008, it was estimated that the
market had grown to $330 billion. Until mid-February 2008,
auction failures were extremely rare and the market was highly
liquid. For a variety of reasons, including the subprime
mortgage and credit crisis that was unfolding throughout the
second half of 2007, the auction rate securities market seized
up in mid-February 2008 and the securities became illiquid.
The SEC staff reacted immediately. The Division of
Enforcement began investigating, and deployed tremendous
resources to the effort. In March of 2008, enforcement staff
began collecting detailed information from 26 broker-dealer
firms. We interviewed investors and other market participants
including employees of broker-dealers and issuers. We
established a dedicated e-mail box to receive investor
complaints.
Since mid-February, the Commission has received over 1,000
complaints concerning approximately 50 broker-dealer firms.
Investors reported that their brokers had led them to believe
that they were investing in safe and liquid investments, cash
equivalents. And when the market froze, they could not access
their funds for important, short-term needs, such as a
downpayment on a house, medical expenses, college tuition,
taxes, and for some small businesses, payroll.
To conduct investigations quickly and avoid unnecessary
duplication, we also coordinated our efforts with other
regulators including FINRA, the Office of the New York Attorney
General, and the North American Securities Administrators
Association and its membership, including, of course, the
office of Secretary Galvin.
The two largest auction rate securities market participants
were Citigroup and UBS. These firms became the primary focus of
the investigations being conducted by the SEC's enforcement
staff and our fellow regulators. We were acutely aware that
time was of the essence, and we expedited our efforts
accordingly. In early summer, enforcement staff, along with our
colleagues for the New York Attorney General's office, embarked
on an aggressive schedule of taking testimony from employees of
Citigroup and UBS.
Our investigative record indicates that both firms made
misrepresentations and omissions to their customers when
marketing and selling auction rate securities. The SEC's
investigation further shows that until the auction rate
securities market seized Citigroup and UBS marketed auction
rate securities as safe and highly liquid investments with
characteristics similar to money market accounts, these firms
misleadingly characterized auction rate securities as cash
alternatives or money market and auction instruments. The firms
failed to disclose, and in late 2007 and early 2008, auction
rate securities liquidity risks had materially increased as the
firms knew that there was an increased likelihood that they and
other broker-dealers would no longer support the auctions.
Early on, the SEC staff, in coordination with the New York
Attorney General's office, took the lead in structuring,
proposing, and negotiating the framework for a settlement that
included liquidity solutions. This framework was developed in
consultation with the SEC's Division of Trading and Markets and
other Federal regulators in light of the potential impact on
the broader capital markets.
Of paramount importance was providing quick liquidity
solutions for retail customers, charities, and small businesses
that were from our perspective most in need of access to their
funds. The agreements in principle with UBS and Citigroup
established a general framework for other firm settlements.
Other State regulators, especially through NASAA under the
leadership of its President, Karen Tyler, and its auction rate
securities taskforce, which included Secretary Galvin who
provided tremendous leadership in this effort, quickly joined
the efforts. And I should note that I believe it was Secretary
Galvin who filed the first suit with respect to auction rate
securities.
Although negotiating global settlements was not easy, the
State and Federal regulators proceeded in good faith, working
virtually round-the-clock for weeks. All of us felt that
working together enabled us to maximize the relief provided to
investors. In early August, the SEC, the New York Attorney
General's office, NASAA, and the Massachusetts and Texas
securities authorities announced settlements in principle with
Citigroup and UBS.
In pertinent part, both firms agreed to offer to purchase
frozen auction rate securities from retail customers, small
businesses, and charitable organizations at 100 cents on the
dollar. Both firms also made whole any losses sustained by
customers who sold their auction rate securities at less than
par after the market had frozen and both will offer no-cost-
loan programs to eligible customers with immediately liquidity
needs.
The settlements also provide a mechanism through FINRA for
customers to participate in a special arbitration process to
pursue consequential damages. As for larger institutional
investors, UBS has agreed to offer to purchase auction rate
securities at par over a longer timeframe, while Citigroup has
agreed to use its best efforts to provide liquidity solutions
for its institutional customers.
The proposed settlements contemplate that the Commission
will defer imposing financial penalties on the settling firms
in order to evaluate, among other things, their performance
under the settlements. The SEC staff is now finalizing the
settlement terms with the firms which it will then recommend to
the Commission for approval. In addition to the first
settlements with UBS and Citigroup, the SEC staff and others
have reached settlements in principle with Wachovia and Merrill
Lynch. And our efforts are continuing.
I would like to thank you for this opportunity to discuss
the Commission's efforts with respect to the auction rate
securities markets, and I would be happy to answer any
questions.
Thank you very much.
[The prepared statement of Director Thomsen can be found on
page 137 of the appendix.]
The Chairman. Thank you for your testimony.
We will now hear from Susan Merrill, the Executive Vice
President and Chief of Enforcement at the Financial Industry
Regulatory Authority, FINRA.
STATEMENT OF SUSAN MERRILL, EXECUTIVE VICE PRESIDENT AND CHIEF
OF ENFORCEMENT, FINANCIAL INDUSTRY REGULATORY AUTHORITY
Ms. Merrill. Chairman Frank, Ranking Member Bachus, and
members of the committee, I am Susan Merrill, Chief of
Enforcement at the Financial Industry Regulatory Authority,
FINRA.
On behalf of FINRA, I thank you for the opportunity to come
and testify here today on these important issues. FINRA is the
largest non-governmental regulator of the securities business
in the United States. All told, FINRA oversees 5,000 brokerage
firms and over 600,000 registered securities representatives.
We at FINRA have been actively involved in working to
resolve the issues relating to auction rate securities. From
our exam staff to our enforcement team, from our arbitration
forum to our investor education group, we have devoted staff
from all parts of our organization to provide a comprehensive
and integrated response to the recent challenges in the auction
rate securities markets.
Along with our regulatory counterparts, FINRA is committed
to continue working on these important issues. We share this
committee's interest in holding industry participants
accountable and providing investors with real and tangible
relief. Today, FINRA is announcing agreements in principle with
five firms for violations regarding the manner in which these
firms sold auction rate securities. The violations include
using advertising and marketing materials that were not fair
and reasonable and did not provide a sound basis for evaluating
the facts regarding the purchase of auction rate securities.
They also include supervisory violations relating to the
firms' failures to achieve compliance with FINRA rules
surrounding the sale of these products. Most importantly, in
settling these cases, FINRA focused on restoring funds to
customers. All of the firms involved in the settlements today
have agreed to offer buy-backs of auction rate securities sold
to their individual and small institutional investors. This
will mean that over a billion dollars of auction rate
securities will become liquid again.
We at FINRA think that this is the right result. By
expanding our scope beyond those firms that the SEC has rightly
focused on, we have protected additional investors and restored
funds to a broader span of customers. As for those firms who
have not chosen to resolve their regulatory investigations and
offer buy-backs of their customers' securities, we will
continue to investigate these firms aggressively with a view to
bringing enforcement actions where appropriate.
The cases we announce today are the result of the work that
FINRA has been doing since the market for these securities
froze up and we began to receive complaints in February. FINRA
immediately questioned more than 200 firms regarding their
holdings in auction rate securities, both proprietary and
customer accounts. We then used that information that we
gathered in that survey to inform our next steps.
After consulting with the SEC in order to avoid duplication
of efforts, we sent out sweep letters in April to 2,000 firms.
This summer, we sent out a second sweep letter to more than a
dozen additional firms. Fifty-three FINRA staff members
conducted on-site examinations of over 32 firms in more than a
dozen States. On-site examinations are continuing as we sit
here today. All told, FINRA enforcement is investigating over
40 firms in connection with their marketing of auction rate
securities.
FINRA has also been active in issuing regulatory notices
regarding auction rate securities. These notices provide
guidance to firms on critical customer protection issues,
including requiring firms to put customers' interests ahead of
their own when allocating partial redemptions, and clarifying
rules that allowed investors to sell auction rate securities at
a discount if they wished to do so.
In addition to our regulatory, examination, and enforcement
initiatives, we at FINRA feel strongly that effective investor
protection begins with education. That's why in March we
published a comprehensive investor alert explaining in plain
English what happens when auctions fail and what options are
available to investors.
In August, FINRA announced the establishment of special
arbitration procedures for auction rate securities cases
administered in our arbitration forum. Under these procedures,
individuals who have worked for a firm that sold auction rate
securities since January 2005 will not be eligible to serve as
arbitrators. There are also special procedures for arbitrations
filed pursuant to the regulatory settlements with the SEC and
with FINRA. But it's important to note that the procedures I
just outlined will be available to all auction rate securities
investors, whether or not their firm has settled with the
regulatory agency.
In conclusion, FINRA has employed a comprehensive and
integrated response to the recent challenges in the auction
rate securities markets. FINRA will continue to aggressively
pursue possible violations by firms and will continue to work
with this committee and our regulatory counterparts to advance
our essential investor protection mission.
I thank you again for the opportunity to testify here
today, and I would be happy to answer any of your questions.
[The prepared statement of Ms. Merrill can be found on page
97 of the appendix.]
The Chairman. Thank you.
And next, a securities administrator of the Secretary of
the Commonwealth of Massachusetts, where we have the securities
in his jurisdiction, who has been a real leader in efforts to
provide protection here and is incidentally a former
legislative colleague of myself, Mr. Markey, Mr. Delahunt, and
Mr. Oliver.
So we welcome him here, Mr. Galvin.
STATEMENT OF THE HONORABLE WILLIAM FRANCIS GALVIN, SECRETARY OF
STATE AND CHIEF SECURITIES REGULATOR, COMMONWEALTH OF
MASSACHUSETTS
Mr. Galvin. You left out Mr. Lynch.
The Chairman. Were you gone by the time he got there?
Mr. Galvin. No.
The Chairman. Oh, you were hanging on longer than I
thought.
[Laughter]
Mr. Galvin. Good morning.
I am William Galvin, Secretary of State and chief
securities regulator of the Commonwealth of Massachusetts. I
want to commend Representatives Frank and Bachus for calling
today's hearing to examine the causes of the failure of the
market for auction rate securities and potential ways of making
our regulation of the financial securities industry more
effective.
I am here today to discuss our findings and investigations
into UBS and Merrill Lynch sales of auction rate securities. I
feel compelled to say at the outset that there is a much larger
issue here, and that is this: The auction rate securities
scandal is just one more variation on a reoccurring theme that
we have seen before. And that theme is the documented belief of
large segments of the financial services industry that they are
above the law, entitled to special privileges, entitled to
engage in conflicts of interest, and have no duty or obligation
to average investors.
I am here to speak of the lessons learned from our
investigations and to present proposals for preventing such
problems. But I must say that without stricter regulation and
sustained and diligent enforcement, this theme will again
emerge. Specifically, five basic facts, I believe, arise from
the auction rate debacle. They are: Conflicts of interest need
to be more aggressively monitored and disclosed to investors;
financial advisor incentives need to be disclosed; financial
advisor training needs to be enhanced; supposedly objective
research reports need to be more tightly regulated; and self-
regulation is not effective to prevent a scandal such as this
one and that the State regulators, in conjunction with their
Federal counterparts, need to continue to be actively involved
in enforcement actions.
I believe that the need to ask ourselves difficult
questions about how we can make our regulatory scheme more
effective is especially important given this week's market
events. Government intervention is more effective when it
monitors aggregate risk-taking and prevents bubbles from
building instead of having to bail out the parties after the
bubble has burst.
In June of this year, my office filed an administrative
complaint against UBS in conjunction with its marketing and
sales of auction rate securities. The details of the
allegations have been provided in my written testimony.
Briefly, our investigation exposed a profound conflict of
interest between UBS and its customers, and the devastating
effect that this conflict had on those customers. It exposed
how UBS was, unbeknownst to its customers, propping up its
auction rate market and manipulating the interest rate at which
the auctions cleared. It also exposed that as the auction rate
markets became more risky, UBS increased its efforts to unload
auction rate risk from its own balance sheets onto the accounts
of its customers.
In July of this year, my office filed an administrative
complaint against Merrill Lynch. The complaint charged that the
firm was implementing a sales and marketing scheme which
significantly misstated the nature of auction rate securities
and the overall stability of the auction market. The complaint
also focused on the extent to which Merrill Lynch co-opted its
supposedly independent research department to assist in sales
efforts be it towards reducing its inventory of auction rate
securities.
Our goal has been that all investors stuck in auction rate
securities will be made whole. My office as well as other
regulators have entered into settlements with UBS, Merrill
Lynch, Bank of America, and other underwriters and sellers of
auction rate securities. In those settlements, the firms have
agreed to repurchase tens of billions of dollars worth of these
securities. Much work remains to be done.
However, it is not too early to step back and attempt to
draw lessons from this experience that might help us prevent
such breakdowns from occurring in the future. The UBS and
Merrill Lynch cases highlight the conflicts of interest that
can arise between a broker-dealer and its customers. It became
apparent that the broker was controlling the interest rates at
which most of the auctions cleared. In doing so, the broker was
beholden to its investment banking clients to whom it had
promised low-cost financing, yet needed to raise interest rates
just enough to be able to unload its own inventory onto
unsuspecting clients.
Prior to the market collapsing, when each firm made a big
push to reduce its own holdings of auction rate securities, it
did so by foisting those securities off on unsuspecting
clients. These conflicts need to be aggressively monitored to
determine whether they fundamentally impair a firm's ability to
responsibly attend to its clients' needs. At a bare minimum,
these conflicts need to be properly disclosed.
Two other points which arose starkly in our investigations
were the significant incentives to financial advisors to move
auction rate products and the profound lack of training those
advisors received with respect to those products and their
attendant risks.
Most investors assume that the financial advisor selecting
financial products for them is indeed applying his or her
professional expertise with the primary goal of choosing
financial products that are most appropriate for that
customer's particular circumstances. However, our
investigations reveal that UBS and Merrill financial advisors
receive substantial incentives unbeknownst to customers to sell
auction rate securities.
I believe that regulators should require a more
comprehensive disclosure of the financial incentives that
financial advisors receive. This would allow the consumer to
better assess whether the advisor is selecting the product
based on customer suitability or maximizing commission revenue.
Another proposal that merits serious consideration is
explicitly holding broker-dealer agents to a fiduciary standard
of care with respect to their customers. Such a step is
especially important given the increased complexity of
financial products and increased dependence of customers on the
advice of their financial advisors.
The next point I would like to discuss is research reports.
Five years ago, a number of securities firms including Merrill
Lynch reached a settlement with regulators that was supposed to
eradicate the conflicts of interest that pervaded Wall Street
research and analysis. However, that settlement technically
applied to only stock research and not to fixed income
research. Merrill was quick to make this distinction in its
statement following my division's filing its complaint.
However, the principles underlying the settlement--that
research reports presented to the public as being supposedly
independent should not be tainted by undisclosed conflict of
interest--have not been adhered to in this instance. As a
result, more rigorous rules pertaining to research reports are
necessary. I believe the overnight disappearance of the $330
billion market for auction rate securities should give pause to
those who think that markets can effectively police themselves.
If the free market is to be truly free and survive, it must
be saved from its own greed and its repeated willingness to
deceive and dissemble in the name of higher profits. The
conflicts of interest raised here stand in stark contrast to
the idea that market participants guided by principles such as
FINRA rule 2110 which imposes high standards of commercial
honor will simply follow those principles and do not need more
detail regulation.
It is difficult to imagine that off-loading a known and
worrisome risk of auction rate failure off a firm's own balance
sheet and onto its customers holdings is consistent with high
standards of commercial honor. I believe that a move in the
direction of principle-based regulation at the expense of
detailed and enforceable rules would simply open the door for
more misconduct. This point is especially important given this
week's market events.
The Chairman. We are going to have to wrap this up.
Mr. Galvin. I would conclude, Mr. Chairman, by saying that
I think we are clearly at the point in time where the entire
market regulatory scheme is going to have to be reviewed and I
would urge this Congress and the next Administration to do so
with a view towards rewriting the entire system.
I think this episode that we are here today discussing
demonstrates the failure of that system, and I would hope that
when it is rewritten, it is written in such a way as to protect
investors first. That should be the first goal of any financial
regulatory system.
I will be happy to answer any additional questions.
[The prepared statement of Mr. Galvin can be found on page
85 of the appendix.]
The Chairman. Thank you.
Next, another State official who has been very active in
the consumer protection field, the Attorney General of
Massachusetts, Martha Coakley.
STATEMENT OF THE HONORABLE MARTHA COAKLEY, ATTORNEY GENERAL,
COMMONWEALTH OF MASSACHUSETTS
Ms. Coakley. Thank you, Chairman Frank, Ranking Member
Bachus, and members of the committee. I, like Secretary of
State Galvin, am pleased to be here today. I appreciate the
invitation. I am the Attorney General for Massachusetts and our
office shares some responsibility with the Secretary of State
for public enforcement for securities laws at the State level
of Massachusetts.
Our office, as in most States, is authorized to bring
criminal and civil actions in our State courts against
investment banks, brokers, and issuers who deceive investors or
fail to meet required legal standards.
Our office also has exclusive authority to bring actions
under our State False Claims Act against entities that mislead
towns, cities, and other State entities regarding investment
decisions.
Auction rate securities sold in Massachusetts have been a
great concern to us, and although these securities have long-
term maturities for many years, they have historically been
offered for sale at weekly or monthly auctions, which provided,
and I stress, the appearance of periodic liquidity. My
colleagues on this panel have discussed that.
That is one of the major issues for us in looking at these,
was the appearance of liquidity. Because of the supposed
liquidity, auction rate securities were touted as being cash
alternatives and, when earlier this year the market for auction
rate securities dried up, the auctions through which they were
sold experienced widespread failures, eliminating liquidity and
making it difficult to dispose of the securities at all, much
of which has been evidenced by my colleagues here today.
When the securities were written down to reflect the
reduced market value, many investors suffered serious losses in
their investment principal.
In early 2008, Secretary of State William Galvin talked
with our office and he requested that our offices divide
responsibility and, frankly, our Attorney General's office
concentrated just on the sales to towns, cities, and State
entities and focused on whether State entities as customers
were misled regarding the appropriateness of auction rate
securities as investments.
We served investigative subpoenas. We met with affected
municipalities. We reviewed documents and we took testimony
from investment banks and their agents. We carefully
scrutinized broker behavior, disclosures, as well as the lack
of disclosure, as we had done in the predatory lending market
and the behavior of investment banks as they sought to transfer
auction rate securities from their own accounts to those of
their customers.
Six weeks after starting our review of the investments of
Springfield, Massachusetts, and days before the broader market
for auction rate securities began to melt down, we recovered
from Merrill Lynch at par, the $14 million that Springfield had
invested in auction rate securities.
We initiated our review of UBS on the same day. The UBS
began letting its auctions fail and we completed that
investigation in 10 weeks. There we recovered over $37 million
for 18 Massachusetts municipalities and State entities. We
began our review of Morgan Stanley in the same timeframe, which
resulted in the recovery of an additional $2 million for cities
and towns. And finally, last Friday, our ongoing review of
Citibank resulted in Citi's agreement to return $20 million to
the Massachusetts Water Pollution Abatement Trust.
Our recovery against Merrill was the first recovery by a
State in the auction rate arena and our consent judgment
against UBS was the first court-ordered resolution by a public
enforcer.
We believe that our early investigations and litigation
efforts helped jump start the broader resolution process and we
commend the terrific work of Secretary Galvin, the SEC, and
FINRA, and other regulators in other States for the roles they
played in moving the larger process forward.
Let me make three quick recommendations. First, any
solutions reached should actually return full investment
amounts to all investors. We talked today about agreements to
repay. I think it is really important that payments, in fact,
be made. Second, that those be made extremely promptly; and
third that nonprofit and governmental issuers should not be
forced to incur additional expenses and losses as a result of
this.
In addition, the committee should not overlook the problems
with the underlying assets backing some of these securities,
and we have submitted testimony for yesterday's hearings
relating to our work around the predatory lending in the
subprime market and how that has affected Massachusetts and how
we, frankly, have not seen any restructuring of transactions to
be successful.
I think that as we have stressed the restitution and having
it quickly is important, and our emphasis obviously in State
government is for our government entities and our nonprofit
entities mentioned by members of the committee earlier,
particularly around the student loans.
Finally, even if the committee is able to resolve the
immediate auction rate problem, as Secretary Galvin has noted,
we still need to consider the stability of the underlying
assets that back these notes.
We should be careful to ensure that intermittent liquidity
crises in financial markets do not disproportionately harm
consumers.
We appreciate the chance to talk to you today. We are happy
to answer questions, and more importantly, are happy to work
with you as you look at further solutions and other
legislation.
[The prepared statement of Attorney General Coakley can be
found on page 80 of the appendix.]
The Chairman. Thank you. When we began, Ms. Merrill, you
mentioned that there were five settlements recently reached. I
am struck by the coincidence of those individuals, those
entities, being willing to sign those agreements on this. Can
you tell us who they are? I assume it would be appropriate to
know who they are.
Ms. Merrill. Absolutely. The names of the five firms that
have settled with us today--the agreements in principle were
reached last night and we are announcing them this morning--
are: SunTrust Robinson-Humphrey; SunTrust Investment Services;
Comerica Securities, Inc.; First Southwest Company; and WaMu
Investments, Inc.
The Chairman. Thank you. I have a couple of questions. This
is one that gets us to another topic, but Secretary Galvin, in
an earlier point, was one of those who called to my attention
problems with the arbitration procedures, and I believe we had
a hearing on this, that the individual one-time investor, or
investor engaged in a one-time arbitration, is at something of
an institutional disadvantage.
I was pleased that you mentioned some special rules, but my
question would be, if those are good rules for this why keep
them special? Why not make those rules for arbitration in
general in these situations?
Ms. Merrill. That is a good question. We had a rule that
covers exactly how our panels are constructed for arbitration.
It would require a rule filing, which would take a good bit of
time to get through the approval process, and so we wanted to
quickly do it for this.
The Chairman. Your intention would be to carry that out for
other things as well?
Ms. Merrill. What we are doing in terms of our broader
arbitration forum is, right now we have announced a pilot
program with 10 firms that have agreed to use a pilot program
for a specified number of cases for 2 years where investors can
choose a non-public arbitrator or an all-public panel.
Once we see the results of that pilot program we will
certainly look at expanding our rule to make that across-the-
board, but we are very pleased that the firms have stepped up
and agreed to the pilot program.
The Chairman. All right, well, we will get back to that. I
don't want to not raise it, but that is important.
Let me go back to a point that Secretary Galvin raised and
that is the principles versus the rules, and I understand the
desire of many in our country to say, well, we like more
flexibility.
But here is the dilemma that we confront. In a number of
cases when people raise objections to certain behaviors, the
defense is, well, it wasn't prohibited. That is, people need to
understand if they are going to use the absence of a specific
in hoc prohibition as a permission to do something, then the
case for more flexibility is undercut.
And I say that because people say, well, we want principles
and not rules. I don't know the exact rules that were involved
here, and in some cases it would seem to be there were rules
probably broken. But I can't imagine that in principle people
do not understand this is the wrong thing to do given what has
been described.
So I ask the Secretary of State this: Is this an example,
frankly, of people taking advantage of an absence of
specificity and a case where principles that we would have
assumed were pretty generally subscribed to didn't serve as an
adequate defense?
Mr. Galvin. Well, clearly I think that is the case if that
were all we had to rely on. In the cases that we brought in
Massachusetts, we alleged that there was fraud on the part of
the two cases that we actually brought and we were still
investigating some of the others.
But I think the absence of detailed rules, the absence of a
requirement for our financial advisors to be looking at the
financial suitability of certain investments, those are clearly
demonstrated by the situation.
Many of the people who called my office, as you have heard
from some of the other witnesses this morning, were
specifically told that these were ``cash-like instruments.''
They were promised liquidity. They were led to believe, not
only because of past practice, but because of what was
specifically said to them, that they would have no difficulty
getting their money out and that obviously was not accurate;
and was particularly sinister when there were firms that knew
these things were going down and specifically had made a
decision at some point no longer to support them. And that is
what we maintained in our complaints.
I think it clearly requires more specific rules, and as I
attempted to point out, I think it is a broader issue than just
this particular type of--
The Chairman. The next question is for Director Thomsen. We
have had questions in the past. Am I correct in inferring that
this seems to be a case where there was reasonably good
cooperation between the Federal regulator on the one end and
the State regulators, and this is an example of how we might be
pulling resources to the common good?
Ms. Thomsen. I think this is an example of terrific
cooperation on all our parts and I should jump in right now to
congratulate FINRA on the recent cases.
But when you step back and think about this, the problem
really arose in dramatic fashion in February of this year and
through the efforts of everyone here, State regulators, Federal
regulators, FINRA, we have reached a solution for retail
investors in very short order that gets them 100 percent
liquidity back and we have worked together to get that. It is
really an exceptional result and it does reflect all of us
working together, I think, quite well.
The Chairman. Thank you. I have to step out for a little
bit and Ms. Waters will preside. I will be returning.
Ms. Waters. [presiding] Thank you very much.
Mr. Bachus, our ranking member, for 5 minutes.
Mr. Bachus. Thank you. Director Thomsen, what is the status
of the Commission's examinations that were announced July the
13th to examine the controls against manipulation against
security prices through the intentional spreading of false
information?
Ms. Thomsen. Well, let me talk generally about where we
stand with respect to that, the concern about spreading false
rumors. As you pointed out in your opening statement, if people
are engaged in spreading false rumors, driving stock prices
down, that conduct is reprehensible. It is also illegal.
Mr. Bachus. Pull the microphone a little closer to you.
That is good.
Ms. Thomsen. Over the past several days, as you have noted,
we have increased our efforts and our tools. As you may know,
earlier this year, a few months ago, we brought our first case
against someone for spreading a false rumor. It was the
Berliner case. It was brought shortly after Bear Sterns
collapsed.
We have been investigating aggressively, and as of 12:01
this morning, new rules went into place to put further controls
on abusive short selling, naked short selling.
Last night we announced that the commission is going to be
requiring reporting of short positions by large investors,
which will help in both transparency and in law enforcement
and, as you know, as part of last night's announcement, I made
clear that the Enforcement Division will be pursuing these
issues with a vengeance.
Mr. Bachus. How quickly will the SEC be able to detect
whether illegal trading or manipulation through illegal short
selling is going on?
Ms. Thomsen. I am not going to lie to you. These are
difficult, difficult investigations. It is going to require
lots of hard work, but we are deploying lots of resources to
get there.
We will follow the evidence as quickly as we can and if
there is evidence we will bring those cases as quickly as we
can. We want to make sure if we bring those cases we have the
evidence to sustain the action because, as I say, I think the
behavior, if it can be established, is reprehensible and as I
said, it is illegal.
Mr. Bachus. Let me ask this question to FINRA and Ms.
Merrill. The current broker licensing examination doesn't have
a single question on auction rate securities. Is that an
omission and should questions be asked of financial
professionals, people who want to be in this regard?
Ms. Merrill. Well, I think your question highlights an
issue with auction rate securities that we are looking at
internally at FINRA, and that is something that we look at on a
risk-based basis.
We saw the securities as relatively low risk. Certainly on
an examination for a registered representative, you can't ask
about every product that a rep can sell, and so this one may
not have risen to the level.
But now as we look back at this, we can see that there may
not have been such default risk, but certainly there was
liquidity risk, and since that is the way this product has
really been marketed, as liquid, that is what we really need to
go back and examine.
Mr. Bachus. Are you all going back and looking when you
train those who are going to market financial products and
license them, whether there are other areas other than maybe
auction rate securities where they simply don't have the
expertise to market certain things; they don't disclose things
because they may not know?
Ms. Merrill. Training is so important. Firms are
responsible for training their registered representatives, of
course well beyond the licensing, the initial Series 7 test.
And what we found when we went out and interviewed the brokers
who are actually on the phones and talking with investors is
that many of them did not appreciate the liquidity risk. They
didn't understand the auction, and that is a failure of the
firms to train their reps.
Mr. Bachus. Okay, thank you. And that is with today's
announcement that 16 firms that have made agreements. You still
have about 35 now with the smaller firms, but some of the main
street firms or regional firms, are you making a lot of
progress with the other 35 firms?
Ms. Merrill. Yes, most of the firms, in fact, that we are
looking at are the smaller, downstream firms. The issues there
are different from the cases that have been brought by
Secretary Galvin and by the SEC and other members of NASAA
insofar as these are really not fraud cases, but we do believe
that every broker-dealer has the responsibility to be marketing
the product fairly; and they may say that they didn't know that
there were cracks in the auction rate system, but the way they
market, the types of disclosures that they make have to be fair
and balanced.
So we have made progress with the firms that we are looking
at. We will continue to look to see if there have been rule
violations, particularly the advertising and supervision rules.
Where we find those violations we are going to apply pressure
on these firms to do the buy-backs.
Mr. Bachus. Thank you. I want to commend the Attorney
General and Secretary of State of Massachusetts. I think your
efforts have led to some recoveries in other States. I think
you benefitted people not only in your home State, but across
the United States, with some of your investigations.
Ms. Waters. Thank you very much. I will recognize myself
for 5 minutes, and I would first like to begin by
congratulating and commending all of you for the work that you
have done in helping to make sure that the investors are made
whole, that they are taken care of.
That is good work and I have a real appreciation for that,
but I would like to continue a little bit, my questioning, to
ask about what I would consider preemptive work, or the kind of
work that regulatory agencies do that avoid the problems in the
first place.
And, of course, as we have entered this very difficult
economic period, our own regulatory agencies that we are
dealing with, not just with SEC, but as we are taking a look at
what we are confronted with now, we are wondering what can be
done.
What can be done to identify, to be able to determine
through auditing, when these problems are beginning to surface?
Do we have to wait until we hear from investors who are now
screaming and calling and accusing and very, very worried and
very scared that they are going to lose everything? What can we
do? What can you do to prevent--and let me start with the SEC--
I know you are Enforcement, but what can be done before?
Ms. Thomsen. Well, thank you very much, and it is a very
important question. To a certain extent there is a part of me
that thinks when Enforcement gets involved, we have already
missed some opportunities and we would like not to miss those
opportunities.
But as Secretary Galvin noted, we are not so naive as to
believe that we are not going to be necessary in some
instances. I think as we have talked about, the problem here is
largely one of sales practice; and that is an important issue
to address.
It is important for all of us to focus on the training of
sales reps and registered representatives who interact with
customers, especially retail customers, to make sure they
understand the products that they are selling. So that is one
thing that we can focus on and that the firms can focus on. It
can surely be something that we focus on during our
examinations.
It is also the case, as Secretary Galvin noted, that many
of the issues that arise in the securities field arise due to
conflicts of interest. It has been noted oftentimes in the past
that we cannot eliminate those conflicts, but we can disclose
them, we can manage them, and we can train around them.
I think one of the things that has been most dramatic here
as we have dug into the facts is to see how little various
registered representatives understood about the products that
they were selling to their customers.
We also do need to be alert to changes in markets and think
about what we do when those changes occur. Secretary Galvin
noted that in some instances compensation was increased to
encourage the sales of products.
I think that is one thing we can look for in examinations
because that may change the incentives. We need to look at
compensation structures, but it is also something firms can be
alert to as they change their compensation practices to think
about why they are doing it and what does that mean from a
conflicts perspective.
Ms. Waters. Let me just ask Ms. Merrill, in keeping with
this conversation, discuss criminal penalties with me. What are
the penalties?
We discovered in the subprime meltdown that, for example,
in California there were two ways that real estate loan
initiators could sell the products on the street. One was they
could go through a licensing operation that we have; or the
company, such as Countrywide, who is licensed, could then hire
a salesperson who did not have to go through the licensing
examinations, and they put them on the street; and we are
finding that not only did a lot of our citizens and consumers
get seduced into products that they did not understand, but
perhaps the salesperson didn't understand them or
misrepresented knowing that these ARMs and these other very
exotic products were going to place these people at risk.
So let's talk about penalties. What should the penalties
be? What are they?
Ms. Merrill. In FINRA, our penalties in auction rate cases
and our whole settlement structure has been focused on getting
money back to investors. As I mentioned, the firms that we have
been focusing on are primarily the smaller, downstream firms
where we have not seen evidence of fraud. So without evidence
of fraud, where we are enforcing our advertising rules and our
supervision rules, we focus primarily on the remedy to
customers.
We do have fines associated with our cases today as high as
$1.65 million down to about $250,000. Those fines are meant to
give those firms credit for the fact that they stepped up and
bought back these securities from their investors, and that has
really been our motivation.
The question that you asked before about what we can do to
make sure this doesn't happen again, I assure you is a question
that we have been asking ourselves internally at FINRA.
We have a group called the Emerging Issues group. We try to
stay ahead of the curve on emerging issues. We talk to member
firms. We talk to customers to find out how things are being
marketed to them. We read the academic journals to see what is
on the horizon and we are very concerned not only about the
cases that we have brought today, but what other kinds of
products are being marketed as cash alternatives or cash
equivalents. Are they really cash equivalents and is the way
these other types of products being marketed fair and balanced?
Ms. Waters. Thank you very much. Mr. Shays for 5 minutes.
Mr. Shays. I am pretty convinced that those who were
marketing these in a way that didn't represent an accurate
picture are going to pay a penalty, and I am pretty content
that fact has been established.
What I am interested to know is, and I guess I would ask
the SEC, are auction rate securities going to disappear? Are
they the same for the corporate, the student, and the muni? I
mean, what is going to survive here?
And then I would like to ask the State folks if they had
any sense, is the State out of the picture in terms of student
loans right now? I am really concerned about student loans and
I hope I get something from this hearing that has me feeling
somewhat hopeful; and if not hopeful, at least a realistic
picture of what is happening.
Ms. Thomsen. Thank you. It is an excellent and difficult
question. First, to start where you started and to reiterate
some of the things that have already been talked about, yes,
the individuals who have been involved in bad behavior will be
pursued. We have not yet brought individual cases, but we
continue to pursue them. We will bring remedies against them to
the extent we can establish cases. And that will also serve a
deterrent purpose and help us avoid things in the future.
As to the future of the auction rate securities markets, I
think right now it is a difficult time for anyone to try to
raise capital through an auction rate securities process in
part because of the failures that have been demonstrated in
this market.
You would have a very difficult time suggesting to an
investor that these securities are liquid against the current--
the freezing up in February. So I think it is fair to say that
raising capital through an auction rate securities process is
difficult right now.
Mr. Shays. In all three areas: Municipal; corporate; and
student?
Ms. Thomsen. I believe in all three, and I have to say that
I believe that student loans are the most difficult because of
the interest caps that are associated with student loan auction
rate securities.
Now on the good news front, to the extent there is some
good news in all this, there is liquidity that is being
restored to these markets, in certain instances, even in, to a
limited extent, the student loan market. And people are engaged
in some refinancing and whatnot, but I think the product itself
is going to have to change--if it is going to be marketed as a
liquid investment, that development's to assure that liquidity
are going to--
Mr. Shays. And we are really talking, this is impacting the
State loans student loans, not the Federal. Can either of you--
Mr. Galvin. I think it has primarily affected student loan
authorities, which many States have established.
I can tell you that in Massachusetts, the Massachusetts
Educational Loan Association had suspended loans back in July
causing great difficulty. Fortunately just yesterday or the day
before, they were able to announce that they have secured some
funding.
I think the general point regarding auction rates is
probably true, that I think not just because of the bad press,
if you will, associated with auction rate, but the whole
concept of this auction has been discredited because the
auction was, in many respects, a fantasy; it never really
happened.
Mr. Shays. Right.
Mr. Galvin. I think the bigger issue as far as financing
educational funds is going to have to be approached from a
number of different ways.
One way possibly is to have States, which was not the case
specifically in Massachusetts but was suggested, have the
States behind it with their State credit to verify for the
authority to be able to go out and solicit some sort of
financing.
Others have suggested, and I found this an appealing
thought, I suppose it wouldn't apply for everybody, but that
some of the large endowments of educational institutions ought
to be sought out to be invested to support these funds. Many
educational institutions enjoy very large endowments. I know in
my State, and I believe in yours, they may well also be a
source. I mean, these endowments--
Mr. Shays. Right. The bottom line is, though, you agree.
This is an issue that we have to pay--
Mr. Galvin. Yes, I would certainly agree. I think that for
many students right now this is a critical time--
Mr. Shays. I just want to ask one last question and it is a
real curiosity to me. If this has been an instrument for 24
years, has false advertising occurred all throughout 24 years?
Mr. Galvin. I rather doubt it. I can't answer you
decisively, but I believe that it became a practice, and
because these instruments were successful for so many years and
they worked for different consumers, they worked for the
institutions who were trying to get some advantage to their
debt, they worked for individuals who were looking for a
slightly better rate. They did work, and as a result of the
credit freeze-up as a result of the market starting to fall
apart, they, indeed, became inoperative.
What we became involved in, and I think it has already been
referred to here by myself and others, is that at some point
the market makers became aware of that and instead of dealing
with it in an upfront way, they went ahead and deceived people.
Mr. Shays. Yes, that point was made, I'm sorry. I
appreciate you emphasizing it. Thank you all. Thank you, Madam
Chairwoman.
Ms. Waters. Thank you. Mrs. Maloney, for 5 minutes.
Mrs. Maloney. Thank you very much and I thank all of the
panelists. I would like to ask Ms. Thomsen and the SEC, when
you censured in 2006, why did you not impose transparency in
the auctions then? As I understand it, there was an
investigation in 2004. Why did you not require disclosure just
like the U.S. Treasury does on all of its auctions?
Ms. Thomsen. Thank you for that question, and indeed there
was a requirement of disclosure at that time. The investigation
into auction rates that resulted in the actions in 2006 focused
on--
Mrs. Maloney. Excuse me, there was a disclosure
requirement, a transparency requirement in 2004?
Ms. Thomsen. In 2006 as a result of--
Mrs. Maloney. Can the committee get a copy of that?
Ms. Thomsen. Oh, sure.
Mrs. Maloney. Did it talk about the fees and the fact that
it is not cash and that it is really a hazard for people to get
into?
Ms. Thomsen. Excuse me, I misunderstood. The disclosure
that was required in 2006 and the investigation that led up to
the cases in 2006 had to do with how the auctions were
conducted and the way the firms conducted the auctions, which
included the fact that the firms went into those auctions and
in some cases sort of gamed the system to get the price sort of
in the ``sweet spot,'' if you will.
Mrs. Maloney. So you were looking at how the firms were
gaming the system. Was there any disclosure or transparency
that was given to issuers and investors to tell them about the
risks? My constituents told me that they were told, ``This is
as good as cash,'' then they found out they couldn't get their
cash. So they feel they were manipulated or treated criminally.
And I just want to know, do we have any transparency now
letting buyers know about the risks that are involved, and if
not, why don't we start SEC rulemaking immediately so that this
type of scam doesn't continue?
Ms. Thomsen. There are certain kinds of disclosures that
are associated with this, and there are certain disclosures
that did not go to investors, as we have talked about. The
investors, as a result of our action in 2006, for the firms who
were part of that process, are given disclosure or have the
opportunity to see disclosure about how the auctions operate.
Mrs. Maloney. Are they told that it is not cash? I am told
they were told it was as good as cash. It is not. Is your
transparency telling them how risky it is, how many billions of
dollars have been lost, how taxpayers have been hurt, how
localities have been hurt? Are you disclosing that, and if not,
why are you not disclosing that now in the billions of auctions
that are currently being conducted each day?
Ms. Thomsen. I think it is fair to say that as a result of
this investigation and focusing on the sales practices, it is
clear that investors were not told about the potential
liquidity risk and--
Mrs. Maloney. Are you telling them now?
Ms. Thomsen. Well, right now there is no requirement for
paper disclosure or written disclosure with respect to this.
Indeed, most of the--
Mrs. Maloney. Why not? We know that millions and millions
of dollars have been lost, there have been two suits settled,
and we know that--
And I want to bring into this and congratulate the State of
Massachusetts for your 2008 lawsuit where the Secretary of
State--I find this astonishing, really astonishing--the
Secretary of State revealed that going back to 2006, nearly 85
percent of the auctions would have failed or produced different
results without the single brokers intervention. So what are we
doing to stop this conflict of interest?
And the SEC, I have to tell you, I have constituents who
have lost their jobs, they tell me, because the SEC didn't act
quickly enough to stop the naked shorts. I am glad that you
have finally stopped it, maybe it can save some other firms.
But we know about this scandal now, and why are we not telling
clients and individuals and investors and issuers about this
horror that it is not cash, they can lose all their money, they
will not get their hands on the money, not to mention the
taxpayers who are supporting these institutions that go into
them, they are not being made whole.
So a lot of people are losing in this, and I think they
should be told. Why aren't we telling them?
Ms. Thomsen. The disclosure obligation is on those who are
selling the product and it is a secondary sale, by and large--
Mrs. Maloney. Well, why aren't you requiring them to tell
the innocent people who are being lied to? You are telling me
they were lied to. Why don't we get an SEC rule in tomorrow
that says don't lie to investors and to consumers, let them
know that it is not cash, that they can lose their money, and
that there have been two lawsuits. Why are we going to
continue?
We are in a financial crisis. We cannot continue financial
practices that lose money, hurt communities, hurt consumers,
and hurt investors.
Ms. Waters. Mrs. Maloney, let us hear her--
Mrs. Maloney. My time has expired.
Ms. Waters. No, we want to hear a response in your time.
You asked questions that have not been answered yet.
Ms. Thomsen. We do have rules, and in fact the fact that we
are able to bring the cases that we are bringing right now
demonstrates that registered reps cannot lie to their clients,
they cannot tell them false information, they cannot represent
something to be liquid that isn't, and that is what we are
doing with our law enforcement efforts here.
Mrs. Maloney. I would like a point of clarification in
writing. Constituents are telling me that they are being told
that they can get their cash back, but the State of
Massachusetts went to court over this, that they can't get
their cash back. Some of them, to this day, can't get their
cash back. So are we clearly telling people in the disclosure
that this is not cash, that you can lose your money? If you
could just get back to us in writing exactly what you are
doing.
Ms. Thomsen. Oh, sure. But the actions here, what happened
was people were told information that was false, and that is
why we are bringing the actions that we are bringing, and that
is why we were able to get the resolutions we were getting. But
you are absolutely right, investors should not be lied to, and
brokers and registered reps who lie to them should be
accountable for those lies.
Ms. Waters. Thank you very much. Mr. Neugebauer.
Mr. Neugebauer. Thank you. I am going to deviate a little
bit from what we have been talking about.
Director Thomsen, I think last year the SEC repealed the
Uptick Rule, and I have had a lot of conversations with a lot
of folks here recently who tell me, really, with the change of
that, it almost becomes a self-fulfilling prophecy that now are
people are shorting on a downtick, and that you keep shorting
and the ticks. One of the reasons that the Uptick Rule was
actually put in place back in the 1930's was to bring some
stability to the markets. Is it time to reconsider the repeal
of that Uptick Rule in this environment that we are in right
now?
Ms. Thomsen. Well, as you know, I do enforcement, but I
have to say that the Commission has obviously been
extraordinarily busy considering the substantive area that
surrounds the Uptick Rule. So for example, the rules that went
into place this morning at 12:01 that relate to short sales, a
hard delivery requirement, the exclusion of certain exceptions
under reg show, an additional anti-fraud rule, all of which
into effect at 12:01 today, the requirements that are going
into effect to report short positions on an extremely timely
basis as well as the enforcement initiatives that are underway
and will continue to be underway, I think they all demonstrate
the Commission's acute focus on the subject matter of how to
address abusive trading.
Mr. Neugebauer. So back to my original question: Do you
think it is appropriate at this time to review that rule?
Ms. Thomsen. I think the Commission is reviewing all rules
and reviewing all options to address market conditions.
Mr. Neugebauer. As we are requiring a number of these firms
to re-purchase a number of these auction rate securities, are
we in any way possibly jeopardizing the liquidity of some of
those firms by putting this enforcement action on them and
maybe creating some other problems?
Ms. Thomsen. As I mentioned, it was something that we took
into account as we thought about the remedy and how to get to
the remedy. I mean first and foremost, I think we were all
focused on restoring liquidity to investors who had done
nothing wrong and found themselves without liquidity. But the
cost of restoring liquidity is, as you suggest, quite high.
So we worked among ourselves, we talked to--certainly at
the SEC we talked to our experts in the division of trading and
markets to understand what were the firms' positions and what
they could undertake and on the timetable they could undertake
it. We talked to the firms themselves who reached these
agreements. Everything we are talking about is something that
firms agreed to and they are very sophisticated firms so we
expected them to be worrying about their capacity as well. We
also, through our division of trading and markets, reached out
to other Federal regulators, the Fed and Treasury, to
understand the positions of the firms.
Baked into these resolutions you will see things like
timetables, and I think at a certain level, all things being
equal, you want liquidity restored yesterday and the day before
and the day before that. But I think the fact that there are
timetables built into the settlements reflects the fact that
people were taking into account the capacity, if you will, of
the firms.
So I think we have worked very hard to get to a resolution
that is good for investors but also takes into account the
cost.
Mr. Neugebauer. Are there auction rate securities that have
begun to trade again in auctions that have been successful?
Ms. Thomsen. Yes.
Mr. Neugebauer. Is there a particular sector where that has
been more prevalent, or is it a--
Ms. Thomsen. Well, I know the one that is hardest hit is
student loans, and the others are coming back. And others, some
of the issues are being restructured so that, essentially, they
are being redeemed and restructured in different kind of
financing.
Mr. Neugebauer. I yield back. Thank you.
Ms. Waters. Thank you very much. Mr. Watt.
Mr. Watt. I thank the chairman and the chair pro tem for
the recognition. I am going to get to a point which I think Mr.
Galvin was about to get to when he almost ran out of time, at
least I hope that is where he was about to get to.
The thing that surprised me as the chair of the Oversight
Subcommittee of this committee more than anything else is two
reactions following this whole big market thing, including this
part of the meltdown. One is everybody is looking for somebody
to blame, and there is a strong desire for retribution. I want
to punish somebody, why haven't we put somebody in jail? And
that reflects itself with me as chair of the Subcommittee on
Oversight because people keep asking me to have hearings about
what created this problem and who is at fault.
I have quite honestly and publicly been very vocal that I
have no intention of having that kind of hearing unless the
chair, of course, asks me to have that kind of hearing, because
I think we need to be focused more on getting the heck out of
this crisis right now than who was to blame for it or
punishment. We don't punish in the Legislative Branch anyway.
Some prosecutor needs to go out there and investigate and
indict somebody, and there are a bunch of people out there who
I think are qualified for that, but that is not my job.
And even the suggestions about reform, really, that I have
seen, haven't been suggestions about reform. They have been
about restructuring the regulatory system, who is in charge
rather than what the person--I mean we had regulators
regulating all of this stuff, and if they had been competing to
do their job rather than competing to protect their particular
constituencies in their industries, we probably would have
avoided a lot of this stuff. So this whole restructuring thing
about, ``Let's name a new regulator,'' seems to me to beg the
question, ``What is the regulator going to do?'' And even all
of this discussion this morning, except when Mr. Galvin was
about to get to it and ran out of time, hadn't gotten to that
question. We have talked about who was at fault, who did what
bad, we need to restructure, we need to realign the regulation.
And the single question that I keep asking, and I would
like each one of you four just to tell me one thing that you
would do in terms of a specific regulation that would stop this
from happening in the future, because we have to do something.
We are already here. Sure we have to dig ourselves out of the
ditch, but I am looking for something that will stop future
crises of this kind from happening.
I have given my speech. Now just one thing. Don't tell me
realign the regulation because that doesn't tell me what that
new regulator is going to do. Tell me, whomever the regulator
is, what they ought to be doing to prevent this from happening
again. In your little area of the world, here, please, just
give me one suggestions.
Ms. Thomsen. I think we ought to do more of what we did in
this particular cases, which is to work together and bring
swift law enforcement action to those who have engaged in
wrongdoing.
Mr. Watt. Unresponsive, I'm sorry. Go ahead, Ms. Merrill.
Ms. Merrill. I wouldn't write a new rule. I think we have a
lot of regulations that cover what we saw here, and that is why
we have been able to bring the investigations and the cases
that we have brought. What you are asking is how can we keep
from having to bring an action, how can we keep there from
being this kind of thing again. And there I think we have been
looking internally, in that when we go out into firms and do--
Mr. Watt. Ma'am, don't tell me what you have been doing,
tell me one thing that you would do to stop this from happening
in the future, please.
Ms. Merrill. I would question firms at our on-site
examinations about how they are actually marketing cash
equivalents, over the phone to their customers, and not just
look at the script, but question people about what they are
saying, are they disclosing the risk?
Mr. Watt. Mr. Galvin. I am sorry.
Mr. Galvin. Thank you. If I were to summarize in one idea,
it would be to revisit the idea of whether the significant or
substantial repeal of Glass-Steagel in the late 1990's was a
good idea. I think by taking down the wall that existed between
investing and banking, you open the door for many conflicts,
and I think if we are going to be serious about regulation you
have to have rules that make some sense, and I think this one
didn't, and it is time to change it again.
Mr. Watt. Ms. Coakley.
Ms. Coakley. Two things, and they are included in Secretary
Galvin's testimony. I think you have to prohibit some conflicts
of interest now, and I think you have to require disclosure on
others. And the second piece is I think you have to look at the
financial incentive piece. You have to prohibit some of them
and you have to disclose others. That has been at the root of
the subprime mortgage problem, and it is at the root of this.
They all come from the same lack of appropriate disclosure
by those who are involved in this. And I say this as an
enforcer, I'm not a regulatory body, Secretary Galvin is. But
we can do the autopsy in what happened in the subprime
mortgage, we can do the autopsy in what happened here, and I
think Secretary Galvin very succinctly says we need to change
those rules, how people play this game, because otherwise we
are going to be back here in 5 years or 10 years with all of
these enforcement actions.
Mr. Watt. I yield back. Thank you.
Ms. Waters. Thank you very much. Mrs. Capito for 5 minutes.
Mrs. Capito. Thank you, Madam Chairwoman.
First of all, before I begin, I would like to ask unanimous
consent to enter into the record prepared statements submitted
by the Municipal Securities Rulemaking Board and the Regional
Bond Dealers Association.
Ms. Waters. Without objection, it is so ordered.
Mrs. Capito. Thank you. I would like to bring the questions
down more on a street level, I guess. Could you quantify, just
approximately, how many holders of these kind of securities
would have been entities and how many would have been
individuals?
Mr. Galvin. If I may, I think it varied by firm. Some firms
tended to sell a higher percentage of theirs to institutions,
nonprofits, for instance. Other firms had a higher percentage
that were amongst individuals.
That is why, when we worked out these settlements, we
focused on different categories such as so-called ``retail
investors.'' Those were individuals, and small businesses,
which, again, it varied from case to case, but we set a dollar
amount, usually about $10 million I think was the number we
were working with, and then the larger so-called institutional
investors which were in most of the settlements the last
category. The theory was that the smaller people, the
individuals, were probably less sophisticated and also,
presumably, more in need of the money, whereas the theory was,
fair or unfair, that the institutions were in a better position
long term. There is a best efforts requirement on most of these
agreements.
Ms. Merrill. I have some statistics that we were able to
gather through our survey of over 200 firms; 43 percent of
auction rate securities were held in retail customer accounts,
another 21 percent were held by customers who were considered
high net worth individuals, and 37 percent were held by
institutional accounts.
Mrs. Capito. Okay, great.
Ms. Thomsen. And to add something else, we believe that
while there were more retail customers in terms of numbers of
customers, that the holdings were about 50-50 between retail
customers and institutional customers.
Mrs. Capito. Okay, another question I have is, for the
individual who is holding a bond, can you make a distinction--
if somebody is watching this today and they are holding
something in their account that they thought was a very solid
State instrument or something that was--how can you make a
distinction for them between what they are hearing today and
what they are holding now?
Ms. Thomsen. Well, I think you raise a very good point and
something that we ought to mention is that by and large, the
underlying securities on all of these auction rate securities
remain solid. That is, the expectation is that the bond will
pay off according to its terms. What has really been lost is
the liquidity, which was what it was marketed to be.
Mrs. Capito. So you couldn't turn around and--
Ms. Thomsen. Exactly. People thought that they could
immediately turn this investment--
Mrs. Capito. Even if it had a 30 year--
Ms. Thomsen. Even if it was a 30-year maturity.
Mrs. Capito. Okay. Let me switch gears a little bit here
then. So the institutions or the folks who have been issuing
these universities--I mean I represent a small area--government
entities. How is there liquidity now and they are going out in
the market and trying to build a new wing to the hospital,
create a new ambulance authority, or whatever transportation or
infrastructure. Where is that now? That really troubles me
because we want to move forward, obviously, for a lot of
different reasons, but there are a lot of jobs involved in a
lot of this issuance as well.
Ms. Thomsen. Well I think this, as a fundraising vehicle,
capital raising vehicle, is not as attractive as it once was.
Even at the time people were using auction rate securities to
raise capital, there were alternatives in underwriting, for
example, that were more expensive. But I think across the
board, not just municipalities, but for just about anybody
trying to raise capital, it is a difficult and more expensive
environment than it was.
Mrs. Capito. So it is tight.
Ms. Thomsen. It is tight.
Mrs. Capito. I noticed, too, in our briefing papers that
the issuers of these auction rate securities were allowed,
permitted in February, to begin buying their own paper,
essentially. Is that still going on, and what is the situation
in terms of--it seems to me that could be almost a double hit
in some ways.
Ms. Thomsen. Well it was allowed and--okay, I have the
numbers here. The public sector borrowers have now refinanced
or made plans to refinance at least $103.7 billion of the
original outstanding $166 billion in municipal auction rate
debt, of 62 percent, according to data that was compiled by
Bloomberg. So that answers your prior question.
The rule that was put in place in March is still in effect,
as I understand it, and I think I am going to have to get back
to you on the impact of that.
Mrs. Capito. Okay. Thank you.
Ms. Waters. Thank you very much. Mr. Scott, we are going to
take you, one from Mr. Royce, and then we are going to go vote,
and then we will return.
Mr. Scott. Okay, thank you very much.
Let me start off by asking, put a quantity around this.
There is $300 billion worth of investor funds that are still
locked up, is that right?
Ms. Merrill. No, they are not still locked up today. That
number has shrunk dramatically over the last few months thanks
to the efforts of the regulators and also thanks to some
restructuring on the part of the issuers. I think we are down
into the 100 billions now, which is still quite a lot.
Mr. Scott. And many of these are small investors?
Ms. Merrill. That is right.
Mr. Scott. As we got into this, basically the auction rate
security market, as it was set up, basically catered to your
smaller individual investor, and as the crisis kind of got
worse and kind of drifted in and the big banks came to be more
relied upon as participants. As many of these smaller investors
are now unable to sell these liquid securities, they haven't
even looked elsewhere for satisfaction, but there really aren't
many places that they can go for help, is that correct?
Ms. Merrill. I think the market actually started out as a
more institutional market, and over time the issuers allowed a
smaller amount to be the minimum that you could invest in an
auction rate security, and once that amount got down to about
$25,000, that is when you started to see more retail investors
buying the product and the broker/dealer firms marketing to
more retail investors. Those investors do, of course, have
other options of where to put their money. This was marketed by
many firms as a cash equivalent, which we think was not a fair
and balanced way to market it, particularly firms that didn't
highlight the liquidity risk if the auctions failed.
Mr. Scott. So many of them, their course of action would
be, as some of the broker firms, some of the larger investors,
were to file lawsuits, and these lawsuits have been settled
with them. I am interested to know, given the smaller investor,
how many lawsuits have been filed by small investors in this
debacle?
Ms. Merrill. We have about 300 claims that have been filed
in the FINRA arbitration forum by investors. Some of those,
undoubtedly, will be dropped because some of those investors
will be part of the buybacks that have been announced today and
previous buybacks have been announced by other regulators. But
certainly there are small institutional investors whose firms
have not yet offered the buyback. We have the FINRA arbitration
forum available for them and we have set up special procedures
to make sure that those claims are being looked at fairly and
effectively.
Mr. Scott. And it is fair to assume that many of the
financial institutions, brokerage firms who represent these
smaller investors, one could say played a role in this. Are
they playing a role in helping these small investors, and what
are the regulators doing to help the small investors? My
information tells me that the lawsuit option has not been that
good for small investors because to file a lawsuit costs a lot
of money in many cases, so that is not an alternative. And my
picture of this is some of them are just left swinging in the
wind here, so what are we doing? Are the brokerage houses, many
of them who might have inadvertently helped get the small
investor in the mess as it is, are they working, are they doing
some things? And then what the regulators doing to help these
small investors?
Ms. Merrill. What we have been doing at FINRA, really from
the beginning, is focusing on getting money back to retail
investors. Our enforcement investigations, I believe, have
provided the incentive for firms to step up to the plate and
offer buybacks to their customers. We have five of those cases
today; $1.8 billion worth of auction rate securities will be
bought back. Other regulators, the people on the panel with me
today, have other settlements that have freed up over $40
billion, I believe, in auction rate securities. So we are
focusing on getting those funds back.
I agree with you that the best solution is to have the
firms do the buybacks as quickly as possible, but we do have
the arbitration forum there for customers whose firms have not
yet entered into those settlements.
Mr. Scott. Thank you very much.
Ms. Thomsen. I think it is fair to say that the settlements
to date, and including the ones that FINRA just announced, if
you focus on retail investors, the smaller investor, a large
majority of those investors will have the opportunity to get
cash back, 100 cents on the dollar, all of their interest paid
to date as well as an opportunity to recover any consequential
damages through a FINRA process that is quite streamlined
without ever having to file a lawsuit.
Mr. Scott. That is good to hear. Thank you.
Ms. Waters. Thank you very much. We have 5 minutes to get
to the Floor. Mr. Royce has a burning question that he wants to
ask.
Mr. Royce. Just one. Director Thomsen, the settlements have
not specified how individuals' funds held in fiduciary accounts
and invested short term in student loan auction rate securities
and now due back to the individual investor, or for closing an
individual transaction, how that is to be handled. And the
investment banks who sold the student loan auction rate
securities for short term investment are unsure if they are to
redeem these smaller individual investments held in fiduciary
accounts on the front end of their settlements. For example,
should they be treated the same as any individual holding the
security directly? That is my short question.
Ms. Thomsen. And our objective is to get the small retail
investor redeemed early and first, and we are working out those
details as we finalize these settlements.
Mr. Royce. In terms of this fiduciary account situation,
that would be an affirmative or--
Ms. Thomsen. It will be something that we are going to
address as we finalize it.
Mr. Royce. Thank you. Thank you, Madam Chairwoman.
Ms. Waters. Thank you very much. Panel, you have been very
patient and very good. However, we do have other members who
have questions that they would like to ask.
We have to go to the Floor; we have two votes. One is a 15-
minute vote, and the other is a 5-minute vote. If we go and
take these votes, and take about 5 minutes to get back, we
should be back in 25 minutes, so I would like to ask you to
please remain so that our other members will have an
opportunity to ask their questions. Thank you very much.
[Recess]
Ms. Waters. The committee will come to order. I would like
to ask our panel, Ms. Thomsen, Ms. Merrill, Mr. Galvin, the
Honorable Secretary of the Commonwealth of Massachusetts, and
the Honorable Martha Coakley, Attorney General, to please
return, and we will start with Mr. Green of Texas for 5
minutes.
Mr. Green. Thank you, Madam Chairwoman. I thank the
witnesses, the members of the panel. I thank the chair of the
full committee. Let's start with acquiring a better
understanding of what the auction rate security is. We are
talking about a long-term bond that has short-term interest
rates that are reset about every 28 days, and they are reset as
a result of an auction process.
Now when we say that it fails, that we had a failure of an
auction rate security, what does that mean, in essence? What
happened in the technical sense, in the procedural sense, what
happened? Some folks showed up to bid, or what happened?
Ms. Thomsen. There aren't enough buyers.
Mr. Green. And when you have a dearth of buyers, how does
that impact the sale itself, the actual--
Ms. Thomsen. The holders continue to hold the security.
There's no sale. So you continue to hold the security, and if--
in a failed auction, the interest rate typically goes up, the
interest rate paid to the holders is--gets higher and it goes
high enough in theory that the expectation is that there will
be an incentive at the next auction for there to be buyers, or
for the issuer to restructure because it's an expense--
Mr. Green. Would you define ``holder'' for me, please?
Ms. Thomsen. The people who bought the securities in the
past auction and who hold them.
Mr. Green. So the person who purchased initially in this
process in a past auction when they had a failure, and you
didn't have enough buyers, that person had a smile, and said,
wow, my interest rate just went up?
Ms. Thomsen. If what they are looking for is interest rate,
that's right.
Mr. Green. Okay.
Ms. Thomsen. The interest rate went up.
Mr. Green. Okay.
Ms. Thomsen. If they are looking for liquidity, they will
have a frown.
Mr. Green. But if the interest rate is important, then that
was a good thing for this person?
Ms. Thomsen. Absolutely.
Mr. Green. The interest rate just went up. Does it go up
exponentially?
Ms. Thomsen. It goes up--depending on the type of security,
whether it's corporate or whether it's a student loan.
Mr. Green. That's a good point. Let's talk about the type.
Individuals can purchase auction rate securities, correct?
Ms. Thomsen. Yes.
Mr. Green. And you have classes of individuals. You have
the average Joe, a person like me who might have $25,000 that
he scraped up and he buys, and then you have a wealthier class
of individuals as well, two classes?
Ms. Thomsen. Yes.
Mr. Green. And these individuals who are holding long-term
bond, short-term interest rate, interest rate goes up,
initially, the impact is not adverse to their best interest if
they are not interested in immediate liquidity?
Ms. Thomsen. If they are not interested in liquidity, they
have earned a higher interest rate. That's correct.
Mr. Green. So it's the liquidity that creates the problem
in terms of persons coming in and saying, hey, I need my money
now--
Ms. Thomsen. Exactly.
Mr. Green. --and I would like to have the interest rate
that you promised me as well. That works pretty fine, it works
well as long as everybody doesn't show up at the same time
usually. Is this one of those cases where if some show up and
say I need my money it's okay, but if you have a great number
that show up, you have a problem?
Ms. Thomsen. No. It is an auction, so the people who want
to sell arrive through their broker-dealer at a certain date,
and there have to be enough purchasers so that they can all be
liquidated at the same time.
Mr. Green. Okay. Now moving forward to the process,
continuing with this, we have in this process a group of people
who are known as broker-dealers?
Ms. Thomsen. Yes.
Mr. Green. Okay. And the broker-dealers, they work with the
investors?
Ms. Thomsen. Some of the broker-dealers just sell the
investments. They are the sort of secondary ones that Ms.
Merrill was talking about. Some are also underwriters and
participated in structuring the products in the first place.
Mr. Green. Do the broker-dealers come into contact with the
average Joe who had the $25,000?
Ms. Thomsen. Yes.
Mr. Green. Okay. These are the people who, in a sense,
engage in some sort of marketing process, whether it's
secondary. There may be a primary marketer that gets me in.
They are secondary tertiary, or maybe even quadirary in the
process, but they are in the process?
Ms. Thomsen. Yes.
Mr. Green. And these broker-dealers are allowed to see the
investors bid before the bid is submitted?
Ms. Thomsen. Yes. I think that's right. Yes.
Mr. Green. They see the bid?
Ms. Thomsen. Yes.
Ms. Merrill. Yes.
Mr. Green. Now if they see the bid before it is submitted,
can that--not saying that it does in every case--but can that
have an adverse impact on the process?
Ms. Thomsen. That was the subject matter of the action we
brought in 2006, that this auction practice itself, and as a
result of that action, those who run auctions and who settled
in 2006 were required to disclose their auction practices.
Mr. Green. Do this because my time is up. Do this for me.
Tell me what is the adverse impact of the broker-dealer
actually knowing what the bid is before it is submitted. Tell
me that, please.
Ms. Thomsen. There's a possibility that there could be
favorable treatment and negotiating towards a price to the
middle, if you will.
Mr. Green. Okay. Explain that, please. This is an important
aspect of it. What actually happens here? Because we are
getting to the heart of this. It's about deception, if not
fraud. Explain it to us, please.
Ms. Thomsen. In the auction rate process, the broker-dealer
who sort of, if you will, underwrote the security, had two
interests that were of interest to that broker-dealer. One of
the issuer. The issuer's interest is to raise capital at the
lowest price possible. The other is the purchaser of the
security, who of course wants the highest interest rate
possible, and not to overgeneralize, but in the case involved
in 2006, we found conduct by broker-dealers that was
undisclosed to the issuers or the purchasers that was trying to
get the price, if you will, into the middle, trying to prevent
failed auctions as well as holder auctions where no one was
willing to sell, and to get an interest rate that was, if you
will, in the middle.
Mr. Green. Thank you.
The Chairman. Thank you. The gentleman from Colorado is now
recognized.
Mr. Perlmutter. Thank you, Mr. Chairman, and my friend Mr.
Green. He and I are always on the same wavelength, and he's
asking a lot of the questions that I would like to ask, because
there's a microeconomic kind of a transaction piece to this.
There's a macroeconomic piece to this, which is what is the
whole world doing with these things, and then there is either
the marketing piece, which can be either fraudulent or accurate
or whatever.
So I just have to say--there are sort of four truisms that
I have to mention before I ask my questions. If it's too good
to be true, it generally is. If something has to come to an
end, it will. Res ipsa loquitur, the thing speaks for itself.
And the last one right up there, e pluribus unum. And I want to
start with that piece, because--and I want to focus this on my
chairman and also the ranking member.
The problems that we have in the financial market today are
gigantic. This is one sliver of it. And when we have good
times, we can be many and do all sorts of things on our own,
and we'll be fine. When we have tough times--and we are in
tough times--we are in the vortex of some kind of financial
hurricane that none of us understands. We come together, and
it's going to take a lot of challenges and a lot of work and a
lot of sacrifice on the part of everybody here is going to have
to pick up the pieces, and millions of people across this
country.
And this committee, because of the--I think the bipartisan
nature and the way that our ranking member and our chairman
work together, we are going to be able to help America get back
on track.
So the res ipsa loquitur, for the lawyers on the panel and
for everybody out there, the thing speaks for itself. This
apparently turned out to just be a mess. Because on one day we
have people investing in these kinds of instruments, and the
next day $330 billion or whatever Mr. Galvin said, is gone.
And--you know, these auctions go from 2 percent to 22 percent
to try to make these things move. So let's go to the
microeconomic piece. My mom comes in, you know, his average
Joe. My mother comes in. She wants to buy $10,000 of these
things. She sees--she's told, okay, you're going to buy a long-
term bond and you're going to get interest rate X and you ought
to be able to get out of this in 30 days, or did they say you
will get out of this in 30 days? What was the promise that was
made by the middle man?
Ms. Thomsen. It depends person to person, obviously, but by
and large, I think our evidence suggests that these were
marketed as you can get out of it any time you want. It's as
good as cash. And it provides a slightly better interest rate.
Mr. Perlmutter. But there--I would say there is some
responsibility on my mother's part to say, wait a second. I'm
buying a long-term bond. I'm getting this little higher
interest rate, and I'm promised this liquidity. At the end of
the day, I'm still buying a long-term bond, right?
Ms. Merrill. Don't be so sure that is what they were told.
I am not sure that--
Ms. Thomsen. Some didn't even know they were in an auction.
Ms. Merrill. Yes. I'm not sure that investors were told
this is a long-term bond with a reset at a short-term interest
rate. I'm not sure they were told anything like that. I think
they were in many cases told, here's a cash equivalent, like--
maybe like a money market. You'll be able to get your cash out
every 7 days or every 28 days, whatever the auction period was.
So, I'm not sure they actually were told this is a long-term
bond with a short-term interest rate.
Mr. Perlmutter. So then it was a fraud from the outset?
Ms. Thomsen. It depends person to person and sales practice
to sales practice. We have seen instances where people did
understand that it was a bond, that it was set at auction, but
they understood that they were getting a higher interest rate,
a slightly higher interest rate than say a money market fund,
because they were giving up liquidity for 7 days.
Mr. Perlmutter. All right. So now let's go to the
macroeconomic piece of this. Who was buying this stuff? Was my
mother buying this or was China buying this, or who was buying
this? And why did they stop buying it? Because they saw the
potential for deception or something else? And I know you're
all on the enforcement side of this thing, but who was buying
it and why did they stop?
Ms. Thomsen. The investors were both retail and
institutions. There were more retail investors in terms of
numbers than institutional investors, but the amount was split
about 50-50 between them. While it's always difficult to tell
the reasons things seize up, beginning in 2007, as the credit--
the subprime credit crisis hit, there was softness in this
market. That was not necessarily transparent to the investors.
But one of the things that happened--the other thing that
happened is that this market grew relatively dramatically. In
2006, the amount outstanding was over $200 billion. By 2008,
when it froze, it was over $300 billion. That is a lot to
absorb. And then in January of 2008, the monoline insurers that
sort of back these securities were downgraded, and that
affected to a certain extent we believe, people's perception of
the creditworthiness of the security. And so it was not very
long after--
Mr. Perlmutter. So would that be the AIG or some other
organization thing? We are going to--
Ms. Merrill. Ambac, BIA, yes.
Mr. Perlmutter. Not only is this a good investment, but we
are going to insure it's a great investment.
Ms. Merrill. Yes.
Mr. Perlmutter. So then the insurer goes down, people start
getting nervous. Now were there any big blocks of purchasers? I
mean, I want to know if there was a lot of foreign investment
that stopped and really started this house of cards tumbling.
So we have a fragile economy, a fragile market, but it was just
generally everybody stopped?
Ms. Thomsen. I don't believe so. What happened was that
increasingly beginning in the summer of 2007, the underwriters
were coming into the auctions to keep them from failing. So
they would put in bids so there were no failures, which meant
that they were taking on more of these securities onto their
books as they were becoming less liquid in a time when they
were having a hard time carrying illiquid securities. And I
think they hoped at some level that the market would recover
and they wouldn't have to keep doing this, and by February, in
combination with the monolines, the pressure became so great
that they simply stopped supporting the auctions.
Mr. Perlmutter. Okay. Thank you.
The Chairman. The gentleman from California and then the
gentleman from Missouri.
Mr. Sherman. Thank you. I would like to digress for a bit
here, Ms. Thomsen, to talk about not securities that are pretty
close to complying with SEC laws, or laws administered by the
SEC, to a different issue. Is the SEC authorized and does it
have people who are pretending to be investors in dealing with
all these investments out on the Internet, etc., that are just
obviously, blatantly in violation of securities law?
Ms. Thomsen. We do not. We cannot operate undercover. We
can't pretend to be anything other than--
Mr. Sherman. And is that a failure of Congress to give you
that authority, or is that also a failure of the SEC to ask for
it?
Ms. Thomsen. I believe it reflects the fact that we are a
civil law enforcement agency, and that we work with--
Mr. Sherman. So if we want to focus on legalisms and we
have always done it that way and we are just civil, then we can
have a circumstance where no one is protecting the investor who
is so unsophisticated that they are willing to invest in
something that is an obvious violation of securities law. The
reason I bring this up is, it's by no means clear that anybody
in this room is going to protect really smart people from
themselves. The one thing we know the government could do is
protect the ignorant. But you don't want to, or you're not in
that business, and Justice doesn't want to either and Congress
doesn't want to do anything about it.
Ms. Thomsen. Actually--
Mr. Sherman. And so as much as we can talk here about
exactly who was an inch over the line, the people who are 10
miles over the line are pretty safe. I'll let you respond.
Ms. Thomsen. Well, I hope not. And it's our effort to not
keep them safe. I was going to say that we have been working--
we work with criminal authorities when they can go undercover.
And one of the things that I put in my submitted testimony is
while we have been focusing on auction rate securities and what
we have been talking about, we have brought three hundred and
eighty-some other cases during that same time period, and
included among them are some really frankly outrageous ponzi
schemes.
Mr. Sherman. If you're not pretending to be an investor, if
you don't want to be in criminal law enforcement, if you
don't--because I'll tell you right now, my local DA has crime
on the streets. He doesn't exactly want to focus on crime in
the suites. And you're here to talk about how we are going to
protect the smart people, and I wish you were here saying we
have to have your people pretending to be unsophisticated
investors in cleaning up the part of this that we can clean up.
Now shifting to the purpose of--I will introduce
legislation, but without SEC support, I'm going to have to be
even more persuasive than my usual level of persuasiveness. I
probably won't be successful. Now what has happened here is
that the market is under price risk. They achieve this by
ignoring risk and telling others to ignore risk. And in
particular, today's hearings focus on 30-year bonds issued by
private corporations and they are priced in the market as if
they are Treasuries or insured deposits.
Now the issue--one view of this is widows and orphans were
sold a bill of goods by smart people who knew better. But as
far as I can tell, all the smart people on Wall Street thought
these were accurately priced. Was anybody selling these short
in a big way? Was there anybody smart enough to say the market
has massively underpriced the risk here?
Ms. Thomsen. I don't believe you can sell these short.
Mr. Sherman. What?
Ms. Thomsen. I don't think you can sell these short.
Mr. Sherman. Okay. Was anybody investing, say selling short
the stock of the monoline insurance companies who insured
these? Was anybody smart enough to realize that these things
were not priced correctly and there was money to be made
because the market was dumb?
Ms. Thomsen. I don't believe we have evidence of that.
Mr. Sherman. So we are in a situation where, yes, it's true
individual investors may have been told, hey, it's as good as
cash, or almost as good as cash, or really what you're saying
is, it's only 100 basis--it's only 20 basis points worse than a
Treasury and you're getting 25 basis points in return for that.
The fact is, the smartest people on Wall Street seemed to have
believed this utterly false tale.
Ms. Thomsen. I'm not sure I would go that far because I
believe those who underwrote beginning in the summer of 2007
knew what was happening in the markets, knew they had to go in,
knew that liquidity was failing.
Mr. Sherman. But they were buying these.
The Chairman. The time has expired. She can finish the
answer, but we are over--
Mr. Sherman. Okay.
Ms. Thomsen. I think that those who underwrote understood
that the liquidity feature was being undermined and degrading
as they continued to sell them.
The Chairman. The gentleman from Missouri.
Mr. Cleaver. I like Dan Quayle--let me just make an
announcement. Dan Quayle's grandfather was a very prominent and
profound Methodist bishop. There are Quayle United Methodist
churches all over the States of Kansas and Oklahoma, Quayle
buildings on college campuses, Methodist college campuses. Dan
Quayle was not quite so profound, however, as his grandfather.
In a speech trying to make reference to the motto of the United
Negro College Fund, which is ``a mind is a terrible thing to
waste,'' Vice President Quayle got a little mixed up and said,
``It's a terrible thing for a man to lose his mind.'' And I
happen to agree with him.
I would like to misquote him some more. A crisis is a
terrible thing to waste. I think that we are in a major crisis.
I don't think anybody who can read or hear would contradict
that statement, and I think that if we are going to go through
all of this pain, we need to come out on the other side, having
made some adjustments and changes, because a crisis is a
terrible thing to waste. And by that I mean I'm wondering
whether or not we need maybe a new kind of an enforcement
structure that will deal with these knotty issues that keep
cropping up, in addition to some stringent regulations.
I'm interested in your comments. But, for example, many of
the ARS contracts actually allowed broker-dealers to see
investor bids before they were submitted to the auction agent,
which of course gave the broker-dealers an unfair advantage.
And if that is legal, wouldn't it suggest that there is a need
for some serious regulations? And then of course as has been
discussed widely this morning, some investment banks actually
sold products as cash equivalents. And if that is legal, we
need some strong regulations.
So I actually have one question with a couple of
components. And the thing is, do you agree that now is the time
for us to deal with this crisis and come out on the other side
with regulations? And then secondly, is there a need for a new
enforcement arm? Not all at once, but--
Ms. Thomsen. Well, let me start by saying I agree with you
that a crisis is a terrible thing to waste. You can learn
lessons from it and decide what if anything you should do
differently. With respect to a new enforcement model, we are
here because the enforcement tools we have allowed us to bring
enforcement actions in this arena. We were able to get this
liquidity back to investors on really very, very short order
because the behavior was illegal and because we worked
together. So I think in terms of enforcement tools, we had some
pretty good ones and we used them well in this instance.
That being said, I always want more, but I think it's fair
to say that in terms of the enforcement tools that were
available to address this problem, they were adequate to the
problem, and I think the combined efforts of everyone you see
here and the hundreds of people who aren't there using them was
used to good advantage.
Mr. Cleaver. I appreciate the fact that the attorneys
general forced a buyback of some of the ARS. I think that was
good. But then the second part comes, and that is, is there a
need for some stronger regulatory components for enforcement? I
mean, I know--before you answer, you know, if you answer the
phones in our offices whether you're a Republican or a
Democrat, people are angry all over this country, and I'm not
sure how many people want to go home and stand up in front of a
crowd and say, well, you know, we had a couple of little
problems and they'll work themselves out, you know. The market
always is self-correcting. I mean, people want to know, number
one, are the people who violated the law going to have to pay
for it? And then secondly, is this going to happen again? Have
you guys done anything to make certain that this doesn't happen
again?
Ms. Merrill. If I may respond to that?
Mr. Cleaver. Ms. Merrill.
Ms. Merrill. First of all, I completely agree with you that
the financial crisis that we see all around us today is
something that we have to review and assess in terms of
reforming our regulatory system.
Our CEO, Mary Shapiro, has talked about the fact that the
regulation of this country, the way we regulate financial
products, has to be fixed. It is a patchwork. Often it is split
on product lines, and yet when you talk to a consumer, the
consumer isn't split on product lines. In other words, they
need an insurance product. They need securities, they need
bonds. And they don't want to hear that a different regulator
is in charge of each one of those different aspects of their
entire financial health. So we do have to do something to fix
that sort of alphabet soup of regulation that we have.
In terms of the enforcement piece, I'll just take another
adage. I don't know if Dan Quayle has used this one, but an
ounce of prevention is worth a pound of cure. And I wouldn't
look for a new enforcement arm. I would go back and look at how
could we have been smarter about seeing these issues before
they came to the enforcement front. And that's where we have
spent time internally looking at what can we do on our
examination program when we are in firms, when we go in to
examine our member firms, what should we be looking at to see
how they are marketing products. Should we be looking at
products that people have been thinking about as safe for 20
years, and really digging down into some of those products?
We spend a lot of time looking at the way firms market very
risky and very complex products, derivative products, but I
think what we are seeing in this crisis of the auction rate
securities is that even something that's marketed as as good as
cash, something that was perceived to be by the firms to be
relatively simple, isn't always as simple as it seems.
Mr. Cleaver. Ms. Coakley, I'm interested--I mean, you have
taken people to court.
Ms. Coakley. We actually didn't, because when we went to
Merrill Lynch and UBS and said you have broken the law under
Massachusetts, you cannot sell these kind of auction rate
securities to municipalities, it's illegal, they said, okay, we
better pay you back, which is what they did. So we didn't have
to sue.
My answers to your questions are yes and yes. I have
forgotten what the questions were but I knew I had the answers
at the time you asked them.
Mr. Cleaver. Well, you know, in my time on this committee,
you are the first person since I have been here who has
answered the question directly and quickly. I have been waiting
for you for years.
[Laughter]
Mr. Cleaver. Thank you. Mr. Galvin?
Mr. Galvin. Thank you. I think you touched upon one issue
in your question, that's clearly I think the conflict of
interest issue, when you spoke of the bidders being--the bids
being revealed, and I think that's something that has to be
addressed. It has to be, in my opinion, this would be a
regulatory change, there has to be much stronger and direct
regulation relating to conflicts of interest, not just in
auction rate securities but in a broader way.
Secondly, I think the concept of a fiduciary duty,
especially in the case of those that would actually be selling
these, and this gets to the sales practices issue, there has to
be some duty imposed upon the seller to be aware at least of
the circumstance of the buyer, and whether that's cast in terms
of disclosure, which many of us have spoken to, or an
affirmative obligation to say that if you know that that person
left your office believing--or is in your office believing this
is liquid and you know it's not, you have an obligation to
disclose that to them and you should not sell it to them if you
know it's not in their best interest. Those are some specifics.
I think on the enforcement side, you can rearrange the
structure. I think this instance here demonstrates I think the
structure has worked collaboratively rather well. I think the
bigger problem, as has been mentioned by Ms. Merrill, is the
anticipatory side of enforcement. In other words, when you have
an enforcement action, you have already had a failure. You have
had something go wrong. There has to be something done on the
other side to anticipate problems with products that are out
there. There has to be a review of products that are out there.
As I said, I think what has clearly been discredited--you
spoke of a crisis, and there's no question that there is one.
What has clearly been discredited in my opinion is this idea
that the free market is going to figure this all out. Products
will fail. No one will ever buy them again and it has corrected
itself. Not without great loss. Not just the individual loss to
the people who have been away for their money for a long time,
but to the collective economy of our country.
This money that has been tied up, whether it's individual
money, small business money or institutional money, is money
that could have been working in our economy during this very
critical time, and it wasn't available. So I think it has to be
an anticipatory enforcement as well as an enforcement after the
fact.
Mr. Cleaver. Your answer is yes, too.
Mr. Galvin. Yes. Yes.
Mr. Cleaver. Thank you.
The Chairman. I thank the panel. We will move on to the
next panel now. I apologize, but--oh, I'm sorry. Ms. Speier. I
didn't see Ms. Speier. The gentlewoman from California is
recognized for 5 minutes.
Ms. Speier. Thank you, Mr. Chairman. I'm going to try and
focus my questions on three areas: Professional misconduct;
cost recovery; and the enforcement activities going on in
States other than Massachusetts. My hat is off to you in
Massachusetts. You are doing an outstanding job. I worry that
we are not doing what you're doing in Massachusetts around the
country.
But first let me move to professional misconduct. As I look
at the description of your organization, FINRA, Ms. Merrill,
it's a little unnerving to me. It's a self-regulatory regime
based on something we took off your Web site, that your focus
is on registering and educating and you're dedicated to
investor protection.
Now based on what we have heard today, the use of auction
rate securities was only used by sophisticated institutional
individuals since 1984. And then 3 years ago, that was changed,
in which it was opened up to less sophisticated investors who
had $25,000 or more. Now who made the decision to reduce the
requirements as to who could get into these auction rate
securities? And maybe this goes to Ms. Thomsen and to Ms.
Merrill.
Ms. Merrill. I'm not sure that the level of $25,000 was
only lowered 3 years ago.
Ms. Speier. It said a few years ago in our packet.
Ms. Merrill. Okay. But it is true that the auction rate
securities market originated as being sold primarily to
institutional investors. The $25,000 level is something that is
set by the issuer, I believe, in terms of what they will allow
as the minimum amount that can be purchased at the auction.
Ms. Speier. Okay. If that is the case, the issuer can do
that on their own. Doesn't it seem appropriate for you to
then--interested in protecting investor interests, to require
greater disclosure to those investors that are less
sophisticated? And why didn't you?
Ms. Merrill. For every security that is sold by a broker-
dealer to a customer, for every one that is recommended, our
suitability rules require that broker-dealers make an
affirmative determination that the product is suitable for that
individual investor. And they have to take into consideration
things like the risk tolerance of the individual, their
investment horizon, and their need for liquidity. And if they
don't do that, then we bring cases against brokers. We have
brought over 500 cases against individual brokers who have just
this year alone, against individual brokers who have
recommended unsuitable investments to their individual clients.
Ms. Speier. All right. I have only 5 minutes, so I am going
to cut you off just ever so briefly.
Ms. Merrill. I appreciate that.
Ms. Speier. Have you filed--do you have authority to file
any action against individual brokers--
Ms. Merrill. Absolutely.
Ms. Speier. --to take their licenses away from them?
Ms. Merrill. Absolutely.
Ms. Speier. Have you done that in this particular scenario
with the auction rate securities?
Ms. Merrill. In the auction rate security area, we started
with the companies, with the broker-dealers themselves because
they are the ones who can supply the solution that we really
wanted, which is to buy back investors' money. But we have not
stopped, and we are continuing our investigation as to
individual brokers, and where we find that there have been
misrepresentations and suitability violations, we do have the
tools and we have used them again and again to bar people from
the securities industry--
Ms. Speier. For how long?
Ms. Merrill. Permanently.
Ms. Speier. Permanently?
Ms. Merrill. Permanent bars.
Ms. Speier. And how often have you used that?
Ms. Merrill. We have over 300 permanent bars this year
alone, and another two hundred and some suspensions on top of
that.
Ms. Speier. But none in the auction rate securities area?
Ms. Merrill. But our investigations are not complete.
Ms. Speier. All right. Let me move on to cost recovery. How
much did it cost you to do your investigation, Ms. Thomsen?
Ms. Thomsen. I don't know the answer to that, but other
than the cost to our budget, if you will, deploying our
resources, this did not cost the government anything.
Ms. Speier. Well, but it did.
Ms. Thomsen. Obviously. Wherever we investigate, we are not
investigating somewhere else.
Ms. Speier. Do you have the authority to seek cost recovery
from the entity that you find has done wrongdoing?
Ms. Thomsen. No. We do have the authority, and we use it,
to get penalties which go back either to the government or in
fair funds to investors. We did not--we have not yet sought
penalties in these matters because we wanted to make sure that
all available resources were being used to recompense
investors, and because we deferred the issue of penalty until
the end of the process to make sure that the firms had actually
stayed true to their word and had made investors whole.
Ms. Speier. I think for the American public, they are less
concerned about making sure that the money just gets back to
the institutions. I mean, they certainly want the money to come
back to them as individuals. But they also want people
disciplined. And they certainly don't want the taxpayers of
this country to pick up the tab to have to do the investigation
of folks who weren't complying with the law to begin with, and
that's why I believe you should have the authority for cost
recovery and why I would seek to have our committee look at
that issue.
The Chairman. If the gentlewoman wants an additional 2
minutes, go ahead.
Ms. Speier. All right. Thank you. And to you, Attorney
General Coakley, I'm impressed by what you did in
Massachusetts, and to you, Secretary of State Galvin. I worry
that unless States have taken on this that there are many
institutions and individuals who are not going to be made
whole. I'm curious as to whether or not the U.S. attorneys
around the country have engaged, and if not, why not, and would
like your thought on whether or not there should be some
nationwide class action brought.
Ms. Coakley. Well, in a nutshell, you know, the SEC as a
Federal agency has regulatory authority over institutions, and
in many instances, States are preempted from banks and
regulatory authority there for a long time. We have approached
it from the point of view of what our own State's statutory
authority lets us do. We have a False Claims Act. We have
Chapter 93(a) that does consumer protection, and we have a
statute in Massachusetts that says you can't sell to cities and
towns products like this that aren't liquid. So that's the
basis on which we were able to go forward in this instance.
But I think your question actually redounds to what the
chairman's comments were at the beginning, that when we look at
the overall picture here in terms of the auction rate
securities and predatory lending and all of these pieces, I
think Secretary Galvin and I would be strong voices, along with
the chairman, to say we need a strong Federal regulatory
scheme.
We need strong enforcement, including whatever else you
think in terms of cost recovery, but you need to allow States,
depending upon how much of this activity takes place in the
State, what is in the interest of that legislature, that
enforcement, to be able to work in a very complementary way to
look at from the ground up what is happening. And I think in
this instance the States--it's not only Massachusetts; New York
has done a lot, and California has done a lot. That's where a
lot of this activity takes place and where these financial
houses live. But that whole piece of how we are going to do
this has to I think be approached with the State piece of it,
not preemption for us and let the States do what they feel they
need to do.
Mr. Galvin. Just to put your mind at ease, the North
American Securities Administrators Association has taken this
on and has worked with the Securities and Exchange Commission.
And while State entities have brought individual actions, they
have been representing the national interests. So in other
words, it's open to every State. And indeed, even in the fining
structure, that is the penalty structure, some States that were
not lead States will still get some fine as a result of this.
So, for instance, when Massachusetts negotiated with regard
to Bank of America, we negotiated for all Bank of America
customers throughout the United States, and the agreement we
secured from Bank of America was applicable to all customers.
Similarly with Fidelity, which was a downstream broker, in
which we just entered an agreement with last week. That's for
all of Fidelity's customers. It's not limited to Massachusetts
customers.
So there has been a comprehensive effort here on the part
of the States, but I think the concern is that, you know, what
about the next time? This was a remarkable case of
collaboration and a very effective case of collaboration, but I
think the anticipatory issues are the really--the bigger issues
that you folks are going to have to deal with.
The Chairman. I thank the panel, and this has been very
useful. We will take the next panel now.
I thank the panel. I apologize for the delay in getting to
you. There is a lot of interest in this subject. We will begin
with Ms. Leslie Norwood, the managing director and associate
general counsel of the Securities Industry and Financial
Markets Association, SIFMA. Ms. Norwood.
STATEMENT OF LESLIE NORWOOD, MANAGING DIRECTOR AND ASSOCIATE
GENERAL COUNSEL, SECURITIES INDUSTRY AND FINANCIAL MARKETS
ASSOCIATION
Ms. Norwood. Good morning, Chairman Frank, and members of
the committee. My name is Leslie Norwood, and I am managing
director and associate general counsel of the Securities
Industry and Financial Markets Association. I serve as the
staff advisor to the Association's Municipal Securities
Division. Thank you very much for the opportunity to testify on
the auction rate securities market today.
The credit crisis over the last 18 months is like none we
have ever experienced before. As problems in the mortgage
market spread into mortgage securitization in 2007, faith in
the monoline insurers, insurers of mortgage bonds and
collateralized debt obligations, began to waiver. Investors
became wary of being exposed to anything with a potential for
downgrades, including any securities connected with the
insurers themselves. Because of the critical role the insurers
play in the ARS market, demand for ARS and other variable rate
securities began to show signs of decline, and the number of
failed auctions increased.
While this is not the first time ARS auctions have failed,
this is the first time a significant number of auctions have
failed. Between 1984 and 2006, only 13 out of thousands of
municipal securities auctions failed. By contrast, 31 failed
municipal securities auctions are estimated to have occurred
during the second half of 2007 alone. As the demand for ARS
began to evaporate in 2007, many broker-dealers purchased ARS
in order to support the market and to prevent failed auctions.
Pursuant to the terms of the legal offering documents, broker-
dealers were not and are not obligated to support an auction.
As the credit crisis began to impact the liquidity and capital
of the broker-dealer firms, many firms lacked the capacity to
continue supporting the ARS market.
The issues in the ARS market are unprecedented and flow
from overall issues in the financial markets. While SIFMA
cannot speak to the specifics of the sales and marketing
practices of various firms, it is fair to say there were
deficiencies in the market. I'm sure you will hear many
anecdotes about sales and marketing practices. It is important
to remember that the liquidity problems in the ARS market are a
result of the ongoing credit crunch. While there were
disclosures made to customers about the risks associated with
ARS, in hindsight, the disclosures could have and should have
been better. As the committee is aware, several firms have
settled or are in the process of negotiating settlements to buy
back ARS to provide liquidity to investors.
While it is of little comfort to investors expecting
liquidity, for the most part, ARS issuers are still to this day
paying interest and principal payments on securities to
investors as they come due and the underlying credit ratings of
ARS issuers remains high. The ARS failures have left issuers to
face steep increases in the cost of capital. Some State and
local government issuers of securities have found their
securities resetting to maximum rates as high as 20 percent.
The high maximum rates compensated the investors for their loss
of liquidity and encouraged issuers to restructure these
securities into a more cost-effective form of debt.
As stated earlier, in 2006, the SEC settled with 15 broker-
dealer firms for auction practices that were not adequately
disclosed to investors. In light of the settlement, SIFMA
developed best practices for broker-dealers of auction rate
securities, which describes the role of the broker-dealer in an
auction. SIFMA also created the SIFMA auction rate securities
indices to serve as a benchmark for issuers and investors.
SIFMA and its member firms have sought action to ease the
regulatory burdens which hampered efforts of the municipal
issuers to redeem or restructure their outstanding ARS. SIFMA
and its member firms are helping issuers to restructure their
ARS. In addition, over the last few months, a number of firms
have agreed to buy back securities at par value from customers.
However, many firms are facing capital limitations as a result
of the continuing credit crunch, limiting the funding available
to buy back outstanding ARS. I would like also to note that not
all firms have the same level of activity in the ARS market.
Some firms underwrote securities, some firms acted as selling
agents, and other firms merely had these securities transferred
to them from other firms due to customer account transfers.
Many firms also faced regulatory constraints. For instance,
if a broker-dealer holds inventory of a particular ARS issuer,
its affiliate bank is limited in how much credit assistance it
can offer a distressed issuer because of Regulation W, which
limits the size of covered transactions. A safe harbor for
Regulation W for these firms would allow banks to buy back more
of their outstanding ARS.
SIFMA and the broker-dealer community are also actively
working with the MSRB, the Municipal Securities Rulemaking
Board, on its new disclosure system for ARS and VRDOs, which
will expand their new disclosure system called EMMA, the
municipal securities version of the SEC's EDGAR System.
In conclusion, auction rate securities were an attractive
source of funding for State and local governments and student
loan financing authorities for over 2 decades. A tightening of
the credit markets led to a sharp decline in the demand for ARS
and ultimately resulted in failures across the ARS market. The
broker-dealer community is working to return liquidity to the
ARS market and to assist issuers in refinancing and
restructuring their ARS as quickly as possible.
Thank you for the opportunity to testify before you today,
and I look forward to answering your questions.
[The prepared statement of Ms. Norwood can be found on page
107 of the appendix.]
The Chairman. I am now going to go a little bit out of
order, and I would ask unanimous consent that we allow our
colleague from New Hampshire, Ms. Shea-Porter, to sit with us.
I hear no serious objection, therefore, she is allowed to
participate. I should note that because of the situation
involving New Hampshire and education, Ms. Shea-Porter has been
one of the Members most active and energetic in calling on us
to do what we can to facilitate this, and I would now call on
her to make a statement and introduce the next witness.
Ms. Shea-Porter. Thank you very much, Mr. Chairman, and
thank you for the privilege of joining you for this important
hearing. I am pleased to have the opportunity to industry a
fellow New Hampshirite, Ms. Tara Payne. Ms. Payne is here to
share with the committee the New Hampshire Higher Education
Assistance Foundation, or as we call them, NHHEAF, experience
with the auction rate securities.
The NHHEAF network is made up of four nonprofit
organizations that collectively serve as New Hampshire's
leading provider of college planning and funding. She has
worked for the NHHEAF network since 1996 and currently serves
as the vice president of corporate communications and
marketing. Thank you so much for being here today, Ms. Payne. I
look forward to hearing your testimony.
And thank you again, Mr. Chairman, for the opportunity to
participate. I yield back.
The Chairman. I thank the gentlewoman. I should point out
that we have had a great deal of cooperation here between this
committee and the Committee on Education and Labor, which has a
specific interest in education. And one of the things I'm proud
of in this Congress is that we really avoided, I think, the
kind of jurisdictional hair pulls that just annoy everybody and
shouldn't happen. And with regard to the impact of auction rate
securities on education funding, we have been able to be
cooperative. I appreciate the Education and Labor Committee,
having worked with them. They have had some constructive
results, the chairman tells me, in dealing with the Federal
Department of Education. So we are glad you're with us. Ms.
Payne, why don't you go ahead, and then we'll get back to the
others.
STATEMENT OF TARA PAYNE, VICE PRESIDENT FOR CORPORATE
COMMUNICATIONS, NEW HAMPSHIRE HIGHER EDUCATION LOAN CORPORATION
Ms. Payne. Thank you. Chairman Frank, Ranking Member
Bachus, and members of the committee, I am Tara Payne,
representing the New Hampshire Higher Education Loan
Corporation. It is an honor to participate in these
discussions. I would like to thank the representative from New
Hampshire who continues to be a strong advocate for student
access to higher education. Thank you.
Thousands of schools and millions of students have relied
upon FELP providers to finance postsecondary costs. In our
capacity as a nonprofit student loan provider, NELCO takes
great pride in educating students about responsible borrowing.
Consequently, we consistently have among the lowest cohort
default rates in the Nation. When students successfully repay
their Federal loans, everyone benefits. Taxpayers don't have to
shoulder the burden of increased Federal debt to cover loan
losses. Schools maintain their eligibility to award Federal
financial aid, and best of all, students realize the full
benefit of the investment they have made in higher education.
The FELP community is dedicated to promoting college
access, particularly for underserved students, and it does so
by offering an extensive array of college outreach programs.
The impact of these programs is enormous and widespread.
Consider that in New Hampshire alone, 95 percent of public high
schools and 34,000 students and parents relied on the services
we provided last year, and I must stress the importance of
having agencies such as ours across the Nation.
One of the unintended consequences of the legislative cuts
to subsidies for nonprofit lenders and the current liquidity
crisis is the risk of losing programs like the Center for
College Planning in New Hampshire. Access to college begins
with increasing aspirations, but it ultimately ends with the
availability of financial aid programs and funding options.
We are proud of the integrity and commitment we have made
to these programs, but in this year, fulfilling our most
essential mission has been extremely challenging. NELCO is New
Hampshire's leading provider of student loan financing and
funded $184 million in Federal loans and $67 million in
alternative loans in Fiscal Year 2007. In all, NELCO has $1.5
billion in outstanding bonds which have funded our program
since 1997.
The auction rate market has been an important key source
for liquidity for student loan lenders. For the last decade,
NELCO borrowed money to fund loans by selling auction rate
certificates. However, investors are no longer investing in the
auction rate market, thus issuers like NELCO can't raise
capital that funds loans.
Our organization has always held itself to a high standard
of financial accountability. We recognize that we bear
responsibility to ensure that whatever taxpayer money is spent,
our program is minimal and that access to higher education is
made possible through our sustaining a strong financial base.
This strong base has been significantly compromised by NELCO's
long-standing trusted financial advisor, the UBS Securities
LLC.
On August 14th, the New Hampshire Bureau of Securities
Regulation announced that it was taking action against UBS for
fraud. The action relates to UBS's representation of NELCO in
the sale of bonds. Essentially, the order issued by the Bureau
states that UBS knew that the market for these bonds was on the
verge of collapse. At the same time that UBS was actively
encouraging NELCO to extend its commitment on these bonds, UBS
advised NELCO to reset the maximum rate on NELCO's taxable bond
to 17 to 18 percent to ensure liquidity and prevent auctions
from failing.
We now know this was a scheme. It was a scheme to make the
securities more attractive to investors and to keep NELCO in
the market. UBS never disclosed to NELCO that the market was at
risk of freezing and that the maximum interest rate payable on
the bonds could lead to NELCO's financial harm, or that UBS was
preparing to end its support of the market as it had always
done.
On February 13, 2008, UBS stopped supporting the market and
it collapsed, leaving NELCO and investors with billions of
dollars frozen. We support the New Hampshire Bureau in its
assertion that UBS failed in its fiduciary and moral duty to
NELCO.
Alternative loans have become a key factor in affordability
and access. NELCO's non-Federal alternative loan program
provided funding to close the gap between what students receive
in financial aid and what the college actually costs. In Fiscal
Year 2007, over 6,000 students borrowed $67 million through our
alternative loan program. Still, recognizing the severity of
the liquidity crisis, the reduction to lenders from recent
legislation, and the lack of viable solutions from our
financial advisor, NELCO was forced to suspend its alternative
loan program in March, leaving thousands of students to search
for other alternatives.
Any interruption in the loan program hurts college-bound
students. It causes a disruption in financial aid delivery and
creates another layer of complexity to a tedious financial aid
process. Naturally, this has the greatest impact on our most
vulnerable students. Following our suspension of the
alternative loan program and becoming gravely concerned about
our ability to fund even Federal loans, NELCO asked the member
institutions of the New Hampshire Bankers Association and New
Hampshire credit unions to provide liquidity that would enable
NELCO to fund the Federal program. Currently, $94 million has
been raised, and I can assure you that NELCO would have
suspended its Federal program if it were not for the
overwhelming support of community lenders to provide a
temporary solution prior to the Ensuring Continued Access to
Students Loan Act.
Thank you sincerely for your time.
[The prepared statement of Ms. Payne can be found on page
123 of the appendix.]
The Chairman. Thank you.
Next, Mr. Roger Sherr, the vice president of Sherr
Development Corporation.
STATEMENT OF ROGER SHERR, VICE PRESIDENT, SHERR DEVELOPMENT
CORPORATION
Mr. Sherr. Thank you, Mr. Chairman. My name is Roger Sherr,
and I am vice president of Sherr Development Corporation, a
Michigan-based real estate company that has been creating
retail and construction-related jobs since the mid-1980's. I
appreciate the opportunity to address this committee.
My purpose is to describe how Comerica Bank's
misrepresentation regarding auction rate preferred securities
purchased on our behalf has harmed our company, individuals who
would have worked for our company if not for the
misrepresentation, our community, and the overall integrity in
the financial system.
In 2005, our company sold a number of retail shopping
centers. At that point, we had an unusually large cash
position. Our intent was to park those proceeds for a
relatively short period of time, intending to pay capital gains
taxes, and then redeploy those monies in other projects as
opportunities presented. Our goals for the funds were safety
and liquidity. We made those goals clear to Comerica Bank,
which has served as our family's and company's bank for over 60
years.
Comerica directed the purchase of specific auction rate
securities as a place to park those funds. Comerica sold these
securities as cash equivalents. There was no disclosure of any
risk to liquidity or value. The particular securities we now
loan are listed for you in my written testimony.
In February of this year, we were stunned to learn that as
a result of the freezing of the market for ARPS, our funds
placed by Comerica were no longer available to support our
ongoing business operations. In multiple letters to Comerica
officials, we requested the bank to follow through and give us
our promised cash on demand. Even though Comerica selected the
specific securities we purchased and earned healthy
commissions, they refused to shoulder any of the responsibility
for their misrepresentation.
Until recently, Comerica has repeatedly refused to
repurchase these securities or participate in any settlements
with regulators. We now understand that as of this morning,
Comerica has agreed to cooperate with regulators and repurchase
the securities that it sold to retail investors. We only hope
that this would have come more voluntarily from Comerica
without regulators and enforcement officers breathing down
their back at a significant cost to taxpayers.
Having cash on hand provides important competitive
advantages for a firm our size. It allows us to move quickly
and pursue projects we may not otherwise have been able to do.
To the extent retail opportunities we pursue create jobs in
America, the liquidity of our balance sheet is important. It
may be of interest that in the past, Sherr Development has
completed retail and residential-related projects with
aggregate values exceeding $250 million. As a result, thousands
of jobs have been created, and millions in taxes have been
paid.
The Michigan economy is facing some difficult times today.
Comerica's failure to fully correct the illiquid condition at
our company has directly contributed to tough times in
Michigan. One investment, for example, we would have pursued is
the development of a large shopping center in the City of
Detroit. It would have provided needed retail services for
people living in the area, as well as hundreds of highly paid
construction jobs and hundreds of retail positions. Because our
funds are still locked up with these auction securities, we
were not able to make a rapid decision and pursue this project.
As of now, the site remains undeveloped, and residents in the
area need to travel further distances for the groceries and
other goods they need. Others in the area may remain unemployed
or underemployed.
Comerica Bank has $60 billion in assets, and ranks as one
of the top 20 banks in the country. It advertises that it puts
its customers first, and has hundreds of branches to serve you.
Unlike Goldman Sachs, Merrill Lynch, or UBS, Comerica is a
hometown regional bank, trusted to sell safe products designed
to protect their customers. Comerica's customers have a good
reason to hold them to a higher fiduciary standard of care than
is applicable to brokers in the fast-paced world of investment
banking.
Comerica sold more than 2 billion of these securities to
individuals, municipalities, and firms like ours that pay taxes
and create jobs. Clearly, given the resources and
sophistication of the bank, they should have understood and
accurately communicated the types of securities they were
selling in large volumes. If they had advised us and other
customers of the true nature of these securities, they would
have not have been purchased as money market instruments. Like
any retailer, they should be held responsible for their
misrepresentation.
It is important to note that judicial remedies alone are
not sufficient here. If we and thousands of other firms,
municipalities and individuals are forced to go to court for
justice and wait months, if not years, to be heard, the economy
will suffer in the short and the long term. In the short term,
without access to funds, firms like ours cannot create
desperately needed jobs. In the long term, trust and confidence
in the banking regulatory system, which is now facing a
critical challenge, will be further eroded.
In conclusion, many firms such as ours relied on their
local bank for sound, conservative money management advice. In
this case, Comerica sold auction rate securities as cash
equivalents and misrepresented the products they sold. As a
result, our business has been damaged, we have been unable to
create needed jobs, and the trust in the banking system has
been undermined.
Thank you.
[The prepared statement of Mr. Sherr can be found on page
134 of the appendix.]
The Chairman. Next, we will hear from Mr. William Adams IV,
vice president of Nuveen Investments.
STATEMENT OF WILLIAM ADAMS IV, EXECUTIVE VICE PRESIDENT, NUVEEN
INVESTMENTS
Mr. Adams. Chairman Frank, and members of the Financial
Services Committee, thank you for inviting me to testify about
the continuing turmoil in the auction rate securities market
and about possible solutions.
We commend you for holding hearings on this important topic
and appreciate the opportunity to express our views. My name is
Bill Adams, and I am executive vice president of Nuveen
Investments. Nuveen sponsored closed-end funds together
represent the largest issuer of auction rate preferred
securities and we share the committee's deep concern over this
issue and its impact on investors.
One hundred of our closed-end funds had more than $15
billion of auction rate preferred shares or what I'll call ARPS
at the time this market failed in February. Since the failures
began, my team has worked very hard to resolve the problem for
our funds shareholders. The failed auctions have prevented tens
of thousands of Nuveen shareholders from selling their ARPS and
have increased fund financing costs for the fund's more than
one million common shareholders.
As you and your constituents well know, this problem has
created significant, financial hardship for many preferred
shareholders. Following the breakdown of the ARPS market,
Nuveen and the funds' independent directors determined that it
was the absence of market liquidity rather than credit concerns
regarding our funds that caused the auction failures. We also
concluded that the existing ARPS market was unlikely to return
to normal.
In March, Nuveen and the funds announced that they would
seek to refinance all the funds' outstanding ARPS. Our goal was
to reduce the funds' cost of borrowing for the benefit of
common shareholders, while providing liquidity at par for the
funds' preferred shareholders. Since then, we have kept all our
shareholders fully informed of our progress and the challenges
we face. The unprecedented turmoil and the financial markets
has made it even more challenging. Still, we have made
significant progress.
To date, Nuveen's closed-end funds have redeemed or have
announced their intention to redeem nearly $5 billion of their
$15 billion of outstanding ARPS. So how have we refinanced the
ARS? Our first approach has been to employ conventional
financing methods to the greatest extent possible. This
includes bank loans, lines of credit, and other forms of
secured lending as well as tender option bonds. Most
importantly, we have created a new form of preferred stock
called, ``variable rate demand preferred,'' or VRDP. This new
security offers two critical benefits.
One, like the ARPS, it allows our municipal closed-end
funds to obtain financing at favorable tax-exempt rates, and
two, because of the liquidity backstop from a bank, VRDP is
eligible for purchase by tax exempt money market funds, the
largest buyers of short-term, tax exempt securities. In fact,
we recently sold $500 million of this new preferred stock to
refinance all the ARPS for four of our funds and we believe
there is a lot more demand for money market funds that could
allow the Nuveen funds and potentially all closed-end funds to
refinance all ARPS to cash out ARPS shareholders.
We appreciate the guidance we have received from the SEC
and the Department of the Treasury, and the sense of urgency
this committee has imparted on regulators and market
participants to find creative solutions. We have made progress,
but clearly there is more to be done. We have learned through
our discussions with banks and institutional investors that a
number of regulations continue to limit our funds' ability to
issue larger amounts of VRDP and resolve this issue more
quickly.
I would like to end by highlighting three suggestions. The
first would be for the Federal Reserve to broaden the ability
of banks to own VRDP in their role as liquidity providers and
to permit banks to pledge VRDP as collateral at the Fed
discount window. This would remove the obstacles that have
limited the ability of banks to provide liquidity backstops for
VRDP. Second, the SEC should expedite its consideration of
relief under the Investment Company Act to temporarily permit
closed-end funds to use debt financing to a greater extent than
currently permitted. And, third, it would help if the Treasury
Department would further clarify the equity treatment of
preferred securities that include liquidity backstops and to
permit not only fixed-income funds but also equity funds to
issue such preferred securities.
Again, thank you for the opportunity to explore these
issues and potential issues on behalf of the millions of
investors caught up in this unprecedented situation. I look
forward to answering your questions.
[The prepared statement of Mr. Adams can be found on page
60 of the appendix.]
The Chairman. Thank you, and finally, I am going to step in
for my colleague, the second ranking member of the committee,
and the chairman of the Capital Markets Subcommittee, Mr.
Kanjorski, who wrenched his back today. He is unlike most of
the people concerned with the financial services interview
today in that he has a pain in his back.
[Laughter]
The Chairman. I am therefore glad to introduce a man with
whom he has worked and who appeared with us at the press
conference earlier on when we announced this hearing. And I
have to say that as important as this hearing is, I think our
having announced it a couple of months ago was probably the
biggest contribution we made to getting things moving.
James Preston is president and chief executive officer of
the Pennsylvania Higher Education Assistance Agency. I know Mr.
Kanjorski welcomes the assistance and advice he has given us.
So, please, Mr. Preston.
STATEMENT OF JAMES PRESTON, PRESIDENT AND CHIEF EXECUTIVE
OFFICER, PENNSYLVANIA HIGHER EDUCATION ASSISTANCE AGENCY
Mr. Preston. Thank you very much. I am Jim Preston,
president and CEO of Pennsylvania Higher Education Assistance
Agency (PHEAA). I would like to thank Chairman Frank and
Ranking Member Bachus for holding this hearing. I am especially
grateful to Mr. Kanjorski for his leadership on the student
loan aspect of this important issue and his support of a
comprehensive solution to the student loan liquidity issue.
As someone with more than 25 years of investment banking
and student loan funding experience, I can attest that today's
situation is unprecedented and is in urgent need of attention.
The fact is nobody knows how long it will be before today's
problems become too deeply rooted to be resolved without
extensive government intervention. The collapse of the auction
rate securities market and the dysfunction of other markets
which might have provided alternative sources of funding for
not-for-profit student loan secondary markets have left
nonprofit agencies with few, if any, ways to raise needed
funds, funds that students and families depend upon to meet
college costs.
In May, Congress took a first step by passing the Ensuring
Continued Access to Student Loans Act, ECASLA, which has been
crucial in assuring access to Federal student loans for this
fall. And last night, an Act passed again to extend it for one
more year. However, this Act is little more than a temporary
solution and applies only to federally-guaranteed student
loans.
Unless Congress and the Administration address the
underlying cause of the current liquidity difficulties, there
will be continued instability in the student loan marketplace.
In March of this year, PHEAA reached the conclusion that we
must suspend origination and purchasing of Federal student
loans. The cost of raising capital to fund student loan
originations and purchases had become financially impossible.
There was no way to generate a positive return on our
investment, and additionally traditional sources of liquidity
were withdrawn and just not available.
We simply could not sustain limitless, unlimited losses,
and continue to provide access to student loans and maintain
essential services to the citizens of Pennsylvania. To finance
the loans we have made and purchased over the years, PHEAA
maintains nearly $12 billion in outstanding debt obligations.
These obligations take many forms and involve a mix of both
taxable and tax exempt; approximately $7.4 billion is in the
form of auction rate securities.
PHEAA uses these funds to originate student loans and to
serve as a secondary market for student loans. By purchasing
loans from originators for par plus a reasonable premium, based
on the value of the loans, PHEAA enables hundreds of lenders to
participate in the Federal student loan program. These lenders,
which rely on secondary markets to recycle their funds in order
to make new loans, now find themselves with no outlet for the
loans they originate. Their balance sheets are filling up
rapidly, which cannot be continued indefinitely.
Today we find ourselves unable to issue new debt
obligations due to the lack of investors, and because even if
investors are found, the price required is too high to allow
issuers to make or purchase loans without losing money on each
new loan. Additionally, rating agencies and credit providers
are demanding that debt issuers add substantial capital of
their own to any new security, which is a significant obstacle
for those of us without access to funds.
We realize that any effort to provide vehicles to fund
student loans must benefit three groups: The investors who find
their assets trapped in these investments; the issuers who are
unable to refinance these securities; and the Federal
Government, which should not bear any financial burden as a
result. Earlier this year, PHEAA in concert with two sister
agencies put forward a proposal to Treasury that we believe
would accomplish all three of these objectives.
Since then, Treasury has adopted the core principles of
this proposal, but has done so not for student loans but for
mortgaged back securities as part of its rescue of Fannie Mae
and Freddie Mac. Treasury's plan is to create a new market for
mortgage-backed securities; in essence, to stand in place of
the global markets, which are unable to supply sufficient
capital to support the homeowners of this Nation.
Our proposal is for Treasury to do the exact same thing for
student loans. In Treasury's fact sheet that accompanied their
announcement on September 7, 2008, Treasury stated clearly that
taxpayers will benefit from this program, directly through
potential returns on the Treasury's portfolio of mortgage-
backed securities. We believe these same principles would apply
to a program to purchase student loan backed securities. And
since FFELP loans are already 97 percent guaranteed by the
Federal Government, such a plan would be 97 percent less risky
for the Federal Government than actions that involve non-
guaranteed assets.
Overall, guaranteed student loans are reliable, performing
assets, and they are not subprime loans. Earlier this year,
Treasury advised Congress that it requires new statutory
authority to purchase student loan-backed securities. Thus, we
urge you Mr. Chairman and members of the Financial Services
Committee to provide Treasury with such authority. You can do
so by adopting H.R. 5914 sponsored by Representative Kanjorski.
Please give us the chance to solve this issue before too
many players are forced to end their participation in the
student loan program to the detriment of millions of Americans.
Thank you for allowing me to appear here today.
[The prepared statement of Mr. Preston can be found on page
129 of the appendix.]
The Chairman. Thank you, Mr. Preston.
I heard what you said, and I really appreciate your
participation. This has been mutual.
We have some votes. They are going to take an hour, so we
are not going to ask you to stay.
I am going to ask Ms. Shea-Porter if she has any questions.
Again, I think the willingness of the people here to
participate in this hearing has moved this ball forward. We
will be looking at your testimony and will try and do it
tomorrow. But Ms. Shea-Porter will have time for questions.
Ms. Shea-Porter. Thank you, Mr. Chairman.
Ms. Payne, I did want to ask you, the collapse of the
market clearly had a significant impact on NHEF. It was around
this time that the auctions failed that NHEF announced it was
suspending its alternative loan programs. How many students
were impacted by the suspension, and what has happened to them?
Ms. Payne. Well, at this point, there have been over 6,000
students who last year participated who this year could not and
had to find other alternatives. Right now, we are actually
doing a survey to find out where those borrowers have landed.
However, we know from past surveys that 28 percent of students,
even prior to the crisis, were putting tuition on credit cards.
I can only imagine that number has increased, particularly now
that parents aren't able to get, say, second mortgages.
It has become more difficult for those private loan
providers out there. It has become more difficult still for
students to access money, because of tightening credit
restrictions. So we are not sure exactly, and I think that we
may see a big shift second semester as well. Students were able
to use summer earnings to manage through a first semester.
We'll be interested to see what happens by second semester as
well.
Ms. Shea-Porter. So do you suspect that not only are they
taking the dead-on on credit cards but that maybe some of them
aren't even trying to go anymore, that they have given up on
the idea?
Ms. Payne. Again, only through stories that we have had
through families who have come into our office overwhelmed by
this. You know, we know the kids definitely were able to get
some funds through other lenders, national lenders perhaps, but
at what price? I mean, certainly, for a much higher price than
they were through a nonprofit agency and that will flush itself
out, I think, by mid-year.
Ms. Shea-Porter. Okay. Thank you.
I yield back. Thank you.
The Chairman. And finally, on behalf of our absent
colleague, I believe the gentlewoman from New York, Mrs.
Maloney, has some questions.
Mrs. Maloney. Just very quickly, Mr. Preston. Earlier this
year, Congress passed the Ensuring Access to Student Loan Act
to ensure liquidity in the student loan market; and, while this
has been beneficial to many lenders, other smaller, nonprofit
lenders still have much of their now illiquid auction rate
securities. What is being done to help these smaller nonprofit
lenders, and what more can be done for them to ensure that they
can continue to lend to our students?
Mr. Preston. The small nonprofit lenders play an important
part in the overall delivery system in the United States, not
only for origination directly to students but also buying from
banks that participate. And it's very important to keep the
banks in this business to support the higher education program.
What we are finding, just like many of the small, secondary
markets in the United States and the not-for-profits is that
there are no financing alternatives available. For example,
when the auction rate started to deteriorate, many of us, all
of us, probably, went and started lining up bond insurance and
letters of credit to refinance.
I was in New York on January 18th, when MBIA and Ambac got
downgraded. That day was a threshold event, because then all
the options started going away and, by February, the auctions
then started failing. So whether it's a big or small not-for-
profit, we are all in the same boat and it's all affecting the
whole chain of delivery of student loans through the banks.
Mrs. Maloney. On that point, can anyone on the panel speak
on the point that he raised on why the auction rate security
market froze back in February?
And then going forward, what reforms do you believe the
auction rate security market needs to be made viable again so
that we can continue these student loans and other activities?
Why did it freeze in February?
Mr. Preston. I will take a shot at it. I think it froze
because it became apparent there weren't other alternatives
available to refinance and that it just became a point of
diminishing returns for those holders. And, you know I think
the auction rate market is not a viable product now or in the
future. If it does come back, it will have to come back as a
specific, institutional product where the risks are clearly
understood and they are willing to hold it. But I just don't
see that product as being viable.
So solutions going forward will have to be the variable
rate demand market coming back, which is insurance and
liquidity from the banks, and the floating rate note market
which is the overseas market. Those are our only options to
finance variable rate products, both tax exempt or taxable. And
until those stabilize, we don't have any options to refinance.
The Chairman. I thank the panel. If there are any further
comments you want to submit later, we will take them. I think
this has been useful.
Oh, I'm sorry. The gentleman from Colorado.
Mr. Perlmutter. I just want to thank the panel and I also
want to say that our Congressional Research Service often gets
overlooked. They have put a heck of a report together that we
got as of today, the kind that goes through the chronology of
this and is very instructional. So I think for everybody on the
panel as well as the members of our committee, and you guys
often go overlooked. You do a great job in helping us
understand these things.
Thank you, Mr. Chairman.
The Chairman. I appreciate that, and I think we have gotten
some resolution on the current situation, although not to
everybody's satisfaction. They weren't entirely satisfied.
As for the future, while this specific instrument is
probably not going to occur, everybody, I think, learned some
lessons about what we should put in place if anything similar
shows up.
I thank the panel, and the hearing is adjourned.
[Whereupon, at 1:45 p.m., the hearing was adjourned.]
A P P E N D I X
September 18, 2008
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